Reflecting on the U.S. stock market in 2023, it really feels a bit magical.

To control inflation, the Federal Reserve raised interest rates a total of four times in 2023. At the beginning of the year, Analysts predicted that continuous interest rate hikes could lead the U.S. economy into recession.

However, unexpectedly, ChatGPT emerged midway; the rise of this generative artificial intelligence has boosted many industries, such as semiconductors, cloud computing, and software industries, among others.

As a result, the U.S. economy not only did not enter recession but also proved to be unexpectedly resilient, with job and economic data being very strong. Ultimately, the economic growth for the year may exceed predictions by 2 percentage points.

Driven by strong economic growth and expectations of a soft landing, U.S. stocks have emerged from the gloom of the 2022 bear market, with all three major indices rising, ushering in a bull market.

In addition to the stock market, Gold has also performed relatively well, with spot Gold setting a new historical high of $2150 in December, rising over 8% since the beginning of the year.

Compared to the stock market and Gold, U.S. Bonds have not been as fortunate, as consecutive interest rate hikes led to rising U.S. bond yields. For example, the yield on 10-year U.S. bonds was 1.5% in 2021, but surged to 5.0% this year. Investors familiar with U.S. bonds know that rising market rates mean falling bond prices. However, starting in the second half of the year, expectations for interest rate cuts intensified, and U.S. bond prices rebounded.

Looking ahead to 2024, it is believed that investors are particularly concerned about these four issues: How many times will the Federal Reserve cut rates? Can the U.S. stock market bull run continue? Will Gold continue to hit new highs? Has the bear market for U.S. bonds completely ended?

This article will discuss these matters with everyone.

The direction of the Federal Reserve's monetary policy.

First, let's talk about the Federal Reserve.

Starting from March 2022, in order to curb rising inflation, the Federal Reserve began a cycle of interest rate hikes. After 11 rate increases, the level of interest rates in the United States has risen from the zero interest rate era to the current 5.25%-5.50%.

The level of inflation in the United States has indeed declined as expected. The latest CPI data released in November 2023 shows that the CPI is 3.1%, the lowest level in five months, which has significantly decreased from the 6.5% level at the beginning of the year and is very close to the Federal Reserve's target of 2%.

From the content of the Federal Reserve's meeting in December, it is almost certain that the interest rate hike cycle has ended; the only question is how many times rates will be cut next year.

The December dot plot from the Federal Reserve shows that officials expect an average interest rate of 4.6% next year, which means three or more rate cuts.

However, the market is greedy. After Powell's press conference, according to the CME FedWatch Tool, the market now assigns a probability of over 62% for rates at the end of next year to be in the 3.50%-4.00% range, which is 150-175 basis points away, implying a potential for 6-7 rate cuts (assuming each cut is 25 basis points).

However, it should be noted that the Federal Reserve ending the interest rate hikes does not mean it will immediately start cutting rates. The market expects the Federal Reserve to begin rate cuts as early as March 2024.

You might wonder why the Federal Reserve cutting rates has such a big impact on the market. In fact, whether it is Stocks, Bonds, or Gold, they are all very sensitive to interest rates. If the Federal Reserve decides to cut rates, it will have a significant impact on all three asset classes.

Next, it will be explained how interest rates affect these types of Assets.

U.S. Stocks

Stocks are sensitive to interest rates because when Wall Street values a company, it often uses the DCF model, which is the Discounted Cash Flow method.

The principle of DCF, simply put, is that the value of a company can be assessed through two indicators: one is the company's future cash flows, and the other is the discount rate. The discount rate is generally calculated from the risk-free rate set by the Federal Reserve.

Assuming that the company's future cash flows are fixed, the higher the discount rate, the less the present value translates to. Conversely, the lower the discount rate, the more the future earnings of the company will translate to present value.

Therefore, a rate cut by the Federal Reserve may help to enhance the overall valuation of the stock market.

Although a rate cut by the Federal Reserve is beneficial for the stock market overall, the degree of Bullish impact from the end of rate hikes varies among different Sectors.

Value Stocks or Growth Stocks?

Generally speaking, interest rate cuts have a greater impact on growth stocks than on value stocks.

This is mainly because growth companies in their early stages have insufficient cash reserves and need external financing to expand, making them heavily reliant on the external financing environment.

In a continuously rising interest rate environment, financing costs are too high and the difficulty of obtaining financing is also great. Without sufficient capital support, these companies may find it hard to grow rapidly and could even face financial crises. However, now that interest rate hikes are nearing an end, their situation should improve, and they may experience a turning point for continued performance growth.

Small-cap stocks or large-cap stocks?

