Market Commentary: December 2023 : Nicola Wealth

Written as of January 15, 2023.

View the Nicola Wealth Investment Returns: December 2023.

Highlights this Month

December in Review

Markets concluded 2023 with a robust Santa Claus rally, marking the end of a remarkable two-month surge. In December, the S&P/TSX Composite Index saw a +3.9% return (in Canadian dollars), culminating in a remarkable +8.1% for Q4. The Canadian equity index experienced a commendable rise of 11.8% in 2023. On the U.S. side, the S&P 500 (in U.S. dollars) recorded a 4.5% increase in December, +11.7% in Q4, and an incredible +26.3% for the entire year. These outcomes defied the predictions made by many strategists at the beginning of the year. The NASDAQ, dominated by technology, outperformed further, posting a 5.6% increase in December, +11.0% in Q4, and an astonishing +41.2% for 2023. According to Scotiabank, in addition to Mexico and Latin America, U.S. stocks turned out to be the preferred investment in 2023.

For bond investors, the last two months of the year were transformative, with the Bloomberg Global Aggregate Total Return Index delivering consecutive monthly returns exceeding 4%, concluding the year with a solid 5.7% gain.

The end-of-year rally in equities was notably driven by "low-quality" stocks rather than the Magnificent Seven. Companies with questionable balance sheets, small caps, and value stocks outperformed. Bloomberg's before-and-after chart, using the November FOMC meeting as a dividing line, illustrated the market's shift. Before the meeting, nearly every asset class, except gold and possibly European investment-grade debt, was in negative territory. After the Federal Open Market Committee (FOMC) meeting, an "everything rally" buoyed the prices of most risk assets.

Reflecting on 2023 and projecting for 2024.

Reflecting on 2023 and projecting for 2024, gaining insights into the trajectory of 2024 and beyond requires an understanding of the dynamics of 2023—an unexpectedly robust year for both the economy and markets. Initially, economists widely foresaw a recession in 2023, predicting scenarios of elevated unemployment or soaring inflation. Yet, as of now, neither has materialized. The Bloomberg Economic Surprise Index highlights that the U.S. economy spent the majority of 2023 defying pessimistic forecasts.

The S&P 500's average year-end projection stood at 4,000 on December 1, 2022, representing a modest 4.2% gain from the previous year's close. However, the actual gain turned out to be approximately 20% higher. Bond predictions also missed the mark, as Bank of America expected 10-year yields to decline to 3.25% by year-end. Contrarily, U.S. 10-year Treasuries concluded 2023 unchanged at 3.87%, following a tumultuous period that witnessed yields approaching 5% in mid-October.

In this month's commentary, we delve deeper into the events of the past year, assess the risks looming in 2024, and explore some long-term considerations for investors.

The Fed’s balancing act and the resilience of the job market.

Explaining the substantial deviation between forecasts and actual outcomes last year, the primary factor is the belief that the U.S. Federal Reserve achieved an unlikely feat—a soft economic landing by curbing inflation without causing higher unemployment. Despite raising short-term interest rates, the job market has outperformed expectations, maintaining tight conditions. Surprisingly, inflation has subsided, despite historically low unemployment rates. The crucial question for markets is whether this unlikely relationship can persist in 2024.

The Wall Street Journal notes that from 2000 to 2008, inflation averaged around 3%, but the Great Financial Crisis lowered the average to 1.6% for the next decade. The pandemic caused a temporary spike in inflation. The key issue now is which normalcy will be reinstated. In the 1970s, inflation occurred in waves, receding for a couple of years only to resurface and reach even higher levels by the decade's end. According to Strategas’ Chief Economist Don Rissmiller, this pattern is not uncommon. Rissmiller's analysis of 2,100 years of inflation data across 24 countries revealed 62 instances where inflation exceeded 6%, and in all but eight, inflation resurfaced in multiple waves. The Fed acknowledges this risk, and Chairman Powell is cautious not to be labelled the next Arthur Burns—the Fed Chairman in the 1970s blamed for unanchoring inflation.

