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The traditional ‘Santa Claus rally’ did arrive after all despite lots of obstacles in the ‘economic chimney’. The gains were more broadly-based than they had been for most of the year but the catalyst for the move, once again, was the recovery in the bond market. Growth stocks, particularly ‘mega cap tech’, had been in the lead for almost all of this year as those stocks had three big tailwinds: they were expected to generate stronger earnings than all other sectors in a slower growth environment, there was extreme optimism around the rapid acceptance of artificial intelligence and the fact that growth stocks tend to lead in a slower growth environment, where interest rates were expected to see their peak and subsequent decline. The outperformance of the largest stocks (Microsoft, Apple, Amazon, Alphabet, Meta, Nvidia and Tesla, nicknamed ‘The Magnificent ‘Seven’) was more pronounced than anything that had been seen in decades. After the October sell-off, the S&P500 Index saw its year-to-date gain reduced to 12%. However, for that same year-to-date period the return on the ‘S&P493’ (the Index excluding the ‘Mag 7’) was actually negative. The rally since the beginning of November has been more inclusive, with the financials, industrials and consumer stocks joining in and small cap stocks recovering. While the Nasdaq is ahead at the time of writing more than 36% so far this year versus a gain of only 3% for the small cap Russell2000, both indices are ahead about 13% so far in the fourth quarter. This clearly shows the rally has broadened out (hence the ‘everything rally’ reference) and is more empowering to stock market bulls since broader advances are more typical at the beginning of a bull market!
Central banks maintained center stage again in December as the stock market called the Fed’s bluff and then Jerome Powell ‘threw in his cards’ on ‘higher for longer’ mantra! To recap the saga of the past two months, stock and bond markets had soared in November on comments from the Federal Reserve meeting that they may be close to the end of their tightening (their exact quote as that they were seeing the risks between excessive inflation and slower growth as “balanced”). Bonds had their best month in almost 40 years while stocks enjoyed an ‘everything rally’ that included lagging sectors such as Financials, Consumer Discretionary and Industrials. Prior to that, stocks had pulled back sharply in the September/October period on worries about economic growth as well as the ongoing ‘higher for longer’ mantra on interest rates from central bankers. Following the stock and bond market reactions to the ‘perceived Fed pivot’ in policy on November 1st, Fed Chairman Jerome Powell seemed to feel he needed to cool down the bullish rhetoric that the Fed had created during the post-meeting press conference. To that end, in public comments on December 1st, he reiterated that the Fed is not projecting any near-term reversals in interest rate policy. Rather than taking that as a retreat from the perceived impression of a pivot in policy, investors seemed to ignore the text of that message and instead took that as another ‘green light’ for even more easing next year, with both stocks and bonds rallying even further after those comments. The 10-year U.S. government bond yield dropped from 4.4% to under 4.2% after already falling from near 5% at end of October. The Fed then got another chance to clarify their stance in the press conference following their December 1st meeting. If the Fed did not want to risk letting inflation rise again by easing on rates too early (a mistake they made in the 1970s) or making monetary conditions too easy, we expected to see Chairman Powell in his post-meeting press conference to come out even more hawkish and for the ‘dot plot’ to indicate far fewer rate cuts in 2024 than markets were pricing in. Moreover, even though inflation was coming down towards the 2% target, headline inflation was still running at 3% and ‘core inflation’, the more important measure for central bankers, seemed to be stuck in the 4% range, suggesting that the fight against inflation was far from over.
