2023 Capital Markets Review

2023 Capital Markets Review

By James Parkyn & François Doyon La Rochelle

2023 was marked by positive returns in all asset classes with the help of a massive rally near year-end. Despite the outbreak of the war in the Middle East, the hope of an imminent reduction in central bank rates – amid receding global inflation pressure – led stocks and bonds to appreciate substantially, with double-digit returns in several asset classes.

Inflation rates were cut by half in Canada (from 6.3% to 3.1%), the US (from 6.5% to 3.1%), and the UK (from 11.6% to 5.3%). Inflation also declined substantially in the European Union, Japan, China, and South Korea.

On the interest rate front, the Bank of Canada and the US Federal Reserve maintained their restrictive monetary policy, increasing their benchmark interest rates from 4.25% to 5% and from 4.50% to 5.50%, respectively. Ten-year government bond yields declined in Canada from 3.3% to 3.1% and were stable in the US at 3.9%.

Nine of the eleven sectors of the global stock market produced positive returns in 2023,[i] the top performers being information technology (47%), communication services (34%), and consumer discretionary (26%). Poland (48%), Greece (47%), and Mexico (38%) were the top‑performing country markets.

Here are our observations on asset-class returns in 2023:

• Short-term and total market Canadian bond indices produced returns of 5% and 6.7%, respectively.

• Short-term and total market global bonds (hedged to the Canadian dollar) delivered 4.7% and 6.3% returns, respectively.

• Canadian stocks delivered a return of 11.8%.

• US stocks returned 23.3% in Canadian dollars and 26% in US dollars.

• International developed market stocks returned 15.7% in Canadian dollars and 16.1% in local currencies.

• Emerging market stocks returned 7.9% in Canadian dollars.

• The Canadian dollar has appreciated relative to the major currencies. This explains the mildly lower CAD returns on US and international stocks compared to local currency returns.

• Large-cap stocks outperformed small-cap stocks in all developed markets and underperformed in emerging markets.

• Growth stocks massively outperformed value in the US, while the reverse occurred in emerging markets. Value and growth stocks had similar returns in Canada and international developed markets.

 Looking forward to 2024, investors will continue to face uncertainty. With an upcoming US election and geopolitical tensions in Europe, Asia, and the Middle East, it could be tempting to question our investment strategy. However, investors should remember that since the turn of the millennium, the global stock market has had positive returns in 16 of the last 24 years. Over this period, despite four bear markets, investors who stayed the course were rewarded. We remain convinced that the wisest course of action is to have a sound investment plan that you can stick with in good times and bad. We will invest with discipline for each client, with an appropriate mix of stocks and bonds. Portfolios will remain extremely diversified globally, and we will avoid the false promises of active management and investment fads. Finally, as always, we will optimize portfolio costs and taxes.

[i] All returns are calculated in Canadian dollars unless otherwise mentioned. Data source: DFA Web.

You will find our best advice on how to cope with the current bear market in our latest blogs and podcasts on Capital Topics and on our team’s Web site. Enjoy! 

Why Your Investing Perspective Needs to Get Much Longer ?

Why Your Investing Perspective Needs to Get Much Longer ?

By James Parkyn

We often talk about the need for investors to take a long-term perspective and look at periods of volatility through the lens of market history.

That’s why we’ve made it a tradition to report each year on the latest edition of the Credit Suisse Global Investment Returns Yearbook. The yearbook is an invaluable resource for investors because it draws lessons from a database of asset returns from 35 countries dating back to 1900.

This year’s yearbook includes an important discussion of just what constitutes a long-term perspective. That’s especially useful after an unusual year when investors suffered negative returns in both the stock and bond markets, amid high inflation, rising interest rates and the war in Ukraine.

The yearbook notes that stocks have outperformed all other asset classes in every country since 1900. The U.S. market, for example, provided a 6.8% annualized real return between 1900-2022. But it’s been far from a smooth ride.

With last year’s decline, we’ve now lived through four bear markets in equities since 2000, including the brief but harrowing COVID crash in 2020. While these episodes have been difficult, the important thing to remember is that living with that kind of volatility is the price you pay to earn a risk premium from stocks, and to a lesser degree bonds.

But to actually bank that premium, you must remain invested and well-diversified through positive and negative periods in the markets. And those periods can be deceptively long. The yearbook offers two examples where 20 and even 40 years of market data could be deceiving.

The first is what occurred in the stock market in the 20 years leading up to 2000. During those decades, global stocks performed exceptionally well, delivering a 10.5% real annualized return. Then, the dot.com bubble burst, kicking off what’s known as the lost decade for stocks when world equities generated a negative real return of -0.6% a year.

The yearbook’s second example is from the bond market where many investors were shocked by heavy losses in 2022. They’d become accustomed to reliable gains over the last 40 years. Indeed, in the four decades to the end of 2021, the world bond index delivered an annualized real return of 6.3%, not far below the 7.4% return from world equities.

It turns out those 40 years were a historic golden age for bonds, meaning, by definition, they were exceptional. When the turning point came in 2022, it was drastic. In just one year, the real return of world bonds plummeted 27%!