Based on the Federal Reserve's preferred inflation indicator, the PCE index (Personal Consumption Expenditures), inflation has not returned to the Fed’s 2% target on a year-over-year basis but has on an annualized 6-month basis. Goods sector inflation has already normalized, and service sector prices, while still elevated, have started to decline, according to Apollo. A critical factor in the coming months is housing costs, constituting about 16% of the PCE index (33% of CPI) and based on the owner’s equivalent rent. Although housing inflation should continue to recede with home prices trending lower since the summer, a recent uptick in home prices, as highlighted by Apollo, could challenge this optimistic trend. The impact of global supply chains on goods prices is also a point of concern. Strategas notes that the NY Fed’s Supply Chain Indices' steep decline has been interrupted, potentially leading to a resurgence in goods inflation in about six months.

Oil, one of the most closely watched inflation components, experienced a decline of over 10% in 2023 and nearly 25% since late September. Lower crude prices have translated to savings at the pump, with average U.S. gasoline prices ending the year at $3.66 a gallon. Despite wars in Europe (Ukraine) and the Middle East (Gaza), forecasters largely failed to predict this price trend. According to Alpine Macro, historical trends associate inflationary peaks with warfare, with oil playing a starring role. The difference this time appears to be record U.S. oil production. However, alongside housing and the global supply chain, oil remains an inflationary risk in 2024.

Deciphering the sudden shift in monetary outlook.

During a December 1, 2023 appearance at Spelman College in Atlanta, Federal Reserve Chairman Jerome Powell exhibited caution, stating it was premature for speculation on when policy might ease. Two weeks later, he nearly confirmed that the Fed was done raising rates and had pencilled in three 25-basis-point cuts for 2024. The markets responded by pricing in six 25-basis-point cuts, with the first expected in March. Powell's actions seemingly saved Christmas, or at least brought on the Santa Claus rally. However, what changed in two weeks? While inflation has trended lower, it hasn't declined enough to justify the probability of a March rate cut going from 10% in October to over 80% by mid-December. Lower inflation implies rising real rates if interest rates remain unchanged. Despite Powell's concern about the rising real Fed Funds rate, Bloomberg Financial Conditions suggest they are currently the loosest since the Ukraine invasion.

Market optimism vs. realistic expectations: assessing the likelihood of 2024 rate cuts.

Markets may be overly optimistic in expecting 1.5% in cuts this year. Scotiabank notes a tendency to overestimate both the timing and extent of Fed rate cuts. Traders, driven by the desire to boost the value of their holdings, advocate for rate cuts. Economists are more balanced, anticipating the first cut to occur in June, followed by only three more cuts in the second half of the year (four 25-basis-point cuts in total). Notably, economists differ in their views, with UBS forecasting 275 basis points of cuts starting in March, while Oxford Economics predicts 50 basis points of cuts starting in July.

If the Fed indeed saved Christmas, they had assistance. At the Treasury Department’s quarterly refunding announcement in early November, Secretary Yellen, a former Fed Chairperson, restructured the allocation of U.S. debt supply to include more T-Bills and less long-term debt. According to Strategas, in conjunction with a tacit confirmation from the Fed that they were done hiking rates, the Treasury Department's decision marked the inflection point for the S&P 500’s year-end rally. The same applied to 10-year bond yields, which rallied from nearly 5% to 3.88% by the end of 2023. While the Fed and Treasury Department seem to have conjured a temporary solution, the increase in longer-term government bonds' supply is inevitable with Treasury Bills now surpassing the 20% target range recommended by the Treasury Borrowing Advisory Committee.

