Craig Basinger – Chief Market Strategist
Let’s start by taking a big step back. Over the past couple of years, we have been enduring a great reset following a decade-long period that was characterized by disinflation, lower economic growth, low yields and lots of monetary stimulus. Disinflation gave way to inflation. Low yields gave way to higher yields. Lots of stimulus has given way to monetary tightening. A period of steady asset price inflation, stocks, bonds, and real estate has given way to the repricing of everything. Credit has gone from widely abundant and very low cost to less availability and higher cost—the result is lower prices of assets.
Some prices adjusted quickly, as was evident in falling stock and bond prices in 2022. Some prices are more sticky due to greater friction in pricing, and transactions take longer. Such as with real estate. 2023, while not a fantastic year, has turned out well. Some equity markets recovered well, including the U.S. and many international markets. Even the TSX, which lagged, has managed high single-digit returns. Bonds, too, are up lower single digits (at the time of writing near the end of November).
As we near 2024, has the great reset run its course? We don’t think so. While parts of the market react quickly to a new world (or, more aptly, a normal world after a decade of too much credit at too low a cost), such as the global equity market and bond market, other parts take time to recalibrate. The economy, corporate and consumer behaviour, and real estate all adjust more slowly and are likely still adjusting.
The good news is we are probably in the final act of the great reset (or 3rd act for any Shakespeare lovers). We believe it will include a recession, higher credit spreads, more bankruptcies, margin pressure and likely lower valuation multiples in the equity market. We are closer to the end and start of a new market cycle, but this act will likely be the most exciting (exciting when it comes to investing is usually not enjoyable).
So, what do we expect next year:
• Recession in 2024• Peak yields are behind us
• Margins have come under pressure
• Bonds outperform cash and likely equities, too
• 2024 will be another exciting year
1. Recession in 2024
Yes, we are one of the many who are calling for a recession, part of the cohort of economists crying wolf and still no wolf in sight. This has become the most talked about recession. We would also point out that the market is very confused at the moment. Some equity markets are pricing in recession risk, just look at the dividend payers or Canadian banks. Some equity markets remain euphoric, such as the S&P. Credit spreads remain close to historical norms, clearly not signalling trouble. Bond yields, still kind of high due to inflation, don’t seem to be worried about economic growth.
Add to this an inverted yield curve that has now been inverted for 13 months, coincidentally around the historical average lead time. Continued slowing global trade. Not to mention countries such as Germany, the UK, and now Canada flirting with recession, China slowing, and the list goes on. But then there is America, bucking the trend.
How to stave off a recession 101 – Let’s start by looking at the track record of policy. Governments around the world went to town implementing MMT to save the economy due to the impact of the pandemic. MMT, for those who hopefully have forgotten about this as it’s a terrible idea, involves the government spending money and the central bank buying government bonds to finance spending. It worked, protecting the economy, but it also created an inflation problem and likely many imbalances.
So now the monetary money printing has gone into reverse, BUT fiscal spending continued at levels rarely seen outside full-on recessions. Think about it: we have central banks trying to get inflation under control, and at the same time, the government attitude remains spend, spend, spend. So far in 2023, the average deficit (as % of GDP) across the US, UK, Eurozone, China and Canada is 5.6%, compared to 2.2% in the couple of years before the pandemic. This is anything but a coordinated response between monetary and fiscal policy. The fun part about economics is you really don’t know the impact or knock-on effects of policy for years.
How does this impact 2024? We believe the credit contraction, high rates, and past inflation will inevitably overtake fiscal spending… recession.
We are not going to bore you with a pile of charts that we have published over the past couple of quarters highlighting the recession’s early warnings. These include the inverted Yield Curve, Fed Recession Probability Models, Slowing global trade, the U.S. unemployment rate rising 0.5%, Negative Leading Indicators, and so on. Instead, let’s talk overnight rates. Most are aware of the historical pattern of the U.S. Fed raising rates, going too far, and presto, you get a recession. But it is not just rates, it's rates and lending standards. Fed hiking cycles that are not accompanied by a significant tightening of lending standards most often result in a soft landing. If lending standards are tightening, that leads to recession. Today, they are tightening.
Yes, continued fiscal spending may stave off recession, but our experience tells us relying on government policy rarely works out. In fact, this fiscal spending during past quarters of decent economic growth may help keep inflation higher than it could have been, which could keep overnight rates higher for longer as well.
