Looking Back and Looking Forward
Glass half full or glass half empty? Glass half full = despite a large, rapid increase in interest rates, rampant inflation, wars in Europe and the Middle East and everything else, the market indices aren’t much off where they were two years ago. Glass half empty = we’ve made essentially zero progress in the major equity market indices over the past 24 months, and inflation has set the average investor even further back while markets have essentially stood still.
While it hasn’t exactly felt great, we believe the past two years represent a period of normalization, following the highly abnormal 2009-2021 period that saw ultra-cheap borrowing costs drive every asset class materially higher. In short, we view 2022-2023 as partial “payback” for the abnormally high returns of 2009-2021. As a point of reference for another very popular asset class, the average home in the Greater Toronto Area (from where we write this piece) sits ~17% below its peak value (attained in February 2022). Relatively speaking, the “flattish” two-year change in the equity market indices (shown in the table above) is a victory of sorts.
Ultra-cheap interest rates drove all assets up for a long time, and now higher rates have brought things somewhat back to earth. What’s next for interest rates?
The most recent economic data suggests to us that Canada is already in recession – certainly on a GDP- per-capita basis, if not on an absolute GDP basis. We believe the next move by the Bank of Canada will be to move rates down, provided the inflation data continues to trend down toward the Bank’s 2% inflation target. While we expect the Bank’s next move will be to cut rates, it is the path of inflation that will largely determine the speed and magnitude of such cuts. However, we don’t believe the ultra-cheap interest rates of 2009-2021 will return any time soon.
The U.S. economy, in contrast, has shown more economic resilience. The U.S. economy may eventually go into recession, or it may achieve the frequently-referenced “soft landing” (which we take to mean economic slowdown without a technical recession). It is with humility that we admit the latter is a possibility, as we had fully expected the U.S. economy to be in recession by now, given the usual leading indicators for recession (inverted yield curve, index of leading economic indicators, PMI measures, etc.) were flashing red. What we perhaps did not appreciate was how “insensitive” the U.S. consumer would be to materially higher interest rates (note the U.S. consumer represents about two-thirds of U.S. GDP).
How has the U.S. consumer managed to mitigate the pain of higher interest rates? For one thing, U.S employment has remained surprisingly strong, enabling consumers to continue to pay ever-higher borrowing costs (though we’re starting to observe layoff announcements in the U.S. with increasing frequency). For another thing, ~80% of U.S. homeowners took advantage of “super-ultra-cheap” borrowing availability during COVID-19 (2020 and 2021) by locking in 30-year mortgages at interest rates of 4% or lower. This is effectively shielding U.S. households from higher interest rates on the biggest asset they borrow against.
So what’s the silver lining here for investors? With valuations flat to lower vs. two years ago, and corporate earnings materially higher than they were two years ago, there are many North American companies that trade at superior valuations today vs. two years ago. If interest rates do decline as anticipated, asset prices should get an even further boost. We would therefore encourage long-term investors to take advantage of the 2022-2023 “sideways” markets and put some new money to work today.
Our Core Model Portfolios
In Q4, the U.S. Federal Reserve communicated that rate hikes are likely done, and that their discussions are turning to rate cuts some time in 2024. In response, we quickly added further U.S. equity exposure to our core capital growth model portfolios. We therefore benefitted from the strong Nov-Dec market rally that ensued. Our core model portfolios also benefitted from the rapid decline in bond yields (and corresponding rapid rise in bond prices) over this same period. Through much of Q4, bond and stock prices continued to demonstrate a high degree of direct correlation.
Also during the quarter we made a noteworthy adjustment by significantly reducing Developed Asia-Pacific exposure in our capital growth portfolios. 2023 was a very good year for that geography, particularly Japan which saw its market indices up 20%+ on the year, and we determined it prudent to reduce exposure after this strong run.
In closing, we wish you and yours a very happy 2024! As stewards of wealth, we will continue to manage client assets dynamically yet prudently in the year ahead.