The Fed and Treasury Department were uneasy with 10-year rates nearing 5%. But at what level are they comfortable? Strategas recently highlighted that 10-year yields, which had been in a downward trend for the past 40 years until recently, might signal a significant shift. According to Ned Davis Research, the 10-year Treasury yield historically slid an average of 90 basis points in the three months leading up to the Fed’s first cut. However, JP Morgan believes forces are pointing to higher U.S. bond yields in the future.

Barron’s Big Money Poll, comprising over 100 professional investors, indicates that 60% see 10-year yields at 4.50% or lower a year from now. Only 26% anticipate 10-year yields at 5% or higher. A December 18th poll by Bloomberg reveals a lack of conviction on Wall Street, with forecasts spanning a wide range. TD is among the more bullish forecasters, expecting the 10-year yield to fall closer to 3% by the end of 2024, while Barclays predicts a year-end close to 4.35%. Bloomberg notes that forecasts for the 10-year yield have typically been overly optimistic, with prognosticators underestimating year-end rates.

Predicting bond yields is inherently challenging. Accurate forecasts require getting short rates right and determining the appropriate spread for longer-term bonds. Short rates are heavily influenced by the Federal Reserve and monetary policy, referred to in bond trader jargon as r-star — the long-term or neutral rate that the Fed believes will balance the economy. Determining r* is notoriously difficult and can only be accurately assessed retrospectively. Bloomberg's model suggests that the natural rate troughed in the mid-2010s at about 1.7%, and Bloomberg believes it should increase to around 2.7% by 2050. This might be conservative, given Apollo's assertion that the Fed’s estimate for the long-run Fed Funds rate is close to 3%, and the 5-year forward Fed Funds rate is trading at about 3.4% in the futures market. For now, assuming the nominal neutral rate, or r-star, is around 2.5%.

Getting r-star or the neutral rate right is only half the battle. Once short-term rates are forecasted, determining the premium investors require for holding longer-dated bonds, referred to as Term Premium, becomes crucial. Term Premium is another unknowable number, even dramatized by some traders as “dark matter.” Since 2016, 10-year bonds have mainly traded with a negative term premium but have averaged about +1.5% over the past 60 years. JP Morgan notes that term premium has been highly directional with the slope of the yield curve during the QE era. A negative term premium accompanies an inverted yield curve, while a steeper positive yield curve historically results in a higher term premium. When inflation is subdued, and bondholders are penalized for taking duration risk, a negative term premium might make more sense. However, in a scenario where inflation poses a greater threat, term premium and the yield curve would likely turn more positive. Using the 60-year average of 1.5% and adding the baseline estimate for the neutral rate of 2.5%, a longer-term estimate for 10-year yields is about 4%, close to current trading levels. Bloomberg Economics believes rates are headed higher in the future as many factors driving r-star and term premiums lower are starting to reverse. Climate action and fiscal imprudence are cited as upside risk factors for 10-year yields.

While Bloomberg suggests the cost of building a zero-emission energy network totals upwards of $30 trillion, recent headlines focus more on U.S. government deficits and debt levels. According to the IMF, the U.S. is expected to be an outlier, with net borrowings of nearly 7% of GDP as late as 2028. Without significant reforms, the Congressional Budget Office forecasts net federal debt held by the public to exceed 106% of GDP, reaching 120% by 2033. Rising government debt levels have been associated with increasing bond yields since the pandemic. Treasury Secretary Janet Yellen’s decision in December to issue fewer bonds and more T-bills turned the tide, driving 10-year yields lower. Government bond supply appears to outpace demand, potentially causing 10-year yields to rise more than expected.

Political realities and the unlikely scenario of spending cuts.

Fiscal spending has boosted U.S. GDP growth, and with an election year, there's little motivation to curtail spending. While current government deficits and debt levels are unsustainable, there's no indication that the answer lies in reduced spending. Defense spending has trended lower, but arguments suggest a reversal as the peace dividend unwinds. Additionally, shifting to a green economy will necessitate higher government spending on infrastructure over the next decade. Although entitlement spending offers potential spending curtailments, it is politically impractical for any party to make unilateral cuts to Medicare or Social Security. Bilateral cooperation is even less likely, unfortunately.

