Goldilocks and the three bears

In an ancient Scottish tale, Goldilocks enters the home of the three bears while they're away, eats the bear cub's bowl of porridge left to cool on the table and finds it perfect: neither too hot nor too cold. She then falls asleep in the bear cub's bed.

The tale of Goldilocks is often invoked to refer to a certain state of grace in the economy: neither too hot (with no inflationary pressures), nor too cold (stable growth and full employment). In the last quarter of 2023, financial markets behaved as if central banks had managed an improbable soft landing for the economy and beaten the inflation that had been raging for 2 years, without causing a recession. In a word, Goldilocks.

The consensus on the stock markets is that - having beaten inflation - central banks will be able to cut interest rates in 2024, which would be good news for just about everyone, including listed companies. After undergoing a correction from the end of July to the end of October, the S&P 500 index of US equities rebounded strongly in November and December - as the soft landing hypothesis gained increasing support - to end the year up 26.3%. Canadian equities had a more ordinary year, up "only" 11.8%.

The bond market also reacted strongly, with the yield to maturity on US bonds maturing in 10 years falling from 5% in mid-October to 3.9% by the end of the year. Conversely, the price of bonds in the portfolio rose by 9.9% during this period, and by 6.7% in 2023.

These returns from the 2 main asset classes have enabled the balanced portfolio (60/40) to record an increase of over 10% in 2023.

Without wishing to be a killjoy, we should point out that we're not necessarily out of the woods yet, since the full effect of an interest rate hike can take up to 2 years to be felt. So we can't rule out the possibility of a global economic recession in 2024.

Perhaps this is how we should interpret the sharp rise in bond prices over the past 2 months: people are buying them not only because they now offer an attractive return, but also because they will protect the value of their portfolio in the event of a recession.

In the earliest versions of the tale, when the bears return home, they kill or frighten Goldilocks to put her to flight. In more recent versions, they are much kinder, and even show her the way back home. In our case, let's hope the bears simply don't return home in 2024!

Happy New Year to all!

Market Review

Canadian equities: Shopify again

Like most of the world's stock markets, Canadian equities have posted strong gains over the past two months, up 8.1% over the quarter, taking annual performance to 11.8%.

The Canadian stock market is poor in technology stocks (9% of the index vs. 29% in the U.S.). It is therefore all the more remarkable that one technology stock - Shopify, +119.4% for the year - alone accounts for over 40% of the Canadian index's return in 2023. Even so, this e-commerce company's shares are still down nearly 50% from their peak in 2021, illustrating the vagaries of stock selection.

The more encouraging economic outlook for 2024 particularly benefited the finance sector, with a return of 11.7% for the quarter and 9.1% for the year.  

The price of a barrel of oil fell slightly during the year, explaining the modest 1.0% return from the energy sector.

With bonds once again offering attractive yields, high-dividend stocks lost their appeal, which partly explains the underperformance of the communications and utilities sectors, down 9.2% and 4.3% respectively.

The price/earnings ratio of the Canadian S&P/TSX index is 13.7x , compared with 19.8x for the American S&P500 index. This gap largely reflects the higher valuation of the technology stocks that dominate the U.S. stock market. Not only are Canadian stocks less expensive, they also pay much higher dividends: 3.2% in Canada vs. 1.5% in the U.S. American investors would do well to make a few purchases north of the border.

US equities: technos again

For a decade now, the U.S. stock market has been beating other global exchanges, largely thanks to technology. 2023 was no exception, with an increase in Canadian dollars of 9.0% for the quarter and 23.2% for the year.

Contrary to the pessimistic predictions of the "experts" at the start of the year, the S&P 500 index has more or less erased its 2022 losses. For its part, the NASDAQ 100 index - even heavier in tech stocks - had its best year since 1999 (shortly before the tech bubble burst!), up 55.1%.

As is usually the case, the sectors that suffered most during the 2022 downturn enjoyed the best returns in 2023: technology (+56.4%), communications services (+54.4%) and consumer discretionary (+41.0%). The last shall be first!

Two factors explain the resurgence of these sectors. On the one hand, signs of slowing inflation are benefiting them more, since their valuation is much more sensitive to changes in interest rates. Secondly, the idea that artificial intelligence (AI) could emerge as a new growth driver for major technology companies has generated a lot of excitement among investors.

Dubbed the "Magnificent Seven", seven companies have been the main beneficiaries of the AI rush, contributing over 60% of the S&P 500's return.

Over the past two months, small- and mid-cap stocks have also done very well, narrowing the performance gap between them and large-caps.

International equities: action in Japan

International equities offered a return in Canadian dollars of 7.7% for the quarter and 15.4% for the year.

As the world's largest market in terms of market capitalization, Japan is currently at the center of a major reform aimed at encouraging companies to focus more on the growth and value of their shares on the stock market. In addition, new tax incentives are being offered to encourage Japanese households to invest in equities. These incentives, combined with robust economic growth and low interest rates, no doubt explain the 27.1% performance of Japanese equities in 2023. However, the yen's depreciation against the Canadian dollar reduces the Canadian investor's return to 15.8%.

On the other side of the Atlantic, the economic outlook is also beginning to improve, which helped European equities post an excellent quarter, up 10.2%, and a 16.3% return for the year. Italy and Spain, led by the performance of their banks, topped the European stock markets, up 31.3% and 26.0% respectively.

Emerging markets: slowed by China

The MSCI Emerging Markets index returned 5.3% in CAD for the year 2023, while the underperformance of Chinese equities cast a shadow over the excellent year of the other main emerging stock markets.

With the economic recovery falling short of expectations, exacerbated by the real estate crisis and trade tensions with the USA, Chinese equities fell by 11.4% over the year. China's woes are nothing new, as the chart below shows. While we wait for recovery, we buy these stocks at a discount when we systematically rebalance the portfolio, as Archer does.

Elsewhere in the emerging markets, Taiwan (32.5%) and South Korea (26.3%) were the strongest performers, largely due to their concentration in the technology sector.

We should also mention the performance of Indian equities, up 25.9% in 2023. As we mentioned this time last year, India is benefiting in part from the inflow of foreign capital from China.

Bonds: the pendulum suddenly swings back

Having just approached the 5% mark in mid-October, the yield to maturity on US 10-year bonds quickly retreated to 3.9% by the end of the year. In Canada, the yield to maturity on 10-year bonds ended the year at 3.1%, while the bond portfolio gained 6.7%.

As with equities, it was the predicted death of inflation that triggered the sharp rise in bond prices at the end of the year. Less inflation means a higher expected real return (net of inflation) for bonds, making them more attractive.

Those who gave in to the temptation to buy 5% GICs rather than longer-dated bonds have already lost out. They are likely to renew their GICs at a much lower rate in 2024.

If the global economy suffers a recession in 2024, we'll be relying on bonds to do the heavy lifting in the portfolio, while equities suffer a correction. Otherwise, interest payments can still be counted on.