In our inaugural edition of The Pinnacle from last quarter, we reviewed some of the key themes we are expressing across client portfolios and by and large, these themes performed very well in Q4-2023. In this report, we will highlight a couple of strategic investment decisions we are focused on for 2024, following an update on the Ascendant Wealth Partners team, and a review of the market developments from the fourth quarter.
Ascendant Wealth Partners – Team Update
We are pleased to report that the Ascendant Wealth Partners team has seen a material increase in the number of clients that we advise, and our assets under management. We started the quarter with a little under $3 billion under management and assets grew to approximately $5.2 billion by the end of the quarter, December 2023. We project continued growth into 2024 and we greatly appreciate the support and confidence from all our clients.
We welcomed four new team members to the Ascendant Wealth Partners team. Two familiar members from the Gluskin Sheff Client Wealth and Client Administration teams, an external hire, and a co-op student from the previous term that will be continuing with us full-time. Connor Kitchen will be supporting Evan Howard and Jonathan Paul with client and portfolio management; and Alicia Adderley, will be assisting Bruce Leboff with various client management and administrative functions. Both Connor and Alicia were colleagues of ours at Gluskin Sheff and they are familiar with many of our clients. Tyler Clemens is joining us after completing his MBA from the Richard Ivey School of Business. Prior to completing his postgraduate degree, Tyler spent several years with Manulife Securities. Tyler will be supporting Bruce Kagan from both a client and portfolio management perspective. Lastly, Rose Wang, will be working with Adam Moody and Bruce Kagan and their teams in an administrative capacity. Above all, we continue to strengthen our team’s culture and capabilities.
Market Briefing
A volatile start to the quarter but a strong finish with central bank easing in sight for 2024
We noted in our last publication that we thought the progress in terms of moderating inflation pressures had been successful and that further tightening from central banks would be a thing of the past. There were in fact no overnight rate increases from either of the Bank of Canada or the U.S. Federal Reserve in the fourth quarter. It was just one year ago when investment strategists were predicting rate cuts for the second half of 2023, but their outlook never materialized. Inflation proved to be stickier than expected – particularly in the services component of the economy, which is the largest share in both Canada and the U.S.
What we saw in the final three months of 2023 was truly unprecedented. Violent swings in the equity market, with persistent selling for most of October led to an early Santa Claus rally in November, which continued throughout the balance of the year. In addition to equity volatility, we also experienced material swings in interest rates across the yield curve. As an example, the widely followed U.S. 10 Year Treasury Note yield began the month of October at 4.57%, only to breach 5% the final week of October, then settled to finish the year at a yield of 3.87% (on the last trading day of the year). The positive correlation of stock and bond prices today are the highest they have been since the 1990s (correlation of more than 60% on a rolling three-year basis).
So, what caused this sudden change and high degree of volatile price action? Several things. In the fixed income market, bonds had become technically oversold when the U.S. 10 Year Treasury Note approached 5%. There was also news that a prominent investor, Bill Ackman from Pershing Square Capital Management, had covered his profitable short bet against U.S. Treasury bonds around that same time. The American economy continues to trend positively, but there are clear signs that the rate of growth is slowing. Inflation, as noted, continues to ease with the latest annual core inflation rate reading at 3.5% in Canada and 4.0% in the U.S. Most notably, and in a turn of events, at the last U.S. central bank FOMC meeting in mid-December, Fed Chair Jay Powell suggested that central bank officials expect three interest rate cuts in 2024. The market reacted quickly, pricing in five to six rate cuts in both Canada and the U.S. It is possible that either the U.S. central bank, or the market’s predictions could be right – but of course, they could both be wrong.
US Federal Reserve: Market Implied Rate Path
Source: Bloomberg.
Data is presented as of January 3rd, 2024.
The important takeaway is that interest rate policy and expectations for easier monetary policy will have significant influence on market performance headed into 2024. Not to mention, will the Fed be able to achieve the desirable “soft landing” and completely avoid a recession? Expect more “two-way” volatility in the coming year, and as active managers, we will navigate and look to take advantage of opportunities as they materialize (and we expect they will).
We have updated the chart below to illustrate that despite strong absolute market performance in 2023, it truly was a year of recovery from where we finished 2022. The cumulative returns presented below are quoted on a non-annualized basis, showing very modest price appreciation across equity indices, and a steep decline in bonds over the span of the last 24 months.