Who will purchase all of these U.S. bonds? Historically, it has been overseas governments and banks. However, the Treasury Borrowing Advisory Committee, a group of Wall Street executives advising the U.S. Treasury Department, recently warned of dwindling demand from both. According to the Securities Industry and Financial Markets Association, foreign investors, both government and private, own about 30% of all outstanding U.S. Treasury debt. This is down from 43% a decade ago, with Japan and China among the countries diversifying away from U.S. debt. The U.S. dollar remains the world's reserve currency, allowing the U.S. to sustain a massive current account deficit. Countries with surpluses need a place for their savings, and U.S. Treasuries continue to be the preferred destination. While foreign governments will still need to hold U.S. treasuries, relying on them to buy more as U.S. issuance increases is uncertain. According to Goldman Sachs, U.S. households are expected to step in and become major buyers of new U.S. debt, but enticing them may require higher yields.

Addressing the U.S. budget deficit could involve another solution: increasing revenue through higher taxes, a logical move given the U.S.'s relatively low tax rate compared to other G7 countries. Alpine Macro reports that U.S. government revenue as a percentage of GDP is under 30%, compared to the G7 average of about 36%. While the U.S. has room to increase taxes, the political challenges are considerable. Another option is financial repression, where central banks artificially maintain interest rates below inflation, inflating away nominal debt levels. However, this strategy carries risks, as seen during the 1970s. The Bear Traps Report suggests a more subtle approach, such as the Fed adjusting its 2% inflation target to 3%, but concerns about potential inflation risks remain.

The direction of bond yields also affects equity markets. If the Fed allows inflation to stay above 3%, stock valuations may suffer. According to a chart by Verdad Capital, bonds and stocks have historically been positively correlated when inflation exceeds 3%. For the equity bull market to continue, a soft landing with decreasing inflation is necessary. Confidence on Wall Street was lacking in mid-December, with the average S&P 500 forecast for 2024 below the current market level, according to a Bloomberg MLIV Pulse survey.

Factors influencing market strategists’ estimates.

Earnings growth and valuation concerns are influencing market strategist estimates. A January 7th Bloomberg MLIV survey reports that 50% of respondents believe earning expectations for 2024 are too high. Current valuations, represented by the S&P 500 Cyclically Adjusted Price/Earnings ratio, are at levels only exceeded during the dotcom bubble. Hedge fund manager AQR notes the challenges, emphasizing the need for a reversion to the mean perspective and the potential positive impact of increased dividend yields.

One of the negative factors cited by Bridgewater is geopolitical risk. According to Bloomberg, a war between the U.S. and China over Taiwan would have the largest negative impact on the global economy, costing the world upwards of $10 trillion and shaving 10% off global GDP. Bridgewater also ranks a conflict over Taiwan as the biggest geopolitical tail risk for investors, with U.S.-China economic competition & declining support for globalization a close second. Not far behind is the 2024 U.S. Presidential election.

U.S. elections typically don’t impact markets, but 2024 might be the exception, and not just for U.S. markets and investors. While it’s still nearly a year away, the 2024 U.S. Presidential election is looking to be a rematch between current President Biden and former President Trump. It’s the second round of a fight no one wants to see, with Trump taking the early lead in recent polling. It’s likely to go down to the wire, with seven swing states destined to determine the winner. According to a December Bloomberg News/Morning Consult poll, Trump is ahead in all seven. Goldman Sachs believes Trump’s Republicans have a public opinion advantage on several issues important to voters. Republicans are trusted more than Democrats when it comes to the economy, inflation, and crime. They are also trusted more on immigration and the Israel-Hamas War, though Goldman believes these issues rank lower in importance to voters. Goldman’s view, not ours. According to Goldman, the Republicans' largest public opinion advantage over Democrats is immigration.

