Weekly Investment Update (12/15/2023)

This Week’s Views and Positioning

Amid continued strong equity markets the past week, there were some notable shifts in undercurrents worth mentioning. The performance of the largest stocks in the S&P 500 index has been one of the most important stories of 2023. To date, the market capitalization weighted S&P 500 has outperformed the equal weighted S&P 500 (which neutralizes the weights of the index's holdings) by a staggering 12.3 percentage points. As the year comes to a close, we observe some early signs of change. Since mid-November, this performance pattern has reversed, with the equal weighted index outpacing the market cap weighted index by about 3.0%. We see a similar pattern emerging between large and small cap stocks. Large cap stocks have dominated year-to-date, with the S&P 500 outperforming the Russell 2000 by 9.1 percentage points. However, over the past month, the Russell 2000 has outperformed the S&P 500 by about six percentage points.

These shifts in relative performance are very recent but certainly notable. Falling inflation and lower interest rates in the absence of a severe recession should provide support for stocks outside of mega cap technology. Therefore, along with our modest overweight to stocks, our positioning focuses on diversification across various industries, sectors, and market capitalizations. This allows us to take advantage of the many opportunities that we believe still exist, particularly from a valuation perspective, across various asset classes. Especially since market positioning is leaning heavily toward recent winners, any rotation toward this year's laggards could be powerful.

Easing Inflation Allows the Federal Reserve to Make a Dovish Pivot

What is happening: The Federal Reserve left the federal funds rate unchanged for a third consecutive meeting. With rates held at 5.25%-5.50%, Fed Chair Powell struck a dovish tone indicating that rate hikes are complete. Notably, the Summary of Economic Projections now includes 75 basis points of interest rate cuts for next year. Powell recognized that inflation has eased, and inflation projections were revised lower following the release of moderating inflation data this week. Given the progress of disinflation, Powell stressed that the Fed can now shift its focus from primarily combatting inflation to focusing on both its mandates of inflation and employment.

Why it matters: This week’s FOMC (Federal Open Market Committee) meeting marked a notable dovish pivot, particularly as Powell acknowledged that rate cuts will be part of the committee’s discussions going forward. Despite the recent market rally and easing of financial conditions, the Fed did not dispute the market’s pricing of interest rate cuts. As interest rates are held steady and inflation declines, the real policy rate will be more restrictive to economic growth, and the need to fine tune policy will become more prominent. In noting that rate cuts could come before the 2% inflation target is reached, we believe this marks an important shift in Fed communications with the stated acknowledgement that the Fed will be more accommodative and cognizant of the risks to growth, focusing on both aspects of its mandate. Equity and bond markets reacted very positively to this meeting: The S&P 500 rallied over 1%, and bonds rallied as the 10-year Treasury yield fell below 4% for the first time since August. Bessemer portfolios maintain an overweight to equities, and a duration above the benchmark in fixed income portfolios given our belief that the Fed has likely concluded its hiking cycle.

Cyclical Pressures for Commercial Real Estate Look Set to Ease; Structural Issues Remain

What is happening: Since the onset of the pandemic, the commercial real estate (CRE) market has seen significant shifts shaped by changing work patterns, higher interest rates, and evolving consumer behavior. Sectors such as industrials (including warehouses, distribution centers, and factories) have benefited from the growing demand of e-commerce, and data centers have seen a tailwind from the rise of artificial intelligence — trends that are expected to continue. However, the picture with regard to offices has been bleaker. According to the National Association of Realtors, U.S. office vacancy rates are at a record high of 13.3%, driven by post-COVID changes in working patterns as many companies have permanently adopted remote or hybrid working policies. The picture is nuanced with underlying dynamics differing on a regional basis across the U.S. Large urban office markets such as Manhattan, Los Angeles, and San Francisco have seen vacancies rise due to relocations, layoffs, and increased remote work. On the other hand, the Sun Belt markets have seen an uptick in vacancy rates due to a glut of new office supply outpacing demand, and inventory has grown 16% in Austin and more than 8% in Nashville, Charlotte, San Jose, and Salt Lake City. South Florida is one of the very few areas that continues to have lower vacancy levels compared to 2020.

Why it matters: One quarter of outstanding commercial property loans, or an estimated $1.2 trillion of commercial mortgages, are due to mature by the end of 2025. CRE properties typically rely heavily on leverage, which has been more expensive and harder to come by since interest rates started moving higher and banks started to tighten credit standards. Local and regional banks provide the majority of financing to the CRE debt markets, and CRE makes up an estimated 18% of total bank loans, with office being 3.4% of the total.

With stricter regulation leading to tighter lending standards and lower loan-to-value ratios than previous cycles, it is less likely any systemic risks across the entire sector will emerge. Although the sector faces many nuanced and diverse headwinds, the peak in the interest rate hiking cycle will provide some overall welcome relief to property prices and lenders.