Additionally, interest rate cuts may have a greater impact on small-cap stocks than on large-cap stocks, as smaller companies often rely more on short-term debt, and reducing interest rates will significantly lessen the burden on them.

Moreover, some analysts say that small-cap stocks may currently be more attractive than large-cap stocks, mainly for two potential reasons:

Firstly, small companies are more attractively valued. This year, large-cap stocks, represented by the so-called "seven giants" in Technology, have dominated the U.S. stock market, while small-cap stocks, represented by the E-mini Russell 2000 Index, have performed moderately. According to LSEG Datastream, the relative value of U.S. small-cap stocks compared to large-cap stocks is close to historical low levels.

Secondly, the profitability of small companies is expected to improve. LSEG data shows that after earnings for Russell 2000 Index constituent companies are projected to decline by 11.5% in 2023, they are expected to grow by about 30% next year.

However, it is worth noting that, compared to large-cap stocks, small-cap stocks are more sensitive to economic cycles. If the economy slows down significantly, it may severely damage the operational capabilities of small-cap stocks.

Therefore, Morningstar analysts believe that if small-cap stocks want to truly explode, they need to meet a rather stringent condition: the Federal Reserve needs to lower interest rates without sacrificing economic growth. But this is not an easy task, as a significant rate cut by the Federal Reserve indicates that the economy may be experiencing a severe slowdown.

U.S. Bonds

The continuous rate hikes by the Federal Reserve have the most direct impact on Bonds, and the end of rate hikes also benefits Bonds directly.

This is because the price of Bonds is inversely related to market interest rates. Simply put, when Bond yields decline, Bond prices rise.

According to Morningstar analysts' forecasts, the Federal Reserve's rate cut cycle may begin in 2024, and they expect the Fed's rate to be lowered to 1.72% by 2027.

However, the transmission of federal rates to U.S. Treasury rates is not linear. Taking the 10-year U.S. Treasury yield as an example, Morningstar expects the yield to decline to 3.6% in 2024 and further drop to 2.75% by 2027. It can be seen that the decline in U.S. Treasury rates is less than the potential magnitude of rate cuts by the Fed.

At the Federal Reserve meeting in December, officials hinted that there could be three rate cuts in 2024. The current yield on 10-year U.S. Treasury bonds has already fallen below 4% (as of December 15, 2023 data), but it is still about 40 basis points higher than Morningstar's forecast of 3.6% for 2024.

Additionally, according to the statistics from iShares, from the last rate hike until the start of rate cuts, Stocks and Bonds often experience a pricing rush, with increases sometimes even exceeding the early stages of the actual rate cut cycle.

This shows that the period of expected rate cuts may be safer than when the target actually lands.

Gold

Gold is also one of the assets influenced by interest rates.

The continuous increase in interest rates in the United States has raised the risk-free rate, causing a large amount of USD funds to flow back to the United States, driving the surge of the USD.

In contrast, if the United States starts cutting interest rates, the risk-free interest rate in the U.S. will decline, and a large amount of dollar capital may flow out of the United States, driving down the USD.

Since gold is priced in USD, a decline in the USD may lead to an increase in gold prices.

However, this is just one of the attributes of Gold, specifically its currency attribute. There are many other factors that affect the price of Gold, such as its financial attribute, commodity attribute, and hedging attribute.

Compared to US bonds, gold is influenced by more factors, making its subsequent trends more difficult to predict.

Potential Risks

Overall, the interest rate cuts by the Federal Reserve positively impact U.S. Stocks, Bonds, and Gold, but it does not mean that the prices of these Assets will definitely perform well in 2024, as there are many potential risks involved:

• Interest rates are just one of the factors that affect the prices of various Assets; many other factors can also influence asset prices. Taking Stocks as an example, if a company is valued using the DCF model, the company's future cash flows are also one of the factors impacting its value. If the U.S. economy declines, the company's future cash flows will also decrease, which will lead to a decline in the company's value.

• Furthermore, it was mentioned earlier that the market is currently very optimistic about the Federal Reserve's interest rate cuts next year. According to the CME FedWatch Tool, the market now expects a probability of 62% for 6-7 rate cuts next year. If the Federal Reserve's rate cuts do not meet these expectations, it may trigger a decline in the prices of these Assets.

• Finally, the optimistic expectations for interest rate cuts by the Federal Reserve may already be priced into the prices of Assets. If future interest rate cuts by the Federal Reserve only meet expectations or do not exceed them, it may also lead to a decline in asset prices.

These are some shares from the outlook for 2024, hoping to be helpful for investors. Investors need to fully consider their financial situation and risk preference to tailor a set of investment strategy suitable for themselves.