Q4 2024 - Market Review
ECONOMIC COMMENTARY
Equity markets were quite erratic during the fourth quarter. It began with trepidation regarding the magnitude of the fiscal measures Beijing would reveal following the monetary measures already announced in late September. Markets initially drifted lower when it became apparent that China was going to wait until after the US presidential elections before providing more clarity[1]. Speaking of the US presidential elections, the markets’ initial reaction to its outcome was rather positive, probably more because Trump’s victory was unequivocal than the fact that Trump won. To this point, financial markets tend to dislike uncertainty and, a neat victory - more than who won - was better than having contested election results. Of course, there is cause for concern about Trump’s 2nd term but, for the moment, market participants choose to think that the positive impacts of his extended tax cuts and deregulation efforts outweigh the negative impacts of his trade and immigration policies. Against this backdrop, the MSCI All Country World Index[2], the S&P 500 Index, and the S&P/TSX Composite settled with returns of 1.93%, 2.31%, and 3.76%, respectively, during the quarter. For the year, these indices gained 20.21%, 24.50% and 21.65%, respectively.
Fixed income markets were broadly neutral to slightly down during the 4th quarter. This was surprising to some since central banks globally continued to ease by reducing their overnight rate. That said, what happened is that, while overnight rates were pressured down through central banks’ actions, rates for longer term instruments increased steadily during the quarter. For example, while the Effective Fed Fund Rate (“EFFR”) went from 5.33% in mid-September when the Federal Reserve lowered the discount rate by 0.50% to 4.33% at the end of the quarter, the rate on US 2-year Treasury Notes went from 3.50% to 4.25% during the same period and from 3.60% to 4.50% or thereabout for US 10-year Treasury Notes. These are significant moves and, as a result, current income did not compensate for the principal loss for most fixed income market segments. To this point, while the ICE BofA Canada Broad Market Index contained losses to just -0.10%, the ICE Bank of America Global Government Bond Index and the ICE Bank of America Global Corporate Index returned -2.06% and -1.32%, respectively. For the year, the ICE BofA Canada Broad Market Index and ICE Bank of America Global Corporate Index gained 4.10% and 4.17%, respectively, while the ICE Bank of America Global Government Bond Index declined 0.03%. I believe that the movement in rates, at least in the United States, has been partly driven by the fear that import tariffs would result in a temporary increase in inflation[3] and a fear that government spending might be getting out of control.
DOES TRUMP 2.0 SIGNAL THE END OF AMERICA’S EXCEPTIONALISM?
The quick answer is probably not, at least in the short term. That would be giving more clout to Trump than any other past president. Also, while the furious pace at which decrees have been issued since his inauguration has kept everyone on their heels, I do not think this pace will be maintained. On the contrary, I anticipate that just like he did during his first term, Trump will quickly reach a point of policy-making fatigue and start spending a greater portion of his time on the Trump International Golf Course at Mar-a-Lago, especially when he realizes that he cannot simultaneously get the stock market to rise, the trade deficit to get more balanced, and the US dollar and interest rates to decline. To this point, the best piece I came across on the subject was written by Olivier Blanchard[4]. In his November 13 article[5], Professor Blanchard argues that while tariffs may initially get Trump what he wants (increased revenues and a narrowing trade deficit), it will be short lived. Effectively, even if China and Europe do not impose retaliatory tariffs, as US demand shifts from foreign to domestic sources when the domestic economy is close to full employment, this is bound to put upward pressure on prices and may lead the Federal Reserve to hike interest rates. This, combined with an improved trade balance, will cause the US dollar to move higher. We know that Trump neither wants higher interest rates nor a higher dollar. According to Professor Blanchard, the situation gets worse if China and Europe respond with retaliatory tariffs because it would hurt US exporters and that might leave the trade balance unchanged even with higher inflation and interest rates. At this point, it is unclear if Trump would double down on tariffs, try to undermine the Federal Reserve’s independence, or accuse the People’s Bank of China’s (“PBoC”)and the European Central Bank ("ECB") of being “currency manipulators” but, either way, I suspect that the impacts of his trade policies will fade before the 2026 mid-terms and that the next administration, Republican or not, will repeal most of them. So, this is a short-term matter.
The same goes for Trump’s deportation policies which Blanchard considers unrealistic. The fact is that the US labor force is comprised of roughly 160 million workers. If Trump achieves his target of deporting 1 million per annum over the next 10 years, the US will lose nearly 5% of its workforce, a significant portion of which operates in the agriculture, construction, and retail service sectors. Naturally, the ratio of vacancies to the number of unemployed workers would skyrocket. It is hard to see how this would not lead to sustained inflationary pressures. Blanchard concludes by saying that for this reason, deportation numbers will end up being more symbolic.
