An Investor's Farewell to 2024

Every year, around this time, I write a piece reflecting on the year that was.

And every year, I publish the piece before the year is over and I worry just a bit that something will happen before year-end that will make the overall tone or some of the observations seem out of touch. And this year is no different!?

With public equity markets up as much as they are year-to-date, a US Presidential transition underway, the French Government in turmoil, talk of large US tariffs, and wars in the Middle East and Europe, it is entirely possible that something could still happen in 2024 that would undermine one or more of the observations below. With that risk in mind, here are my observations on the year that was…

The US market

One of the most powerful investment phenomena in 2024 was the continued strong performance of US public equity markets. The S&P 500 was up about 29%, so far this year, on a total return basis (all figures in USD).

The outperformance of US public equity markets in 2024 continues a longer trend. Since 1980, the MSCI US index has returned 10.7% on an annualized basis. That is an annual outperformance of 2.7% versus the MSCI EAFE index (the developed world, excluding the US and Canada). The Russell 1000 Growth index has returned 11.2% on an annualized basis over that same period, outperforming the MSCI EAFE by 3.2% per year on average. And NASDAQ has risen 12.1% annually, which is equivalent to a 4.1% annual outperformance versus the MSCI EAFE!

Despite that long term outperformance, it is worth keeping in mind that not all segments of the US market have outperformed other developed markets at all times. And over periods of time where some segments of the US market underperformed, others outperformed. For example, between 2000-2009, the annualized total returns of the MSCI US index and the NASDAQ were lower than the MSCI EAFE index (by 3 % and 6.6%, respectively). Meanwhile, over that same period, the total return of the Russell 2000 index was higher than the MSCI EAFE index by 1.8%.

For investors with large allocations to US risk assets, this reinforces the importance of diversifying their exposure across sectors, and large and small cap companies. As tempting as it may be to double down on the biggest winners in recent years (e.g., US large cap, growth and public technology companies), this could very well lead, at some point, to a long period of disappointing results.

The Recession that has (still) not materialized

The long-feared US recession did not materialize in 2024. In fact, US GDP and employment growth continued to chug along at a healthy pace.

In March 2022 the US Federal Reserve began to raise interest rates to combat the highest rates of inflation in decades. It eventually raised interest rates by close to 500 bps, which was more and faster than at any time in decades. Then in July, the yield curve inverted, which was an ominous sign, given this phenomenon has reliably presaged every recession since 1970.

And yet, here we are at the end of 2024. The Federal Reserve has reduced rates by 75 bps???????? so far this year, and the long-feared recession still has not materialized.

In fact, since the Federal Reserve began raising rates in 2022, inflation has been reduced to 2.3%; total returns of the S&P 500 are up, close to 45%; total US employment is up 5%, reflecting the creation of 7 million jobs; and the US economy has grown by about 16% or US$4.14 Trillion.

This is not what is “supposed” to happen when central banks step hard on the brakes. The ongoing strength in the US economy and markets may well be because we have moved from a period of ongoing monetary stimulus (between the GFC and Covid, interest rates were kept extremely low) to a period of ongoing fiscal stimulus (the US Government now regularly runs deficits that, as a percentage of GDP, would only have typically occurred in a recession in the past.)? It’s hard to know.

The moral of the story is: Investors should not base their investment decisions on predictions of near-term macroeconomic or capital market events. What may seem obvious, often turns out not to be so. Instead, investors should: build diversified investment portfolios that are meant to generate strong returns over the long term; rebalance portfolios when markets move asset classes off their long-term targets by meaningful amounts; and maintain adequate liquidity to avoid being a forced seller of growth assets when they are down. And if an investor has a long investment time horizon and stable liquidity requirements, they should be patient and invest more in growth assets to generate higher returns.

Net Value Add

2024 was a year where positive net value add (over or underperformance relative to benchmarks) was hard for many institutional investors to generate. It was hard to “beat the market.”

For private asset classes with public market benchmarks, the “lag effect” was almost certain to generate negative net value add. Private market valuations do not move up and down at the same time or pace as their public market benchmarks. This means that private market net value add is more likely in years when public markets decline, and less likely when they rise. Because public equity returns were so strong this year, investors with large private market allocations were unlikely to have positive net value this year.

