December 23, 2024
This past year saw significant positive developments for markets. Economic growth came in better than forecasted, inflation fell and central banks across the globe cut interest rates. This provided an excellent backdrop for markets and the results were
remarkably better than forecasted, particularly for equities.
This year was about winners and bigger winners; and the United States (US) economy and market were the biggest winners of all. The S&P 500 is up 36% as of this writing. Notably, the largest seven stocks in the US market are up 62%. It was tough for
the rest of the market to keep pace with this “Magnificent 7,” however, 21% returns for Canadian equities (TSX Composite) and 15% for developed international stocks (MSCI EAFE) were nonetheless fantastic results. Bonds had a good year
too, with the FTSE Canada Universe Bond Index up 4% and credit strategies, including high yield bonds, outperforming.
That being said, we leave 2024 with some notable uncertainty related to the potential for inflationary policies, continued high levels of fiscal spending across most of the globe, lacklustre economic performance from China, and ongoing geopolitical
uncertainty. While these are all risks to watch, the current economic landscape is a decent starting point for 2025.
Equities - earnings expected to drive returns
It is wise not to extrapolate the outsized gains from 2024 into the new year. However, we think earnings can remain solid for 2025 given the decent environment for economic growth. The strength of earnings is important because valuations have moved materially
higher over the past two years. In the chart below we see that the US market is particularly expensive when compared to other leading markets, as well as its own historical average. The US large cap market is now 29% higher than its historical valuation.
While the US economy may continue to stand out for its strength, it’s less clear if the US market will continue to outperform. Other markets, such as developed international and emerging markets, could start to close some of the performance gap
with the US.
Traditional bonds - a bumpier ride
On one hand, interest rates are set to decline in 2025 as central banks continue to cut rates. On the other hand, this is already priced into the market. In fact, there may be more priced in than will occur because there are a number of factors that might
cause inflation to get stuck at current levels. If this happens, bond yields may rise or remain near current levels. This means that current yields could be a good proxy for total return in 2025. That said, returns likely won’t be a straight
line. Traditional fixed income returns have been volatile over the past few years and we expect this to continue in 2025.
Credit - expected to outperform traditional bonds
The conditions for credit remain strong. We are in an environment of moderation. Financial conditions are easing, corporations and borrowers have sound fundamentals, and there is solid liquidity and favourable sentiment towards this asset class. We think
a diversified allocation to credit will continue to outperform in the year to come.
Alternatives - diversification to work again
Alternatives serve as both diversifying and return-seeking components of a balanced portfolio. Absolute returns have been mixed over the past couple of years. Most investments are delivering absolute returns in line with target while others like real
estate and private loans have been affected by higher interest rates. On a relative return basis, it’s notable that returns from alternatives have been much lower than equities and some have underperformed bonds. This is expected in periods
like 2024 when traditional market returns are very high. However, this is unlikely to persist. The outlook remains positive for infrastructure and the headwinds to real estate and private loans may be largely behind us. Hedge funds are very good diversifiers
in periods where volatility is likely to remain for equities and fixed income. Higher volatility can benefit hedge fund strategies as there is more opportunity to deliver returns from investment insights.
Getting through with a long-term view
There is a lot of uncertainty when forecasting over a single year. As we cast our eye over a longer 10-year period, we think current conditions are set for solid – albeit more modest – returns than we have seen over the past two years. We
estimate 6-7% returns from equity, 4-5% returns for traditional bonds and 6-7% returns for credit. For alternatives, we anticipate returns in line with target which, while these vary, are around 7-10%. In many ways these returns would be different
to those of 2024, but also a return to more “normal” levels. Given the strength of many markets this year, it’s worth reviewing your long-term asset allocation, the amount of cash you hold, and deciding whether or not you have the
right commitment levels for alternative assets.
In 2025, we will continue to steward client capital through shifting environments: both the strong markets that we have seen recently and the more challenging ones that inevitably lie ahead. We always seek to balance short-term tactical views with long-term
assessments of risk and reward. It is in our DNA to evolve our investment capabilities as opportunities arise. These approaches have served our clients well and we expect that they will continue to do so in 2025 and beyond.