Let's talk investing: Q1 2024 in review 

Speaker Key:

GS              Gregory Sweet

CM             Craig Maddock

WB             Wesley Blight

VO              Voiceover

00:00:00

GS Welcome to our listeners. I’m Greg Sweet, director at Scotia Securities Inc. Today we’d like to bring you a new podcast to continue empowering our clients and help them make important financial decisions.

The first quarter of 2024 is now complete. We saw a continuation of the rally in equity markets. I’d like to take some time to hear directly from our portfolio managers on what has happened so far in 2024 and what we can expect from the remainder of the year.

I’ve asked Scotia’s Multi-Asset Management Team to chat with me today, and here are our special guests. Craig Maddock, senior portfolio manager and head of the Multi-Asset Management Team, as well as Wesley Blight, vice president and portfolio manager on Craig’s team. Welcome, Craig and Wes. Thanks again for being here.

As mentioned, the first quarter saw a continuation of upward trend in equity markets, with global indices hitting all-time highs. What drove equity market performance during these first few months of the year?

00:00:56

CM Well, the recent rally in equity markets from Q4 into Q1 can really be attributed to a continuation of the same themes. We’ve got inflation. After the surge caused by the pandemic, inflation’s now moving significantly closer to central bank targets, which is around 2%. And while we haven’t definitively reached that mark, it certainly feels a lot closer to 2% than the 10%. And that’s of course a positive sign.

As well, we’ve seen economic performance. So, despite some of the challenges, the economy actually continues to perform quite well, specifically looking at the US economy. And that introduces this idea that maybe we’re going to end up with a soft landing, and that’s the idea that the central banks can bring inflation back to their roughly 2% target without fundamentally disrupting the economy. That’s actually quite attractive.

Market expectation is that the restrictive policies can be eased, which relate of course to interest rate cuts, and these cuts were initially planned for the first half of the year, but even that, the timing’s a little bit flexible. And then the large central banks, especially the US Federal Reserve, are likely going to start doing this later in the year.

00:01:59

And then final piece of that is market sentiment. This positive outlook has fuelled a euphoria in the stock market. There’s this widespread belief that we’re going to miraculously avoid a recession in the US. Companies are expected to maintain improved profitability, and consumers’ ability to spend remains robust.

So this convergence of these factors has contributed to this optimistic outlook for both the economy and the stock market.

Then we get a final piece which is sort of like a cherry on top. It’s artificial intelligence. AI continues to evolve, and it’s resembling an ability to replace not just traditional intelligence but also traditional work. Its role involves filling the gaps and theoretically making companies more efficient. Artificial intelligence has the potential to displace expensive labour across a wide range of areas. This, coupled with advancing technology, generates excitement that permeates the market. It’s one of the reasons people went into stock markets reaching all-time highs.

This prevailing optimism hinges on two key factors. One is the economic outlook and the expectations that the economy will remain stable. Two is sector growth. Certain sectors, particularly technology in the US, are expected to yield long-term benefits. However, it is essential to acknowledge that perhaps everything is priced to perfection, and therefore the inherent risk lies in the possibility that we may not achieve that elusive perfection after all.

00:03:23

GS Although there’s been a short timeframe, how have the Scotia portfolio solutions performed year to date?

WB All in all, we’ve seen a great start to the year in the first quarter. A key takeaway here has revolved around the distinction between income oriented strategies and equity oriented strategies. Over the long term, these approaches align differently. They’re targeting different total return outcomes.

Now, income oriented strategies, they have a higher allocation of fixed income. They tend to yield lower returns relative to their equity focused counterparts. That’s directly aligned with our long-term capital market assumptions. And that was the case during this most recent quarter.

Now, the equity oriented strategies, on the other hand, those with higher allocations to equities, have performed remarkably well, and this outperformance is actually above our long-term capital market assumptions and underscores the positive backdrop that Craig discussed initially.

On the bond side, fixed income return from the Canadian Universe mandate perspectives, and the benchmark, has been negative year to date. But because of the active strategies that we’ve implemented in our more fixed income oriented portfolios, specifically focusing on lower duration and having an increased allocation to credit, we were able to mitigate some of the adverse impact that was caused by rising bond yields early in the new year.

00:04:56

Now, our positioning across the yield curve and our duration positioning helped to preserve capital as bond yields increased, which resulted in moderately negative fixed income returns. Now, this approach benefits our active portfolios and may not have been equally advantageous for all fixed income investors in the Canadian market.

So in summary, our portfolio solutions, particularly those emphasising equities, have exceeded our long-term projections within this single quarter, and that’s thanks to the strong performance of equity markets.