The recession probabilities for the U.S. have been coming down over the past couple of months (currently 51% over the next year), but at the same time, have been rising in the UK (60%), Eurozone (65%), China (18%) and Canada (42%). We remain in the camp that preparing or positioning for a potential recession is the best path. And focusing market exposure in pockets that provide an added safety buffer from lower valuations.
2. Peak yields are behind us
It is not a huge leap of logic to connect our view that we have seen peak yields with our concern of a recession in 2024. We continue to believe, as we did a year ago, that inflation fears will soften, and this will lead to a rise in markets, both stocks and bonds. Yet this sweet spot for markets would pivot at some point as inflation fear would be gradually replaced by economic growth concerns. Today, we are still in the sweet spot. In 2024, we expect the pivot.
The naysayers of a recession continue to focus on the strength of the U.S. economy, helping offset global weakness. And the U.S. economy has proven very resilient, keeping U.S. yields higher. This strength is likely attributed to leftover stimulus or savings from the pandemic years, a decent labour market (which is weakening), and, of course, added stimulus following the regional bank funding mechanism. However, those savings are dwindling, labour is softening, and stimulus has turned in the other direction.
But you don’t need to look at the forward-looking recession warning signs any longer, as the real-time indicators are starting to pile up. U.S. unemployment has risen 0.5%, which has always been a threshold associated with the near onset of recessions. And then there are the Phili Coincident indicators. This index tracks multiple data points that have historically turned at the same time as the overall economy. It has never gone below zero without a recession in tow.
If this trend continues, yields will go lower.
3. Margins to come under pressure
Full disclosure: we have been expecting margins to come under pressure for a bit now (we are most often a bit early). Rising wages, rising interest costs, and rising input costs certainly have risen over the past couple of years for corporations. But we underestimated how easily companies would pass on those rising costs, perhaps because for much of the past two decades, companies did not have much ability to raise prices. With inflation rampant, companies did not hesitate to raise prices; everyone just sucked it up and paid higher prices. $900 to fly to Montreal, really? And no, it wasn’t business class. But we all managed to save margins, keeping them high and healthy; go, team!
Here comes the hard part: if inflation fueled higher input costs and higher sales revenue, now that inflation is cooling, how does it all work out? Or, more specifically, will cost inflation for corporations slow down faster, the same or slower compared to output price inflation? This does become very company or industry-specific, but a couple of factors have us believing costs won’t slow down as quickly, leading to margin pressure.
Interest costs are on the rise due to higher rates and yields. A handful of companies that have net cash may benefit from this but the VAST majority are seeing rising interest expenses. Variable debt costs have moved quickly, but now fixed term debt is gradually rising as bonds mature and are refinanced. In Q3 of 2022, S&P 500 companies paid a total of about $51 billion in interest expenses. This latest quarter, $64 billion. And this will continue to rise even if rates/yields start to come back down given its lagged temporal dynamics.
Then there are wages. Not sure if anyone noticed, but when inflation jumped to 7%, not many employers opted to increase wages in line. That was the sweet spot for margins, keeping wages in check and raising prices. Well, labour now has more bargaining power, and wages have been rising, playing catchup. Given the lagged dynamic in wages, it too could continue rising even as corporate pricing power wanes.
Finally, the mother of all determinants of margins, sales growth. Sell more units, raise prices, it doesn’t matter which. Sales growth and margins move hand-in-hand. Simply because corporations are leveraged entities, both operationally and financially. So the question then is where are sales heading? Once again, if we are in the recession camp, sales growth is going to keep coming down, and this will drag down margins too.
4. Bonds outperform both cash and likely equities, too
The U.S. aggregate bond universe has a yield to worst of 5.3%; the Canadian equivalent is about a point less at 4.3%, while cash is hovering at about 5%. Let’s go through some scenarios. Cash wins if inflation re-accelerates, leading to rising yields. Or perhaps strong issuance of bonds (supply) outpaces demand, leading to higher yields. While not impossible, we believe improbable. The economy is slowing, which should put continued downward pressure on inflation and yields. If yields fall even just a little further from current levels, which have already declined, bonds will perform better than the current yield to worst.
Cash rates are not likely to change in 2024. While the Fed Fund futures are pricing in 4-5 rate cuts in 2024 (1-1.25%), we remain unconvinced. Inflation should continue to moderate, but inflation is pretty sticky and likely not to fall enough to warrant such cuts. Of course, if the economy does weaken substantially, we could see more rate cuts, but this would also coincide with significantly lower yields, which would benefit bonds even more.
