“When the facts change, I change my mind. What do you do, sir?”
– John Maynard Keynes or Paul Samuelson (variously attributed to both 20th century economists)
When we look back on 2023, the tragedies in Ukraine and the Middle East will sadly stand out in our memories.
For capital markets, banks at all levels (regional, global and central) drove a volatile year.
Barbie, Tay Tay, Musk, ChatGPT, plus politicians far and wide made headlines and impacted individual stocks, sectors and regions. However, nothing had more overall impact on performance than central banks, led by the U.S. Federal Reserve (the Fed). A plot twist to shake up the narrative and close out the year saw a broad basket of global stocks rise over 21%, and Canadian bonds bounce back with a 6.7% return, outpacing both cash and GICs.
Last year began positively if only because it started at a low bar. Central bankers laid the groundwork for their 2023 starring role in December of 2022; they scuttled markets at year end with their pledges to raise interest rates until inflation and wage growth return to normal (around 2%), adopting the mantra “higher for longer.” From their subdued starting point, it didn’t take much to get stocks and bonds off to a positive start.
Enter regional and global banks to round out the cast of bankers who moved markets in 2023.
It was the biggest year ever for U.S. bank failures in terms of combined assets. First Republic was the second-largest bank collapse in U.S. history, Silicon Valley was number three on the all-time list, and Signature was the fourth-largest to fail. In Europe, global banking giant Credit Suisse almost imploded before an emergency takeover by rival UBS. These failures – all in March – were thought to prove Wall Street’s collective wisdom that central banks tighten monetary policy until something breaks. A widespread spillover into the whole banking system would have negatively impacted the flow of credit in the economy – a quick way to provoke a recession. Of course, for much of 2023 an imminent recession was almost everyone’s standard narrative (but not ours).
When these cracks appeared, markets thought central bankers would scrap their role as inflation fighters and jettison their pledge of higher for longer. However, instead of cutting rates to halt a contagion of bank runs, central bankers pumped targeted liquidity into the economy by taking discounted collateral from banks at par. This creative solution worked; contagion never happened and a rally in stocks and bonds followed. It didn’t click with markets that central bankers were then free to return their focus to fighting inflation and continue with higher for longer. Markets would have to grapple with this factor later in 2023.
Dude, where's my recession?
Outside the U.S., economic growth did stall in much of the world. Europe and Canada flatlined; Germany registered a technical recession, and Canada missed one on revisions alone. China’s economy continued to lose momentum.
No major central bank was willing to retreat from higher for longer while inflation remained stubbornly elevated everywhere. This was especially true in the U.S., home to the world’s most influential central bank – thanks to the world’s most important currency. (We don’t see this changing anytime soon. Name me a viable alternative?)
Although U.S. inflation was retreating at a reasonable pace, the U.S. economy kept right on trucking. Supply-chain bottlenecks were largely resolved, and even strike activity in key transportation sectors couldn’t derail this resilient economy.
For all of 2023, the Fed hiked four times to a developedworld-leading rate of 5.5%. Other central banks had to toe the line amid sticky inflation. The Bank of England hiked five times to 5.25%. Canada came in third with three hikes to 5%. Despite confronting the weakest economy, the European Central Bank raised its policy rate six times to 4.5%. Central bankers followed through on the higher part of higher for longer.
The middle of the year brought a puzzling development. With inflation declining faster than expected, why were bond yields still rising? Enter the politicians. The U.S. is running a large fiscal deficit, which suggests that Uncle Sam’s massive borrowing requirements might lead to higher-for-longer borrowing costs even if inflation is slain. In case anyone missed this point, credit rating agencies Fitch and Moody’s downgraded the U.S. Fitch cut one notch to AA+ from AAA and Moody’s lowered its outlook to “negative” from “stable.” This issue has come off the front pages but has not gone away.