A notable weakness for the Democrats revolves around their presidential candidate, incumbent Joe Biden, whose approval rate stands at a mere 39%. This level of popularity is surprisingly low, especially for a first-term incumbent seeking re-election. Goldman Sachs notes that incumbents typically secure re-election outside of recessions, and the U.S. is currently not in a recession. The reasons behind Biden's poor polling are subject to extensive debate.

While factors such as his age and the perception that he is showing signs of aging contribute to the challenges, a more symbolic indicator of the negative public perception of Biden lies in polling around the impact of his policies on individual voters. Only 23% of respondents feel that Biden's policies have personally benefited them, while a substantial 53% believe his agenda has had a negative impact on their lives. In contrast, during Trump's presidency, nearly half of voters believed his policies were beneficial, with only 37% feeling adversely affected. This outcome is particularly disappointing for President Biden, considering the positive state of the economy.

There's still an opportunity for Biden to make a turnaround. As highlighted in a recent New York Times article, historical examples, such as Truman's post-WWII era, demonstrate that voters can be discontented even when the economy is improving. Pollsters were so confident of Truman's defeat that newspapers prematurely distributed editions with Dewey victory headlines.

For Biden to follow Truman's path, he needs to emphasize that the economy is nearly as robust as pre-pandemic levels. Specifically, he should underscore that workers are making progress, with wages rising faster than inflation. According to Strategas, it's uncommon for a President's approval rating to decline simultaneously with gasoline prices. As Democratic strategist James Carville famously said during Clinton's successful 1992 presidential run, "It's the economy, stupid." Biden must remind the American voter that the key issue is the economy, not implying any lack of intelligence on their part.

However, it's worth exploring the reasons behind Biden's low popularity. Yet, the question arises: are voters somewhat misguided? The contrast in public perception becomes more apparent when examining Trump's continued political relevance. Despite his refusal to accept the 2020 election results, a Monmouth University poll reveals that nearly 70% of Republicans believe him. In a December New York Times/Siena College poll, the same percentage of respondents expressed the view that Trump should still be the Republican nominee, even in the face of the four indictments and 91 charges currently against him.

Ironically, Trump's legal challenges seem to be working in his favour, as highlighted by recent observations from Strategas. The question lingers: are voters perhaps navigating a complex political landscape, or is there a deeper dynamic influencing their perspectives?

The perplexity arises: how can Americans interpret this situation in such diverse ways? The answer lies in their varied news sources. Gallup reports that Americans' trust in mass media has plummeted to an all-time low of 32%, with deep polarization evident in the news outlets preferred by Republicans and Democrats. Democrats often turn to CNN and publications like the Washington Post and New York Times, while Republicans lean towards Fox News and talk radio. Media sources themselves tend to tailor content to align with their audience's viewpoints, as evidenced by CNN and MSNBC leaning more left-wing, and Fox News and Breitbart drifting towards the right in recent years.

A concerning trend further complicates matters, as Pew Research indicates that over a third of U.S. adults under 30 obtain their news from TikTok. Notably, TikTok is a Chinese-owned platform, raising eyebrows about potential national security implications. This underscores the intricate landscape of media consumption, where diverse sources contribute to varying perspectives, making it challenging to achieve a unified understanding of events.

From Wall Street's perspective, the potential emergence of "The Don Part II" is not viewed as a financial risk. A Bloomberg MLIV poll conducted from November 27 to December 1 found that 47% of respondents believed the election would have no impact on their finances. Gallup reports that 53% of Americans believe the Republican party would do a better job in maintaining the country's prosperity.

JP Morgan holds a positive outlook, suggesting that the risk to the U.S. dollar would be skewed positively if Trump were to be elected and fulfill his promise of a 10% across-the-board increase in tariffs. Despite Trump's current lack of detailed policy proposals, a protectionist platform, coupled with pro-business measures such as lower taxes, reduced regulation, and less anti-trust scrutiny, is expected to be prioritized. Such a scenario is perceived as favourable news for Wall Street, satisfying the financial interests of some stakeholders.