Put all this together, cash likely delivers about 5% in 2024, or a bit less if we get a few rate cuts. Bonds, using the U.S. aggregate, provide about 3.5% in coupon yield, plus 2% in price appreciation as most bonds are below par simply from moving one year closer to maturity, plus X% from a move in yields. A 0.5% move lower in yields across the curve would roughly add another 3% to returns given a duration of about 6. 3.5+2+3, sign me up. Double-digit bond returns in 2024 are not out of the question.
Equity returns, of course, will likely prove the most volatile and challenging, as they usually do. Global equities are currently trading at 17x estimated earnings for the next 12 months. It is a bit more expensive in the U.S. and less expensive in most other markets, including Europe and Canada. Meanwhile, earnings growth is estimated at about 10-12%.
Equity returns can be decomposed into three sources: dividends, earnings growth and a changing market multiple. Dividends will likely deliver about 2% of gains, and if earnings estimates prove accurate, markets would gain 12-14%, assuming a constant valuation multiple. These are big IFs. Since we believe a recession has a good chance of becoming a reality, the earnings growth could prove aspirational. And, if a recession starts to take shape, uncertainty about the future may have investors not willing to pay as high a multiple for estimated earnings. Also, let’s not forget that the longer-term average multiple is closer to 16. Many factors move the market valuation multiple, with rising uncertainty not being conducive to a historically elevated multiple. In short, this could easily lead to lower equity markets.
However, a full-year outlook for equities is challenging. The timing of this potential recession is very uncertain, and just as uncertain is when the market begins to price in the risk. Timing-wise, we could see a drop in equity markets and a subsequent recovery by the end of 2024. Of course, the depth and duration (or existence, for that matter) of a recession will be a huge determinant.
In short, expect a challenging year for equities and a bumpy ride. Add to this, the risks continue to rise as the current year-end rally, while enjoyable, further tempers our enthusiasm for 2024. There are some positives, though. If bond yields continue to come down, this is supportive of the market valuation multiple. And many pockets of the market are already pricing in some sort of recession, just look at international markets, the TSX at 12.5x earnings or those beloved dividend names that currently enjoy a solid valuation safety buffer.
We love bonds, we like cash, and we worry about equities. Hence our moderate underweight in equities and overweight bonds + cash. If it all works out, we will pivot to more equities on weakness. Timing will be everything, as Jack Burton often said – it’s all in the reflexes.
And finally...
5. 2024 will be an exciting year
View From the Top
Greg Taylor – Chief Investment Officer
It’s probably safe to say that 2023 didn’t follow the script that most investors had envisioned to begin the year. Coming off a rough 2022 that saw almost all asset classes fall, the mood was very sour and not many investors were optimistic about the future. Consensus expectations at that time centred around the removal of Covid stimulus programs and higher rates, leading to a global recession that would take down corporate earnings and result in another negative year for equity markets. However, as is often the case when everyone is looking for the same thing, the opposite can happen.
Now, as we look forward to 2024, it feels like almost everything has reversed from a year ago. Central bankers are signalling that they are ready to pause their rate hikes, maybe even do some cutting. And while many are still calling for a recession, those predictions seem less dire. We are hearing more comments that it will be more of a mild recession than one that would shake markets. There even remains a camp of investors calling for a ‘no landing’ scenario, meaning that we can avoid a recession. This sudden change in tone has helped valuations expand for many companies, in addition to earnings expectations of high single digits for the next year. So, as sentiment is seemingly positive and with last year as a good reminder, are markets at risk of missing something?
There are many sayings in financial markets, but one of the most dangerous is ‘it's different this time’. Unfortunately, we are hearing a lot of that lately, and this remains a risk to markets.
The ‘no-landing’ camp of investors are making the leap in their thinking that both markets and the economy will be able to withstand both one of the most aggressive interest rate tightening environments in history, along with one of the most inverted yield curves we have ever seen. This is dangerous thinking. In almost every case that we have seen both a large move in rates and an inverted yield curve, a recession has occurred, and markets have declined.
One of the problems that led some towards this line of thinking is general complacency. A quick glance at the year-to-date performance for the S&P500 will show high teens returns. With most understanding markets are forward looking, this can be taken as a sign that everything is ok. But it doesn’t take long to pull apart the returns to see that the overall numbers at an index level have been masked by the stunningly positive returns of a few mega-cap names.
