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Hope for the best, prepare for the worst. That’s the headline of a recent Scotiabank report looking ahead at the markets in 2024. I’m Stephen Meurice, host of Scotiabank’s weekly podcast, Perspectives. Today you’ll be hearing an episode I recorded recently for Perspectives with Hugo Ste-Marie, and while his outlook is aimed at large institutional investors, his insights will be of interest to investors of all kinds. He’ll tell us what the markets might look like in the year ahead, where there may be some opportunities, what a ‘perfect soft landing’ is — and whether or not we may see one — and much more.
Before we begin, just a reminder to consult your own advisor before making any investment decisions.
Hugo, thanks so much for joining us again.
Hugo Ste-Marie: Pleasure to be here.
SM: All right. So, as I mentioned in the introduction, your title is Director of Portfolio and Quantitative Strategy in Equity Research at Scotiabank. Now, that’s quite a mouthful. Can you give us an explanation of what that means exactly?
HSM: Yeah, sure. In a nutshell, I provide advice to global institutional investors, so it’s not necessarily directed towards retail investors.
SM: Okay. That said, I think some of the information that you’re going to provide, particularly in terms of the macroeconomic outlook, which we're going to talk about in a second, I think that's going to be of interest to lots of people.
HSM: Yeah, exactly.
SM: So, let's just jump in with that, with the big picture. Part of your report looks at the macroeconomic factors that affect investing. What are the big conclusions you came to about where the economy, both in Canada and globally, is headed?
HSM: Yeah, sure. Let’s do a step back first. When you enter 2023, I would say myself and a lot of investors were thinking that the global economy — U.S. and Canada included — could face a lot of headwinds coming from a very aggressive monetary tightening cycle. What surprised us clearly is the resiliency of the U.S. economy, Canadian economy; the consumer has been extremely, again, resilient in the face of an aggressive tightening cycle, elevated inflation. And I think to me this is the surprise of 2023. That explains why I think equity markets have done way better than expected. Now, when we look at 2024, I think we still have to or at least the economy still has to digest a big chunk of the Fed tightening cycle. You have to keep in mind that usually it takes between 12 to 18 months for a rate hike to filter through economic activity. So, when you look at the Fed tightening cycle, I would say the last almost 40% of it, so the last 225 basis points of tightening, really occurred just in the last 12 months. So a big chunk of it has to be, again, digested and we could see the impact of that tightening more in 2024.
SM: When you talk about tightening, you're talking about that series of interest rate hikes that central banks all over the world, but in Canada and the United States as well, have imposed over the last two years or so?
HSM: Exactly.
SM: And when you talk about the Fed, that's the Federal Reserve. So that's sort of the equivalent of the Bank of Canada in the United States?
HSM: Yep.
SM: So, because you did mention the Fed a couple of times. When you're looking at the global economy, I guess that's your starting point? You're looking mostly at what's happening in the United States and the decisions that the Fed is making about monetary policy?
HSM: Absolutely. Well, this is the largest economy in the world. So, what the U.S. economy does tend to have ripple effects, I would say, around the world, too. So, the Fed is a key component in our outlook. We have to figure out what the Fed will do, what's happening with either the monetary easing or the monetary tightening. As we speak, when you look at the market, expectations are for a lot of rate cuts for 2024. I think it's probably a bit too optimistic. I think the economy will be resilient to some extent; that might prevent the Fed to cut as much as the market anticipates next year. You have probably between four and five rate cuts priced in as we speak by investors. I think that's probably too much. And I would say if we were to get that many rate cuts next year, it's probably because not just inflation is going down, but demand is going down, meaning that economic activity is struggling. That would force the Fed to do way more than expected. The way I’ve envisioned this is resiliency continues for some time, [and] the Fed maybe will give you some rate cuts, but certainly not four to five. So that would be less than the market envisioned and that could lead to pressure on P/E ratios in the market.
SM: So you talked about that resiliency both in Canada and the United States. And by that, I guess you mean that the economy maybe hasn’t slowed as much as might be expected. Consumers are doing better maybe than has been expected. So maybe you can catch us up a little bit on the GDP numbers in Canada and the United States, sort of in the latter half of 2023 and now heading into 2024. What have the economies actually looked like?