Large individual drawdowns can impact returns and looking at the U.S. equity market as an example (S&P500 Total Return Index) this is abundantly clear. The S&P 500 had a very strong year in 2023 led by the biggest of the tech names. However, 2022 was a challenging year for U.S. large-cap equities and the 18.1% decline wasn’t completely earned back until the very end of 2023, despite the strong year. When we think of risk management and portfolio construction, our objective is to optimize a portfolio that has good downside protection and strong upside capture – a proven winning strategy and an effective approach for compounding wealth. Borrowing a baseball analogy: hitting singles and doubles, as opposed to swinging for the fences and occasionally striking out.
Summary of Market Index Performance
Data is presented as of December 31st, 2023.
The Return of Reinvestment Risk
One hazard facing investors today is that of reinvestment risk. Given the sharp rise in interest rates, a flood of liquidity over the last two years was converted into cash and cash equivalent investments. For all of 2022 and the first half of 2023, we were consistent in this behaviour and held outsized cash weights in portfolios. Not only did this provide a high degree of safety, an inflation and fear-driven inverted yield curve meant that short-term maturities (less than one year) offered superior interest over those of five and even ten year maturities (with an inverted yield curve often viewed as an early recession indicator).
We noted in our last issue that the current tightening cycle was likely coming to an end. Our conviction has strengthened as both central bank policy makers and market investors are signaling for cuts in 2024. Should overnight rate cuts come to fruition, the earnings at the front end of the curve (shorter maturities) will decrease – reducing the level of interest received by an investor.
Material exposures to high Interest cash and savings accounts, cashable GICs and GICs nearing maturity, present re-investment risk. As yields are likely set to decline, traditional cash and cash equivalent investments nearing maturity, and investment products offering a floating rate of interest, will soon be replaced with lower yields.
With this in mind, we believe that intermediate fixed rate bonds (specifically three-to-five-year maturities) are increasingly attractive in the current environment. Our preference is in investment grade corporates. These bonds offer an assurance of return for a fixed investment term to maturity, barring a negative credit event such as a bankruptcy, restructuring, etc. Further, given the inverse relationship between interest rates and bond prices, these bonds offer an effective hedge should interest rates decline (as interest rates decline, bond prices increase). In addition, many bonds can be purchased at a discount to their par value, which leads to tax efficiencies in taxable accounts and depending on the term, taxable equivalent yields of 5.5% to 7.5% can be earned.
The fixed rate bond asset class is generating the highest level of income in 15+ years. Given the current opportunity available in fixed income, we feel that investors should consider the inclusion of short-term, fixed rate bonds as an alternative (or complement) to traditional cash and equivalent investments.
The Ascendant Wealth Partners team can customize a fixed income solution that meets your investment objectives and takes full advantage of current market opportunities and match any future liquidity requirements.
The Opportunity in Mid-Cap U.S. Equities and Madison Investments
As discussed in our Q3 issue of The Pinnacle, bonds presented an attractive opportunity for risk-adjusted returns by mid-2023. Furthermore, as global interest rates increased, both bond yields and equity valuations (in many market segments) rose in tandem. In the U.S., we saw the emergence of the “Magnificent 7” during 2023, which contributed to strong returns and put the composition of the market-cap weighted S&P 500 index under a spotlight. Today, the seven largest stocks in the S&P 500 account for approximately 26% of the total market capitalization of the index, even exceeding the approximately 22% concentration level reached during the dot-com bubble of 1999/2000. The current concentration level in U.S. large cap equities (specifically in the S&P 500 index), coupled with inflated valuation metrics (28x forward P/E), warrants further consideration when determining the appropriate weight of U.S. equity exposure in an overall portfolio. The below chart highlights historical concentration levels in U.S. large cap equities, demonstrated by the seven largest companies as a share of the S&P 500’s total market capitalization over time:
Market Weight of Largest 7 Companies in the S&P500 Index
Source: RBC Wealth Management, Bloomberg.
Data is presented as of December 31st, 2023.