This is why we never assess net value add on a short-term basis.

Net value add was also hard to generate in the public equity markets in 2024. That is nothing new. The annual S&P Indices versus Active (SPIVA) Scorecard has, for years, documented the challenge many public equity funds have, beating their index.

But recent market dynamics have arguably made net value add even more difficult than usual to achieve. US markets have become very concentrated in a few names. Today, the top 10 companies in the S&P 500 represent about 36% of the index. The last time the top 10 companies represented this large a percentage of the index was 1964!? And, as can be seen in the table below, the market behemoths then and now are completely different, reflecting the “creative destruction” that defines US capitalism. Three of the top 10 from 1964 went bankrupt (GM, Sears, and Kodak) and two merged into other companies (Gulf and Texaco).

(At the total portfolio level, today’s concentration within US public equities shouldn’t be alarming for investors with a well-diversified portfolio that includes material allocations to other asset classes, such as non-US public equity, private equity, credit, real estate and infrastructure.)

With the index as concentrated as it is today, it is hard to generate net value add without making a “big bet” for or against these large and high performing stocks. This is why our approach to Public Equity is to have a significant percentage invested in passive and low tracking error factor public equity strategies and aims to maintain market weighted exposure to things like the US market overall and the Mag 7. At some point, the small number of companies that dominate the US index today will stumble and be replaced by a new crop of dominant companies. But, trying to identify when is a very risky investment strategy. There could be many years of forgone gains and underperformance.

Real Estate

It feels like 2024 was the start of recovery for real estate.

For years, real estate has been battered by several powerful forces. Retail real estate was hurt by the shift to online shopping. Office real estate was hurt by the shift to hybrid work. And most real estate was hurt by higher interest rates and construction costs.

As measured by the MSCI private real estate index, over the last 5 years, Canadian and US private office and retail real estate have generated zero to slightly negative returns because of large write downs. Multi-residential real estate has generated low to mid-single digit returns. Only industrial real estate has generated strong returns, in the low double digits. Thankfully, year-to-date, with the exception of US office space, further large write downs haven’t been necessary and all those segments in Canada and the US are either flat to positive. The worst – fingers crossed – seems to be behind us.

The last few years have been a good reminder of the need for diversification across and within asset classes, including privates. No big bets. For real estate, this means balanced exposure to office, retail, multi-residential, logistics and life science. We continue to believe in this asset class over the long term and are focused on ensuring our clients have a well-diversified real estate portfolio.

Generative AI

This year, the excitement around generative AI continued to drive investment returns across a number of sectors. The AI trend drove Mag 7 values up by about 35%. It even drove up the value of utilities. The S&P utilities index was up 26.3% YTD on the expectation that massive new amounts of electric power will be required to support the computing and data requirements that underly generative AI.

We believe generative AI will have a powerful effect on economic growth, productivity, employment and capital markets in the years to come. However, we also believe it is very difficult to predict the specific long-term winners when new technologies emerge. Netscape was the dominant search engine when internet search first took off. And Nokia was the dominant mobile phone technology in the early days of cellular communications. So, rather than trying to identify the big winners and long-term dominant players, we are focused on investing in the infrastructure that will support AI, like data centres, fibre optic telecommunications and electricity generation.

While we are investing in data centres, fibre optic telecommunications and clean energy generation, we also limit our overall exposure to these sectors because we believe that as powerful as the AI trend is likely to be over the long term, unpredictable developments do happen, and we do not believe in making big bets. We are also mindful that our exposure to US public equity automatically gives us significant exposure to the AI trend, just by owning the index.

Geopolitics

We continue to live in highly charged times from a geopolitical perspective.

The tragic war in Ukraine continues, with alarming new developments like Russia’s use of hypersonic missiles and soldiers from North Korea. The Middle East seems to wobble on the precipice of an all-out direct war between Iran and Israel. This year, incumbent Governments were voted out in the US, UK and South Korea. And the governing parties of France, Japan, India and South Africa lost legislative power. ?

