Q4 2023 Market Commentary: Despite economic challenges, 2023 rallied to finish as it began – on a strong note.
Vittorio Ciccone | M.Sc | Louisbourg Investments
Fuelled by a population surge, the Canadian economy started out strong in 2023. However, this strength tapered off as household purchasing power was strained under rising debt payments and heightened fuel/grocery costs. At the same time the Canadian labour market weakened, needing help to support the available workforce. The housing market also displayed weakness but was supported by limited home supply.
But Canada wasn’t alone. Slowing growth, attributed to central bank rate hikes and the constraints on household purchasing power, became a global trend. Commodity prices moderated.
The one exception: the resilient U.S. economy. Consumers there remained strong, though economists cautioned against slowing spending and cited rising unemployment.
Despite the economic challenges, 2023 concluded with a Santa Claus rally, i.e., markets’ tendency to enjoy gains over the holiday season. By signaling an end to rate hikes and potential cuts, central banks played a pivotal role. In Canada, the S&P/TSX surged 8.1% in Q4, ending the year up 11.8%. The U.S. S&P 500 increased 11.7% in Q4 and finished the year up 26.3%. The NASDAQ, driven by high-powered technology names, rose 11% in Q4 to close the year up 41.2%.
Bond investors enjoyed solid gains, with the Bloomberg Global Aggregate Return Index up 5.7% for the year. In a signal of their own resilience, both bond and equity markets rallied despite the economic headwinds.
In the following Q4 Market Commentary, Louisbourg Investments’ Mathieu Roy, CFA Head of Equities, and Heather Hurshman, Head of Fixed Income. offer their insights, detailing perspectives on the economic backdrop and future strategies.
Mathieu Roy, CFA on Q4 Equity Markets
From greed to fear, to greed again! That can be one way to summarize the volatile equity markets of 2023. In the most recent quarter, a discernible shift in investor expectations took center stage. This was on the back of the US central bank softening its messaging on how tight monetary conditions are likely to be. Investors are now broadly expecting falling interest rates as we have been witnessing diminishing inflation readings, all the while benefiting from an economy that is holding in pretty well. Equities powered ahead in the final stretch of 2023, with the S&P 500 posting nine consecutive weeks of gains. The other main asset classes also benefited from this shift in expectations. This was the strongest quarter of the year and elevated Canadian, US, and international equity returns to a fruitful year.
Canadian equities: The main driver was consistent across all global risk asset classes: falling interest rate expectations. Ten of eleven sectors generated positive gains in the fourth quarter. The most impressive performance was generated by Technology (+24%), Financials (+13%) and Real Estate (+11%). This makes fundamental sense if rates do indeed start falling, as they should be strong beneficiaries. The only holdout across sectors was Energy (-1%). The North American crude oil price fell from $85 to $72 during the quarter as investors continued to debate the near-term outlooks for the supply and demand of the important commodity.
US equities: Looking at a sectorial basis, the rally was driven by a growing risk appetite for sectors considered more exposed to a recession, including Financials (+14%) and Industrials (+13%). The significant drop-in interest rates also spurred a rally in growth stocks, primarily benefiting the Technology (17%) sector. Recession-resilient sectors were the main laggards, with Consumer Staples (+6%), Health Care (+6%), and Utilities (+9%) all underperforming. Energy (-7%) faced a challenging quarter following a steep correction in commodities.
International equities also performed admirably, returning 7.7% in the quarter and 15.1% for the year, both in CAD. Looking at a sectorial basis, the rally was also driven by a growing risk appetite for sectors considered more exposed to a recession, including Materials (+14%) and Industrials (+13%). Just like it was the case in Canada and the US, the significant drop-in interest rates also spurred a rally in growth stocks, primarily benefiting the Technology (18%) sector. Recession-resilient sectors and Energy were also the main laggards here.
We certainly appreciate the progress we have achieved on taming inflation while not damaging the economy much at all in the process. We understand the investor enthusiasm. While recent inflation and economic data do give reason for optimism, we believe it remains difficult to gauge how quickly interest rates should be reduced. Central banks are intent on fighting inflation and can still maintain higher interest rate levels if inflation progress does not persist. We believe that business conditions will likely get a bit more difficult for companies as they refinance debt with higher interest costs. We are not convinced that equity markets are discounting this enough. Given the recent run-up in prices and the discussed backdrop, we believe the risk-reward proposition for equities is only fair at this point and that investors should not hold more than neutral equity allocations. Taking a view for the next few years, we are sitting at levels of monetary policy providing flexibility to adjust policy in any direction, making conditions attractive for equities.
Heather Hurshman, on Bond Markets
The bond market ended the year with a bang as the dramatic rise in rates came to an abrupt halt driven by weakening economic data and indications from central bankers that policy rates had peaked. For the first time since the battle against inflation began in March 2022, the FOMC acknowledged that inflation had notably slowed down and that monetary policy easing was likely. The messaging by the Bank of Canada was more subtle, where they indicated during their December 6 meeting that they are not ready to declare victory over inflation, but also noted that “the economy is no longer in excess demand” and removed the reference to a tight labour market.
The Bank of Canada acknowledged that economic growth had stalled with 2nd and 3rd quarter annualized growth contracting by -0.2% and -1.1%, respectively. The overall conclusion by the market was the same in Canada with the Bank of Canada considered to be on hold with a policy rate of 5%. Following the December central bank meetings, which was the first confirmation by central bankers that the fight against inflation was gaining ground and policy rates were sufficiently restrictive, the bond market reacted quickly, with buyers of bonds stepping in across the yield curve. The market quickly began to price in additional rate cuts and moved up the first rate cut to March 2024.
There were several catalysts for the dramatic turnaround in bond yields this quarter including weaker inflation data and the acknowledgment by central bankers that further rates were likely off the table. Economic data indicates that inflationary pressures are weakening, evidenced by weakening growth, a more balanced labour market and the deceleration in price pressures as the last headline CPI rate in Canada ended the year at 3.1% (November) versus a rate of 6.3% YoY at the start of the year.
The weakening in the economic data contributed to the steady decline in rates throughout the quarter. However, Fed Chairman Powell’s comments at the December meeting took the market by surprise as he set an overall dovish tone and openly acknowledged “that rates were sufficiently restrictive”, despite the fact that 10-year US treasury yields had already decreased by 47 basis points from the start of Q4. It was this stance by the Federal Reserve at the December meeting, despite the recent decline in rates that served as one of the primary drivers for the more sustainable reversal in the outlook for the bond market and lowered yields across the entire curve.
During the fourth quarter of 2023, bond yields declined dramatically, and the curve steepened slightly as the market moved toward the timing of rate cuts in 2024. Over the period, two-year Canada bond yields declined 98 basis points to 3.89%, while five-year yields declined by 107 basis points to 3.17%. The ten-year Canada yield decreased by 91 basis points to 3.11%, while thirty-year yields decreased by 78 basis points to 3.03% over the same period. Going forward, the Bank of Canada will need to see more sustained weakening in the core inflation rate which remains well above the 2% target at 3.4% (median core). In addition, a slowing in wage growth toward 3% is necessary for inflation to converge toward target as hourly wage growth in Canada is currently running at 5% (November) which is too high, particularly when considering the absence of any productivity gains.
As always, for more information about Ciccone-McKay Financial Group, or if you want to chat with someone at the firm, we welcome your call: 604-688-5262.
