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5 key themes that will shape the Canadian and global economy in 2023
Vanguard has released its 2023 forecast. You can access it by clicking on this link to a PDF.
We first looked at this in this Hub blog on December 12: Vanguard says Balanced portfolios still offer best chance of success as Inflation gets beaten back.
In this follow-up blog, we’re looking in more depth on the Canadian portion of the report, which begins on page 23. We have reproduced some of the text and charts from that section in the second half of this blog.
“Generally, we are calling for a global recession next year, including a milder recession for Canada with economic growth pegged at 0.7% (for Canada),” says Matthew Gierasimczuk, spokesperson for Vanguard Investments Canada Inc.
Vanguard expects five key themes will shape the Canadian and global economic environment as we move into 2023:
- Central banks’ vigilance in the fight against inflation
- Spillover effects of global economy, energy, and real estate markets on the Canadian economy
- Economic effects of the energy crisis in Europe
- China’s long-term structural challenges as it aims to end its zero-COVID policy
- Last, but not least, a more positive outlook for long-term investors across bonds and equities
Fighting inflation: Central banks maintain vigilance
Vanguard says 2022 has proven to be “one of the most rapidly evolving economic and financial market environments in history. Across the globe, central banks have responded with coordinated monetary policy changes that have outpaced anything we’ve seen for several decades.”
A globally coordinated monetary tightening regime
“This is the greatest inflation threat we’ve seen since the 1980s,” it continues, “Central banks have a difficult path ahead that will require being more aggressive with policy, making additional rate hikes, and maintaining vigilance as the inflation situation shifts.In the U.S., the Federal Reserve has adopted the position that there is still work to be done, and it appears to have the resolve to stick with it.”
For the balance of this blog, we’ll drill down on the report’s prognosis for Canada, which starts on page 23 of the forecast. We’ve selected large chunks of text, which is as it appears in the report, with minor excisions such as references to some charts not reproduced here. Therefore, we are not using quotation marks. An ellipsis (3 dots as here: …) is used to indicate sections excised between passages. With one or two exceptions, most subheadings are from Vanguard. Readers who want the full report should of course click on the PDF link above.
Canada: Reining in an overheating economy
The year 2022 has seen persistent global inflation followed by rising policy rates as central banks across the world played catch-up. Over the course of 2022, inflation in Canada continued to tread higher driven by a combination of rising demand, tightening labor markets, and volatile energy and food prices as a result of ongoing supply constraints and geopolitical events. Heading into 2023, there are growing signs that inflation will moderate due to recovery in global commodity supply and slowing economic growth driven by tightening monetary policy.
In 2022 we discussed how policy tightening will be a crucial risk behind a lower growth environment among other factors such as high inflation, further supply disruptions, and new virus variants. Looking back most of these risks occurred throughout the course of 2022. The unexpected Russian invasion of Ukraine added to supply disruptions and pushed headline CPI inflation to its historically highest level of 7.9% YoY. Continue Reading…
Accelerating your Legacy Planning by Gifting In Advance
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By Steve Lowrie, CFA
Special to the Financial Independence Hub
Most posts about legacy, wills, and estate planning focus on how to settle your estate after you pass: ensuring your intentions are met, your family is cared for, charitable gifts are fulfilled, taxes are minimized, and so on.
Estate planning is important; we help clients with it all the time. But today, I’d like to offer a valuable twist on the theme of estate, life, and legacy planning:
Instead of your excess wealth being distributed after you die, you may find even greater value in giving some of it away while you’re still around.
Properly managed, making gifts and charitable donations while you’re alive can offer solid tax-saving benefits to you and your estate financial planning. In particular, targeted charitable giving can be a powerful tool for business owners and similar professionals who are approaching retirement and facing high-tax events, such as selling their business, or exercising highly appreciated stock options.
As importantly, it can be incredibly rewarding to witness the results of your generosity. Don’t underestimate the value this intangible benefit can add to your life and legacy planning.
Legacy Planning for Quality Living
First, what is “excess wealth?” Is there such a thing as too much money??? Not really.
This is where legacy planning is essential. If you’re thinking about spending, gifting, or donating significant wealth, don’t just guess at the dollar amounts. Instead, you and your financial advisor should periodically crunch the numbers to determine how much you and your loved ones conservatively need to remain well-positioned, even under worst-case scenarios (such as, say, a global pandemic).
After that — if you and your loved ones are indeed set for life — any extra resources become the financial equivalent of gravy on your entrée. How will you use your excess wealth to add flavour to your life and to the lives of others so that you are leaving a legacy you can be proud of?