The global community is closely observing and contemplating the potential ramifications of another four years of Trump and his isolationist policies. Geopolitically, concerns arise about the support for Ukraine being most at risk, with broader implications for NATO as a whole. Economically, Trump's perspectives on trade and building partnerships to counter threats from China could face challenges. Given the existing trend of globalization in retreat, Trump's potential return to office might accelerate and widen this process.

While Trump's policies may have short-term benefits for U.S. markets, there are considerable long-term risks. Determining how to accurately assess and discount these risks poses a challenge for the market, creating an atmosphere of uncertainty and caution on the global stage.

While our attention is focused on the 2024 U.S. Presidential election, it's crucial to acknowledge that this year holds global significance, being labelled as the most extensive election year in history by countries representing 40% of the world's GDP, according to Strategas. This massive global electoral event carries the potential for both positive and negative outcomes.

However, amid this democratic process, concerns arise about the rising trend of autocracies worldwide, putting the very essence of democracy on the ballot and making it particularly vulnerable this year. A notable threat further complicating matters is the potential manipulation of public opinion through AI-generated misinformation. The World Economic Forum's Global Risks Perception Survey highlights AI-generated misinformation as the second-largest threat for 2024, underscoring the importance of addressing and mitigating this risk in the context of global elections.

The most significant threat, often overlooked in headlines and social media feeds, is extreme weather. In 2023, there was a notable surge in extreme weather events, marking it as the hottest year on record, as per the Copernicus Climate Change Service. Average temperatures rose to 1.48 degrees Celsius above pre-industrial levels. In Canada, the impact was severe, with a record-breaking 45 million acres devastated by wildfires, surpassing the previous record of 17.5 million acres.

Despite the increasing threat, climate change tends to be perceived by many as a concern for the future, particularly among younger generations. Surprisingly, a larger percentage of respondents aged 29 and younger, 50.6%, identify rising prices as a more immediate problem, compared to 46.7% who consider climate change an issue. This brings to question the urgency of addressing climate change and calls to mind figures like Greta Thunberg, prompting the query: Where are the voices championing environmental action in the face of such challenges?

Renewable energy investment surges to record highs.

As previously mentioned, climate change is not being overlooked, and a significant transition is underway. Billions of dollars are being invested in alternative energy infrastructure, driving a surge in global renewable energy investment. According to Bloomberg, this investment reached a record-breaking $358 billion in the first half of 2023.

Another beacon of economic growth is artificial intelligence (AI), notably generative AI. Goldman Sachs has highlighted that generative AI alone has the potential to boost U.S. labour productivity growth by around 1.5% over the next decade. Alpine Macro points out that labour productivity growth often experiences long swings in trends, and the current phase could be the early stages of a new long-term higher trend. Higher-than-expected productivity growth would enable countries like the U.S. to achieve faster economic growth without triggering higher inflation. This underscores the positive economic impact of investments in renewable energy and AI technologies.

Why Canada is at risk of falling behind.

Unfortunately, Canada appears to be at risk of falling behind in certain economic aspects. According to Rosenberg Research, labour productivity growth in Canada is trailing behind the United States. The CD Howe Institute goes further, indicating that Canada ranks only behind New Zealand among developed economies in terms of non-residential capital stock per available worker. William Robson, the CEO of CD Howe, notes that Canada's capital per worker has been declining since 2015, a situation not seen since the 1930s depression.

The complexity of the issue is highlighted, with rising population growth often cited as a potential cause of lower productivity. Abundant labour may deter businesses from making capital investments aimed at enhancing productivity. According to Statistics Canada, Canada's population growth of 3.2% was the fastest since the 1950s, outpacing any G7 nation. Traditionally favourable views on immigration in Canada are shifting, as per a survey by Environics Institute, where 44% of respondents now believe there is too much immigration to Canada, compared to only 27% the previous year. This shift in perception adds another layer to the challenges Canada faces in sustaining productivity and economic growth.