Surprisingly, the information coming out after the meeting had a very dovish tone. The Federal Reserve’s ‘dot plot’, which outlines Board members individual views about the path or interest rates, indicated that members now expected three interest rate cuts over the next year rather than the two which had been in the prior dot plot release. Then, when the Chairman began to speak at the press conference after the meeting, his rhetoric was much more dovish than his comments two weeks earlier and clearly more dovish than investors were prepared for. The ‘everything rally’ got yet another boost and the Dow Industrials surged over 500 points that afternoon to a new high while 10-year bond yields dropped under 4%! Investors once again ignored the prognostications from the Fed ‘dot plots’ and have now prices in no less than 6 interest rate cuts in 2024, starting as early as March. With tax loss selling mostly done, no economic reports, central bank meetings or profit reports before year-end, there seemed to be little to slow down the buying frenzy. How this plays out in 2024 is clearly a different story but we have seen most strategists revise their year-end targets higher in the past few weeks on the consensus belief that the Fed has truly done a pivot in their monetary policy. This seems vaguely similar to the late 2017 period, when the ‘Trump tax cuts’ propelled a stock market into year end that had been climbing most of the year. The rally then continued into January of 2018 before succumbing to a brutal sell-off in February and another sharp decline in the fourth quarter of that year. While history rarely repeats, the old adage is that it often ‘rhymes’, suggesting that we could see a similar sell-off early next year once this euphoric buying loses momentum. Fourth quarter earnings reports will probably be the biggest determinant of the next move in the stock market. But one thing we can be relatively sure of is that interest rates will continue to go lower over the next year, which argues for continued holdings of bonds as well as interest sensitive stocks. In the meantime, the pivot caught most investors offside and lead to much confusion among the stock market bears.
Everyone seems in agreement that the economic data in 2023 was much stronger than expected given the sharp interest rate increases seen over the prior year. The typical ‘long and variable lags’ of monetary policy have been longer than normal and aggressive fiscal spending offset the economic weakness seen in most other economies across the globe. Rather than assuming the inevitable slowdown or recession has only been delayed, investors have instead taken this as a clear signal that the U.S. economy will see a ‘soft landing’ despite the very aggressive interest rate hikes of the past two years. Investor views on the outlook for financial markets can change in a heartbeat (as witnessed once again from the extreme bearishness of Sept-Oct to the rampant bullishness seen in November-December) but global economies are slow moving behemoths that maintain momentum in one direction for a long time. Changing course is a slow process at best. We think the ‘soft landing’ that we have seen so far will soften even further and that the economic data will be much weaker as the delayed impact of higher interest rate increases flow through the consumer and business sectors. One reason that investors seemed less concerned about a significant slowdown in growth next year is due to optimism about the profits cycle. The consensus view seems to be that the corporate sector has been saved from a default cycle by having locked in debt for longer periods at the record lows of the past few years. But that is not necessarily the case. In fact, the ratio of short-term debt to total debt is around 32%, which is at the high end of the range over the past 15 years. On top of that, the corporate sector needs to re-finance over $4 trillion of short-term debt, at an average interest rate that is more than 300 basis points higher than the existing debt. That difference in interest payments alone could shave over US$100 billion from corporate profits next year and would clearly have a negative impact on employment levels and capital expenditures. That will make it very difficult to meet the bullish consensus expectations of double-digit profit growth in 2024. In that regard we see the economic data as ‘stuck in the mud’ of slower growth, much like they have been for the post Financial Crisis period, and thus a ‘muddy landing.’ Recession risks seem to have dissipated given economies’ resilience so far. There was no crisis in the financial system as interest rates rose despite the SVB and regional bank failures in March of this year. With bond yields now falling, investors seem to believe that the risk of these exogenous threats has diminished. We still think that a lot of the drag from tighter monetary policy has yet to come and that the associated economic weakness is understated by consensus forecasts. We anticipate a period of very slow growth in the U.S. and mild recessions across Europe. But this cycle has been unusual on both the demand and supply sides given the distortions caused by the pandemic, so there is still uncertainty over the timing and severity of any downturn. Ultimately though, those unique and perhaps temporary circumstances will wear off and the economic trends of the prior decade will reassert themselves.
