IMCO's CEO Bert Clark Bids Farewell to 2023

By

Bert Clark, IMCO's President and CEO wrote a comment on LinkedIn on an investor's farewell to 2023:

Like a movie with many plot twists, 2023 is the kind of year where you want to see the ending before making any pronouncements!  The end of the year is still about two weeks away, so I am taking some risk publishing a farewell today!  But, here we go…

2023 has served up many surprises.

At the beginning of the year, things did not look promising. The Economist World Ahead 2023 predicted: “Major economies will go into recession as central banks raise interest rates to stifle inflation, an after-effect of the pandemic since inflamed by high energy prices.”

Blackrock Investment Institute commented: “The new regime of greater macro and market volatility is playing out. A recession is foretold; central banks are on course to overtighten policy as they seek to tame inflation.”

These did not seem like wild or contrarian predictions at the time. Central banks had raised short-term interest rates by more than 4.00% over 10 months and the yield curve was inverted – a phenomenon that has presaged every recession since the 1950’s.

By the Spring, there were some ominous signs.

Both Silicon Valley Bank and Signature Bank failed in March – the largest bank failures since the GFC – and US regulators had to take the unusual step of guaranteeing all deposits to ensure financial system stability, particularly among regional banks. In June, JP Morgan Chase CEO Jamie Dimon said he was preparing the biggest US Bank for an economic “hurricane.” Things did not look good!

And then things mostly settled down.

By the third quarter, US GDP growth was 5.2%, on an annualized basis. And in November, investors began to anticipate monetary easing by the Federal Reserve – assets rallied across the board. By early December, the Federal Reserve confirmed what markets were anticipating – that it expected rate cuts in 2024 and assets and markets again moved up.

Today, as shown in the table below, almost all public indexes are up year to date.

2023 serves as another good reminder of just how hard it is to accurately predict near term macroeconomic or capital market events. A recession and market correction will come – they always do. But investment success that is premised on near-term macro or capital market predictions requires not just predicting the event, but also getting the timing right. That is hard to do on a consistent basis.

As John Meynard Keynes said: "the markets can stay irrational longer than you can remain solvent.”

Here are our reflections on a year that looks like it will turn out much better than many expected at the outset.

A Turning Point?

The last few years (especially in 2022) saw historically weak returns in a number of asset classes, including long term bonds, real estate and emerging market public equities. Since January 2022, US 10 Year Treasury returns have fallen 9%; the benchmark FTSE EPRA NAREIT index is down 12% from its all-time high; and the MSCI EM index fell 9%. This combination of weak results across asset classes that are included in most diversified investment portfolios has meant distinctly weak overall portfolio returns for many investors.

The chart below shows how the annual return of a “60/40” portfolio in 2022 was worse than all other years, but two—1931 and 1937.

We are hopeful that 2023 will end up being a turning point. Today, expected future returns on all asset classes look higher than 3 years ago when monetary stimulus reached what may turn out to be its peak – pushing bond yields low and valuations on growth assets high.

However, even though expected long-term returns look better today than they have in recent years, it’s important to keep two things in mind. First, these are long-term (10 plus years) expected returns. It is highly likely that we will have one or more market events over that period, during which time growth assets will perform much worse than the assumed average long-term return. And that sort of event could happen at any time.

Second, we never recommend that our clients rely exclusively on long-term expected returns when setting their long-term asset mix. Asset mix should not be a mechanical process based only on capital market assumptions, because they are just that, assumptions. Setting asset mix is a judgment-based exercise and needs to consider potential liability matching objectives, liquidity considerations, risk tolerance, areas of comparative investment advantage, and an investor’s world view. Long term capital markets assumptions are just one part of the asset mix setting process.

Some highlights from 2023

US Public Equity Markets – AI Tailwinds

In 2023, the total market returns of the SP/TSX, SP 500 and the developed market EAFE index have all been positive, with S&P 500 generating the highest local currency total returns (25%).

Investors with a long-time horizon, stable liquidity requirements and scale have good reason to invest in private assets. But, 2023 served as a reminder that there is also an important role for public equities in most client portfolios.

Public equities provide liquidity and broad geographic and industry segment diversification. They also provide diversified exposure to new trends and disruptive technologies – like generative AI – which appears set to have a significant impact on many companies and jobs and was a serious tailwind for public equity markets in 2023.