Lots has been written on the performance of the Magnificent Seven stocks that have led the advance. There are lots of reasons why these few stocks have had such a strong year, and a good part of it is simply because they were down so much the previous year. But it was also a very good environment for these companies. The AI boom has kickstarted a wave of spending in this area and generated investor excitement of a new theme (reminding many of the dot.com hype). These large companies are also unique. Most have pristine balance sheets, and with no debt and lots of cash, they are benefiting from the rise in interest rates vs other parts of the market.
A reversal in bond yields next year, or even a drop from peak levels, will go a long way to reversing the negative sentiment around the sectors that have lagged the most this year. The divergence in performance between the winning groups (technology-focused) and the losing (REITs, Utilities, Financials) is close to extreme levels. The common factor is whether these groups are being helped or hurt by the increase in interest rates. Having these trends reverse will narrow this gap and sector outperformance could flip.
Having more sectors participate in a move higher can lead to an environment that is ideally situated for active management and security selection. Picking between winners and losers and sorting out overlooked names should add value. At the least, the losers certainly enjoy a valuation safety buffer. This would also be setting up for a change that investors would want to get away from just buying the index. With the huge returns of a very few names, the index is as concentrated as it has ever been before (U.S. market), and investors holding it are not getting the diversification they would normally be expecting as they are exposed to only a handful of these large stocks.
From a factor point of view, it may be time to look at quality. Companies across sectors that have been able to manage through higher costs and rates will be ideally suited to see margins expand if yields fall. It is also not the time to take on huge amounts of risk by buying deep value with a recession on the horizon; the margin of error will narrow, and many will wait for an all-clear to invest in some of the riskier parts of the market.
Putting it all together next year should remain volatile. We expect to see some form of a recession next year in North America. Canada may have a more challenging environment, given its housing market is more sensitive to moves in interest rates, but the US economy is also beginning to show signs of stress. On top of that, a US presidential election that looks very contentious will not help matters. Uncertainty is not the friend of markets. While valuations have rebounded on the back of a more positive outlook there is a risk markets have gotten ahead of themselves and pulled forward too much of the good news. This has left the market in a situation in which good news is priced in, and the only real surprise will be if it fails to materialize; that isn’t a good setup.
The risk/reward for investors is not great for 2024 at an index level. But it doesn’t mean all is lost. There are lots of outcomes that would lead to lower bond yields next year, and that will be a tailwind for markets. Bond-like equities that have underperformed for the last year should begin to turn up and outperform. Companies that showed leadership in a high-rate environment may lag. This reversal may be difficult to manage around but could also result in many opportunities for those who are nimble enough to take advantage of the swings and willing to do the work to determine which companies have been overlooked
The 5% Hurdle
Craig Basinger – Chief Market Strategist
Over the past year, we have all had to wrestle with a new, often uncomfortable question – will that new investment do better than cash? Yep, the hurdle for a good idea has gotten a lot higher, given the risk-free rate, which, at about 5%, is pretty attractive. It has been a long time since we have been paid this much to sit on the sidelines, and based on fund flows into cash products, the bleachers are pretty full. The logic of this increasingly popular choice is sound. Let’s say the long-term annualized return for global equities is 9%. Is that extra 4% over cash returns worth the risk? Especially since there is a ton of variance around that 9% with lots of 20%+ years and lots of negative ones, too.
In a perfect world, equities would return what they usually return plus a few points extra given cash, or the risk-free rate, is providing such an attractive return. Let’s call this a mythical world where the equity risk premium remains steady. (Equity Risk Premium is the excess return from equities over the risk-free rate). What a boring world that would be, and clearly, this world is not boring.
So, let’s dive in to see the historical impact of higher rates on historical returns. Seems like a good time to consider the impact of higher cash returns across the portfolio. Here we go:
We looked at returns from the 1950s till today, slicing the world into periods when the risk-free rate was above or below 3%. On a marginally positive note, the average monthly returns for various equity markets were a bit higher when interest rates were elevated. Global equities returned about 1% higher when cash yields were over 3% compared to below 3%. Also worth noting is that the average performance improvement in a high cash rate environment is more pronounced for bonds.
Of great importance is what happens next. If rates continue to rise, say as inflation starts to reaccelerate again, well that is not good for equities and worse for bonds. It's interesting that Canada does ok in this scenario; we will return to that shortly. If rates stabilize up here, well, returns are decent, a bit better than bonds. But if we get rates coming down, that is the sweet spot. Historically, it is very good for bonds and equities.
