Insights
Periodic insights from our Investment and Private Client Teams on a broad range of investment and advice-related topics
Published by the Private Client Team at KJ Harrison Investors
At KJ Harrison, we embrace a balanced, disciplined approach that focuses on preserving and growing wealth by investing in high-quality companies and securities for the long term. We do that the old-fashioned way: in-depth research, due diligence, and careful risk assessment. In short, our goal is to invest in businesses that will do well when times are good—and when times are bad.
However, that does not mean prevailing economic and market conditions are irrelevant. Quite the contrary. In assessing opportunities, we continually review and assess macroeconomic forces, which play an important (if often short-term) role in asset valuations and are crucial to accurately assessing risk. To do otherwise would be tantamount to burying one’s head in the proverbial sand.
In that spirit, we offer the current outlook for the rest of the year. It outlines our view on where markets are, how they got here, and where they may be headed.
The Recession That Never Was.
It might seem like forever ago, but 2023 began with nearly every economy-forecaster and market watcher predicting a downturn. In the spring, the collapse of three major U.S. banks – prompting a rapid and massive government bailout of the financial system – seemed to confirm all the dire predictions. As the U.S. Federal Reserve and the Bank of Canada, among other central banks, continued to raise rates into the summer, demand destruction in the name of defeating inflation, not to mention a dramatically inverted bond yield curve, pretty clearly implied a recession was imminent. The only real debate was how bad it would be.
And then a funny thing happened on the way to hard times: nothing. In the end, 2023 may be best remembered for the most predicted recession that never occurred.
Why not? One big reason was the jobs picture. In both Canada and the United States, the unemployment rate remained low and jobless claims barely budged. When people have jobs, they tend to keep paying their bills, no matter how high mortgage rates and other expenses may be. On top of that, one legacy of the COVID-19 period was very high savings rates. Consumers emerged from the worst of the pandemic relatively flush with cash, which provided a cushion for spending (and, by extension, corporate earnings) as inflation and interest rates rose.
We should note that there were sectoral slowdowns in 2023, for example in commercial real estate (another pandemic effect) and the industrials sector. Yet, despite pockets of weakness, the economy in aggregate avoided succumbing to systemic pressure. As the year ended, consensus grew that the Fed had managed to pull off the nearly impossible: engineering a “soft landing” for the economy despite hiking rates aggressively for the first time in years.
How real is the rebound?
In financial markets, a similar defiance of expectations occurred, although it unfolded in a much more dramatic fashion. Pessimism reigned from late July through late October, when the S&P 500 declined by more than 10% – a technical correction – and rate fears sparked the 10-year U.S. Treasury yield to above 5%. And then, on Oct. 31, Fed chair Jerome Powell lit a fire under market sentiment by suggesting that the world’s most influential central bank may be done raising rates and that it might in fact begin to lower them in 2024.
Given widespread expectations of a “hawkish hold” from that Fed meeting, the shift to dovishness caught investors off-guard. But they were quick to respond. Through November, the S&P 500 climbed by nearly 10%. It ended 2023 up 24%, while the U.S.10-year Treasury benchmark yield declined 3.8% by late December – a stunning rebound that was highly concentrated into the last two months of the year.
The obvious lesson from those remarkable events is that staying invested, through economic fears and financial market volatility, can certainly yield benefits, as we have been saying for quite some time now.
Looking more closely, however, there may be reason to temper one’s enthusiasm for the unforeseen rally. For one thing, a handful of equities—the so-called “Magnificent Seven” of Apple, Meta, Alphabet (Google), Microsoft, Nvidia, Amazon and Tesla—was responsible for a disproportionate share of the S&P 500’s gains. Take them out of the picture, and the two-month upswing was “only” 12%. This significant concentration of returns in a few stocks is certainly concerning.
However, two considerations provide reason for optimism. One is that despite the outsize performance of the Magnificent Seven (or eight, if you include Netflix), the late-year rally did indeed broaden out the return profile of the market. That is a function of declining rate expectations, which has the very democratic effect of supporting asset valuations on a discounted cash flow basis.