We need to remember that it was only five or six years ago that central bankers were frustrated that they could not get inflation up to their 2% target, despite maintaining interest rates near zero for almost a decade. But inflationary pressures were muted by the combined effects of the globalization of supply chains, the disinflationary impact of the increased use of technology and resultant higher productivity and the fact that the largest economies in the world had entered their slower mature growth phases. Central bankers even floated the absurd concept of ‘negative interest rates’ and many actually took that step, with over US$10 trillion of global debt in 2019 having negative rates. The pandemic ended that experiment as supply chains were shut down, ‘onshoring’ started to replace ‘globalization’ and a flood of fiscal spending unleashed a massive pent-up demand for goods that just could not be met. Larger than normal sums of money chased the supply-constrained goods market, particularly since spending on services (i.e. travel) was not an option. We believe that we will slowly move back to those trends of the post-Financial Crisis period, meaning that inflation will come back down and global growth will remain muted. It could be even slower in fact since one of the only regions of superior growth, that being China, has also entered a period of slower growth as it deals with its own debt crisis and tries to migrate from a capital spending economy to a consumption economy. All of these slower growth factors will push interest rates lower in 2024, but they will not return to those record low levels prior to the pandemic. Record levels of global debt means that the ‘term premium’ on debt (i.e. the rate on top of inflation that interest rates need to be in order to attract the capital needed to maintain these debts) will be higher than it has been. We continue to believe that 2% inflation and a 1.5% term premium is a reasonable target, meaning that we should expect nominal funding rates (i.e. 10-year government bond yields) to settle in the 3.5% range. If the economy weakens more than we currently expect in 2024 (i.e. a hard landing) then rates could drop below that target. However, given that the 10-year yield in the U.S. has already fallen from almost 5% to under 3.9%, future gains will be more muted.
Back at home in Canada, the economic data has weakened much more in 2023 than our neighbour to the south. Second quarter growth was barely positive, while the 3rd quarter was negative and the 4th quarter looks to extend that trend. One reason that the U.S. has stayed stronger has been due to much higher fiscal spending there, including the Chips Act and the Inflation Reduction Act, which has pushed almost US$2 trillion of additional stimulus into that economy. More importantly, though, 30-year fixed mortgages are no longer available in Canada and debt maturities are notably shorter, meaning that the impact of rising interest rates is being felt earlier here than in the U.S. Canadians are spending more of their disposable income to pay down debt than ever recorded, as mortgage interest payments have nearly doubled since the Bank of Canada began hiking interest rates in early 2022. The household debt service ratio, which tracks the total payments (principal and interest) that Canadians are required to make as a proportion of their disposable income, reached 15.22% in the third quarter, the highest since data started being collected in 1990. Since the early 2000s, Canadians have dramatically ramped up their debt levels, partially overlapping with a period of rock-bottom interest rates that were meant to stimulate the economy after the Great Recession of 2008-09 and subsequently during the COVID-19 pandemic. But these low rates, combined with a housing shortage, fuelled a massive appreciation in home prices across the country, with buyers forced to take on ever increasing amounts of mortgage debt. These elevated debt levels will be a hindrance to consumer spending going forward, even if they haven’t as yet had as much of an impact as expected. The biggest impact from the move in interest rates is on the change in ‘real’ interest rates (which are nominal interest rates less the rate of inflation). The chart below shows real interest rates over the past 60+ years. It can be clearly seen that the increase in rates over the past two years has been the sharpest in over 40 years, eclipsing all but the ‘Volcker era’ move in rates in the late 1970s/early 1980s, which lead to back-to-back recessions in 1981 and 1982. Given this history, it seems inconceivable in our view that we won’t see a similar slowdown in growth in 2024!
Stocks have surged since the end of October and are on pace for the strongest finish to any year since the 1990s. Many economists and strategists have warned about a growth slowdown and much of this sentiment has been mirrored in both economic releases globally as well as the rhetoric from many global companies in recent earnings reports and outlooks. From many ‘barometers of economic strength’ such as the rail companies to the large retailers to mature tech companies such as Oracle, Texas Instruments and Cisco and, most recently, FedEx, we have heard about more reticence from customers to undertake larger spending and reasons to be cautious on the outlook for 2024. But those fears about the economic outlook have clearly been trumped by the ‘liquidity argument’ much like they were in 2020. The potential for lower interest rates drives money into financial assets irrespective of the economic realities. But for those expecting the interest rates cuts expected to come in 2024 to reverse any economic slowdown, we think they will be disappointed. Lags in the impact from rising interest rates are still working their way through the economy and, as I learned as an economic student at the monetarist U of Western Ontario in the 1970s, the lags are even longer when it comes to interest rate cuts. It’s the old ‘pushing on a string’ phenomenon. Bottom line is that this liquidity argument may take stocks higher in the short term, the economic and corporate earnings recoveries to justify those moves could come up well short of expectations next year.