It seems that the concerns Canadians express about immigration are more closely tied to its perceived role in exacerbating inflationary pressures affecting the Canadian consumer. According to Bloomberg, overall Canadian prices have surged by at least 10% from pre-pandemic levels, with food prices experiencing a nearly 14% increase. Housing is a particularly contentious issue, as shelter costs have skyrocketed by 13.9%, reaching record levels of unaffordability, as highlighted by Strategas. Higher interest rates contribute to this scenario, but the fundamental issue lies in increased demand outpacing supply.

Despite immigration being one of Canada's key competitive advantages, concerns arise due to its potential contribution to inflation. Canada's aggressive immigration policy, while strategic in addressing demographic challenges, can lead to inflation when not carefully managed. This poses a dilemma for the Bank of Canada, as noted by Northern Trust, given the country's higher sensitivity to interest rates, especially concerning residential investment. Striking a balance is challenging, as providing relief to over-indebted mortgage borrowers risks driving housing prices and inflation even higher. This complex situation has contributed to the sharp erosion of support for Prime Minister Trudeau and his Liberal colleagues. Fortunately for the Liberals, Canada is among the few countries not scheduled to have a general election in 2024.

Evaluating the speculation of a new normal.

For investors, the future may not mirror the recent past, and there is growing speculation about the emergence of a new normal characterized by lower investment returns. A recent Wall Street Journal article suggests that the summer of 2020 could be viewed as a high point for investors. To illustrate, $1,000 invested in Wall Street Journal’s hypothetical 60% stocks/40% bond portfolio at the end of 1981 would have grown to $18,728 by the end of 2020 when adjusted for inflation. Remarkably, investors during this period experienced only five down years.

In contrast, those who invested $1,000 at the end of 1965 would have been left with only $785 in real terms by the beginning of 1982. Bridgewater recently highlighted global examples where investors in balanced portfolios of stocks and bonds endured lost decades of returns, as seen after the U.S. financial crisis, stagflation in Europe during the 1970s, and the depression in Japan during the 1990s. According to Bridgewater, the exceptionally strong returns observed in the past decade (2010-2019) are unlikely to be repeated, signalling a shift towards a potentially less lucrative investment landscape.

There are still promising investment opportunities to consider.

While current valuations may not be particularly attractive, and duplicating the impressive earnings growth of the past decade could be challenging, there are still promising investment opportunities in both private and public markets. Bridgewater recently highlighted that the last decade was characterized by negative cash returns but exceptional beta returns (overall market returns), making alpha (stock-specific or investment manager skill) less crucial. Looking ahead, Bridgewater believes the next decade will see a shift towards a more normal beta, emphasizing the increasing importance of alpha.

According to finance professor Hendrik Bessembinder from Arizona State University, alpha has always been significant. His study of nearly 100 years of market data revealed that a surprisingly small number of companies contributed to the majority of the market's return over the past century. Only three stocks generated 10% of the market's total return, and 72 stocks created half of the market's total wealth. This concentration of returns is not a recent phenomenon, as similar patterns were observed in periods ending in 2019 and 2016.

A noteworthy example is the best-performing stock of the past 25 years, as reported by Barron's on August 28, 2023. Surprisingly, it is not a tech stock or a member of the current "Magnificent Seven" (Mag 7). Apple is the only Mag 7 member to crack the top five. The top spot went to Monster Beverage, with an annualized return of just over 31% per year from August 21, 1998, to August 22, 2023. This example underscores the unpredictable nature of top-performing stocks and the potential for alpha to play a crucial role in investment success.

Assessing cash as an investment option amidst record highs.