Turning to taxation, Blanchard says that the extension of tax cuts enacted in 2017 is very likely to happen, but that incremental measures such as the reduction of the corporate tax rate for manufacturing firms and making social security benefits payments tax exempt would likely be challenged by a Congress controlled by a Republican party. Nonetheless, what should not be forgotten is that the US fiscal deficit is currently running at 6.5% per annum. This would increase by 1% to 2% per annum according to the Congressional Budget Office if Trump manages to enact his most drastic proposals. We have to wonder how long it takes for bond vigilantes to put the government on notice…
Basically, in the short term, it appears that the path of least resistance in response to Trump’s policies is for the equity markets to go up, interest rates to go up, and the US dollar to go up, which is exactly what happened. So, the question is, how much of the Trump factor has already been priced in across various asset classes?
The long-term picture is where it gets more complicated. The US institutional checks and balance system survived Trump’s first term and remains on its feet, albeit severely bruised. To this point, the judicial branch, the military, an alive independent media ecosystem and, more importantly, an open economy and capital markets have been formidable ramparts against Trump’s worst impulses. That being said, this time around, Trump arrives to the White House with a cohort of appointees that are more devoted to him than ever before in his crusade against the “deep state.” To this point, since November, Trump has already launched attacks against the Environmental Protection Agency (“EPA”), the Federal Emergency Management Agency (“FEMA”), the Internal Revenue Service (“IRS”), the Federal Bureau of Investigations (“FBI”), and the Central Intelligence Agency (“CIA”) and is already coercing the Federal Reserve to do his bidding. The danger with this, as the political think-tank Eurasia Group hinted in their annual Top risk report is that:
“…the erosion of independent checks on the executive power and on the rule of law will increase the extent to which the US policy landscape depends on the decisions of one powerful man in Washington rather than on established and politically impartial legal principles. Mergers between firms Trump perceives as adversarial will face higher regulatory scrutiny… If Trump systematically rewards politically aligned business figures with preferential treatment on regulatory, legal, and contracting matters—among other things—he will enable a system where proximity to power, not market competition, determines success… This will amplify crony capitalism in the world’s largest economy, with risks for firms that must spend more time and money cultivating transactional relationships with Trump’s political apparatus than creating economic value… Its descent into a de facto oligarchy will ripple far and wide. It will depress economic innovation and productivity as the US government rewards the most politically connected firms (and implicitly or explicitly punishes the rest) rather than the most competitive ones. Corruption will flourish. In the long term, the US would become a less attractive business and investment environment, and Americans would see their living standards stagnate.[6]”
This is not the type of stuff that develops overnight, but it is worth thinking about how a risk premia could emerge out of the US as we ponder over the pictures of Silicon Valley tech titans walking in the US Capitol Rotunda…
KEEP IT SIMPLE, STUPID
Finance 101 teaches us that one of the only free launches in capital markets is diversification. The idea is that if one holds many distinct investments, if one or more investments go down in value, others may help to mitigate the loss by remaining unaffected or even increase in value given certain market conditions. In this way, diversification may help keep a portfolio in balance and still have the possibility of producing positive returns. Naturally, a diversified portfolio may not provide returns comparable to single-asset portfolios, but it may help, however, to reduce the risk of incurring significant losses during periods of extreme volatility. The challenge is that while this concept worked well for fifty years after the mathematical proof was published[7], since 2015, a passive portfolio comprised exclusively of an S&P 500 exchange traded fund (“ETF”) has yielded the best results rather consistently.
Perhaps this is the capital markets’ way of telling participants to keep it simple, stupid[8], in contradiction with one of the core tenets of modern investment theory. This phenomenon has incited investors to transition an increasing percentage of their portfolio in US equities and to put an increasing portion of that into passive strategies. In fact, Blackrock and Vanguard’s S&P ETFs are strategies that saw the most inflows in 2024[9]. This leads us to a point where according to Bank of America’s most recent Global Fund Manager Survey, the percentage of fund managers indicating that they are overweight US equities was at its highest level in 20 years and that the “Magnificent 7” theme, which had been the most crowded theme for 21 consecutives months, was becoming even more crowded[10].