Another worry for the stock market are the sentiment indicators, which are almost frightening in terms of how frothy things have become. We need look no further than the December Bank of America Global Fund Manager Survey. This is a survey of roughly 250 global fund managers and is a very good gauge of sentiment among fund managers. They are typically the most bearish at bottoms and most bullish at tops. Some of the most notable responses are:
While sentiment is not necessarily a wonderful market timing tool, it is no coincidence that extreme readings such as these have almost always been associated with market tops (and similar negative sentiment readings at market bottoms) and is enough to temper our enthusiasm for stocks. ‘Don’t fight the Fed’ has always been a mantra for investors so the pivot towards a more dovish outlook on interest rates should not be underestimated, particularly in this seasonally strong period for stocks. But valuations are near record levels, expectation for earnings growth in 2024 seem far too optimistic, sentiment is at extreme bullish levels and our outlook is for a sharp deceleration in economic activity over the next few quarters.
So where does this leave us in terms of our investment strategy as we enter 2024? What we have the most confidence in is the idea that interest rates will finish 2024 lower than where they started. That alone is enough to keep us with at least a ‘market weight’ in bonds. Given that the 10-year in the U.S. has already rallied from almost 5% to under 4%, we are reticent to go overweight on bonds but would look to do that on any move in yields back above 4.3%. Our bond weight in balance portfolios is around 37%, with another 6% in preferred shares. In terms of stocks, we have used the strength into year end to go slightly underweight and expect to maintain that position. Our stock weight in balanced funds is around 45%, which is at the lower quartile of our typical 40-60% range. While we are more bearish than consensus on the outlook for the economy and corporate earnings, we understand that the flow of liquidity into stocks could continue into the early months of 2024. The biggest areas of earnings risk are in the cyclical sectors such as industrials, consumer goods, financials and basic materials. The only caveat in those groups though is that valuations are already reflecting poorer economic conditions, even after the rally of the past few months. For that reason we continue to hold some auto-related names (General Motors, Magna and Martinrea) as well as RV manufacturer BRP Inc. now that it has already lowered expectations for next year. While we are underweight banks in Canada, for valuation and yield we continue to hold TD, CIBC and Bank of Montreal. Technology and consumer staples sectors usually do well in periods of falling interest rates, but the valuations of those sectors is already at the high end of their traditional range so we don’t see much upside from the big names but do see more opportunities in some of the mid-sized names, including Open Text, Lightspeed, Telus International and Nuvei in Canada as well as PayPal and Alphabet in the U.S.
The sectors that offer the best downside protection in a slower growth environment as well as reasonable valuations are the telecom, precious metals, pipelines, energy and, in the U.S, health care. In that latter group, big cap pharma has under-performed over the past year as the decline in Covid and other vaccine sales offset the bullish views on GLP-1 weight loss drugs from industry leaders Eli Lilly and Novo Nordisk. This has created great buys in big names such as Pfizer and Bristol Myers. We also expect more corporate activity in the biotech space and have added the more diversified biotech exchange traded fund XBI. Telecom (BCE and Telus) and pipeline (TC Energy, Enbridge and Pembina) fit the mold of what we are looking for as their earnings have more resilience to the economic cycle, their valuations on cash flow are very reasonable and their dividend yields (as well as dividend coverage and dividend growth) are exceptional, with most sporting dividend yields in excess of 6%. Precious metals should finally get a lift in 2024 as valuations are at multi-decade lows, corporate activity should pick up and weaker economic growth in the U.S. should undermine the U.S. dollar and give a further lift to gold prices. In terms of the Energy sector, we recognize that weaker global growth will cause a fall in global demand for energy and may also make it more difficult for the OPEC+ group to maintain their production discipline. However, valuations in the Canadian producer sector are attractive even with oil in the US$70 range. Our focus in the sector is on mid-sized oil levered producers such as Baytex Energy, Crescent Point and Cenovus, all with double-digit free cash flow yields and ‘investor friendly’ activity such as debt reduction, special dividends and share buybacks.
Our investment management team is made up of engaged thought leaders. Get their latest commentary and stay informed of their frequent media interviews, all delivered to your inbox.