With short-term rates still offering attractive returns of upwards of 5%, cash has become a viable investment option. Apollo notes that money market assets have recently reached a record high of $6 trillion, with Strategas reporting a significant increase in investors allocating over $1 trillion to money market funds last year, indicating a 24% year-over-year growth rate.

However, the challenge with cash investments lies in the potential for rapid downward adjustments in returns if the Federal Reserve aggressively cuts rates in 2024. While a steeper yield curve could benefit longer-term bonds, their yields may also decline, albeit to a lesser extent. The combination of a high relative coupon and capital appreciation resulting from falling yields might make 2024 a favourable year for bonds. Nonetheless, investors need to tread carefully because, as mentioned earlier, a surplus of government bond supply is expected to enter the market in 2024. Investors are well-positioned to demand higher yields in exchange for their support, adding an element of caution to bond investments.

Analyzing the complex dynamics of gold as a hedge to geopolitical risks.

For investors looking to hedge geopolitical tail risks, gold has historically been considered an alternative to cash in certain situations. As of August 7, 2023, The Wall Street Journal stated that during market uncertainties, individuals often turn to gold. However, making a case for investing in gold becomes challenging when the real return (nominal yield less inflation) on U.S. T-Bills is positive. Investors can rest assured with their funds in U.S. T-Bills, as the U.S. government is unlikely to default, and unlike gold, they provide investors with a real yield. Historically, the price of gold has correlated with inverted U.S. real rates until recently. Since the beginning of 2022, real rates sharply increased into positive territory, but instead of declining, gold prices continued to rise. Bloomberg noted last October that traditional safe havens like long-term treasury bonds and the Yen failed to provide shelter to investors during market volatility after the Hamas attack on Israel. According to Strategas, neither did oil prices, which continued to trend lower after a brief spike in spot prices. However, gold continued its upward movement, leading Strategas to ponder the message conveyed by gold's price action. The key point here is that investors aren't obliged to invest in gold; there are alternative options for those seeking portfolio diversification. Still, they should remain vigilant to any signals that gold's price action may convey.

What message or warning does gold's price action convey? There's no shortage of choices as we venture into 2024. While elections attempt to take center stage, they may share the spotlight with central banks and plans to cut interest rates. Given the general forecasting inaccuracies of 2023, definitive predictions are approached cautiously. In this context, we present a list compiled by Bank of America highlighting their clients' least expected outcomes for 2024, termed "angry trades." Improved geopolitics tops the list, but other contrarian outcomes include a "hard" landing, higher inflation, increased bond yields, flatter yield curves, outperformance by low-quality (high-leverage) companies, and underperformance by the Mag 7. Embracing the opposite of conventional expectations, a strategy that worked for George Costanza in Seinfeld circa 1993, might hold potential for investors in 2024.

Disclaimer

This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information presented here has been obtained from sources believed to be reliable, but not guaranteed. Nicola Wealth Management Ltd. (Nicola Wealth) is registered as a Portfolio Manager, Exempt Market Dealer, and Investment Fund Manager with the required securities commissions. All values sourced through Bloomberg, unless otherwise specified.

Hypothetical performance results have many inherent limitations, only some of which are described below. No representation is being made that any account will or is likely to produce profits or losses similar to those shown. In fact, there are frequent sharp differences between hypothetical performance results and the actual results subsequently produced by any particular trading approach.

1) Hypothetical performance results are limited in that they are generally prepared with the benefit of hindsight.

2) Hypothetical trading does not involve financial risk and no hypothetical trading record can completely account for the impact of financial risk in actual trading. The ability to withstand losses or adhere to a particular trading program in spite of trading losses are material points which can adversely affect actual trading results.

3) Numerous other limiting factors related to the behaviour and performance of markets in general and/or to the implementation of any specific trading approach cannot be fully accounted for in the preparation of hypothetical performance results all of which can adversely affect actual trading results when compared to the hypothetical model.

Market Commentary: December 2023