Despite widespread expectations for recession, the economy proved resilient in 2023. US GDP growth was supported both by continued fiscal stimulus as well as consumer spending driven by the drawdown of savings and an expansion in debt levels. Corporate earnings grew modestly at 2%. Inflation, as measured by the Consumer Price Index, fell from over 6% at the beginning of the year to 3.1% by November in the US and Canada. Alongside sustained economic growth and US job gains, investors became convinced that the Federal Reserve will be able to ease interest rates in 2024 and avoid the fate of every major historical rate hiking cycle – a recession. Following a ~20% decline from July to October for the equal-weighted S&P 500 Index, stocks surged into year-end in response.
Within equity markets, it was yet another year of historic extremes. The ‘Magnificent 7’ stocks rose 112%, almost single-handedly driving the S&P 500 to a 26% return while the technology heavy Nasdaq 100 rose 55% – its best year since 1999 in a major reversal of 2022’s crash.
*Magnificent 7 – Apple, Microsoft, Alphabet, Amazon, Tesla, Nvidia, Meta.
Source: Capital IQ
Meanwhile, the median stock in the S&P 500 underperformed the broader index by 16%, the most since 1999, and the TSX lagged US stocks by 12% in USD. ‘Value’ stocks1 underperformed ‘growth’ stocks2 by 31%, the second worst outcome since 1979, in what was a year of extraordinary divergences and concentration of market returns among a relatively small number of large stocks. Such extreme differentials in performance are rare and can be telling of the nature of the market environment and where future opportunity is likely to be found (hint: it’s probably not 2023’s big winners).
Within fixed income, a late-year rally in US treasuries buoyed returns from what would have been the third consecutive year of losses as the US 10-year rate fell from an intra-year peak of ~5% to finish the year at 3.9%. Real yields, which reflect bond yields less inflation, are hovering near the highest levels since 2007. After a decade and a half of financial repression, fixed income is offering savers an attractive inflation-adjusted proposition once again.
QV’s strategies generated reasonable performance in the year. Our small cap and fixed income funds outperformed their respective benchmarks but our Canadian and global large cap strategies failed to keep pace with major indices that were driven by frothy price movements in the most highly valued areas of the market. Over a three-year period, the strategies have beaten their respective benchmarks – indicative of what we believe is still the early stages of a multi-year opportunity for value-conscious investors that began in the fall of 2020.
*Since inception (April 1, 2021)
Note: Returns in CAD, gross of fees
UNCERTAIN, VOLATILE OUTCOMES
Stocks have been on a wild ride over the last three years. With US corporate earnings set to rise just 7% between 2021 and 2023, the violent swings in equities shown below have been overwhelmingly driven by expectations for the economy, interest rates, inflation and, most recently, the promise of artificial intelligence rather than improving business fundamentals.
Source: Capital IQ
However, with US corporate earnings growth expected to re-accelerate to 11% in 2024 and the S&P 500 trading near 20x expected earnings, the pendulum of fear and greed has swung a long way from early 2023 when recession calls were widespread. Yet, numerous indicators continue to signal an elevated potential for negative surprises in the economy. This suggests that the path to further market gains in 2024 could be narrow and that investors may be rewarded for prudence over exuberance.
A SHORT LIST OF CONCERNS:
Economic indicators continue to suggest a very late stage of the economic cycle: Unemployment remains at very low levels which tend not to be sustained; rising loan delinquencies and bankruptcies suggest growing pressure on consumers and businesses; bank lending remains restrictive; industrial activity has been in contraction for 15 months – a feat that has never occurred in the absence of recession.
Source: J.P. Morgan, Federal Reserve Bank of NY, Bloomberg Finance L.P.
The historical record of rate hiking cycles and yield curve inversions continues to suggest a high probability of recession: Historically, recessions generally occur 8-14 quarters after the first rate hike and an average of 17 months after yield curve inversions as measured by the 10-year and 2-year treasury yield spread. The yield curve has now been inverted for 18 months.
Expectations for earnings growth appear high: Despite risks to the economic cycle, US consensus earnings are expected to rise 11% in 2024 – a growth rate that is more consistent with mid-cycle/early-cycle recovery. Investors appear to be pricing in a near perfect landing for the economy.
Market valuations provide little room for error: At ~21x 2023 expected earnings, US stock valuations are towards the high end of historical ranges. Additionally, the spread between the S&P 500’s earnings yield and the inflation-adjusted 10-year treasury yield, which shows the premium investors receive for the risk of owning equities, is the lowest it has been in 20 years. While this is partially reflective of a higher rate environment, if we apply historical average spreads since 1960 for periods when the US treasury yielded between 4-5%, the market still looks potentially overvalued today.
*Earnings Yield = Earnings/Price
Source: Capital IQ
Investor sentiment is elevated: There are numerous signs of overt risk-seeking behaviour among investors. Late 2023 saw strong inflows into risky leveraged ETFs; speculation on rising stock prices through short-term options trading reached all-time highs during 2023; and professional and retail equity exposure has risen back towards prior peaks. Great outcomes for stocks typically arise when investors are fearful rather than risk-seeking. The current level of bullishness suggests optimistic outcomes may already be priced into many stocks.