HSM: Well, if we start with the U.S., Q3 GDP was extremely strong. I would say close to 5% GDP growth in the third quarter. So, with consumer spending around 4% in the third quarter as well, 4% growth. So, we still have a decent pace of expansion in the U.S. that's going to slow down in Q4 for sure. When you look at the economic outlook or the consensus growth forecast for 2024, consensus is looking for around 1.2-ish GDP growth this year.
SM: In the United States you mean?
HSM: In the United States. In Canada, when you look at the last couple of quarters, consumer spending, while GDP growth first has been revised up to over 1% in the second quarter, but the third quarter was outright in contraction territory. And consumer spending in Canada for the last two quarters has been flattish. As you know, 60/65% of GDP is generated by consumer spending. So having flat consumer spending growth is not good news for the Canadian economy for sure.
SM: Okay. Just one last thing about last year, about the end of 2023, before we look at the outlook into 2024. Is, if I recall, I mean, at least in the last couple of months of the year, markets were doing okay? I guess, along with consumers and the economy more generally. There seemed to be a certain amount of optimism. Was that the case towards the end of last year?
HSM: Yeah, the last couple of months have been extremely strong. When you look at November, particularly the S&P 500 accelerated and posted a gain of 8% plus; the TSX was up strong as one of the global equity markets [that] were upbeat as well. I think what investors have started to discount, as I mentioned before, is inflation coming down. That could give some room for central bankers to cut. As I mentioned, you have four to five rate cuts priced in. And clearly investors are positioning for the perfect soft landing in 2024. What does that mean? You have a soft landing, but on top of it you have inflation coming down pretty quickly towards the central bank target of 2%. That would give them room to cut aggressively with economic activity being way more resilient than expected. If you have this perfect landing, you could get earnings growth. On top of that, you would get P/E expansion plus dividend. If that's the case, obviously, the stock market could probably score a double digit gain this year. But I would say to get that you would have to have the stars be perfectly aligned. And this is where I think it could be a bit tricky next year. I don't think the stars will be perfectly aligned.
SM: Right because we are hearing quite a bit these days about the possibility of a soft landing, of maybe avoiding a recession and all of that. But I guess there's a difference between a soft landing and a perfect soft landing as you're talking about where all of the factors are positive.
HSM: Yeah, correct. In a soft landing, we could see a bit of upside for stocks, but that would be very limited. I think in a type of soft landing that I would envision is, okay, the economy is resilient, but you do not have four or five rate cuts. That means on the P/E side, bond yields and interest rates remain relative elevated. So that would probably give you some gains, but very limited gains for equities. That's the key difference between having a perfect landing and having a more bumpy landing.
SM: And could you maybe just give me a quick explanation of what the P/E is that you keep referring to?
HSM: Yeah, the P/E is the price to earnings ratio. So that's an index level divided by the earnings generated by that index. Usually when a price to earnings ratio is pretty high, and especially in a tightening cycle, it's difficult to go much, much higher. The S&P 500 P/E ratio as we speak is around 19 times, the long run average is around 15 and a half. So at 19 times, you’re close to one standard deviation above the long run average. So, you're already on the high side. So, to go much higher, you clearly need to have bond yields and interest rates moving down sharply in 2024. And that's what I struggle to see.
SM: I see. So, I mean, there has been a lot of volatility on the stock market over the last couple of years coming out of the pandemic and so on. Do you see volatility in 2024? It kind of sounds from what you're saying that you're seeing sort of more flatness than a lot of up and down?
HSM: Yeah, for a one-year period, we have kind of flat markets. It doesn't mean in between it's going to be a steady ride. Usually when you looked at the market level over the last, I would say 30, 40, 50 years, you have intra-year pullback that could run between 5 to 15, 16% in most years. So I don't think that's going to be a smooth ride. Even though we're forecasting for no return or flat returns, doesn't mean the market will just be flattish all year. I don't think that's going to happen like this.
SM: Right. So obviously someone like you, anybody who's investing at any level, I suppose, is just looking for opportunities. So, what do you see going into 2024? What are the main markings that you're looking for? What are you suggesting?