GS Do you see this performance continuing into Q2 or do you see risk in overvaluation at the current levels?

CM This is an important question, and one that many investors are asking themselves. Will this strong trend continue over the next couple of quarters? Perhaps not, given the rapid and robust performance we’ve witnessed in the last few months. In fact, relative to our long-term assumptions, we’re currently ahead of the curve, which doesn’t necessarily make equities more likely to correct from here, but it does make it potentially more painful if they do.

But when discussing equity markets, I think it’s essential to consider the total portfolio, which encompasses both equities and the fixed income side of things that we use to balance out the total portfolio.

00:06:11

GS As Wes mentioned earlier, the story wasn’t quite as positive during the quarter. We saw a trend reversal from last year’s performance and bond indices finished in negative territory. What was the reason for this performance?

WB Entering the year, the market’s expectations were more aggressive. They were anticipating additional central bank rate cuts beyond what we had initially foreseen. And as the market gradually realised that these central bank rate cuts were unlikely to materialise until the latter half of the year, fewer than what they’d expected entered the year. Bond yields were ultimately driven higher.

Now, our belief being that there was going to be fewer cuts than what the market had assumed, we’d actively positioned our portfolios with a more defensive posture by reducing exposure to duration.

Now, additionally, we maintained an overweight allocation to credit, and that strategic approach that we carried through aligns with Craig’s earlier discussion about equity markets outperforming. By emphasising and higher allocation to credit across our fixed income exposures, we not only preserved capital, we also added value at the portfolio level.

Ultimately, as the market’s interpretation of monetary policy actions unfolded rapidly earlier in the quarter, so think back to January and February, we were able to take advantage from a fixed income perspective to capitalise on the opportunity to preserve capital and our agile process allows us to adapt promptly if things continue to change, ensuring that we can seize any advantages that come our way.

00:07:53

GS There’s a lot of discussion about the magnificent seven companies recently and their influence on market dynamics. Do you see this concentration as a risk, and how are you positioning our portfolios to manage this risk?

CM Part of the growing risk lies in this increasing concentration of market capitalisation within just a handful of companies. When a significant portion of the market relies on these select few, their performance becomes pivotal for the overall trajectory. And let’s face it, markets can appear priced for perfection, riding high on optimism, but really it’s a little bit more nuanced.

Think back. Initially, we had the FANG stocks, Facebook, Amazon, Netflix, Google, yet over time this group has evolved to include Microsoft, Tesla, Apple, while dropping Netflix and eventually adding Nvidia. While not performing as strongly this year, this group has remained extremely influential. And of course, Nvidia continues to surge.

So the composition of this elite group changes dramatically. The notion that these seven companies will forever control the world is flawed. New players do emerge. Existing giants adapt. Thus, the risk lies in overpricing these companies, assuming that they’ll maintain their perpetual perfection.

00:09:05

Of course, concentration feels wonderful during the ascent, but for those who can recall the IT bubble collapse in the 2000s, a true word emerges, risk. Our approach differs. We don’t limit portfolios to just seven stocks. Our portfolios are built off of hundreds of different stocks with select styles, using different individuals and teams and processes to select them and to figure out what makes sense today and going forward.

So, we’re not ging to overconcentrate or emphasise on a particular group of companies or stocks in our portfolios. Now, arguably, if a client wants to that on their own, I would caution them to do it lightly. But for us, we will always manage a well-diversified portfolio.

GS Inflation continues to be top of mind for investors and central banks. There has also been rising expectations of US economic growth throughout the first quarter. Do you think the Fed will still be able to cut rates with this backdrop?

WB Inflation certainly has been stickier than many market participants and even us have expected, particularly the core components of inflation. Headline inflation dominates the news. That’s what we continue to see in the headlines. But it’s actually the core inflation that truly matters. And housing prices, both in the US and in Canada, have remained elevated for structural reasons. This is resulting in a return to central banks’ long-term inflation targets having taken longer than expected.

Now, that does bring up an interesting point though, in that central banks’ forward-looking view continues to indicate a decline in anticipated inflation, and that aligns with their guidance that they provide to the market. It also aligns with economists’ forecasts.

00:10:48

Now, we’ve clearly moved away from peak inflation levels, and looking ahead, inflation is projected to gradually recede. That allows central banks the flexibility to consider rate cuts in the latter half of the year. Now, it may take even longer for central bank changes to have the desired impact in the economy because there is a lag for how long that takes. The transition from lowering rates to actually seeing inflation come down, we’re seeing that lag today.