It’s hard to predict the long-term market leaders that will emerge due to new disruptive technologies, like AI. Recall that Netscape was the early dominant search engine and Nokia the early dominant mobile device. Public markets allow investors to easily “spread their bets” on which companies will dominate from new technologies, while also benefiting from the broader market uplift of new technologies. In 2023, investors in the broad public equity markets benefited from the excitement around the potential of AI and the spectacular run-up in certain stocks like Nvidia, AMD, Microsoft, Alphabet, Amazon, and Meta. Whether Nvidia and other 2023 AI winners are the long-term dominant AI players remains to be seen. If they are, investors in the broad market will benefit, but even if they aren’t, investors in the broad market will also have exposure to alternative companies.

For IMCO clients with growth-oriented portfolios, we typically recommend significant allocations to public equity (20-30%), including clients with large allocations to private assets. Within public equity, about 50% of our program is either indexed or factor-based, allowing us to “spread our bets” and get broad market exposure to countries, market segments and new disruptive technologies without having to correctly identify the long-term winners.

Credit – Many Attractive Opportunities

2023 saw some of the best investment opportunities in private credit in years, as both returns and credit quality increased. Base rates rose with central bank tightening while the typical loan-to-value ratio on new deals decreased. The rise in rates led to all-in rates of 9% to 12% for corporate credit and 13% to 16% for capital solutions credit, compared to single digit yields as recently as 2022. 2023 also saw the continued expansion of private credit investing to larger corporations, infrastructure and hybrid capital solutions.

IMCO capitalized on these opportunities by growing our private credit allocation to 46% from 37% of our credit program.

Energy Transition – Still Moving Forward

In 2023, it was easy to get down on the prospects for the energy transition. Those looking for ways to question the power of this long-term trend could point to things like the decline in renewable energy stocks (the S&P Global Clean Energy Index was down approximately 23% year to date), the highly publicized failure of Ørsted’s offshore wind project in New Jersey, or the fact that China continued to approve new coal fired power plants at a rate of two per week.

But there were at least as many developments that reinforced the power of this long-term trend. Although they are building more coal plants than any other country, China also leads the world in constructing new solar and wind generation capacity. The UK, Spain and Germany all reached or came close to reaching the 50% threshold in terms of the amount of electricity they can generate from renewables. The world is on pace to add 440 GW of new renewable power generation in 2023, an increase of 107 GWs from the year prior and an amount that exceeds the total electricity generation capacity of Germany and the UK combined. The unsubsidized, levelized cost of renewable power continues to outcompete fossil fuel generation in most jurisdictions, even after significant increases in capital and financing costs. And on the consumption side, the electric vehicle (“EV”) market continues to grow with 14 million EVs sold globally in 2023, up from 10.5 million in 2022.

We continue to believe the energy transition is a long-term trend that will create significant investment opportunities and risks. The trend will not be linear nor move at the same pace in all countries, but we are well positioned to navigate it. The keys to success include investing in markets committed to stable energy transition policies, being willing to develop new assets and create value through operational improvements, and taking a measured approach to deploying capital.

Consistent with this strategy, in 2023 we invested over one billion dollars in energy transition investments, including NorthVolt and NextWind.

Bonds – Finally Offering Decent Yields

It has been a tough road for bond investors over the last few years. Yields on the 10 Year US Treasuries bottomed out at 0.5% in July 2020. By October 2023, yields had risen to 4.9%, resulting in significantly negative total returns: the US 10 Year Treasury lost 26% over that period and posted its biggest ever loss in a calendar year (-16.5% in 2022).

In recent weeks, the yield on US 10 Year Treasuries has fluctuated around 4% to 5%, higher than it has been at any time since 2007. The most recent U.S. inflation figures suggest that annual inflation has slowed from 9.1% in June 2022 to 3.1% in November. If interest rates and inflation are indeed stabilizing, bonds should provide much better returns than they have in recent years. And when those who predicted a recession earlier this year are eventually right, there is much more potential upside in bonds than in recent years!

Public-Private Market Valuation Convergence

Public and private market valuations do not move in unison. Over longer periods of time they should be highly correlated, but over shorter periods of time there can be large valuation discrepancies. In 2022, many private markets outperformed their public market equivalents by a wide margin. For example, in 2022 the NA REITs index (an index that tracks public REITs) declined by 24.5%. Meanwhile, the IPD index (an index that tracks private real estate) was up 12%. This resulted in 36.5% difference in annual performance. This kind of difference in performance would not make sense over the long-term. Convergence in valuations was inevitable at the end of 2022 and has been happening in 2023: the NA REIT is up 8.5% and the IPD index is down 6%, narrowing the two-year performance gap to 14.5%.

