Quarterly Markets Update: Q4 2023
February 6, 2024
February 6, 2024
2023 was a productive year for investors. We’re also pleased that Matco investment platform performed very well, with positive, absolute returns across all asset classes managed in ascending order. Our fund performance for the year, Macto Fixed Income Fund, which was up 6%. Our Canadian small cap fund, which was up seven and a half percent. Our Canadian Equity Income Fund up 7.7%. Our balanced fund up 8.5%. And lastly, our global equity fund up 15.4%.
As we look out to 2024, the markets remain focused on whether a soft landing will be achieved. This has been and remains an ongoing debate for investors from our perspective. There are three potential outcomes for 2024. The optimistic scenario, which is the immaculate soft landing where the wheels touched down perfectly and the economy continues to expand. We put a probability of about 15% on that scenario. Now, our base case is that a turbulent landing where the wheels hit hard, the plane skids while the economy reaches a stall speed before recovering to renew growth. We put the highest probability on this one at 65%. Lastly, our pessimistic scenario of a crash-landing nose into the asphalt and ultimately a recession ensues. We put a probability estimate of 20% on this one.
Now, the sensible investor understands that the future is fraught with uncertainty and that managing investments is a practice best approached with humility and preparedness. The number of variables that will impact the future course of the economy and therefore the capital markets is so large that to consider one future path is simply ill advised. A much more pragmatic approach is to understand what fundamentals are suggesting about the current health of the economy, while also allowing history to instruct the likelihood of potential outcomes. It’s from this perspective that we assign the greatest probability to a turbulent landing. Historically speaking, central banks, unfortunately, have had a terrible track record of tightening financial conditions, increasing interest rates and reducing the money supply without causing an economic slowdown. That task at hand has been to bring down inflation from extremely high levels, while not causing significant damage to both the labor market and economic growth. This task is surgical and central banks unfortunately operate with the blunt force tools of monetary policy. Now, as an investment manager. We’d certainly prefer the best-case scenario, but preparing for all possible outcomes from our perspective is the most prudent approach.
Now as it relates to our Matco Balanced plan, the scenarios and respective probabilities that we have laid out suggests that economic risk tilts to the downside. As a result, it is likely that central banks will be easing financial conditions., corporate profits will struggle to meet investor expectations and growth will unfortunately decelerate. As a result, we favor fixed income in multi-asset class portfolios, given current valuations in equity markets and an outlook that highlights challenges for growth.
Although the odds of equities outperforming are nil, the path forward for bonds simply faces less challenges. Nonetheless, the soft-landing scenario isn’t entirely out of the question. So our stance on equities is still neutral. We favor quality companies with more resilient revenue profiles in a decelerating growth environment is very critical. Companies that benefit from decreasing interest rates and return capital to shareholders through dividends also have a greater probability of performing well.
Our Matco Balanced Fund returned 8.5% in 2023 and has delivered a 5% annualized return over the last five years. Our current investment mix favors fixed income with a 50% allocation of 10% greater than our long term structural allocation to the asset class. Within equities, we have a slight bias to Canada with a 28% weighting and a lower weighting of 22% to global equities. The tilt is largely a function of more attractive valuations in Canada, combined with higher dividend income levels. Our current investment mix offers excellent diversification and downside protection in the event of a harder landing for the economy and a softer landing environment. Our exposure to equities will still allow for robust capital appreciation. As always, our mandate within the macro balanced fund is to first protect and then grow the capital for our investors.
Currently, the Canadian stock market has the lowest valuation and highest dividend yield among adult markets. Several large cap Canadian companies are now trading with dividend yields north of 5% with significant earnings growth for the next year. Although recession headlines continue to dominate investors minds, we see great buying opportunities for long term investors. In a flat to falling interest rate environment the financials, pipelines and telecommunications and utilities sectors should rebound strongly, given the current driven yields north of 4% and attractive valuations. On the technology side, select companies have specific catalysts that could see their stocks generally trend higher. We remain bullish on the industrial sector as it has several sector tailwinds such as automation and infrastructure spending. Within the materials sector, we like exposure to agriculture as global food demand continues to grow. Within consumer staples and discretionary sectors, we see a few unique opportunities for earnings growth, regardless of the economic uncertainty.
Small cap stocks globally have lagged their large cap peers for the last three years. Concerns about a global recession have driven valuations on small cap stocks into deep value territory. In fact, today, small cap stocks are the cheapest valuation in over 20 years relative to large cap companies and now are trading at 0.6 times price to book. If interest rates do fall in 2024, we expect small cap stocks to simply outperform large cap stocks.
The energy sector continues to trade at depressed valuations, even though companies continue to pay down debt, increase dividends and buyback shares. We expect the recent energy patch consolidation to continue as the market now values disciplined mergers and acquisitions more than capital discipline and production growth.