We would point out that the TSX was one of the best equity markets in the 2022 bear and has trailed other markets in 2023. Given our resource and bank exposure, the TSX has a bit of a built-in hedge against inflation and movements in yields. This helps explain the underperformance of the TSX in the 2010s and may be setting the stage for outperformance going forward, if you agree inflation will be a recurring risk in the coming decade.
It is not just rates that matter so much for market returns, it is inflation, too. And while they both do follow each other rather loosely, whichever is higher matters for future bonds vs cash returns. You see, if rates are higher because of economic activity and inflation is below cash rates, it's good news for bonds. Conversely, if inflation is running higher and cash rates are lower, this is bad for bonds. It is worth pointing out that the bond bear market over the past few years really started to get going at the end of 2021, when cash rates were 0.1% and inflation was 7%. They didn’t stand a chance.
But today, inflation is down to 3.2% (U.S. CPI), and cash is up at 5.5% (3-month Treasuries). You may love the 5% or so provided by cash or cash products, but we love bonds more.
Portfolio Positioning
Macro Team
We would characterize our portfolio positioning as moderately defensive. Holding above-average bonds and cash and less equities. However, there is still enough market exposure to enjoy the party in case this Santa Claus rally makes it all the way to the holidays, or dare we say, into January, which is typically a good month. But defensive enough that should things begin to deteriorate, we are decently positioned and becoming full-on defensive is just a few short trades away.
Among equities, we still favour international equities given the valuation safety buffer and since earnings estimates have already been revised lower. The allocation does have a developed market Asian tilt, with a positive view of Japan (more on this below). Underweight U.S. given valuations and earnings that we believe remain too optimistic. And finally, Canada market weight. The dividend factor is so beaten up, valuations so appealing that we can handle the economic risk inherent in the TSX. However, we would point out our underweight on banks… for now. More on this topic below as well.
This has our bond allocation boring as well. Focusing on government, investment grade, and now more comfortable with duration.
Recession risk is rather high as we head into 2024, and defense is the more prudent positioning. We, of course, will be closely monitoring our Market Cycle Indicators. They did capture the improving data trends earlier in 2023 but have started to roll over again of late. The recent weakness has largely been for the U.S. economy, while signals elsewhere have remained stable or even shown some little bits of improvement. If the signals deteriorate much further, we will likely be moving to be more defensive.
Sticking with the party terminology, we are at the party, standing near the door, sipping a light beer.
Japan Still Rising
Brett Gustafson – Analyst
Our positive view towards Japan started in the summer of 2022 with the rationale based on 1) a crazy weak yen, 2) Japan is a safer way to gain exposure to Asian economies that were coming out of lockdowns later than the West, 3) Valuations had the PE ratio near the lows of the past 25 years and the dividend yield near the top. And it has worked out; Japan is up about 23% since then, roughly the same as the S&P 500’s 25% advance. And well above the mere 10% for the TSX.
The yen did strengthen in late 2022, but in 2023, it reversed all the way back to about 110 yen to the Canadian dollar. In other words, it is still really cheap from a currency perspective. If you have come across anyone travelling to Japan, they can attest to their dollars going a long way, especially if they had travelled there a few years prior.
Of course, a cheap currency doesn’t mean it will go up. One factor that does matter is the relative hawkishness/dovishness of the central banks. For the past year, the U.S. Fed and Bank of Canada (BoC) had been increasingly hawkish, while the Bank of Japan (BoJ) was on this trend, too, but much more tepidly. Today, it appears the Bank of Canada and Fed are done hiking. If we had to guess who cuts first, we believe it would be the Bank of Canada (or should be). Meanwhile, in Japan, the more tepid moves from dove to hawk continue, albeit slowly. Put it all together, the direction of the relative hawk/dove tilt between the Fed/BoC vs BoJ should support the yen going forward. Or the historically high-rate differential between Japan and the U.S. or Canada should narrow or at least not widen anymore. The wildcard is if or when the BoJ relaxes yield curve control, this could result in a rapid rise of the yen.
But a weak yen has a silver lining even if it doesn’t strengthen. It is a boon for Japanese equities, notably those that have exposure to exporting. A good portion of the Japanese equity market sales are external, at about 50%. All these business lines, arguably, are more competitive when the yen is weaker. This should remain a boost for earnings. This is one of the reasons recession probabilities across major economies remain the lowest in Japan.