This is one more reason we don’t put a lot of stock in short-term net value add at the asset class or total portfolio level. It is often driven by differences in valuation methodologies between private market investments and public index benchmarks. Those dynamics in 2022 would have tended to generate net value add; and those dynamics in 2023 are likely to generate negative net value add.

Staying disciplined in 2023

There are number of strategies that have been shown to reliably improve long-term investment results. But, as the saying goes, “they are simple, but they aren’t easy.”  In 2023, we did the hard work of sticking to these strategies.

We maintain a growth-orientation

One of the biggest advantages investors can have is time. It allows them to own more growth-oriented assets and earn higher long-term investment returns. While growth assets are subject to more variability of returns in the short term, over the longer term they generate higher returns. $100 invested in the S&P 500 at the beginning of 1928 would have appreciated to over $600,000 by the end of 2022. $100 invested in 10 Year US Treasuries would have been worth less than $10,000. Even over much shorter periods of time, growth assets have outperformed lower risk assets. For example, there are only a few instances where the rolling 20-year returns of the S&P 500 underperformed the rolling 20-year returns of US 10 Year Treasuries. These were relatively short periods of time and include major market corrections.

We continue to recommend growth-oriented portfolios to clients with the right risk tolerance and liabilities.

We manage costs

Costs matter when it comes to investing. They directly impact net returns. Larger investors like IMCO can leverage scale to reduce costs and improve returns, by negotiating better fees with key partners and investing directly alongside them. Research by CEM Benchmarking shows that costs can play as big a role in returns as active management, particularly for smaller funds. This was one of the reasons four smaller funds (OC Transpo, OCWA, the PBGF and Tarion) joined IMCO in 2023.

We manage liquidity carefully

To be a long-term investor, you must be able to hold onto long-term investments through challenging markets. Being forced to sell growth assets in challenging markets – crystalizing losses – directly undermines the powerful long-term strategy of investing more in growth assets. In fact, investors should manage their liquidity so that there is sufficient liquidity (cash or liquid assets) in portfolios to meet cashflow needs through good and bad times.

In 2023 we continued to monitor and optimize each of our clients’ liquidity.

We focus on generating outperformance where we have an advantage

Outperforming the markets is difficult. There is considerable evidence that most funds cannot consistently outperform over the long term. Consider for example, the SPIVA Scorecard (S&P indices versus active) which has tracked the performance of actively managed funds versus benchmarks for 20 years. It has found that most active funds in all categories have underperformed their benchmarks over the longer term.

We are fortunate to have numerous advantages that position us to outperform over the longer-term. Our size allows us to reduce costs. Our long-term investment time horizon allows us to invest in more growth assets. Our predictable and relatively low outflows allow us to invest in private assets. We have the scale to invest in systems to understand the risks we are taking and ensure we don’t have accidental concentrations of risk or “diworsification” (unintended over-diversification that can result from the activity of uncoordinated external managers). And our scale and operational latitude also allow us to build investment teams that can assess the relative value of public and private investments and more structured illiquid investments like private credit and pre-IPO companies.

In 2023, we continued to deploy capital on behalf of our clients into strategies where we have comparative advantages, particularly in private markets.

Over the last four years, we have grown our clients’ allocations to private infrastructure, credit, equity, and real estate by more than $15 billion.

Farewell, 2023

2023 looks like it will turn out to be a much better year for investors than many expected at the start of the year. We are optimistic that it represents a turning point with long-term expected returns much better than they were only a few years ago. In 2023, we continued to focus on our areas of competitive investment advantage and navigating long term trends, like the energy transition.

Merry Christmas, Happy New Year, and season's greetings!

Alright, Bert Clark wrote an excellent overview of 2023 from IMCO's perspective, highlighting why proper diversification across public and private markets helped the organization withstand the shock over the past two years where stocks and bonds got hurt (until mid-October where long bonds rallied hard).

Bert also explains the main advantages IMCO and other large Canadian pension funds have, namely, large, stable capital inflows, ability to internalize asset management and use their size to negotiate lower fees, especially in private markets.

IMCO still has a large exposure to public equities and stocks, which hurt it last year as the Fund lost 8.1%.

The losses can be explained by IMCO's asset mix which is roughly 55% weighted into public markets:

And in a year like 2022, when stocks and bonds get hit in a high inflationary environment, that doesn't bode well for returns.

Still, if IMCO didn't diversify into private markets like real estate, infrastructure, private equity and private credit, the losses would have been steeper.