Taken together, the largest unpriced risk to equities in 2024 appears to be a disappointment to an optimistic consensus.
Of course, the above concerns are no guarantee of a particular outcome for stock markets. While the 2024 US election is sure to be a spectacle, stocks tend to be strong in election years. Going back to 1928, stocks have risen 83% of the time in election years with an average return of 11%. Additionally, equities tend to initially respond positively to central bank rate cuts (provided inflation is low) and there is a reasonable case that the Fed may begin to cut in 2024. Finally, momentum can often sustain market sentiment in the near term. Since 1950, years that follow >20% annual gains for the S&P 500 are positive 80% of the time, with an average return of 11%.
Beyond stock market statistics, two other fundamental factors do not confirm the risks suggested earlier:
Credit spreads remain unusually tight: A weakening economy often translates to rising corporate credit spreads as investors begin to worry about deteriorating creditworthiness. Non-investment grade credit spreads continue to offer slim premiums, which suggests a lack of major near-term concern on this front.
High bank liquidity is supportive of financial system stability: Even though the yield curve is inverted and real rates have spiked upwards (classic preconditions for recession), monetary conditions are different today relative to prior cycles. In the past, bank reserves were low and the Fed actively drained reserves and liquidity from the banking system as it raised rates. In contrast, US banks currently hold over $3 trillion in highly liquid, interest-paying reserves. With reserves so abundant, the classic risk of late-cycle illiquidity aggravating credit and economic conditions appears diminished relative to the past.
POCKETS OF PREDICTABILITY
While we don’t pretend to know what stocks will do in the near term, there are still important outcomes that should be more certain with the benefit of time:
Greater clarity is coming: The inherent contradiction between sky-high equity markets pricing in a soft landing and late-cycle indicators suggesting downside risk is unsustainable. Through the balance of the year, either equity markets will have to re-price to what appears to be growing risks or the current consensus will prove-out and the economy and corporate earnings will continue to grow. We remain skeptical of the latter because consensus has become so directionally skewed in valuations and earnings estimates that risk appears tilted to the downside rather than the upside.
The yield curve will steepen (eventually): Inversion is also an inherently unsustainable state for the yield curve and by extension, the economy. With time, long-term interest rates will settle back above short-term rates. This could happen in a variety of ways. Central banks could meaningfully cut short rates, ostensibly in response to inflation declining to the Fed’s 2% target rate and/or as the economy and asset prices begin to falter. Alternatively, a positively sloped curve could be achieved if the Fed cuts rates slightly while the US 10-year treasury yield rises. For example, the US 10-year could trade between 4% to 5%, which is reasonable if we assume 2% real economic growth and structural inflation in the range of 2% to 3%. Since 1976, 10-year treasuries have yielded an average of 85 basis points above 2-year treasuries, but this premium has often peaked above 2.5% in economic recoveries. The long-term average suggests that short-term rates may only need to fall towards the range of 4% in the near term to achieve a reasonably healthy yield curve.
We believe the fundamental qualities of our strategies position them well for either scenario. If long rates rise, long duration assets (growth stocks) are likely to be pressured. Meanwhile, our skew to defensive quality and value (shorter duration) should be less impacted. Banks could do quite well as pressure subsides on the cost of funding and they are able to extend credit at higher rates.
Alternatively, in the first scenario where central banks aggressively cut rates due to economic concerns, the most cyclically exposed areas of the market as well as the most highly valued relative to reduced growth expectations would be most at risk. QV’s strategies have taken care in recent years to manage exposures to such extremes.
While these are only two simple scenarios, they illustrate a crucial theme for investing amidst uncertainty – simply avoiding outcomes that pose a real danger to capital impairment can go a long way to securing reasonable long-term returns. It sounds obvious, but if investors are not being adequately rewarded to take outsized potential risks, they should be avoided.
A bull market for risk-conscious value investing: The S&P 500’s 18% decline in 2022 was a violent, if fleeting, reminder of the importance of risk management. Unfortunately, the sharp recovery of highly valued stocks in 2023 likely reinforced the wrong lessons for many investors – that ‘buying the dip’ is the right thing to do for all stocks and that valuations don’t matter much in comparison to narratives.
Risk management played a crucial role in helping to preserve QV clients’ capital in 2022. Similar to early 2022, many areas of the market exhibit extremes yet again in 2024.
Source: Capital IQ
This is in sharp contrast to the disciplined approach with which we’ve managed risk among our holdings. Collectively, our strategies offer meaningful valuation advantages to the broad stock market as well as a thoughtful balance towards resiliency and growth potential. Our fixed income strategy remains defensively positioned between government bonds and high quality corporate debentures. Its 4.2% yield provides attractive income and stability for balanced clients’ portfolios. While the outlook for the stock market is always uncertain, we continue to see plenty of reasons why it remains an attractive environment for risk-conscious value investing.
1,2 Russell 1000 Value Index; Russell 1000 Growth Index