We believe that high quality, large cap U.S. stocks still have a place within a diversified portfolio; however, we strongly believe attractive opportunities can also be found elsewhere. Within equities, we are favorably positioned in areas with more attractive valuation support. More specifically, in the U.S., we see an opportunity in the mid-cap market. The S&P 400 Mid-Cap Index’ forward price to earnings multiple is highlighting an attractive absolute level and a material discount to its 10-year historical average. In contrast, the S&P 500 index is trading above its 10-year historical average forward price to earnings multiple. Forward price-to-earnings (forward P/E) uses future earnings expectations to relate a company's (or index) share price to its earnings per share. This measure is often used to determine the relative value of a company's shares in an apples-to-apples comparison to other similar investments. The chart below shows valuation trends for large-cap and mid-cap U.S. equities over the past 10 years:
Forward P/E Ratios: Large Cap and Mid Cap US Equities
Source: RBC Wealth Management, Bloomberg.
Data is presented as of December 31st, 2023.
Despite the relative and absolute attractiveness of the broader US mid-cap market, we feel that the opportunity can be most effectively realized through an active investment management approach. Active management refers to a professional money manager and team of professionals who actively make buy, hold, and sell decisions based on market trends, fundamental analysis, and quantitative analysis regarding the assets owned in a closely monitored investment portfolio, given a specific investment mandate. By contrast, passive management, also known as indexing, seeks to track an index or benchmark by replicating both its composition and performance.
Our team methodically monitors market opportunities across a broad spectrum of asset classes and selects the most appropriate investment solution for each individual investor. Active investment strategies are employed where an investment manager has a demonstrated track record of consistently delivering outperformance, net of fees, on a risk-adjusted basis. Leveraging the RBC platform, our team has access to a universe of 3,000+ active investment strategies, including separately managed accounts and pooled funds managed by RBC and leading third-party managers. In the U.S. mid-cap space, both RBC’s Global Manager Research group and the Ascendant Wealth Partners’ Investment Committee have identified a proven, high quality U.S. mid-cap equity investment manager in Madison Investments.
Founded in 1974, Madison Investments is an independent, employee-owned firm that provides active, high quality and high conviction investment portfolios to its clients. The firm operates via four distinct investment teams based on asset class coverage, all supported by a centralized back office, administration and client services team. This structure allows the investment team to focus 100% of their time on portfolio management, free of any distractions or administrative burden.
In the U.S. mid-cap space, Madison Investments is a market leader through their flagship Madison U.S. Mid-Cap Equity strategy. The portfolio is managed to a disciplined investment approach based upon a growth at a reasonable price framework. Growth at a reasonable price (GARP) is an equity investment strategy that seeks to combine characteristics of both growth investing and value investing to select individual stocks. GARP managers typically look for companies that are showing consistent earnings growth above broad market levels, while excluding companies that have very high valuations. The Madison team screens companies possessing attributes such as double-digit sales growth, improving margins, positive cash generation, low debt to capital, and sustainable competitive advantages. The U.S. Mid-Cap Equity portfolio differentiates itself from many of its peers through its concentrated, yet risk-controlled approach to investment in U.S. mid-cap equities. The limited number of holdings (typically 25-40) provides investors with true active management, while the emphasis on identifying individual company risks allows for a more consistent (ie. less volatile) return experience.
As of December 31st, Madison’s mid-cap equity fund has outperformed the Russell Midcap Total Return Index benchmark over 1, 3, 5, and 10 year time periods. Below is a summary of gross performance for the strategy:
Madison U.S Mid-Cap Equity Fund Performance
Source: Madison Investments, RBC Wealth Management.
Data is presented as of December 31st, 2023.
All returns are presented gross of any fees or expenses.
2024 Outlook
We are cautiously optimistic heading into 2024. With general yields at levels not seen in over 15 years, and the economy appearing to have escaped a recession in 2023, economic data remains strong, though there are signs that growth and leading indicators are slowing. As noted above, we continue to believe that:
- Inflation will trend lower over the next 12 months, with some unexpected upticks along the way
- Reinvestment risk of short-term cash instruments becomes a concern given the pending shift in central bank policy to rate cuts
- Intermediate fixed rate coupon bonds are once again an attractive opportunity in a diversified portfolio
- U.S. mid cap equities are quite appealing in an asset class dominated by seven influential and expensive tech companies
We will be hosting a live and interactive webinar update where the Ascendant Wealth Partners team will share highlights and recent milestones for the business, and a review of our market outlook and portfolio positioning for 2024. This event will be held at 1pm EST on Tuesday, January 23rd. For those who are unable to join us live, a recording will be made available at a later date.
Wishing you and your family a happy, healthy and prosperous 2024!
