Martin Pelletier: Don’t bet your wealth on Federal Reserve policy

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As 2024 has officially come to a close, investors have a lot to be thankful for, with equity markets continuing to surprise to the upside, providing a second year of solid gains.

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It certainly made for an interesting 12 months, with the United States Federal Reserve cutting rates and yet long-term U.S. bond yields holding steady.

At the same time, there was a massive amount of liquidity pumped into the market via the reduction in the Fed’s reverse repo account (RRP). In particular, U.S. money supply grew 3.7 per cent over the last year, the biggest yearly increase since August 2022.

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Monetary liquidity has played a crucial role in supporting the equity markets ever since quantitative easing emerged after the 2008 financial crisis. More money in the system directly increases the demand for risk assets driving prices higher while inexpensive capital allows companies to financially engineer growth via share buybacks.

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Meanwhile, you now have Elon Musk and president-elect Donald Trump pumping up crypto, alluding to its potential role in the U.S. Treasury. Crypto is the ultimate risk trade, given it performs akin to a levered-beta asset (essentially a security that has more volatility in returns than the broader market).

We do worry that this has turned a lot of investors into speculators, and Wall Street has been more than happy to comply by providing a growing number of niche, high-risk vehicles. For example, ProShares filed for approval of exchange-traded funds (ETFs) that track the S&P 500 and Nasdaq-100 denominated in bitcoin, meaning they will be taking a long position in underlying stocks then a short U.S. dollar and long bitcoin position using futures.

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The big question is if all of this can continue in 2025. We do worry what happens when incoming U.S. Treasury secretary Scott Bessent does what he says he’ll do, and issues longer duration debt to offset upcoming maturities, as this could have the impact of draining liquidity from the markets. This is because bank reserves will be redirected away from stocks toward debt.

All of this couldn’t come at a worse time, as the RRP has now been drained therefore no longer a source of cash to buy equities. The Fed may also be limited in its ability to cut rates further from here because of the potential inflation that may result if Trump enacts some of his promises. Even if they do, unless there is a meaningful reduction in the U.S. deficit, the large supply of new debt hitting the market will keep longer-term bond yields higher.

This is important because the higher cost of debt and tighter financial conditions will impact companies, directly impeding their ability to deploy more financial engineering to grow. And so the big question is if the monetary tailwinds dissipate, what will be the catalyst to drive multiples higher from already record setting levels? Can these companies generate substantial organic growth that is being expected by market participants?

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Take Apple Inc. for example, the world’s largest company which is fast approaching a $4 trillion market cap. It is currently trading at about 40 times earnings, and 10 times revenue, its highest level in its entire history. 10 tech companies now encompass 40 per cent of the S&P 500, and U.S. companies now encompass 75 per cent of the MSCI World Index.

For those who say multiples (a company’s market value compared with a financial metric, such as earnings) don’t matter, they actually do when looking out over the next decade with a high level of correlation with forward returns. It’s quite the scary chart as multiples as of Dec. 31 are signalling subsequent 10-year returns in the low to mid-single digits.

So, investors need to be careful here and perhaps start taking advantage of current valuations by rebalancing their portfolio in January and deferring the tax until 2026.

For those wondering where to go, we still like defensive sectors such as utilities that are offering attractive dividend yields and will benefit from falling rates here in Canada. We also like infrastructure, which will do very well in an environment where rates return lower. Structured notes continue to be a huge focus for us, especially within registered accounts given they have built in downside protection and asymmetric return profiles.

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Finally, we would caution against deploying a binary approach, meaning avoiding going to all cash and going levered long. Good advisers will help you avoid this through neither cheerleading and telling you everything will be great, nor spreading fear. They should remain focused on helping you to achieve your financial goals while mitigating the risk of doing so.

There is so much value in being able to sleep at night instead of trying to compete with and beat everyone else by betting your wealth on central bank policy.

Martin Pelletier, CFA, is a senior portfolio manager at Wellington-Altus Private Counsel Inc., operating as TriVest Wealth Counsel, a private client and institutional investment firm specializing in discretionary risk-managed portfolios, investment audit/oversight and advanced tax, estate and wealth planning. The opinions expressed are not necessarily those of Wellington-Altus.

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