An anecdote about Lifetime Charitable Giving
To envision what it would be like to make one or more significant charitable donations during your lifetime, consider the story of “John and Jane,” an earnest couple in their 60s who came to me for advice a few years ago. John came from meager roots, but he was determined to make his own way. With a boost from some financial aid, he put himself through college, where he met Jane. Together, they worked hard, scrimped and saved, and raised two kids. Along the way, John started his own business, which prospered.
Fast forward to 2020, when John was able to sell his business for a substantial sum of money. After we ran all the numbers, it was clear he, Jane, and even their kids would be able to live comfortably for their remaining days. Both personally and in a holding company, the couple also owned some taxable investments that had appreciated nicely.
So far, so good. However, there was one challenge (even if it was a nice “problem” to have): even with extensive planning in the anticipation of an eventual sale (purified operating company, multiplying the lifetime capital gain exemption, etc.), the business buy-out would generate hundreds of thousands of dollars in taxes in the year of the sale. As the saying goes, when you’ve incurred taxable gains, you can choose who’s going to benefit the most from the taxable portion: the government, or your favorite charities. I suggested to John and Jane, they could reduce their taxes owed in the year of the sale by instead fulfilling some of their existing charitable intents that same year.
To manage the significant donation they had in mind, we established a Donor-Advised Fund (DAF) in their name. They then donated into their DAF an equal amount to the taxes incurred from the sale of John’s business. This helped them accomplish several goals:
- They were able to fully offset the taxable buy-out gains with their charitable contribution.
- John was able to fulfill a lifelong dream by using some of the DAF assets to establish a scholarship at his alma mater. By doing so during his lifetime, he has been able to see others benefiting from a solid education, just as he had when he was young. On a personal level, he and Jane have found the experience highly rewarding.
- Moving forward, they can donate highly appreciated assets to their DAF to wash away those gains as well.
A DAF offers a few other benefits as well. For example, you can direct how to invest undistributed DAF dollars in the market, potentially increasing your giving power over time. You can also keep your charitable giving anonymous if you’re so inclined. Continue Reading…
Price, Value & the CAPE’d Crusade
By Noah Solomon
Special to the Financial Independence Hub
According to Warren Buffett, “Price is what you pay. Value is what you get.”
The cyclically adjusted price-to-earnings ratio, commonly known as CAPE, is a valuation measure invented by Nobel Prize recipient Robert Shiller. It is calculated by taking the price of an index and dividing it by its average earnings over the past 10 years, adjusted for inflation. The ratio’s use of average earnings over the last decade helps to smooth out the impact of business cycles and other events and thus provides a better picture of a market’s sustainable earnings power.
The CAPE ratio is commonly used to gauge future returns over medium to long-term horizons. In theory, higher than average CAPE levels imply lower than average future returns, while their lower counterparts suggest that future returns will be relatively high.
In the following piece, I analyze historical data to determine if the CAPE ratio has been a useful predictor of future real (i.e., after inflation) returns. In my view, including real rather than nominal returns is appropriate given the recent resurgence of inflation. Investors must be mindful of inflation’s potential to erode a substantial portion of their portfolios’ purchasing power. Lastly, I comment on what investors can expect going forward given the current CAPE level.
The following table presents average real future returns following various CAPE ranges.
S&P 500 Index: Average Real Returns Sorted by CAPE Ratio (Jan. 1970 – Nov. 2022)
There has been an inverse relationship between CAPE ratios and future returns. When the CAPE ratio has been near the high end of its historical range, future returns have tended to be relatively low. Conversely, low CAPE ratios have tended to foreshadow higher returns. Whereas this relationship has not been statistically significant over shorter holding periods, it has been strong over the medium to long-term.
When CAPE ratios have been below their historical average of 21, annualized real returns over the subsequent five years have averaged 8.3%, as compared to only 3.3% when CAPE ratios have stood above this level. The corresponding numbers for 10 year holding periods have been 8.8% vs. 4.2%.
The difference in average returns cannot be understated. On a $10 million investment over 5 years, the difference in return equates to a real value of $14,922,900 vs. $11,754,768. Adding in the average inflation rate since 1970 of 4.04%, the corresponding nominal values have averaged $17,920,804 vs. $14,240,696.
Over ten-year holding periods, the average real values of a $10 million investment made when CAPE levels were below vs. above average were $23,290,712 and $15,137,096, respectively. After adding back the post-1970 average inflation levels of 4.04%, these figures rise to $33,533,809 and $22,140,747.
