Market Update - Q4 2023 in Review
This quarter finally delivered the much-wanted relief of no rate hikes and, in the first weeks of the quarter, all of the talk surrounded “higher for longer”.
Market Update - 2021 Year End Review
January 18, 2022
2021 had been a splendid year for the equity markets of most developed nations. In the U.S, the S&P 500 rose <green>+26.89%<green> while the DJIA rose <green>+18.73%<green> [1]. In Canada, the TSX rose <green>+21.74%<green> [1].
A Year of Recovery
The world economy enjoyed a rapid and sustained recovery in 2021, a year after Covid-19 plunged the world into its deepest recession on record. According to the IMF, the global economy is expected to grow 5.9% in 2021 [2]. The U.S economy is expected to grow 6.0% for the year, while the Canadian economy is looking at a 5.7% growth [2]. China is expected to grow 8% for 2021, beating out the 6% growth that had been expected [2]. This recovery was helped to a large degree by the successful provision of vaccinations and an easing of lockdowns that devastated much of the world economy. The unprecedented combination of fiscal and monetary stimulus from governments and central banks around the world also provided the much needed tailwind for the economic rejuvenation.
Meanwhile, unemployment rates plummeted in the U.S, Canada, and Europe. As of December, the U.S. unemployment rate dropped to a low of 3.9%, compared to the 14.8% witnessed during the height of the pandemic [3]. The unemployment rate in Canada plunged down to 5.9% [4].
Still, not all nations have enjoyed an equal share of this recovery. Emerging economies have lagged those of the richer ones, as vaccine access for the poorer countries had been more limited. The IMF estimates that total GDP for advanced economies will exceed its pre-crisis growth path by 0.9% in 2024, but the emerging economies, apart from China, will undershoot that target by 5.5% [5].
As lockdowns were lifted and the economy started recovering, demand came roaring back. However, much of the global supply chain still remained in shambles, and this has in part led to the surging inflation we witnessed over the past year. In the U.S, inflation rose to 7% in 2021, the highest since 1982 [6]. In Canada, inflation hit 4.7%, the highest in 18 years [7].
In the corporate world, things started looking rosy again. Corporate earnings posted a strong rebound. Corporate revenues are estimated to grow 15.9% for the year while earnings are estimated to grow 45.2% [8]. This unusually high growth rate was due to a combination of earnings recovery in a growing economy and easier comparisons to weaker earnings in 2020.
However, it should be recognized that investors have raced ahead and priced the stock market up to record highs even as earnings improved. According to Bank of America’s Flow Show report, global equities attracted a record $949B of inflows in 2021, exceeding the cumulative inflow of the past two decades [9]. We believe the U.S equity markets at current price levels are fully incorporating the upsides. The current forward 12-month P/E ratio stands at 21.2, which is above the 5-year average of 18.5 and the 10-year average of 16.6 [1].
Finally, we witnessed increasing speculation in some corners of the market - a worrying trend for 2021. We saw elevated gambling on so called meme stocks and expanded speculation on cryptocurrency. We believe speculating on these names can have dangerous consequences, and we have repeatedly warned our investors over the past year not to partake in these trends.
Looking Ahead to 2022
The omicron coronavirus variant surfaced near the end of last year, dealing a major blow to investor confidence. However, recent data suggests that although the variant is more infectious, it causes less severe illnesses compared to previous strands [10]. Nonetheless, Covid-19 and future variants of the virus remain risks that investors need to be mindful of as we enter into the New Year.
Central Bank actions are another major event to watch out for this year. As inflation soared alongside a recovering economy, the Federal Reserve, together with other central banks, started to roll back the drastic support they implemented in response to the pandemic. In December 2021, the Federal Reserve announced an acceleration of its tapering pace. Tapering here simply refers to the Federal Reserve slowing its monthly asset purchases, which were used to stimulate the economy. It is now looking to end its asset purchase program in March instead of June [11].
The market now nervously awaits central bank policies on interest rates for the year. Undeniably, the central bankers’ jobs are presently more difficult, as they seek to respond to inflation without curtailing economic growth. The central banks of some countries, such as Great Britain, Russia, New Zealand and Brazil have already started lifting rates [12]. Still, the actions of the Federal Reserve remain the focus of the financial markets. The key question relates to how soon the Fed will raise its key interest rates from near zero. The market is anticipating three rate hikes in the coming year. Further, the Fed has discussed the option of reducing the size of its balance sheet soon after raising interest rates. For those who are unfamiliar with the concept, the Fed balance sheet is a financial statement showing what the U.S central bank owes and owns. The balance sheet can be used to orchestrate some of its nontraditional policies which are used to prop up the economy during downturns. The balance sheet expands to stimulate the economy, and it shrinks to slow it down/stabilize it.
Central bank actions are so closely watched because higher interest rates will negatively impact both stock (with certain exceptions, such as financial companies) and bond prices in general. These price declines will be more pronounced in certain groups of stocks, such as high multiple growth stocks. Growth stocks are equities that usually sell at a high multiple because they are expected to grow at a faster pace than the market. Sometimes these companies may not even have any positive earnings at the moment, but they are expected to eventually reward investors with future earnings. Some examples of current growth stocks include electric vehicle (EV) companies. These companies will do worse as interest rate increase in part due to the fact that when a higher discount rate is used to value equites, cash flows further into the future get a much bigger discount compared to present cash flows. Growth stocks tend to derive a much higher percentage of their value from the future, and thus their intrinsic value will be impacted more severely than value stocks. Furthermore, growth stocks need capital to grow. A higher discount rate will make it more expensive for these companies to raise capital, thus affecting their value.
A general decline in asset prices will undoubtedly affect our portfolios. However, we have positioned our portfolios in such a way as to reduce the impact such rate hikes will produce. For instance, over the past year, we have positioned our bond portfolios with a low duration strategy, which effectively makes it less sensitive to interest rate increases. Further, we have avoided the highly speculative, high multiple stocks, which are especially sensitive to interest rate hikes. As a side note, the tech stocks we do hold have very strong fundamentals, and should do well in the years ahead. Given that we bought these stocks at very low prices, we do not see a reason to sell them simply because the market might temporarily price them lower. Moreover, we have invested in several good financial companies, at attractive prices, during the depth of the crisis in 2020. These financial companies have already rallied substantially from their lows, but these businesses should continue to benefit as interest rates increase.
Investors should be aware that there may be increasing volatility around central bank actions this year. However, we would like to remind our investors that stocks represent ownership in businesses. As such, although volatility and fluctuations in market prices seem frightening, they are not true representations of risk. These factors should be evaluated in relation to the business fundamentals. Often, if fundamentals are agreeable, volatility and price declines may present good opportunities to buy. Overall, we are hopeful because although there are risks and pitfalls to be mindful of in the year ahead, there are also opportunities for the watchful investor.
1 Factset December 31, 2021 Price Return – End of Trading Day
2 https://www.imf.org/en/Publications/WEO/Issues/2021/10/12/world-economic-outlook-october-2021
3 https://tradingeconomics.com/united-states/unemployment-rate
6 https://www.theguardian.com/business/2022/jan/12/us-inflation-rate-december-2021
7 https://www.cbc.ca/news/business/inflation-canada-november-1.6286464
9 https://stansberryresearch.com/articles/equity-inflows-continue-into-2022-following-record-2022
10 https://globalnews.ca/news/8492903/omicron-covid-variant-mild-symptoms-who/
12 https://www.global-rates.com/en/interest-rates/central-banks/central-banks.aspx
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