“To understand risk and return in capital markets…we must examine periods much longer than 20 or even 40 years,” the yearbook says. “Since 1900, there have been several golden ages, as well as many bear markets; periods of great prosperity as well as recessions, financial crises and the Great Depression; periods of peace and episodes of war. Very long histories are required to hopefully balance out the good luck with the bad luck, so that we obtain a realistic understanding of what long-run returns can tell us about the future.”

In other words, it’s important to guard against recency bias, the tendency to give undue importance to recent events. And, when it comes to the markets, recent should be measured in terms of decades.

Investors are too often lulled into complacency by trends that are too short to make prudent asset allocation decisions. Maintaining a disciplined approach to diversification and portfolio rebalancing through thick and thin will remain the best way to combat recency bias and other mental errors that can undermine your financial plan.

For more on the Credit Suisse yearbook and a discussion of the new First Home Savings Account, download episode 52 of our Capital Topics podcast and subscribe to get more insights into the capital markets, personal finance and growing your wealth.

The silver lining from a tough year in the markets is higher expected returns.

by James Parkyn

Anyone who is familiar with PWL Capital will know we don’t make predictions about the future direction of financial markets, the economy or anything else.

We accept the large volume of academic research confirming that no one can accurately forecast the future. Renowned economist John Kenneth Galbraith may have captured our attitude best when he said: “There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know.”

Nevertheless, we still need estimates of future investment returns to use in financial planning models for our clients. For this purpose, we use future expected returns, and they are quite different from predictions made by analysts, pundits and gurus.

In estimating future returns our research team at PWL doesn’t pretend to know what will happen in the markets or the economy in advance. Instead, they take the average of all possible return scenarios for a broadly diversified portfolio of publicly traded investments over a 30-year time horizon.

They generate these scenarios by combining observations of current market conditions and more than 120 years of historical returns for various asset classes.

Of course, we don’t know which scenario will come to pass in the markets in any year, which explains why our research team also estimates standard deviation – the percentage that an actual return could fall above or below our estimate in a given year.

This last point is important. In the short-term, returns will likely be substantially different from the expected return. Over the long-term, however, the dependability of the expected return estimate increases (although there remains a substantial margin of error). 

Last year was an example of short-term returns coming in far below long-term expectations for both the stock and bond markets. Both asset classes fell by double-digit percentages for one of the few times in history.

That was painful for investors, but the silver lining is that those market declines improved long-term expected returns, especially for bonds. We can see this in PWL’s recently published update of our Financial Planning Assumptions, authored by Ben Felix, Portfolio Manager and Head of Research, and Raymond Kerzérho, Senior Researcher and Head of Shared Services Research.

It shows that higher bond yields in 2022 produced a remarkable increase in our estimate for expected bond returns going forward. It climbed to 4.15% a year from 2.5% the previous year.

Gains in expected returns for stocks were less impressive because PWL’s equity estimates are based much more on historical returns than on current market conditions. Our estimated return for global stocks is 6.9% a year, compared to 6.6% a year earlier.

For a balanced portfolio composed of 60% stocks and 40% bonds, PWL estimates an expected return of 5.81% annually. Again, we can expect actual returns to deviate widely from this estimate in any given year.

Specifically, if we say the expected return is roughly 6% with a standard deviation of 9%, it means that two-thirds of the time, annual returns will be between -3% and +15%. The other third of the time the deviation will be even further from the mean. This is why investing often calls for patience and discipline.

PWL’s Financial Planning Assumptions makes a few other observations that may come as a surprise to you. Our research team estimates inflation at 2.4% annually over a 30-year-time horizon. That’s well below the current 5%+ inflation rate in the U.S. and Canada.

The report also estimates future returns for Canadian residential real estate market. Here, the recommended planning assumption is that an investment in a primary residence will return just 1% a year net of inflation, or 3.4% including inflation.

Return estimates are an important planning tool, but you should always keep in mind that we can’t know in advance what markets will return. Instead, you should seek to capture available returns as efficiently as possible while controlling risk through broad diversification and prudent asset allocation.

Then, it’s a matter of keeping the faith and patiently letting compounding do the work of building your wealth.

I encourage you to download a free copy of PWL’s Financial Planning Assumptions, and for more insights on investing and personal finance, listen to our Capital Topics podcast and subscribe to never miss an episode.

The experts’ crystal balls were as foggy as ever in 2022

by James Parkyn

To kick off the new year, our Capital Topics podcast looked at investing lessons from 2022. In this article, I want to focus on two of those lessons because they are so important for your financial health.

For our first lesson, we looked at last year’s events to see what they could teach us about what’s to come in 2023.

That’s just what’s done by the many financial experts who produce forecasts about the economy and the markets. We take a different approach. We look at those forecasts and wonder why anyone would pay attention to them.

To understand our attitude, let’s step back a year and consider some of the events you would have had to predict at the beginning of 2022 to have made winning bets.

