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Based on past experience, similar economic readings have generally produced decent equity returns, at least in the short term. Caution is warranted however, since current conditions are also associated with the late stages of the business cycle, increasing the risk of a reversal. In this update, we discuss the opportunities and risks this creates for 2024 and how we are positioning our portfolios.
Weighing Past Experience
There is a lot that is unique about the current investment climate, owing to the after-effects of the pandemic, geopolitics, shifting demographics and changing trade patterns, to name a few factors. But within the overall backdrop, the current set of economic circumstances – not too hot and not too cold – has happened before. Since 1950, about 8% of periods have started with:
- 10-year U.S. treasury yields at 3.5% to 6%;
- U.S. unemployment at less than 6%; and
- Go-forward U.S. inflation at 3% to 5%.
The good news is that these instances have preceded positive one-year returns about ~78% of the time – about the same as in other periods – and their returns have had a lower standard deviation of 11.6% versus 16.3% in other periods, which narrows the risk distribution.
The bad news is that the average one-year return in these periods is lower at +7.3% versus +12.7% in other periods. This particular economic mix also tends to be transitory, leading to much riskier markets in subsequent years. Historically, the periods which included similar conditions were:
- Late 1966 through early 1969, which featured stronger equity markets that benefitted from sustained productivity growth (unfortunately, this may be the lone positive example);
- 1972/1973, which coincided with the breakdown of the gold standard and Bretton Woods, leading to the stagflation problems of the later 1970’s;
- Late 1996 and early 1997, which preceded the Asian crisis of 1998;
- Most of the year 2000, which was a precursor to the dot-com crash;
- Most of the period from late 2004 to 2008, which reflected the bubble years preceding the Great Financial Crisis.
Three-year forward returns in these periods are quite weak at 2.8% CAGR versus 11.8% in other periods, with a higher standard deviation of 9.0%, versus 8.1% in other periods and roughly a 42% chance of posting negative 3-year returns versus about 8% in other periods.
The general conclusion is that low unemployment, higher inflation and higher 10-year yields are characteristic of the later stages of the business cycle when economies are more prone to stumbling.
If we were to point to one culprit for increased risk this time around, it would be very high fiscal deficits in the U.S. and elsewhere.
The Fiscal Picture: A Decade of High Deficits
With all the interest rate speculation and Fed speak, it is easy to overlook what’s happening on the fiscal side of the ledger. Globally, government spending has been propping up economic conditions for some time now:
- Only nine years since 1950 have featured U.S. deficits larger than 5% of GDP;
- A startling eight of those years have occurred since 2008 and the Great Financial Crisis; with
- Four of those years occurred from 2020 onward, post-pandemic.
As U.S. politicians push for re-election in 2024, we expect U.S. spending to continue this year, with the deficit likely to remain at 5%+ of GDP on tax bracket indexation and rising Social Security, Medicare and Medicaid outlays. With a wave of baby boomer retirements still looming, the U.S. faces unfunded liabilities stretching out many years.
Undoubtedly, the recent effects of increased government borrowing and deficit spending have been a net positive for U.S. economic performance. Households have kept more of their money and de-levered even as the U.S. government has gone further into debt. As evidence, U.S. household debt to GDP is at a twenty-year low, while U.S. government debt to GDP remains near its all-time high reached in 2020 at the height of the pandemic.
While borrowing from the future pumps up growth in the short term, eventually, the party does end, as deficit spending tends to drive up the money supply, inflation and borrowing rates, while slowing down economic activity and burdening governments with higher interest costs. The global economy appears to be in the late stages of this process.
Momentum Reversed in 2023
After an equity market retreat in 2022, equities rebounded sharply in 2023, with the S&P/TSX returning 11.75% and the S&P 500 26.29%, led by a handful of mega-cap stocks. The equal-weighted S&P 500 index returned 13.87%. Our defensive positioning early in the year meant our funds underperformed in 2023, with the Veritas Canadian Equity Fund (VCE) returning 7.65% and the Veritas Absolute Return Fund (VAR) down 0.56%.
In both funds, our 2023 results reflected the challenging environment faced by the long side of our book, as Staples, Utilities and REITs underperformed in a better-than-expected economic environment that saw interest rates climb quickly. In VAR, our long-short strategies also suffered as higher-leverage, lower-quality names tended to outperform early in the year.
Our investment approach remains consistent, however, as we look to invest in high-quality companies that we expect to deliver outperformance and lower volatility over a multi-year horizon. At December 31, 2023, our trailing three-year return for VCE was 9.70% annualized, which was ahead of 9.59% for the S&P/TSX, and delivered 20% less volatility than the index.
Meanwhile, our Absolute Return Fund has delivered a three-year return of 4.98% with 35% less volatility than the index and a low correlation of 0.35.
Weighing Opportunities in 2024
Considering present circumstances, we think there is room to be cautiously optimistic about returns this year. S&P/TSX stocks are at a considerable discount to S&P 500 names based on relative earnings yields, despite similar expectations for low double-digit earnings growth this year.
Our Canadian Equity Fund is positioned to avoid some of the key risks we see in Canadian stocks this year, while our Absolute Return Fund, through its long-short strategies, offers a way to hedge overall equity exposure and reduce volatility, particularly if markets go sideways or down in the coming years, as we expect they might.
As the Canadian mortgage market rolls over and debt service costs rise, we anticipate weaker economic performance in Canada this year. Even so, we are still seeing many opportunities to invest in high-quality Canadian companies with long-term potential for earnings improvement and growth, especially those with a global footprint.
We are underweight Canadian banks based on our analysis that Canada’s tightening credit conditions will continue to weigh on profitability. We have targeted positions in Consumer, Utilities and REIT stocks, where we see earnings growth potential and benefits from flat to lower interest rates.
We will continue to keep a close eye on risk throughout the year. As always, we remain focused on managing market volatility, preserving capital and seeking out the best opportunities to drive returns.