HSM: When we looked at our main Canadian portfolio, it's been a barbell positioning for most of the year. Let me explain. We’re, in a grand scheme of things, we have some offence and some defence. We're not all in defence. We're not all in offence. So, we have some offence. By that I mean, I'm currently overweight like energy, slightly overweight industrials and consumer discretionary. Not by much, but just slightly overweight. That helps the portfolio to, I would say, keep track with the market when the market is going up. At the same time, we have some defence, we have more cash in the portfolio. We're overweight staples this is a defensive sector. We're overweight utilities and pipelines. Again, those [are] defensive sectors. So, the portfolio positioning helps us to do better on the downside. So, the portfolio is going down, but going down at a slower pace than the market if the market were to tank. When the market is going up, we kind of track the market not necessarily outperforming much. So that gives us protection on the downside, and that helps us to at least kind of track the market if the market keeps moving up. So that's why I call that a barbell, meaning it's not all in offence, not all in defence.
SM: Right. And I think in your report you did talk about small cap versus large cap. Maybe you can first say what that means and then describe your feelings about both.
HSM: Yeah, I would say small cap — it depends on the market — but when you look at the Canadian equity market, I would say anything below like 2 to $3 billion [market capitalization] would be considered a small cap. In the U.S. obviously a small cap could be much bigger than in the Canadian equity market. I would say anything under 5/6 billion could easily be considered small cap in the U.S. equity market. As we speak, we have a preference for larger cap stock versus smaller cap stocks. Why? Well, again, the macro conditions are not very favourable to small cap stocks as we speak. Small cap equities are extremely sensitive to two things: macroeconomic conditions and the credit conditions as well. So, the economy’s slowing, will likely slow further. So that should be more difficult for small cap stocks to generate earnings. And on the credit side, as probably all of us know by now, interest cost is extremely elevated. If you're a small business in the U.S., you want to borrow short term at a bank, we're talking 9 to 10% interest rate on those short-term loans. This is probably among the highest levels in the last 20 years. Not only the cost of credit is elevated, but the access to credit is more difficult as well. So, if you want to borrow, you have to show a pristine balance sheet to get access to that credit. So, you need both macro conditions, I would say, to improve and the credit conditions, so the cost and the access to credit [need] to get better, I think, for small caps to outperform larger cap stocks. So, we're not there. I think eventually in 2024, we might get an entry point for small caps. But for now, as we enter 2024, I'd prefer to remain large over small in portfolios.
SM: So, the large caps, which generally means just larger companies?
HSM: Larger companies. They usually tend to have on average, stronger balance sheet, easier access to capital markets. So, if they want to borrow, they need cash, it's easier for these guys. So, when macro conditions or when risk appetite is not very strong, usually investors tend to go towards what we call higher quality, which tends to rhyme with larger cap equities versus smaller cap equities.
SM: Right, so they just have the ability to…
HSM: To ride the storm a bit more, correct.
SM: Let's move on to geography, let's say. You look at investment opportunities, I suppose, all around the world and what the markets are doing all around the world. Are there places that you think are showing more of a positive outlook than others?
HSM: Well, it depends. Let's focus on emerging markets for a second. Emerging markets, I would say, have underperformed on a year-to-date basis, dragged down by China. The Chinese equity market has not done well. The economy's facing a lot of headwinds. So, within the emerging market sphere, clearly LatAm looks good to us.
SM: LatAm is Latin America?
HSM: Latin America, correct. I think it's a place where we should see more monetary easing, where valuations are attractive and where LatAm, relative to other EM countries, surely look great from a valuation standpoint.
SM: Okay. So, you have this great detailed report looking at 2024; is it possible to sum it up in a pithy sentence or two, what does 2024 look like for Hugo Ste-Marie?
HSM: Yeah, markets have been on fire lately, but I would say probably 2024 will be more complicated than the markets believe. I think being balanced as we enter 2024 could be key for our clients. As I mentioned, maybe we have this decent, perfect soft landing, but I would say it’s not my base case. As I mentioned, most years you have decent pullbacks, use those pullbacks at your advantage. If you have a lot of money on the sidelines, that could be opportunities to reload on equities. Don’t chase the market and again keep a decent balance between offence and defence in your own portfolio. Don’t try to hit the ball out of the park. That’s the best recipe to get burned. And hopefully we all make money in 2024.
SM: Those are excellent words to end on. Hugo, thank you so much for joining us. Really happy to have you on the show again.
HSM: Thank you very much.
SM: I've been speaking with Hugo Ste-Marie, Director of Portfolio and Quantitative Strategy in Equity Research at Scotiabank.
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