This brings us to valuations. A year ago, the Japanese equity market was trading about 13x earnings; today, it is about 15x. It's a bit more expensive but still on the cheaper side of historical averages. Price to sales at 0.8 remains near trough valuation levels. In total, it is not as compelling a reason to buy, but it is certainly still supportive.
When it comes to valuations, PE ratio in this case, it is important to remember that it is not just the P (Price) that can move; it is also the E (Earnings). Earnings expectations for Japanese equities have fallen decently over the past year. This may not sound like good news, but it means the market has started to price in an economic slowdown. For instance, earnings for 2024 have come down from 106 in January of 2022 to only 80 today. That is a 25% haircut. Conversely, S&P 2024 earnings forecasts have come down a paltry 7% during the same period. In a nutshell, earnings estimates appear more conservative for Japan vs the U.S. Add to this that revisions have stabilized and turned a bit up of late.
And then there is diversification. Sometimes good, sometimes bad, the TSX and the S&P are rather directionally correlated. I know, then, why isn’t the TSX up 19% this year like the S&P? Well, it's directional but not necessarily the same magnitude. Besides, the TSX did hold up better in 2022. The S&P does offer diversification as the correlation to the TSX is about 0.6, based on 3-month rolling returns back to 1990. Japan’s index on the surface may look roughly the same at 0.5, but this misses a key factor. Nobody cares about higher correlations when things are going up; it is more important to have a lower correlation when things are going down. Based on the same time period, only looking at periods when the TSX is in the red, the S&P 500 correlation remains at about 0.6, but Japan’s is much lower at 0.3.
Japan in a 2024 Portfolio
Suffice it to say that we remain positive regarding our overweight position towards Japanese equities in a multi-asset portfolio as we near 2024. The original investment thesis has an ever-increasing opportunity to come to fruition throughout 2024 as the BOJ continues to feel inflation, currency, and rate differential pressure. The opportunity is there; it has taken a little bit longer than originally anticipated to develop.
Japan has not been an easy place to invest for the past few decades. The challenging corporate environment has resulted in many portfolio managers being significantly underexposed to the second-largest developed economy in the world. However, it feels like the tides may be turning, as we have seen some improving economic conditions, such as wage growth and EPS growth over the past few years. If you believe in the overall thesis for Japan, do not lean on active international managers for a Japan allocation. Many remain underweight Japan’s weight in the passive MSCI EAFE Index. This presents an opportunity for multi-asset portfolio managers to stand out amongst their peers in what is seemingly a contrarian bet with much-improving fundamentals.
There are a few reasons why managers could still be underweight in Japan, including the perception of limited growth opportunities, demographic challenges ahead with an aging population or the expectation for continued currency pressure. While these are certainly risks for the market, we believe the story of improving fundamentals continues, and throughout the coming years, we expect to see a reversal in the above chart. The BOJ has already taken a few steps to loosen yield curve control and bring growth back into the Japanese economy, and with inflation steadily above their 2% target, we may yet see some additional tightening. The process will not be entirely simple, but if we get a US recession where they eventually cut rates, we may get a more successful pathway to outperformance in Japan. All in all, attractive valuations, a depressed currency, conservative estimates, and a low downside correlation to the TSX are enough to outweigh the risks.
Are the Banks a Buy? Banking on a Better Opportunity
Derek Benedet – Portfolio Manager
Once the bastion of safety, Canadian banks were long heralded as the world’s best boring banks. The big six are, for good measure, a staple across most investment portfolios. Love them or hate them, with a 19.4% weight in the TSX, their fortunes, for better or worse, play a large role in the overall performance of the Canadian market. Thanks to a long, steady history of solid profit growth and consistent dividend growth, it’s no wonder they are held in such high esteem.
But something isn’t quite right. The group is on pace to post their second consecutive negative annual return, falling 9.3% in 2022 and currently down –1.8% on a total return basis compared to a 7% gain for the S&P/TSX Composite for 2023. Consecutive down years are a rare occurrence, last happening in 07-08 and 98-99. Both periods saw pretty decent bounce back for the group, which begs the question: should we be buying the banks?