Alarm bells have been ringing for at least four years already, but to no avail. To this point, the S&P 500 earnings multiple has only gotten higher, both in absolute terms (relative to history) and relative terms (compared to other country indices). Is this justified? Well, earnings explain a big part, and it just so happens that the S&P’s earnings growth has beat consensus estimates in all quarters, except one[11] since Q4-2022, and they are expected to grow by roughly 14% in 2025[12]. These are better numbers than what’s been projected for most other major countries. So, from that standpoint, there are reasons to be optimistic about US equities. Furthermore, we must acknowledge that US companies benefit from a more favorable tax regime, a better industrial policy framework, lower energy and materials input costs, and less stringent environmental protection laws. The extent to which these arguments are priced in is debatable. Our concern lies with the fact that the ten largest companies in the S&P 500 now comprise approximately 1/3 of the overall index and are expected to contribute roughly half of the earnings growth over the next 24 months[13]. Granted, these companies have delivered on their promises in the past and they’ve become gigantic precisely because of their spectacular earnings momentum[14]. That being said, we believe that one of the indirect risky assumptions that investors are making about them right now is that the dominance of these companies will be permanent. That is a major assumption because, if history is a guide, the US stock market has underperformed global equity markets during 6 of the last 11 decades, and Microsoft is the only current top ten constituent that was a top 10 constituent at the turn of the century[15]. So, things tend to change instead of staying the same.
The above discussion matters in the active versus passive debate because it is not unusual for active managers to hold underweight positions in the largest index constituents and, conversely, hold overweight positions in smaller index constituents or even off-index issuers. It is one of the reasons why the last few years have been difficult for active equity managers. As S&P Global discussed in its most recent SPIVA™ update:
“…this is… more likely to be of greater consequence when those constituents are themselves of greater aggregate weight and when they have notably different performance compared to the rest of the benchmark, as has been the case recently. But since market concentration increases when the very largest stocks outperform (and thereby take up great capitalization weights) and concentration decreases when smaller stocks outperform larger ones, the evolution of market concentration offers a powerful perspective on the relative prospects for the typical active manager in each market[16].”
One conclusion we can draw from the above is that since stock market concentration is at a historical peak, should a reversal occur and the largest constituents lose momentum, passive investing strategies could be hurt disproportionately. This could happen if Nvidia missed earnings estimates or lowered revenue guidance or if one of its hyperscaler clients[17] cut back on capital spending due to margin erosion.
We have been wrong on this for at least two years. Championing diversification when simplicity was rewarded has been costly. Moreover, there is no catalyst to justify displacing assets from the United States to the rest of the world, apart from valuation discount that is approaching 3 standard deviations[18]. Nevertheless, we feel we must persist with this idea because when people assume and price in an expectation that a trend can only get better, the damage done by negative surprises is profound. I understand that it rings hollow, but I suppose we can never be more wrong as the moment right before we turn right!
To summarize, the message is the following: diversification does not cost much. That is the simple thing to do. Sure, odds are that you will underperform if the cluster of large cap stocks that has worked best recently is the same cluster of stocks that does best in the future. However, odds are that you will do better if the positive momentum shifts to something else.
PORTFOLIO CALIBRATION FOR 2025
“Did you have more luck with your capital markets forecasts last year than you did calling the US presidential election results or the Stanley Cup champions?” asked my girlfriend, with a cheeky grin, half interested.
“Barely”, I responded.
The truth is that looking back at our Q4-2023 review released on January 19th of last year[19], I didn’t expect equity markets to advance as much as they did, and I didn’t expect US large caps to lead the markets so decisively for a second consecutive year. In my defense, few did. Nonetheless, the group of external fund managers to whom we outsource the management of global equity portfolios for our clients only lagged their benchmark by one or two percent last year on aggregate, depending on the mix. On a rolling four-year basis, most of them remain ahead of their representative style benchmark.
My forecast for fixed income was a little better, but I have no merit as the decline in short-term rates that took place was in line with the beginning of year consensus expectations. I was right to caution about adding long-term instruments as the term structure of interest rates steepened, but I was mistaken to caution against high yield bonds, which continued to outperform, even though corporate default rates increased modestly. Separately, none of the geopolitical scenarios that could have contributed to derail the markets from their course played out. For the record, I was wrong about the outcome of the US presidential election, and I did not think that the Florida Panthers would get past the Eastern Conference finals. With that, I encourage everyone to take what follows with a grain of salt.