• Russia’s invaded Ukraine to start the biggest land war in Europe since 1945.

• For the first time ever, both U.S. stocks and long-term bonds registered double-digit losses for the year. Value stocks outperformed growth by the largest margin since 2000, amid a tech stock crash.

• Runaway inflation took hold around the world, including rising to a 40-year high in the U.S. Major central banks hiked interest rates aggressively in response.

• China abandoned its zero-COVID policy as its economy stalled and widespread street protests emerged.

No one could have predicted these developments, but that’s not unusual. Every year, the markets are buffeted by unforeseen events that make a mockery of expert forecasts. If you want another example, look no further than early 2020 and the start of the global pandemic.

Yet, economists, analysts and money managers continue to confidently predict what’s going to happen at the beginning of each year. Why? It’s precisely because the future is unknowable that people crave the illusion of certainty that comes from predictions.

“The inability to forecast the past has no impact on our desire to forecast the future,” financial author Morgan Housel writes. “Certainty is so valuable that we’ll never give up the quest for it…”

Despite this deep need for certainty, one of our most important lessons from 2022 is to ignore the forecasts and outlooks. Instead, we recommend you focus on maintaining a steadfast commitment to controlling risk through broad diversification and a long-term investor mindset for whatever may come in 2023.

The second lesson we take from 2022 is related to the first. It’s to watch out for hindsight bias in your thinking and decision-making. This is the tendency to look back and delude yourself into believing you knew what was going to happen all along.

Writing in the Wall Street Journal, Jason Zweig explained it this way: “Countless hunches and gut feelings flicker through our consciousness over the course of a year. We naturally remember the ones that turn out to be right. The multitude of other hunches that turn out to be wrong go into our mental garbage can.”

Zweig writes that that hindsight bias translates into “what if” thinking. What if I’d only acted on this or that hunch last year, I would be so much richer today. However, our memory of past predictions is often faulty.

To prove the point, Zweig surveyed readers of his newsletter in late 2021 and asked them to forecast where a series of market indicators would be in a year’s time. Then, a year later he asked them to recall those predictions with the knowledge of how the year had actually turned out.

On average, the readers’ recollection of their forecasts was closer to how the markets actually performed in 2022 than their predictions back in 2021, which turned out to be far too optimistic.

This points to the human tendency to reconstruct the past based on what we know now. As Zweig notes the danger is that mistakenly thinking you knew what was going to happen in the past may lead you to think you know what’s going to happen in the future.

For more insights on how to navigate the markets, please check our PWL team website. And if you’re not already a listener of our monthly Capital Topics podcast, I encourage you to download the latest episode and subscribe to receive future episodes. 

Our best investment advice of 2022

by James Parkyn

As 2022 draws to a close, we wanted to look back at the blog posts that drew the most positive reaction from our readers during the year.

As markets gyrated, the focus in 2022 was on how to deal with a protracted downturn and prepare for the next bull market. I looked at everything from how to keep a tight rein on your emotions to avoiding poor decisions when markets are falling to the importance of not falling prey to unhelpful predictions.

1. You can’t catch a market rebound if you’re not invested—U.S. stocks and bonds suffered through one of their worst ever six-month periods to start the year. The Canadian markets were also down, although by a smaller margin. Naturally, these declines made many investors nervous about just how bad the losses would get. Then, the markets rebounded powerfully over the summer. A similar pattern played out in the fall. A steep decline in September was followed by rebound in October and November. These episodes show just how fast the markets can move.

2.  4 ways to prepare for the next bear market—I wrote this piece before the U.S. stock market had fallen into bear market territory by dropping more than 20% during the spring. It contains timeless advice on how to prepare for serious market downturns and ride them out when they inevitably come.

3. Ask yourself this simple question before changing your portfolio—From the field of behavioural finance we know that people tend to feel the pain of losses much more intensely than the joy of gains. That’s why falling markets can provoke so much anxiety and lead investors to make wealth-destroying decisions. One way to deal with the temptation to overhaul your portfolio in the heat of the moment is to ask this simple question: Once I make this move, then what?

4. Will higher interest rates push the economy into recession? —Predictions come in many shapes and sizes. This year the media has been focused on how high interest rates will have to go to bring down inflation and whether these hikes will push the economy into recession. In this article, I discuss an interview with former Bank of England Governor Mervyn King who offers some sage advice about the value of predictions. (Spoiler: He’s not a big fan.)

5. Does diversification still make sense? —With stocks and bonds falling around the world this year, there seemed to be no safe harbour. Since the financial crisis of 2008-09, global markets have appeared to move in lockstep during times of trouble. This has led some investors to question the value of portfolio diversification. I take a closer look at this question with the help of the Credit Suisse Global Investment Yearbook, which is a guide to historical returns for all major asset classes in 35 countries, stretching back in most cases to 1900.

To get more advice on investing and personal finance, please subscribe to our Capital Topics podcast and download our popular eBook, Seven Deadly Sins of Investing.

We hope you are enjoying a restful and joyous holiday season and the whole team joins in wishing you a healthy and prosperous 2023.