Positioning and valuations
Across our funds, we’ve been significantly underweight Financials, specifically the banks, for some time. This has worked out well. However, a time will come when we will be buyers. Valuations have declined by a decent amount this year. The average P/E across the big size is 9.3x forward earnings estimates. A full point and a half lower than where it stood at the beginning of the year. Looking back over the past twenty years, there have been only a few periods with such enticing entry points. Those were the financial crisis as well as the brief Covid sell-off. Both periods saw lower earnings valuations, so from a multiple standpoint, sentiment could get worse. On a price-to-book basis, with an average of 1.33, the group is nearing all-time lows but still trades above one times book value. It's enticing, but in our opinion, not enough.
Storm clouds are forming, and with profit expectations across the Big Six shrinking, we remain firmly on the sidelines. Across the Big Six, earnings estimates for 2024 have declined an average of 12% this year. Even with the recovery amongst the banks in November, the earnings expectations have continued to deteriorate. On Bay St., banks have been diligently slashing costs, with an increasingly widespread trend of reducing headcount. Besides recession concerns, the trajectory of Canadian housing remains front and centre. Mortgage book quality, negative amortizations, and renewal risks are all large and valid concerns. Shares certainly reflect some of the prevailing pessimism, but are likely not enough.
When deciding whether to add materially to the Canadian banks, there are a number of important factors to consider, which we’ve outlined in the table below. Before we get more constructive, we prefer to see more checks and fewer strikes.
In our previous report, "Preparing for the Next Bull," we also delved into the banking sector. Specifically, investors are shifting focus from growth and profitability to prioritizing credit quality, capital, loan losses, and overall financial strength. Lenders face significant challenges during periods of slowing economic growth, declining yields, and an excess of available capital. When capital becomes scarce and in demand, the advantage moves back towards lenders.
While we anticipate that banks will eventually thrive, we currently recommend a cautious approach, recognizing that there is no immediate need to rush given the looming recession risk combined with concerns about the housing market. Despite attractive valuations and yields, we believe that patient investors may find a better opportunity to buy the banks in the future.
2024 – The Year to Start Thinking Differently About Decumulation
Fraser Stark - President, Longevity Retirement Platform
The topic of ‘decumulation’ – the phase when investors draw income from their portfolio to meet their retirement goals – has become a sharper focus this year. Given our focus on outcome-oriented and lifecycle-driven investing, Purpose has written about it from several unique angles. These articles collectively address today’s challenges of investing for retirement in Canada and emphasize the need for further education and innovative solutions, personalized approaches to retirement income planning and a shift toward holistic wealth planning. Many Canadian retirees live off the returns of their investments in fear of seeing their portfolio balances decline and running out of money. Financial professionals who play a role in supporting Canadian investors through this phase must focus on providing them with the tools and education necessary to navigate retirement finances effectively while accounting for individual goals and circumstances. With 40% of advisors’ clients in Canada today in the decumulation phase, this is highly relevant to many investment advisors in this country. As we approach the end of the year, we wanted to weave four of these articles together into a more cohesive narrative.
"How to Solve Canada's Slow-Moving Retirement Crisis”
There is a retirement crisis slowly unfolding in Canada as a large number of baby boomers transition into retirement and life expectancy increases. The multiple intersecting uncertainties investors face in retirement – around market returns, cost inflation, and the unknown length of each individual's lifespan – make financial planning and portfolio construction immensely challenging. At the same time, the steady disappearance of Defined-Benefit pensions adds to the complexity, as these DB plans had muted the impact of these uncertainties for previous generations. Financial products like lifetime annuities and innovative lifetime income funds (such as the Longevity Pension Fund by Purpose) can play a role, yet much more innovation is needed. Further collaboration must follow between governments, private-sector firms, and non-profit organizations to provide Canadians with the tools and education needed to navigate retirement finances effectively. Governments have a strong incentive to see this happen, as the goal is not just personal financial security but also reducing the burden on public resources.
Full article HERE
“Consider that a 65-year-old woman entering retirement can expect to live on average to age 87. This average hides variability: she still has a 10-per-cent chance of living past 100, a one-per-cent chance of living past 105 and a tiny chance of reaching 110 or even beyond that (the oldest Canadian on record passed away at 117 years and 230 days). This variability makes determining how much to safely spend from her nest egg rather tricky.”
"Beyond the 4% Rule: Improving Your Safe Retirement Withdrawal Strategies"
The conventional wisdom of relying on safe withdrawal rates, such as the 4% rule, for safe retirement income is inadequate. The approach of self-insuring against the small risk of living a very long life is, for many people, suboptimal, while blindly withdrawing from one’s portfolio without consideration of evolving market and personal circumstances lacks plausibility.