These differences, although significant, represent the divergence in average returns during times when CAPE ratios have been merely above or below average. As the table above demonstrates, the difference in returns following investments made in very low vs. very high CAPE environments has been far greater.
Explaining the Anomalous “Bump”: Where Behavior Confounds Theory
Although low CAPE levels have been associated with higher future returns, and vice versa, the relationship is far from perfect across different CAPE ranges. Specifically, there is an anomalous “bump” whereby future returns for the 20-25 CAPE range have been nearly as high or higher than those that have followed any other CAPE level.
My best guess is that this peculiarity relates to human psychology and behavior. Historically, when stocks have risen for an extended period following a bear market, investors have been increasingly willing to believe that “it’s different this time” and that the good times will continue indefinitely. At these times, FOMO (fear of missing out), greed, and momentum have taken center stage until valuations reached levels which all but guaranteed a catastrophe.
Greed, Fear, & Where we Stand Today
The above relationships are a powerful representation of investor psychology. Historically, when the crowd’s greed manifests in lofty stock valuations, future returns have tended to be anemic. On the other hand, when widespread skepticism and despondency have caused earnings to go on sale, above average returns have tended to ensue. Alternately stated, investors would be well-served to follow Buffett’s advice to be “fearful when others are greedy, and greedy when others are fearful.”
Recent market malaise notwithstanding, stocks remain overvalued by historical standards. Taking the most recent data available, the CAPE ratio currently stands at 27.42, which is 30% higher than its historical average since 1970. This CAPE level implies real annualized returns over the next five years of 3.6%, which is approximately 50% lower than the 6.9% average that has prevailed since 1970. Over the next ten years, the implied real rate of return is 4.3% as compared to a historical average of 6.6%.
When the Going Gets Tough, the Tough get Tactical and Seek Dividends
Over five decades spanning January 1970 to December 2019, the two worst periods for the S&P 500 Index were the 1970s and the 2000s. Continue Reading…
Diversified & Dynamic: 2023 Global Investment Outlook
By Ian Riach, Franklin Templeton Canada
(Sponsor Content)
Investors may see key improvements in conditions in the capital markets and the wider economy in 2023 and beyond, according to the Capital Market Expectations (CMEs) from Franklin Templeton Canada. We presented our CMEs at Franklin Templeton’s Global Investment Outlook in Toronto on December 6.
We develop a proprietary set of CMEs annually, using top-down fundamental and quantitative research. Using an outlook for the next seven to 10 years, we review the expected returns and risk of investable asset classes: equities, fixed income, alternatives and currencies. Our economic outlook and 10-year asset class forecasts are driven by macro expectations, current valuations and various asset class assumptions. The CMEs are annualized 10-year return expectations, and they are intended to coincide with the average length of a business cycle and are aligned with the strategic planning horizon of many institutional investors.
Our process also considers long-term macroeconomic themes to complement the objectivity of our quantitative analysis. This year, we factored in three major themes:
Growth: We expect to see moderate growth in the next phase of the economic cycle, driven by advances in technology and increasing productivity. Demographics will likely be a slight headwind to growth as populations in developed markets age.
Inflation: Inflation is expected to remain slightly higher than the targets established by central banks over the medium term. Rising wages and energy prices are sticky aspects of inflation.
Fiscal and monetary policy: Central banks, including the Bank of Canada, will keep up their aggressive fight against high inflation. Not surprisingly, this will hamper economic growth. On the other hand, we expect fiscal policy by governments to remain accommodative. Fiscal policy can result in higher government debt, which can be inflationary. But if government stimulus targets, say, capital projects such as infrastructure, then it can be beneficial to long-term growth. Policymakers are walking a tightrope now.
Capital Market Expectations
With that background, here is a concise summary of our expectations over the next several years:
- The expected returns for fixed income assets, like bonds, have become more attractive. We also expect the recent volatility in fixed income markets to subside.
- The returns of global equities are expected to revert to their longer-term averages and outperform bonds.
- Stocks in Emerging Markets are expected to outperform developed market equities over the next seven to 10 years.
- A diversified and dynamic approach to investing is the most likely path to achieving stable returns over the long run.
The chart below sets out our range of expectations for key assets compared to historical averages:
Note that these return projections are higher than our 2022 outlook and are closer to their long-term averages.
Franklin Templeton Canada uses its CMEs to shape strategic asset allocation for our portfolios. However, we do not just “set it and forget it”. We employ a dynamic asset allocation process over the shorter-term, taking into account market conditions. While we are optimistic over the next decade that returns will favour risk assets, our short-term preference (next 12 months) is to be cautious as recession risks rise. Continue Reading…