So, what‘s in store for 2025? First, Wall Street expects the S&P 500 to reach 6614 by the end of 2025[20]. Roughly, this represents a 12.5% appreciation over the closing price of the index at the end of 2024. Add to that a little over 1.5% from reinvested dividends and the share buyback effect, and we’re looking at a 14% total return for the US main index, which corresponds more or less with the expected growth in earnings which have been pushed upward to reflect a range of Trump policies that are expected to be net positive for corporate earnings. The S&P 500 earnings multiple is thus expected to remain stable in the 22x to 24x range. My base view is not far from this consensus. I believe, however, that the consensus is predicated on China delivering a massive stimulus plan – which will happen, if only to dampen the impact of US imposed tariffs – and on investors being right in their current assessment that Trump v2.0 won’t cause too much damage and that central banks globally will not have to resort to recessionary rate cuts. So far, it appears that the baseline tariff scenario is being priced in, but a scenario in which Trump decides to go after China through countries like Mexico, Malaysia, or Vietnam is not. This leads me to believe that the odds of a negative surprise are greater than the odds of a positive surprise relative to the base scenario.
With respect to fixed income, the consensus currently calls for two rate cuts in Canada and one-to-two rate cuts in the United States in 2025. This would translate in total returns in the mid- to high-single digits for 2025, depending on the market segment and bond maturities. I think that the consensus is consistent with the projected trajectories of growth and inflation. I suspect, however, that these forecasts are a presidential tweet away from moving radically higher or lower. As such, my conviction is rather weak. One area of concern which I feel does not get enough attention is that the United States Department of the Treasury will have to refinance over 7 trillion dollars of debt in 2025, half of which is scheduled to take place in the first quarter. Unfortunately, this is not something that the man in the White House can toss aside. For this reason, I believe that the largest and most liquid segment of the fixed income market could feel the pinch and that long-term treasury yields in the United States could move above the dreaded 5% psychological threshold. This is the reason why we are reluctant to add to long-term US treasuries despite the fact that the yield to maturity on long-term bonds is superior to the yield to maturity of short-term bonds and remains markedly over long-term Canadian bond yields. Because I am concerned about long-term treasury bonds, I have reasons to be concerned about high- yield corporate debt as well. Granted, the total expected return is attractive relative to investment grade credit and treasury yields. Moreover, EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) margins are healthy, leverage ratios are reasonable, and the amount of speculative debt maturing in the next 18 months or so appears contained. The issue is that relative to historical levels, high-yield spreads are essentially at record lows. For me, this is an ominous sign as it bears similarities to the late 2007 high-yield market environment. For this reason, we are not going out of our way trying to earn an extra 0.50% on fixed income by piling up into high yield. There will certainly be a better entry point.
Dimitri Douaire, M. Sc., CFA
Chief Investment Officer
[1] Beijing eventually announced a series of measures from November 8, starting with a debt package of 10 trillions Yuans to ease local government strains..
[2] Local currency returns unless specified otherwise
[3] The breakeven inflation rate on 2-year and 5-year horizon has increased by approximately 0.3% during the quarter, consistent with the tariff scenarios that has been floated by source close to Trump and his main economic advisors.
[4] Olivier Blanchard is senior fellow and former C. Fred Bergsten Senior Fellow at the Peterson Institute for International Economics. He is the Robert M. Solow Professor of Economics emeritus at the Massachusetts Institute of Technology (MIT).
[5] Blanchard, Olivier. « How will Trumponomics work out? », Peterson Institute for International Economics, RealTime Economics, November 13, 2024. How will Trumponomics work out? | PIIE
[6] Eurasia Group, Top Risks 2025, Ian Bremmer & Cliff Kupchan.
[7] Sharpe, William F. (1963). "A Simplified Model for Portfolio Analysis". Management Science. 9 (2): 277–93
[8] Popular expression attributed to a senior engineer for a US Navy contractor in reference to an essential design element for systems that needed to be maintained and repaired on the field by anybody with the most basic tools available.
[9] Source: Bloomberg.
[10] BofA Global FMS, December 2024.
[11] Source : Factset
[12] Idem.
[13] Idem.
[14] The S&P 500 Net Total Return Index was +24,5% in 2024 in US$ terms but the S&P 500 Momentum Net Total Index was +45,7%, it biggest outperformance spread in the past 10 years.
[15] Source: Michael Cembalest, JP Morgan Asset Management.
[16] S&P Global SPIVA™ Global Scorecard, Mid-Year 2024
[17] hyperscaler clients: Clients, which as suppliers, provide cloud computing and data management services to organizations that require vast infrastructure for large-scale data processing and storage.
[18] Source: Bank of America.
[19] https://www.patrimonica.com/all-news/q4-2023-market-review
[20] Source: LPL Financial, Bloomberg.