We believe that 2024 could be the year of small cap stocks as active stock picking to find great companies trading at attractive valuations with companies specific catalysts that are growing faster than the economy will be the key to generating returns.
The Matco Canadian Equity Fund last year was up 7.7% and has a three year and five year annualized return of 8.2%. The fund has a dividend yield of 3.7% as of December 31st. The fund’s three main sector exposures are 28% in financials, 23% in industrials and 16% in energy. The Matco Small Cap Fund was up seven and a half percent last year. The fund’s three year annualized return is 4.4%, and over five years it’s 4.7%. The fund’s three main sector exposures are financials at 18%, energy at 17% and industrials at 14%.
Financial jargon comes in many shapes and sizes. In 2023, I believe we should crown resiliency as the term of the year. It was used so many times in the context of the US economy and stock market. Now investors always have to navigate a winding path, and each year we get a new piece of jargon or a recycled term to describe the path that we’re on. Take your guess on what 2024 will be. Over the last three years, equity investors have been rewarded despite a rather windy path fraught with a global pandemic, inflation, war and the most anticipated recession that so far is not materialized in 2024. My base case is for slower GDP growth as advanced economies navigate a decline in excess savings and a cooling job market. Firms focused on efficiency and pricing power hold the best odds of coming out on top, embracing our growth at a reasonable price investment strategy.
We will continue to put capital to work in areas we believe to be fairly valued and present an opportunity for earnings growth. So regionally, we hold the largest exposure in the United States at 60%. Europe represents a 17% weight and emerging markets make up 9%, which means going into 2024, our top three holdings are Fastenal company, Applied Materials and MasterCard. Over the last quarter, Macto Global Equity Fund Series F returned 7.4%. In 2023, the total return was 15.4%. Over the last three years, the fund’s annualized return was 7.6% and over the last five years, the fund’s annualized return was 10%.
In 2024, Bonds emerged as a standout asset class, offering healthy income, downside portfolio protection and attractive valuations when compared to equities. The fixed income sector is producing some of the healthiest income we have seen in over a decade. North American central banks are now firmly on the sidelines. And more recently, both Federal Reserve Chair Jerome Powell and Bank of Canada Governor Tiff Macklem have cracked open the door to rate cuts in 2024.
The market will continue to debate when the first cut will take place and how many cuts will follow before year end. In our view, the timing and magnitude are a bit less critical. As we previously laid out in our possible economic scenarios, the degree of deceleration will dictate the course of future monetary policy. In each case, the path of least resistance for rates is lower, and for us that is the key.
Now, within fixed income, portfolio positioning is as important as ever. After sheltering in shorter term bonds and floating rate notes throughout 2021 and 2022, we began extending the term and duration of our bond portfolio. Throughout 2023. The end of the rate hiking cycle was on the horizon and the swap market had begun pricing in future rate cuts well before the central banks had in fact cracked open that door. As interest rates move lower, bond prices move higher and longer-term bonds stand to benefit the most. Historically speaking, long duration positioning is beneficial prior to the first cut taking place, and these positions must be closely monitored as the rate easing cycle unfolds. Eventually, the yield curve will flatten and refocusing on medium term bonds will be wise.
Now, with respect to corporate bonds, our view is a bit more tempered. Credit spreads, this is the additional yield offered to investors for taking on the fundamental risk of a specific company, are historically tight. When you add in and consider the economic uncertainty ahead, credit spreads appear to offer even less value for investors. Now they are blacklisted from our portfolio, but focusing on high quality investment grade corporate bonds in the shorter end of the yield curve seems more prudent. This will provide a modest yield increase for the portfolio while minimizing the potential negative impact if those credit spreads do move wider or higher.
Now, with the year of the landing on the horizon, investors now have access to a more conventional set of opportunities. Fixed income, which has been less attractive for about the last five years, now, offers significant portfolio value. In comparison to equities, bond valuations appear more attractive. This relative value relationship can be observed by looking at the current level of the equity risk premium. With a long-term average of 4.2% and the current risk premium being at 1%. A lower value indicates that equities are expensive relative to bonds. Economic deceleration, don’t get me wrong, isn’t an exciting outlook, and multiple scenarios are certainly possible. But, from a risk adjusted perspective, it does paint a positive outlook for the bond asset class. Investors who focus on income in both bonds and equities are likely to be rewarded with a lower path of volatility and potentially higher returns in 2024.
2023, again, going back, was a positive year for fixed income investors, and Matco’s Fixed Income Fund was no exception. The fund had a return of 6.0% in 2023. The fund’s current duration is 7.9 years, with both a current yield and yield to maturity of 3.8%.
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