A more dynamic and personalized approach to retirement income planning is warranted for almost all investors. Instead of focusing solely on portfolio management, clients should consider options like delaying CPP and OAS payments, purchasing lifetime annuities, or investing in lifetime income funds. By adding an element of longevity risk pooling to a portion of the portfolio, these products better align the assets with the total needs, making it a sort of personal liability-driven investing (LDI). The key is to tailor the portfolio approach to each individual's goals, risk tolerance, and desire for guaranteed income versus flexibility.
“One notable by-product of following this approach is that an investor should expect to leave to their estate an amount approximately equal to the “real” value of the starting retirement account. For some people, this might nicely align with their personal preferences and wishes, while it might be of little value for others and create suboptimal outcomes, effectively obligating them to leave a sizable estate even if that’s not their intent.”
Full article HERE
"Why Separating Planning for Retirement Income and Estate Goals Can Lead to Better Outcomes"
It is important to clearly articulate retirement income and estate planning goals and the trade-offs between them to achieve better outcomes for retirees. The traditional investment approach utilized during accumulation must be fundamentally rethought as clients enter the decumulation stage. Here, a holistic wealth planning approach is needed that considers clients' goals around spending vs. leaving a meaningful estate for their heirs and frames the client’s complete financial picture. The retirement portfolio can be divided into three functional sleeves:
- The first sleeve is for basic income needs (e.g. housing and healthcare) with lower-risk investments and steady cashflow; though not addressed in the article, suitable asset classes here would include ultra-short duration bonds, money market instruments, and lifetime income funds (e.g. annuities, longevity risk-pooling mutual funds, etc.).
- The second sleeve is for the client’s “wants and wishes” spending (e.g. travel, hobbies, gifts), with more risk-tolerant investments and less cashflow requirements than the basic needs sleeve; suitable asset classes to support this spending could include global equities and corporate bonds with less allocation towards cash and lifetime income funds.
- The final sleeve is purposefully designed for the estate, with a longer-term investment horizon allowing investors to take on more risk with little liquidity; additional asset classes to consider as part of this sleeve include long-duration bonds, private assets and alternatives.
The objective is to align investments with the client's desired lifestyle and legacy goals while balancing the trade-offs between those two.
“Every advisor will differ in what investments they use for their basic needs, wants and wishes, and estate sleeves, and how much to allocate towards each investment. What’s critical is that they first identify their clients’ goals across each of these sleeves and use outcome-oriented investments designed to reach each of the specific sleeve’s objectives.”
Full article HERE
Help Wanted: Navigating Decumulation for Plan Members
Decumulation is a critical transition within the second pillar of the Canadian retirement system: workplace savings programs. The challenges of converting lump sum retirement savings into lasting income are probably most acute for this group of middle-income Canadians. As these plans evolve, employers must maintain focus on helping their plan members achieve income security in retirement. With a growing number of Canadians entering retirement, portfolio construction alone cannot address the income planning challenges caused by lifespan uncertainty. It’s important to provide retired workers with complete confidence that their income will endure throughout their lifetime. Various strategies can be embraced by employers to make these savings programs more effective, including allowing members to stay in the plan after retiring, offering in-plan retirement income product options, providing financial planning consulting, and establishing a variable benefits program. For advisors, it’s essential to factor these workplace plan assets into your clients’ holistic financial picture, even though they fall outside the account they hold at the firm.
“But what do plan members want? Greenwald Research found that workplace retirement plan participants in the United States are looking for more options, specifically those that generate retirement income for increased security: 85% of plan participants wished their employer’s retirement plan offered an option designed to generate a stream of income in retirement. Consequently, the decision to include decumulation options is intensifying through industry associations.”
Full article HERE
Final Note
We’ve explored decumulation this year as a generational societal challenge and as a dimension of employers’ overall pact with their employees as key stakeholders. We’ve argued why applying simplified heuristics is inadequate and then shared a new approach to compartmentalize an investment portfolio into ‘sleeves,’ each in clear pursuit of a specific objective. Everyone involved in wealth management for retirement has an important role to play. Yet investment advisors, as trusted partners to their clients, can make a pivotal difference in whether those clients achieve their desired outcomes – or fail to. In 2024, rise to this challenge and lead as the tide continues shifting towards decumulation thinking.
Authors: Craig Basinger, Greg Taylor, Derek Benedet, Brett Gustafson, Fraser Stark
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Sources: Charts are sourced to Bloomberg L. P.
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