In his comment, Bert touches upon something worth mentioning here, the valuation gap between public and private real estate:

Public and private market valuations do not move in unison. Over longer periods of time they should be highly correlated, but over shorter periods of time there can be large valuation discrepancies. In 2022, many private markets outperformed their public market equivalents by a wide margin. For example, in 2022 the NA REITs index (an index that tracks public REITs) declined by 24.5%. Meanwhile, the IPD index (an index that tracks private real estate) was up 12%. This resulted in 36.5% difference in annual performance. This kind of difference in performance would not make sense over the long-term. Convergence in valuations was inevitable at the end of 2022 and has been happening in 2023: the NA REIT is up 8.5% and the IPD index is down 6%, narrowing the two-year performance gap to 14.5%.

This is one more reason we don’t put a lot of stock in short-term net value add at the asset class or total portfolio level. It is often driven by differences in valuation methodologies between private market investments and public index benchmarks. Those dynamics in 2022 would have tended to generate net value add; and those dynamics in 2023 are likely to generate negative net value add.

Now, as everyone knows, private market asset classes are not marked-to-market, they are appraised once or twice a year and there is a lag between their valuations.

However, as Bert notes, over a longer period, these performance gaps between public and private assets converge and this is why it's better to look at performance of private markets over a longer period to gauge value add.

The NAREIT he's referring to here measures the performance of REITs in public markets real estate investment trusts while the IPD index measures the one in private markets.

Now, without getting too technical, these things do not measure the exact same things but they are good proxies of each other and in a year like 2022 when REITs got slammed, you bet it will impact private real estate valuations over the subsequent year.

This valuation gap or stale pricing benefits pension fund managers because if they are properly diversified across public and private markets, they will always show better performance than the traditional 60/40 portfolio Bert refers to in a year like 2022 and some of 2023 where stocks and bonds got hit hard.

Some pension funds are much more aggressive than others in writing down private market assets and some use dispositions -- or targeted asset sales at year-end -- to boost returns of some private market asset classes.

For example, OTPP sold Shearer's Food recently to private equity firm Clayton Dubilier & Rice and OMERS' real estate subsidiary, Oxford Properties sold a controlling stake in C$1.3bn Canadian industrial parks to TPG.

In both cases, these sales will boost the return of the private equity portfolio (OTPP) and real estate portfolio (OMERS). 

It's well within their right to sell prime assets when an opportunity presents itself but you can't do this every year. Mature Canadian pension funds typically sell when others are buying like mad or when they need to boost returns.

Some argue this isn't in the best long term interests of their members but it's well within their right to sell and asset whenever they deem it's appropriate.

But like I said, you can't do this every year and most of the time it is worth keeping these assets on your books for as long as possible. 

Public Markets are far from perfect

As far as public markets, yes they're marked-to-market but they're also much more prone to irrational behavior.

2023 is a perfect example where large hedge funds and asset managers herded into seven mega cap tech stocks:

More recently, this rally has broadened out to other tech stocks, large cap stocks and even small cap stocks, but this is very recent activity:

And let's be clear, apart form extreme herding, public markets are also prone to corporate manipulations like end-of-year buybacks to boost earnings per share:

My point is investors do NOT realize all the games and manipulative practices going on in public markets, they think it's extremely well regulate and shady stuff only goes on in private markets where valuations are done by appraisers.

Trust me, there's shady stuff going on in private and public markets, but it's rare.

And if you get the approach right, co-investing alongside private equity funds in larger transactions, there's no question you come out ahead over the long run.

That is where IMCO, CPP Investments and other large Canadian pension funds excel, in their co-investment program.

Alright, I can go on and on to discuss Bert's comment above, there's a lot I agree with, some I disagree with.

Right now, inflation expectations are dropping like a stone and if a recession hits, you'd expect them to continue dropping but the easy part of disinflation is going from 5% to 3%, much harder going from 3% to 2% where central banks want inflation.

We shall see if the recent bond market rally extends into 2024 but if inflation persists, it will not.

And I expect a whopper of a recession to hit all assets next year so be prepared (I know, we might avert it next year to but you're delusional if you believe this).

Below, Tom Lee, Fundstrat, joins 'Closing Bell' to offer his bullish take on the markets as the rally begins losing steam.

I tend to agree, today's selloff in markets was some profit-taking, not something more ominous for markets. As of this writing, futures are up across the board.

Also, Tom Keene, Jonathan Ferro and Lisa Abramowicz have the economy and the markets "under surveillance" as they cover the latest in finance, economics and investment, and talk with the leading voices shaping the conversation around world markets

Comments

Post a Comment