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Even so, equities have sprinted out of the gate, with 2024 Q1 ranking in the top quartile of post-1990 returns for both the S&P 500 and the S&P/TSX. Veritas’ funds have participated nicely in the rally, but we continue to exercise caution.
We are seeing pockets of weaker consumer spending as inflation and higher borrowing costs pressure household budgets. It is often a short step from consumer weakness to a slowdown in corporate earnings growth, an outcome which we think is far from priced in. Risk premiums for equities are quite low and analysts are still projecting double-digit earnings growth for both 2024 and 2025, increasing downside risks for equity prices if earnings miss expectations.
In this update, we discuss how we are positioning our funds to generate attractive returns for investors while at the same time managing emerging risks.
First Quarter Performance
Our three funds performed well through March 31, 2024, with the Veritas Canadian Equity Fund up 7.7%, the Veritas Absolute Return Fund up 5.3% and the Veritas Next Edge Premium Yield Fund up 6.3%. The S&P/TSX Composite returned 6.6% over the period, while the large-cap focused S&P/TSX 60 index was up 6.3%.
On a three-year basis through March 31, 2024, our Canadian Equity Fund has outperformed the S&P/TSX with a 9.3% annualized return versus a 9.1% return for the benchmark. The fund also delivered the return with 19% less volatility than the index.
Designed to be a hedge against equity market risk, our Absolute Return Fund has returned 4.2% annualized over three years with a 0.37 correlation to the benchmark and 40% less volatility than the index.
With a yield and larger cap focus, our Premium Yield offering has returned 10.4% annualized from its June 28, 2022 inception date to March 31, 2024, which compares favorably to the 9.0% returned by the larger cap S&P/TSX 60. Over the period the fund return includes an from distributions.
A Mixed Economic Outlook
Since mid-2022, the U.S. Fed has rolled out a program of high interest rates to combat inflation. Paradoxically, markets have rallied despite Fed tightening and the U.S. economy has thus far avoided a recession. In our view, despite the rebound in earnings and valuations we have seen since 2022, the economic dust has not settled.
Monetary and fiscal policies are at odds: In large part, the U.S. economy has not stalled out because the U.S. government has posted large fiscal deficits, stimulating household demand. As we have noted before, only nine years since 1950 have featured U.S. federal deficits larger than 5% of GDP. Eight of those occurred after 2008, of which four were posted from 2020 onward, post-pandemic. The U.S. has a structural deficit problem.
The effects of the fiscal stimulus may be weakening. Progress on inflation is slowing while borrowing costs have been rising. We see considerable risk that long-term rates and yields rise to reflect the inflationary pressure of sustained government deficits.
The Fed is operating with very high real rates: Real borrowing rates, measured as the Fed Funds Rate less expected 10-year inflation, have now crossed above 3% for the first time since June 2000, at the height of the dotcom era. Current real rates are also higher than their peak of 2.9% ahead of the great financial crisis of 2008/2009.
Can the economy ride out 3% real rates? The U.S. economy has weathered high real rates before but the effects can be uneven. The Fed kept real rates above 2% for all of the 1980s and for the period between 1995 to 2000. While markets were volatile, the economy benefited from consistent productivity growth and stocks did well.
Even with U.S. deficits likely to top 5% again in 2024, there is a growing risk that inflation and high borrowing costs may cause North American growth to stall, at which point we would expect a considerable pullback in U.S. and global equity markets.
We are not there yet. Right now, the greater threat may be complacency, as the possibility of a slowdown does not appear to be priced into equities.
Equities offer little in the way of premium: The core return offered by equities is currently very low relative to bond yields, with the S&P 500 earnings yield (the inverse of the P/E) less than 20 basis points higher than U.S. 10-year Treasury yields. Historically, the lack of significant premium is not unusual for Treasury yields in the 4% to 5% range, however there is also no reason to think equities are ‘cheap’.
Analysts are very bullish: The low earnings yield also reflects very strong expected earnings growth, with analysts forecasting S&P 500 operating earnings to rise 12.5% in 2024 and 13.9% in 2025. For reference, S&P operating earnings grew by 8.5% in 2023 and 7.2% annualized between 2010 and 2019.
Three sectors are driving consensus growth: S&P 500 2024 growth expectations are led by three sectors in particular: Health Care (+33% vs. 2023); Information Technology (+30%); and Communications Services (+17%). Together, these three sectors contributed ~44% of S&P 500 operating earnings in Q4 2023.
The path for the S&P/TSX is likely to be very different: We note that the S&P/TSX has very little Health Care (<35 bps weight), while its IT (+4.8% YTD) and Communications (-8.2% YTD) listings have underperformed the broader TSX index year-to-date. Representing more than a quarter of the S&P/TSX index, we expect the path of the Energy (+13.9% YTD) and Materials (+5.8% YTD) sectors to be much more influential through year-end.
How We Are Positioning Our Funds
Over the medium term, fiscal deficits, onshoring and the demographic hand off from boomers to millennials are all inflationary. Additional costs brought on by geopolitics and climate change can also be added to this list, although their timing, duration and effects are even more difficult to pin down.
Inflationary trends suggest a healthy weighting to commodities, energy and materials, which feature inelastic supply and tend to hold their value against inflation. Commodities nonetheless require a close eye on the global economy and supply conditions because demand can be highly cyclical. We are prepared to lighten exposures should we begin to see signs of oversupply or an economic slowdown.
We are also paying close attention to interest rate sensitive stocks, particularly those that trade on yield. The on-again, off-again nature of rate-cut expectations has made these names a more volatile proposition recently, even as many of these companies carry attractive dividend yields. We are prepared to accept near-term price volatility provided companies have attractive growth prospects and sustainable payout ratios. Over the longer term, we expect risk-free rates to stabilize, shifting attention to the earnings power of dividend-paying companies.
We remain cautious on Canadian financial firms, which we expect to come under further pressure for mortgage rollovers and weakening credit conditions. There are, however, opportunities outside of the biggest banks in targeted niches that offer loan book growth with attractive risk profiles.
Our Canadian Equity Fund and Premium Yield Fund are positioned to capitalize on near-term upside in equities while looking to minimize the inflationary risks we have outlined.
Our Absolute Return Fund, through its long-short strategies, offers a way to hedge overall equity exposure and reduce volatility, which provides diversification benefits as we head into another period of market uncertainty.
We are sticking to our discipline of investing in attractively valued companies with strong balance sheets, sustainable cash flows and capable management teams. Over time that has proven to be the best way to manage market volatility and grow investor capital.