Another positive consideration is that most of the Mag 7 benefited from investor enthusiasm for the potential of artificial intelligence. Certainly, the craze for AI has its doubters, and it is usually prudent to be skeptical of market fads. However, our view is that AI can and likely will have materially beneficial impacts across many industries over time. Already, large companies that have the capital to invest in technologies such as machine learning and predictive modelling are seeing results. Yes, as with any promising new technology, there will be winners and losers, and there will be overhyped opportunities. But we believe that AI is real, and the AI trend—in the real world and in financial markets—is likely to accelerate this year.
Yellow Flags
Despite the relatively buoyant macroeconomic landscape with which 2023 ended, the clouds of concern have not fully dissipated. To mix metaphors: We are not out of the woods yet.
Geopolitical volatility remains a key concern. The Russia-Ukraine war is approaching its second anniversary, with no sign of resolution in sight. Neither is there an apparent end game at hand in the Gaza conflict, which could spark a powder keg of wider conflict throughout the Middle East. Meanwhile, Western tensions with China are unlikely to lessen in this, a U.S. presidential election year. And the threat of China embarking on military adventurism in Taiwan (home, by the way, to the world’s largest producer of semiconductors) has not weakened despite continuing conflicts elsewhere; in fact, the distraction provided by those conflicts may well embolden the Middle Kingdom to act. When considering the likelihood of such events and their potential impact, the only solace is that they are impossible to handicap. Yet they remain risks—potential “black swans” that could upend the most robust-looking markets.
Another risk is perhaps less frightening but could ultimately be more damaging to asset valuations, namely, that inflation is not defeated after all. The market is now discounting either a soft landing, where higher rates slow economic growth without creating a recession, or no landing at all. This strong consensus alone should give one pause, if only because market expectations have been so wrong before. (See January 2023.)
Meanwhile, inflation remains above the central bank target of 2%; completing the “last mile” in inflation reduction could be far more difficult than what monetary policymakers have accomplished so far. Indeed, there is still a chance that inflation re-accelerates, which could lead to another step up in rates, which would not be good for stocks or bonds.
It might also be too soon to call a soft landing for the economy. Given the lag effect of monetary policy, it is quite possible that the impact of higher rates has not fully worked itself into the economy. If higher rates are just taking longer than expected to destroy demand, then a recession may still be in play for 2024.
Opportunity in 2024
Despite those risks, the year has begun on a strong foundation. The economy is strong. Employment is robust. There does not appear to be any undue stress on the system, at least not yet. Importantly, expectations of further rate hikes are exceptionally low. That provides some stability from which investors can model out assumptions on asset valuations and risks.
In the stock market, valuations are rich, especially in the very large cap names. When those are factored out, however, valuations are fairly reasonable. If current conditions continue or improve, we expect market broadening through the year. That could favour the small and mid cap segment of the market, which has underperformed over the last five to 10 years.
Another bit of good news for investors is that with interest rates still high, fixed income can provide equity-like returns in a more senior security. Some high-quality bonds are providing coupon rates of 8% or more. From an investment strategy perspective, such returns do not require perfect market timing and can help investors ride out the good or the bad. All they have to do is clip coupons and earn interest, with generally less risk than equities. For the first time in a long time, bonds can be a real contributor to portfolio returns.
On the equity side, current events have done nothing to dissuade us from our conviction that investing in high-quality businesses and owning them for long periods of time is the preferred way to grow and preserve wealth. Often, that approach requires patience, because the question of when a stock fulfills its potential is out of the investor’s control. In mid-October last year, no one could have predicted that some stocks would gain 50% or more in November and December; no one can really see what the next significant market move will be, either. Our focus is not on calling markets per se, but rather on investing in businesses that can navigate through good economies and tough economies, to their (and their shareholders’) benefit.
That said, the macroeconomic backdrop for 2024 supports a cautiously optimistic outlook, with the emphasis on “cautiously.” We will continue to watch economic data closely, particularly on employment, which seems to us to be the most likely source of either a recession or inflationary pressure. Central bank communications, both formal and informal (i.e., hints), bear careful parsing, as well; monetary policymakers have been intentionally trying to slow the economy, and they might decide they have more work to do to get there.
In short, as much as we recognize the tailwinds for markets now, we are well aware that things could change, and rapidly. If nothing else, recent history has proven that much.
