2023 Q4 Coleford Quarterly Commentary

As we step into a new year, it is worth taking a moment to reflect on 2023, a period that defied expectations and challenged investors and analysts alike. In economic terms, it will be remembered by recessions that never came, interest rate cuts that never materialized, and market behavior that left many participants bewildered.  In point of fact, the past two years were befuddling: short-term interest rates increased by over 20 times, longer-term rates more than doubled, and yet equity indexes in Canada and the U.S. are largely unchanged.

At the heart of the challenges faced by investors was the profound macroeconomic uncertainty that gripped the world. As 2023 unfolded, it became increasingly clear that (accurately) predicting market movements would be more difficult than ever. This is evident in the wide dispersion of US GDP forecasts – among the widest of the past 40 years.

The graph illustrates that range of predictions, highlighting the difficulty of arriving at a consensus. This dispersion of estimates reflects the uncertainty that pervaded 2023 – a year of surprises.

A Rollercoaster Fourth Quarter

The fourth quarter of 2023 was emblematic of the year’s overall unpredictability. After a brief continuation of a September swoon, equity and bond markets experienced a sharp upswing from November through the end of the year.

On the heels of this rally came a notable change in language from the Chairman of the U.S.  Federal Reserve.  Jerome Powell began the month of December with a cautious outlook, stating, “It would be premature to speculate on when (monetary) policy might ease.” However, just days later, he indicated that monetary easing was on the horizon, when he surprised the market by saying “rate cuts are something that begin to come into view.”

This surprising change in tone – in only a handful of days – reflected the central bank’s responsiveness to rapidly evolving economic conditions and provided additional fuel that propelled markets higher.  Additionally, this pivot in interest rate policy highlighted the ongoing challenge of navigating an uncertain macroeconomic environment, with the Fed seeking to balance the need for continued economic stability and vigilance against potential inflationary pressures.

In Canada, Bank of Canada Governor Tiff Macklem followed Chairman Powell’s pivot with one of his own.  Just two days after Powell opened the door to lower rates in 2024, Macklem pushed back on that idea for lower rates in Canada when he stated, “it’s still too early to consider cutting our policy rate.”  A mere three days later, Macklem responded, “I think it is sometime in 2024,” when asked on BNN Bloomberg Television when he sees the central bank lowering its benchmark overnight rate.

As we usher in a new year, the lessons from 2023 linger. The year taught us that certainty is a rare commodity in today’s complex economic landscape. It’s a time when recessions that were widely anticipated never materialized, and the elusive rate cuts teased the market’s expectations.

As we look ahead to 2024, let us remember the lessons of the past and approach the future with a healthy dose of humility, a quality that we very much admired in the late Charlie Munger and pay tribute to on the back cover of this issue. While we can (and do) analyze historical data and study economic indicators, we must be prepared for the unexpected.

EQUITIES

Throughout most of the year, equity market progress was dominated by a few major stocks. Namely, the so-called “Magnificent 7”, which includes, Apple, Microsoft, Alphabet, Amazon, Meta, Tesla and Nvidia. In contrast, the majority of S&P 500 stocks remained stagnant. This trend dramatically shifted in November as investors began to build confidence that the Federal Reserve had finished increasing interest rates.

“Magnificent 7” Contribution to S&P 500 Return

This newfound optimism triggered a widespread rally, propelling both stocks and bonds upward. The Federal Reserve’s recent economic forecasts, hinting at potential rate reductions in 2024, further bolstered this momentum, reinforcing beliefs that the era of rate hikes might be concluding.

In this wave of market enthusiasm, the S&P 500 and its price-to-earnings ratio soared, nearing historic highs established in January 2022. This rally was notable for its inclusivity, with a vast majority of stocks realizing gains. The S&P 500 equal-weighted index, a measure less swayed by large company stocks, mirrored this trend, nearing its own historical peaks. Even smaller companies began to show resilience in recent weeks.

The Federal Reserve’s change in stance was a key driver of this rally. The Fed’s updated dot plot, which illustrates individual committee member’s projections, now suggests up to three rate cuts in 2024, a forecast swiftly reflected in market expectations.

This shift is rooted in logical reasoning. With inflation receding from its mid-2022 peak, the Fed appears ready to reverse some of its rate increases. The critical query remains how swiftly and significantly these adjustments can be made without destabilizing the economy.

Two primary risks loom over 2024. First, the Federal Reserve might need to recalibrate its rate cut narrative, as premature reductions could undermine efforts to control inflation. Second, current valuations may have already integrated a soft-landing (for the economy) scenario, potentially limiting future equity market gains.

Ultimately, market trends are transient and seldom remaining static. 2024 will undoubtedly bring its own set of challenges and opportunities in the ever-evolving landscape of the financial markets.  With this perspective guiding us, we continue to believe that Structurally Advantaged businesses in the Coleford Model Portfolio will weather whatever 2024 brings.

FIXED INCOME

In the Coleford Q3 Quarterly Commentary we highlighted a strong rise in fixed income yields – which we attributed to the market underwriting a higher for longer interest rate environment.  In November market perception reversed, and yields followed suit across the board.

Government of Canada Interest Rate Curve – Q2 2023 to Q3 2023 to Q4 2023

As an example, last quarter we mentioned that the yield on a 10-year Government of Canada bond increased to 4.0% from 3.25% in the third quarter. This instrument ended the year at 3.11%

For perspective, 3.11% is roughly equivalent to the yield in the early part of 2022 when the Bank of Canada began its cycle of interest rate increases. It still compares favourably to prior decades when the 10-year Government of Canada yield often started with a “2.”  We continue to follow a proven approach to investing in bonds with staggered maturities.

CLOSING THOUGHTS

2023 demonstrated that even central bankers cannot accurately foresee short-term movements in inflation. To speculate on monetary policy responses to inflation is ultimately fruitless and yet is a major preoccupation of capital market analysts and the media because rates move the economy. At Coleford, we do not speculate. We invest in Structurally Advantaged companies with fundamental attributes that allow them to sustainably earn high returns on capital and outpace their competitors.

While volatility is a fact of life in investing – as Coleford has witnessed time and again over the past three decades – a conservative, consistent and committed approach to ownership of Structurally Advantaged companies is the peace-of- mind way of steadily building real wealth over time.  We encourage readers to review our publication called The Journal for more insight into our investing approach. Please let us know if you would like an assortment of back issues. In the meantime, we wish you a healthy and prosperous 2024.

Acknowledging what you don’t know is the dawning of wisdom.
— Charlie Munger —