Unfriendly rates took a toll on housing markets and global manufacturing. Still, globally, consumers continued to spend on services (thanks, “Swifties”) buoyed by solid employment and wage gains that now outstrip inflation. By late summer, capital markets worked alongside the Fed, tightening financial conditions through higher longer-term bond yields and lower stock markets.
From Groundhog Day to Goldilocks
At October’s end, with only two months of 2023 remaining, the situation was looking gloomy. Bond investors were staring at an unprecedented third year of losses. Major stock markets had tumbled 8% to 10% from their peaks earlier in the year. Even the juggernaut Magnificent Seven (the seven largest weights in the S&P 500: Apple, Microsoft, Amazon, Nvidia, Alphabet, Meta and Tesla) succumbed. Their combined shares, which had risen nearly 100% for the year, fell 11% in two weeks.
At that time, given tandem declines for stocks and bonds, many were feeling that 2023 was going to be a nasty, Groundhog Day reprisal of 2022.
To us, the general situation looked less precarious than it was in 2022. We stuck to our long-standing conviction that capital markets were closer to the end than the beginning of working off imbalances created by the pandemic and a decade of ultra-low interest rates. October’s media drumbeat of pessimistic news was a classic sign to us that things were about to get better.
And get better they did. Globally, inflation continued to fall faster than expected. Capital markets began to see a realistic path toward 2% inflation and central bankers who would stop hiking and even start cutting in 2024.
The U.S. economy had been the sole bastion of strong economic growth, but that growth appears to be slowing (not collapsing). Although this is usually an unwelcome situation, it opens the door for the relief the world needs from high interest rates by paving the way for the Fed to turn dovish. To everyone’s surprise, at its December meeting the Fed did just that. It admitted what markets had begun to believe weeks earlier – that 2024 would be the year of the pivot from rate hikes to rate cuts. The Fed would now pay attention to economic growth as well as inflation. We expect every other major central bank to follow suit.
This poured fuel on a market rally for stocks and bonds already underway from October’s lows. These sharp, late-year upward moves have many market forecasters revising their 2024 outlooks penned in November. It’s back to the drawing board for them and for us.
Capital markets and key asset price recap
It was a seesaw year for just about everything. The S&P/TSX Composite Index rose 8.1%. The European Stoxx 50 Equity Index rose 19.2%. Japan’s Nikkei 225 Equity Index rose 28.2%. Adjusting for a deeply discounted Japanese yen, this return shrinks considerably to 19.3% in U.S. dollars.
In emerging markets, the MSCI China Equity Index fell 13.2%, but the MSCI Emerging Markets ex-China Index (USD) rose 20%, leaving the combined benchmark MSCI Emerging Markets Index (USD) up 7%.
For U.S. stocks, the Magnificent Seven are the stars. An equal-weighted basket of these big-tech supernovas rose 107% on the year. However, this same basket of stocks fell 45% in 2022, leaving a much more modest annualized two-year return of 6.2%. The S&P 500 Index rose 24.2%, and the (Magnificent-Seven-heavy) NASDAQ Composite rose 43.4% (same reminder, down 33% in 2022). An equal-weighted version of the S&P 500 rose 11.6%, while the Dow Jones crested a fresh all-time high with a 13.7% return.
Bonds delivered positive returns, surprising many. The FTSE Canada Universe Bond Index delivered a 6.7% total return. Broad bond indices1 for the U.S., Europe, Japan, and emerging markets delivered 5.5%, 7.5%, 0.5%. and 9.1%, respectively.
Buffeted by geopolitics, slowing global growth, OPEC+ supply restraint, plus Middle East and Ukraine wars, oil ranged between US$66 and US$93 per barrel, closing at US$71.65, down 10.7% on the year. Our loonie ranged between US$0.763 and US$0.721, ending at US$0.755 or C$1.324, stronger by 2.3%.
Our strategy – Balanced with an equity overweight
Our asset mix strategy involved an overweight to equities and an underweight to fixed income within our balanced framework.
Given that every client situation is unique, not all accounts required trading in all our asset mix decisions. Below is an outline of major trading activity for our most representative portfolios.