Meanwhile, the positive geopolitical trends that dominated in the years around the turn of the millennium have reversed and are hard to imagine today. Today, only 8% of the world’s population live in full democracies, according to the Economist Intelligence Unit. In 2023, about twice as many countries experienced a decline in democracy (67) than an improvement (32). And, according to data released by the Armed Conflict Location and Event Data Project, the number of recorded incidents of political violence will reach almost 200,000 by the end of 2024—25% higher than last year and double what it was five years ago. The Peace Research Institute Oslo tracks equally depressing statistics. It found that there were more state-based conflicts in 2023 that at any time since WWII.

This increasingly volatile environment is among the reasons we focus on investing in developed markets. We believe they are subject to less geopolitical risk. They are also places with less ESG, corruption and FX risk. And they are places where we can leverage our advantages as a large institutional investor (e.g., accessing private assets alongside best-in-class investors). Approximately 93% of the assets we manage are in developed markets.

The Election of Trump

It’s impossible to reflect on this year without saying something about the re-election of Donald Trump.

The US is exceptional. It produces outstanding companies, an unmatched level of technological innovation, incredible wealth and philanthropy, and global leadership at critical moments, such as rapidly inventing, producing and distributing vaccines during the Covid pandemic and coordinating central bank responses to the GFC. It has very often served as an example of things to emulate and aspire to. We, in Canada, are fortunate to live next door to the US and enjoy access to their markets, investment opportunities, protection and friendship.

But the US has a much more tumultuous society than Canada. Canada’s constitution speaks to “peace order and good government” as opposed to the US’s “life, liberty, and the pursuit of happiness.” And the US is, arguably, more tumultuous today than at other times, as it works to resolve some deep cultural schisms and revisits decades-old policy orthodoxies, including how they think about trade and immigration.

Ultimately, we believe that despite the current cultural and political tensions in the US, the breadth and quality of US investment opportunities are likely to continue to be driven by things like their high level of technological innovation, culture of entrepreneurship, competitive tax and regulatory environment, flexible labour markets, large and relatively barrier free internal markets, deep public and private capital markets, and overall economic dynamism. We believe the US will continue to represent a very attractive long term investment market and warrants a large allocation within our clients’ portfolios.

We continue to have a significant amount of our clients’ portfolios invested in the US.

The importance of diversification

One of the more disappointing developments for us over the course of 2024 was Swedish EV maker Northvolt’s Chapter 11 bankruptcy.

This would have been hard to imagine only 17 months ago when we invested in a company that ticked a lot of boxes for us: it had an experienced management team, contractual purchase commitments from some of the largest automotive companies in the world, and a deep roster of experienced Canadian, US and European institutional investors.

Downside surprises are an inevitable part of investing and one of the reasons we help our clients build diversified investment portfolios. Individual investment results will not be clustered around our overall target return. There will be outliers at either end of the spectrum.

Northvolt represents a small percentage of the funds we manage for our clients. And, throughout 2024, we had a number of investments surprise to the upside, such as our investment in CoreWeave. Its most recent valuation was several times what it was at the time of our initial investment, resulting in a significant valuation increase to date.

We continue to believe that the energy transition will be a powerful trend over the coming decades and one that will present real risks but also many opportunities for investors. We believe it is a technological trend, and not just a policy trend. 47% of automobiles sold in China are EVs. Year-to-date, 50% of electricity produced in Europe is from renewables (including nuclear). And the levelized cost of renewable power is often less than coal or natural gas. We continue to invest in energy transition investments.

Still, when things don’t go as planned, reflection is important.

Northvolt serves as a good reminder of the importance of diversification.

Farewell, 2024

2024 has been a good year for growth-oriented investors, particularly those with material exposure to US large cap and technology public equities. Not every year will be like this. The S&P is up about 29% year to date. Last year it was up 26%. When the S&P 500 has been up as much as it has over the last two years (55%), there have only been 6 years since 1901 when returns the following year were above the long-term average of 11.8%. This is in no way meant to sound like a prediction for 2025 or a “macro call”! But it’s a good reminder to be thankful for the year that was!