Market Musings

Dear friends, Happy New Year!!!!

We hope that this first communication of the year finds you well and having enjoyed a great holiday break. Spending quality time with family and friends around the holidays does us all a lot of good.

With a new year beginning, we thought we would share a few ideas or thoughts with you, relating to what things will be topical (in our minds).

We expect that central banks’ overnight rates will start to fall over the next two quarters. This will provide some relief for debt holders but gone are the days of two per cent mortgages for five years. At the same time, expectation for longer dated rates remaining higher for longer will provide some solace for pensioners looking for fixed income.

The higher rate structure is having an impact on the real estate sector. It works differently in different countries, but the result could be very similar.

In the U.S., most mortgages are 30 years long, and most of those outstanding were re-financed for long term at low rates (before the hikes). So, no real estate market crisis expected. Unfortunately, it also means that new home constructions could be impacted (an important sector), as people will not want to “trade” real estate, as they will have to give up on the current low 30-year rates that they have on their existing real estate holding. This can lead to inactivity in the sector.

In Canada, on the other hand, most mortgages are five years in maximum length. Over the next 18 to 20 months, about 31 per cent of existing mortgages are up for renewal. In the Canadian context, the situation could be more dire. Here is why: Rates two years ago for a Canadian mortgage were about two per cent. Today, the best rate is for five years at roughly five per cent. Translation: on a $650,000 mortgage, over $1,000 per month higher mortgage payments on a 25-year amortization. At the end of the amortization, based on the five per cent vs. two per cent, it will cost an extra $13,000 per annum, or an extra $300,000 during the amortization period.

The Toronto Star recently suggested that up to 60 per cent of mortgages issued by the chartered banks would need to renew between now and 2026. That’s $900 billion, in case you were wondering. Yikes!! A serious question is how over-extended these mortgage holders are. If they bought more that they should, there could be trouble. The federal government put in a type of safeguard in 2018: the mortgage stress test. The stress test requires that a home buyer looking for a mortgage must be evaluated on the ability to pay in the highest of the following two situations: 1- at a rate of 5.25 per cent, or 2- the current rate plus two per cent. As the rule states, they must pass the higher of the two standards. Current rates are more than 5.25 per cent. For someone to qualify, they would need to prove the ability to afford the mortgage at a rate somewhere north of seven per cent. This applies to both new buyers and existing mortgage holders who wish or need to change their bank during refinancing or renewal. In the above $650,000 scenario, it would mean that the applicant would need to be able to pay not just an additional $1,000 per month (or just about $13,000 per annum) and an additional $300,000 in interest over the amortization period, but an additional $2,000 per month (around $25,000 per annum), and over the amortization period, would pay an extra $600,000 in interest, due to the rate calculation at north of seven per cent. So, short-term rates being lowered will provide some relief on variable rate mortgage holders who have seen their rate go north of seven per cent. As longer-term rates should remain higher for longer, the real estate market in Canada, in part due to the affordability as well as the amount of debt for renewal, could be dramatically affected. This is why you may be reading and hear more frequently about a “buyers’ market” being the next phase: more sellers than buyers, making prices fall. Not all experts agree on this scenario, among other things because of the still very present housing shortage. Stay tuned…

The markets fared well to close out the year. The media focused on the great annual result for the S&P 500 achieving a stellar 24.23 per cent return. What is worth noting in this case is that slightly over 60 per cent came from just seven of the 500 stocks. Translation: seven stocks contributed 14.4 per cent of the total return while the remaining 493 contributed under 10 per cent. In Canada, the TSX eked out an eight per cent return.

In both cases, there was a significant amount of volatility during the year. For example, the level of the S&P 500 on Jan. 1, 2023 was 3,824. At the end of 2023, the closing value was 4,769. During the year though, the large up and down moves accounted for 4,425. By this, we mean that the cumulative absolute movement of the S&P 500 for the year was 116 per cent from starting value. All that movement, and yet the return for the year is only 24.23 per cent. As above, that is a lot of volatility.

The first few days of 2024 seem to indicate a falter, as the prospect of a recession (long overdue?) becomes more mainstream. The fear relates to a number of issues around corporate earnings strength, expectations of rate cuts (too few, and not soon enough) and even some speculation that the Fed may raise rates one more time (a limited probability, but still out there) as inflation rears its ugly head again, following a healthy holiday spending season.

The market appears to be signaling a pause, if not a retreat, after a strong close to the year.

The view on earnings growth for 2024 is positive, but most of that expansion is expected in Q4 of 2024, with not enough (potentially) to sustain current equity valuations. Total earning on the S&P 500 expected for 2024 is at $246.30. Based on the current multiple, the S&P is trading at 19 times expected full year 2024 earnings. Yes, it is true that the market trades ahead of earnings (as much as six to nine months, on average), but 19 times is still above the historical average. Definitely justifiable if we are in a full recovery, but we have some doubts about the resilience of corporate earnings in the face of the projected recession.

We expect that the recession call is imminent, and that it will not be as soft a landing as required for the current asset value levels on the equity markets to be maintained. As such, while we remain exposed to equities, we stay cautious.

In our experience over the last 38 years, cycles ebb and flow, and a market correction does not spell the end, but rather opportunity to deploy the accumulated cash or reallocate the investments in bonds that we have been safeguarding over the last period.

Apologies for the gloomy commentary, but an ounce of caution, on several fronts, is warranted.

Thank you for your loyalty and confidence. We look forward to seeing you and working with you again this year.

As always, we welcome your comments and questions.

Many thanks to you all.

Erik, Guillaume and your Patrimonia Team