In Q1, we lightened up on mega-cap U.S. technology stocks, taking advantage of their strong performance. We bought international developed-market equities to offset these sales, bringing that weighting up to neutral. Additionally, in portfolios with exposure, we rotated some Canadian and U.S. large-cap equity exposure into small- and mid-caps.
In Q3, we shifted some of our bond positions. We purchased medium-term bonds (lengthening duration) to take advantage of the higher yields available. This also positioned us for superior gains should bond yields fall.
In October, we reduced our exposure to high-yield bonds (loans to companies with lower credit ratings), deploying the proceeds into higher-quality corporate, provincial and government bonds.
After the Fed’s December 13 meeting, North American bond yields plummeted and prices rose. We took advantage of this move to crystalize gains from the duration-lengthening we undertook in September. We didn’t expect this trade to bear fruit so quickly, but we felt that bond yields represented fair value and perhaps overshot in the near term.
We remain overweight to North American stock markets, neutral to international developed markets, and slightly underweight to emerging markets. Equities provide a hedge to inflation and are always leveraged to growth – two scenarios we see more likely than recession. In an ugly scenario, growth and inflation fall too much. If that happens, we expect bond yields to fall even lower than recent levels, and our fixed income positions to provide ballast to portfolios.
The last word – An update to our 2024 Outlook
For our overall take on what will happen in 2024, see our 2024 Capital Markets Outlook: Plenty of Progress, Solid Foundations Laid. Below is an update.
In choosing a path, our goal is to remain objective. While we often take decisive actions, we know that hubris doesn’t pay. Open to opportunities, we forge ahead and strive to remain flexible in our choices, avoiding the pitfalls of dogmatism. Like Keynes and Samuelson, when the facts change, we change our views.
We remain constructive on the investment outlook. A strong foundation is laid for a continuing return to normal, where investors are rewarded across the risk spectrum. However, given the rally in stocks and bonds, we believe some of the returns we expected in 2024 began to materialize late in 2023. We reiterate our S&P/TSX Composite Index end-of-2024 target of 23,000 (a full-year gain of 10%) and are upgrading our S&P 500 target of 4,900 to 5,100 (a 7% gain). We see upside risk to these targets as initial 2025 estimates call for 10% to 12% earnings growth. Much like what happened in late 2023, markets can move to price in the coming year in advance.
We are lowering our forecast for Canadian bond yields and bond market returns. We expect interest rates available on cash balances to be in the 3.75% range by the end of 2024. Our end-of-2024 call is for Canadian 2-year yields at 3.5% and 10-year yields at 3.25%, with total return potential from the broad Canadian fixed income market around 4%.
To you, our clients, we offer a heartfelt thank you for your faith and trust in us, allowing us the privilege of working on your behalf. Our responsibility to you is always front of mind.
Best wishes for 2024 to you and yours.
Please contact your Investment Counsellor if you have any questions or would like to discuss your investments.
1Bond indices are Bloomberg U.S. Aggregate Bond Index; Bloomberg Emerging Markets Aggregate Bond Index USD; Bloomberg Pan-European Aggregate Bond Index; and Bloomberg Japanese Aggregate Bond Index. Returns as of December 31, 2023.
Information contained in this publication is based on sources such as issuer reports, statistical services and industry communications, which we believe are reliable but are not represented as accurate or complete. Opinions expressed in this publication are current opinions only and are subject to change. BMO Private Wealth accepts no liability whatsoever for any loss arising from any use of this commentary or its contents. The information, opinions, estimates, projections and other materials contained herein are not to be construed as an offer to sell, a solicitation for or an offer to buy, any products or services referenced herein (including, without limitation, any commodities, securities or other financial instruments), nor shall such information, opinions, estimates, projections and other materials be considered as investment advice, tax advice, a recommendation to enter into any transaction or an assurance or guarantee as to the expected results of any transaction.
You should not act or rely on the information contained in this publication without seeking the advice of an appropriate professional advisor.
