Reflecting on the unexpected

I would like to start by wishing everyone a Happy New Year. I hope that 2025 is filled with good health, joy and financial success!

What I thought we should do for the newsletter today is recap the themes that have directed markets in 2024, with a particular focus on those that could continue into 2025. I’ve separated these into sections below but as you can imagine, many of these are intrinsically linked.

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The economic downturn that never occurred

We have to start with the U.S. because of its economic size and impact on global investors. The biggest investment theme of 2024 was that the U.S. economy skirted an economic downturn. It was so impactful because it was on everyone’s radar screens and the market was on tenterhooks to find out how big of a downturn it would be (remember the terms hard-landing or soft-landing?).

The first six months of the calendar year were choppy but as it became clearer that the U.S. economy was able to? withstand higher interest rates and inflation was trending back towards target, stocks were given the green light. What was deemed to be good for the economy was good for profits, good for investor sentiment and good for risk assets. The U.S. stock market outperformed in 2024 and dragged most global indices higher with it.

I must admit that at the beginning of 2024 it didn’t feel like we were going to be an above average year for risk assets such as stocks and corporate bonds. As I have experienced many times since 2009 and the chart below demonstrates, not every year is created equal. The long-term average annual return for a balanced risk portfolio might be 7% but calendar years returns are all created different.

U.S. Supremacy

Looking back at 2024 performance, it is clear the global investors put a premium on investing in the United States. The U.S. economy has outperformed its peers, U.S. companies experience the highest growth and have the best profit margins in the world. To boot, the U.S. nation have just elected a president on a pro-growth agenda which aims to keep the U.S. at the top of the food chain. I think it’s fair that U.S. companies trade at some level of premium to Canadian, European or Asian businesses.

On top of the company outperformance, the U.S. Dollar has appreciated this year versus its peers. The U.S. Dollar appreciated 8% compared to the Canadian Dollar, close to 12% versus the Japanese Yen, 7% versus the Euro and a whopping 23% compared to the Mexican Peso in 2024. Whether the U.S. will continue to reign supreme is a big talking point heading into 2025.

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Inflation concerns are muted

Following on from above, the U.S. is currently experiencing what some are labelling a goldilocks scenario: solid economic growth, a strong labour market and inflation that has been trending back down to target. If you cast your mind back a few years, inflation was a major concern across the world after the pandemic. Broken supply chains couldn’t keep up with demand thanks to the trillions injected into the global economy by governments and households who started spending again. Higher inflation took a huge bite out of financial markets in 2022 because of the uncertainty it posed for the future. On top of this, the models used to value stocks and bonds are based on discounted cash-flows, with an interest rate that is influenced by inflation.

Fast forward to 2024 and inflation doesn’t seem to be the problem anymore. Most central banks around the world have been reducing interest rates to get them back down to “normal”, although the Federal Reserve has been a little slower than others in this task. The outperformance of the U.S. economy has led to the Federal Reserve taking a pause after their most recent cut in December. They now expect two interest rate cuts in 2025, which if implemented, would leave their benchmark rate right around 4%. This compares to an expected 2.75% for the Bank of Canada, which explains a lot of the weakness of the Canadian Dollar in recent months.

There is always a caveat, which is that there are no inflation concerns for Canada, Europe or Asia, but there are a few people talking about the potential risk that U.S. inflation accelerates again. One of the measures that is being pointed at is the cost of debt. With the Federal Reserve not expected to bring their target interest rate back down so quickly (previously there were 4 cuts in for 2025, now only 2), it has increased the cost of government debt, which in turn has increased the cost of mortgages.

As pointed out by Jim Bianco on X: since the Federal Reserve first cut interest rates this summer, mortgage rates are 0.7% higher. This is the biggest rise in the cost of a mortgage, during a period when the Federal Reserve is reducing rates, in 40 years. Does this spell trouble for the U.S? I’m not sure at this stage, but I don’t think the inflation story is dead and buried just yet.

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Politics can matter

Another theme we have seen played out in 2024 is that politics can take center stage. As investors we often try to look through politics and focus on monetary policy set by the central bank instead. However, in certain times, politics can have an outsized impact on markets over the short run. We have seen this in a positive way for the United States in 2024 but also in a negative way for Canada.

In my view, if you were to design a country built for success, you would design Canada. It has an abundance of minerals, energy, water, agricultural land and shares a border with an economic superpower. However, on the global stage Canadian businesses are currently viewed as less attractive and have seen valuations decline. Businesses and investors prefer a stable political environment, a strong domestic economy, access to talent & low taxes. I expect Canadian politics to remain front of center, for obvious reasons, and I am optimistic that we can refocus on the key criteria for business in 2025.

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Artificial Intelligence & Quantum Computing

There is no denying that a big part of stock market performance over the past couple years has been on the back of Artificial Intelligence and the benefits it can bring to society. The exact benefits are unknown at this stage, but AI is being discussed as being as influential as the birth of the internet. Google also recently announced a quantum chip called Willow. This new chip can perform a standard benchmark computation in under five minutes which would take one of today’s fastest supercomputers 10 septillion (that is, 1025) years. While it all incredibly exciting for the human race, investing always comes down to dollars and cents.

Billions of dollars have been spent on coding large language models, buying AI chips and building data centers to serve all our future AI related needs. The hyper-scalers will need to show a return on their AI chip investments and 2025 could be the year where investors start asking more detailed questions. As big tech and AI chip companies make up a large part of the S&P 500 index, the result of this will impact us all.

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Growth for the long-term

The final theme for 2024 is the investor preference for growth. In making a massive generalization, companies typically fall into one of two types. The first set of companies are more mature, grow at a pace more in-line with the economy, have stable cash-flows and typically return a large portion of their profits to shareholders in the form of dividends. The other set of companies grow at a much faster pace, reinvest the majority of profits back into their business, and are younger which provides a future that is more unknown.

Your preference for which type of company may depend on a number of factors, generally centered around your risk profile and time horizon. However, over the last decade, global investors have placed an increasing premium on the fast-paced companies and much lower value on slower companies. Like anything there are exceptions to the rule, but this has produced a significant difference in performance between the two segments of companies. For example, over the last 5-years the MSCI World Growth index has delivered 100% return. This compares to 30% return for the MSCI World Value index over the same period. However, as history has showed us, this can work both ways. As the chart below shows, between 1974 and 2007 there was significant outperformance of the stable mature businesses.

I’m curious to know which economic environment we will have in 2025 and how this impacts investor sentiment towards the type of stocks they want to own. Generally, the more optimistic investors are, the better the growth names perform. The more concerned investors are for the future, the more stable companies perform better. Circling back to inflation, does this impact the equation for 2025, if it all? That’s a question I’m looking to get answered next year.

As I have written about before, there is wide range of criteria that go into building a diversified portfolio. Ultimately, we want to buy a portfolio of high-quality companies and own them for a long period of time. Whether they pay a dividend or reinvest profits back into the business, a best-in-class management team will determine the best way to allocate capital. In 2025 we will keep focused on what matters most to you, invest wisely, and taking advantage of any opportunities that arise in the short-term.

With that I will wrap up for another year! If you have any questions about the newsletter and would like to go into more detail, or would like to discuss anything related to personal finance, please don’t hesitate to get in touch. I wish you a wonderful start to 2025 and we will speak soon.

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- Chris

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