Monthly commentary - Mackenzie Bluewater Team

Written by the Mackenzie Bluewater Team

It wasn't until late 2023 that the narrative pivoted towards the anticipation of a decline in policy rates. This shift signaled a reversal in the trajectory of interest rates, resulting in a subsequent upwards spike in stock prices. Investors began recalibrating their strategies as the prospect of easing monetary policy hinted at the possibility of a more favorable interest rate environment for equities.  Curiously, historically significant declines in policy interest rates have tended to be highly unfavourable for equity markets, as they have been a product of sharp economic weakness heralding the beginning of a recession.  Despite the equity market’s initial enthusiasm, it remains to be seen if this time is truly different.

One striking development in 2023 was the concentration of returns within the S&P 500, where the “Magnificent 7” (Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta Platforms, and Tesla ) contributed over 60% of index performance in 2023, after having generally been significant laggards in 2022.  These 7 companies were predominantly companies that experienced accelerated growth during the pandemic. These firms possessed products and services that were already performing well before the pandemic, but witnessed a significant uptick as consumer and corporate behaviors underwent substantial transformations that favored each of these companies.

However, as the world gradually returned to a semblance of normalcy, the outlook for these companies moderated. This, combined with a shift in investor sentiment due to the sharp rise in interest rates and inflation, resulted in a notable correction for these market leaders in 2022.  This correction was, in many cases, disproportionate to the fundamental realities of the actual companies.

Despite the temporary setback, the resilience and underlying strength of these firms became evident as they continued to grow, resulting in their stock prices experienced a sharp rebound in 2023.  Consequently, they not only recovered but went on to dominate investment returns for the S&P 500 index over the year.  Given their size, this resulted in a very challenging year for active managers to beat their benchmarks.  With the stocks having returned to more normal-- arguably above normal--valuation levels we do not expect a similar highly concentrated return environment in 2024.

Although the Magnificent 7 were the most significant in terms of impact on the global equity markets, we continue to see other businesses and industries experience similar Covid-normalization aftereffects.  In some cases, demand was well below normal during Covid before spiking to high levels post lockdown and only gradually returning to normal now.  In other cases, the opposite was true, with pandemic created one-time demand spikes followed by a post pandemic revenue collapse.  For other business and industries, the distortions were less obvious.  The supply chain turmoil during Covid caused over-ordering and overstocking by customers, resulting in companies continuing to discover that customers have excess inventories of their products.  In other cases, companies continue to have unusually high backlogs which they are working through, leading to strong current revenue but low or negative orders for future sales.  While the economy will eventually return to normal, we are certainly not fully there yet.

In addition, as we continue to transition into the post-pandemic era, we are seeing increasing evidence of the impact of higher interest rates on overall economic growth.  Some of this impact is already evident, with stress emerging among lower-income consumers in the US and Canada. Canada faces additional vulnerability due to mortgage structures that rebase interest rates more frequently, raising concerns about how consumers will adapt to significantly higher borrowing rates.  On a global scale, economic growth remains sluggish, particularly in China. The nation continues to grapple with challenges associated with transitioning to a more consumer-oriented economy amidst a complex demographic landscape. While China has been a trailblazer in electric vehicles and aspects of the energy transition value chain, political pressure from Western economies, concerned about the implications of China's success on their own domestic industries, adds an element of uncertainty.

Simultaneously, China's emphasis on advancing its technology and its domestic semiconductor industry is encountering rising hurdles, including import restrictions from the Western world. The 2024 US election, with the potential re-election of a protectionist Donald Trump, combined with an ongoing Middle East conflict further contribute to the prevailing climate of uncertainty and potential surprises.

Outlook

We anticipate the onset of a more challenging economic landscape as central bank tightening gradually takes full effect. With the extraordinary savings from Covid stimulus programs nearing depletion, consumers are displaying increasing signs of financial strain. Bluewater has delivered value to investors by concentrating on a select group of companies that stand as leaders in their respective industries. These companies are spearheaded by best-in-class management teams and exhibit growth rates surpassing those of the overall economy. Their resilient business models enable them to navigate uncertain environments adeptly and enhance their competitive advantages. All our businesses boast high profitability, generate substantial free cash flow, and maintain robust balance sheets. We anticipate that the earnings resilience of our companies will be significantly more resilient compared to the broader market, positioning them well in the face of economic headwinds.

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