So, think back to late 2023. They started guiding that they were going to be cutting rates, and it’s really the same thing that they did when they were starting to raise rates back in 2021. They started to guide first, hey, we’re going to have to increase rates. Eventually they did increase rates. We’re in the same spot now in that they are going to be cutting rates, and providing guidance that they’re going to be cutting rates, but we need to be patient for that cycle to begin.

CM This discussion brings me back to a point I briefly touched on at the beginning but didn’t really delve into deeper. It’s this idea of a soft landing, a scenario where the economy settles into a reasonable growth rate and inflation also recedes. Previously, the Federal Reserve discussed this concept of transitory inflation. Many people interpreted that to mean that inflation would just swiftly revert back to its previous levels, almost magically.

00:12:09

But I believe there’s a subtle undertone to this transitory concept. It suggests that the policy rate hasn’t necessarily done much to either drive high inflation or curtail it. Instead, we’re just simply working through the supply dynamics, such as the release from our COVID-induced home confinement. And this leads us to an interesting question. Can we say with complete certainty or even a high degree of confidence that the Federal Reserve will need to cut interest rates?

Typically, the Fed cuts rates because the economy has stalled out, crashed into recession and needs a kickstart. But what if the economy never stalls out and doesn’t need a kickstart? What would they need to cut rates for in the first place, if the economy’s functioning well? So, if people are willing and able to borrow and the higher cost of borrowing isn’t providing to be too restrictive, then there’s no need for further restrictive policy. Perhaps this is the new neutral.

And this is the ongoing debate that the markets have. Will the Fed cut rates? We think they probably will a bit, but will they cut as much as people previously thought? Well, it certainly doesn’t seem so now.

GS What about the Canadian story? Inflation has decelerated here more than south of the border. Are we going to see rates come down, and when?

WB We’ve seen a growth slowdown in Canada, and we are expecting that there’s going to be further slowdown in Canada relative to the more resilient and robust growth that we’ve seen in the US. Our view is the knock-on impact of that slowdown in growth is that inflation is going to continue to come down and decelerate more quickly in Canada than what we’re expecting to see in the US.

00:13:42

This is likely in our view to cause the Bank of Canada to move more quickly in terms of cutting its rate, and then cutting its rate to a lower, neutral rate, that’s the long-term equilibrium, than what Craig just referred to in the US. So, our view is that these changes are going to happen.

There are some additional considerations however for the Bank of Canada that they need to think through and that ultimately, they could potentially re-accelerate inflation through housing, as we know that the supply-demand mismatch in Canadian housing is still pretty high.

Now, we do have that lack of supply for the continued demand that does keep house prices elevated in Canada, and if you see the Bank of Canada rate coming down, which we do, it’s possible that we’ll see a re-acceleration of that house price problem that we’ve had since at least the mid-2000s.

Now, I think that you will see the Bank of Canada cut rates more aggressively, but there’s a limit to how fast they can go relative to what the US Federal Reserve can do.

GS During our last Q4 podcast we talked about some Canadians who unfortunately got out of the market during volatile times in 2022, and may have found it very difficult to re-enter the market. Now that we’ve seen some significant rallies, is it too late for these investors?

00:15:04

CM Assuming we’re referring to long-term investors here, these individuals are looking to participate in market growth over decades, as opposed to focusing on the next quarter. But as we’ve recently discussed, there’s potential volatility due to uncertainties around inflation or other market dynamics, which may cause some ups and downs.

However, my guidance for these long-term investors is not to overthink it or try to predict these market movements. Even for us professionals, timing the market is particularly challenging. It’s even more difficult for an individual investor to time their entry or re-entry to the markets perfectly.

So, no, it’s not too late to invest. If you have a long-term perspective and you use a portfolio approach, there’s no reason why you shouldn’t be in the market today. And of course, if you’re already in the market, there’s no reason for you to not continue investing. So I’d say, if you have a significant amount of money on the sidelines, it’s advisable to get back into the market. And of course, you can certainly work with your advisor to come up with a plan that suits your needs the best.

At the end of the day, what truly matters is that clients invest in the right strategy and stick to it. This approach offers the highest probability of realising your long-term objective. It’s not really about timing the market perfectly but really staying invested and reaping the benefits over time.

00:16:14

GS Well, Craig and Wes, I think that’s probably a perfect place to cap our conversation today. I’d like to thank you both for sharing such great insights to our clients. Our goal is to deliver with advice for every future.

To our listeners, thanks so much for investing your time in this discussion today. Thank you very much, and keep investing.

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00:18:01