“When performance is measured, performance improves. When performance is measured and reported back, the rate of improvement accelerates.”
– Pearson’s Law (Karl Pearson established the discipline of modern statistics.)
Surprises, good and bad, marked the opening half of 2023. Investment results are better than expected because the economic situation is largely better than expected. Equity market returns across the globe are generally positive – the NASDAQ is up 32%, one of its best opening six months in history. The broadest measure, the MSCI World Equity Index, is up a solid 14% on upbeat global economic data and stronger-than-expected corporate profits. Bond markets have been volatile as central banks continue to battle inflation. Despite this volatility, the Canadian bond market delivered a 2.5% return for the first six months; higher yields have put the “income” back in fixed income.
Stresses in the U.S. banking system topped the list of negative surprises. After the U.S. Federal Reserve (the Fed) raised interest rates 500 basis points over the last 15 months, we should regard stress in the banking system as a feature rather than a bug of monetary policy. These bank crashes aren’t surprising, considering the ones that failed were focused on lending to the venture capital, technology, and cryptocurrency sectors, areas most inflated by past free money and low borrowing costs. Thankfully, the fallout from these collapses seems to be contained.
Among the positive surprises is the return to dominance of the mega-cap companies that are becoming an increasingly large share of major U.S. benchmark indices. The recent euphoria around AI and ChatGPT has propelled the stock prices of companies associated with this space to exceptionally lofty levels (Facebook, Nvidia, Tesla, Microsoft, Google, Apple, Amazon). No question these companies have bright prospects, but the pace and size of the moves should raise eyebrows.
Additional pleasant surprises have come from the global economy, which is proving resilient despite slowing growth in some areas. Most economies have avoided shrinking: Germany and the eurozone are notable exceptions, but even there the declines are slight. Consumers are the driving force; fuelled by excess savings, their pent-up, post-COVID revenge spending continues. Real wage gains are increasingly contributing to the strength as inflation has now fallen below the pace of wage growth and labour markets remain robust. Canada’s massive flow of immigrants is keeping our economy outright ebullient.
The other half of the story is about misplaced expectations. Many pundits have been predicting a recession since the middle of 2022 (à la waiting for Godot). These downbeat expectations saw 2023 open with bonds and stocks positioned for upside should good surprises arrive. So far, they have: corporate earnings, employment, and GDP growth have generally come in better than anticipated.
Inflation is cooling in most parts of the world and now the race is on: will inflation fall to an acceptable level fast enough to prevent central banks from hiking interest rates so high (or holding them at such high levels) that a recession is almost unavoidable? We are sticking to our base-case scenario, which forecasts an economy that slows, but endures. We expect inflation to cool, allowing central bankers to back off on interest-rate increases before the economy buckles.
If this scenario unfolds, several catalysts can drive future investment performance. Investors are sitting on a pile of cash due to heightened angst and the attractive yields available in short-term cash instruments. Historically, equity markets benefit when the mountain of cash flows from the sidelines into stocks. Even if this sugar rush doesn’t materialize, money can rotate from the most hyped-up market segments to areas offering greater value. Our equity portfolios are well positioned should this occur.
Bond investors can win here, too. Current bond yields reflect an expectation that central banks will need to increase interest rates to finish the job of bringing down inflation. Any respite on the inflation front should see bond yields cool somewhat, boosting fixed income returns above the decent level of yield income.
Inflation’s trajectory remains key to a soft landing and the fate of stocks and bonds. A soft landing is our long-held base case. Back in January, many market watchers were doubtful a recession could be avoided. Six months later, the odds have improved.
Canada – Still good on average
The S&P/TSX Composite was a solid outperformer in 2022, leaving less room for our market to play catch-up in 2023. Combining 2022's above-average performance with 2023’s below-average performance to date puts the 18-month S&P/TSX return at ‑5.0%, better than the S&P 500’s ‑6.6% and the NASDAQ’s ‑11.9% return for the same period. For Q2, the TSX rose 0.3%, pushing it to 4.0% year to date. The price of West Texas Intermediate oil fell 6.7% in Q2, down 12.0% on the year to US$70.64 a barrel. Our loonie gained 2.1% in Q2, delivering a year-to-date gain of 2.4%, closing at US$0.755, or C$1.324.
United States – The average stock has room to run
All four major U.S. equity market indices have made gains in 2023, with the divergence in results due to sector composition and index construction. The NASDAQ leads the pack, up 31.8% thanks to its 62% exposure to the information technology and communications sectors – home to the companies most levered to AI. The 30-stock Dow Jones Industrials Average trails at 3.8%, owing to the obscure weighting structure that leaves it with only 20% exposure to these same sectors. The Russell 2000 is up 7.2%, which is not too bad given that small- and mid-cap companies are more impacted by U.S. banking woes, face greater challenges arising from labour costs/availability, and are less able to pass on price increases. The bellwether S&P 500, the best representative of corporate America, sits in the middle, up 15.9%. However, even in this well-diversified index, just seven stocks are responsible for 70% of the year-to-date gain.
Some pundits are alarmed at the level of concentration in the returns, but we’ve seen this situation before. Historically speaking, once the outperformance of the mega-caps settles down, the broader market can do just fine. Herein lies the opportunity. A few stocks have surged ahead, making them quite expensive, but in their wake lies a vast swath of stocks that have more attractive valuations.
Europe – Better than average
Entering 2023, expectations for Europe’s performance were low. European economies and their stock markets are loaded with export-heavy companies (autos, industrials, and luxury brands). However, better-than-expected global growth delivered corporate profits above expectations. Decreased global recession fears are boosting sentiment. The combination puts continental European equity markets above average in 2023. The U.K. stock index is the exception. A large weighting of energy and commodity stocks led to poor performance. Additionally, the U.K.’s stubborn inflation is forcing the Bank of England to raise rates in a weak economic environment.
Equity market results for Q2 and year to date are as follows: Euro Stoxx 50, 2.0% and 16.0%; German Dax, 3.2% and 16.0%; and the U.K. FTSE 100, ‑1.3% and 1.1%.
Asia – One below, one above average
Chinese stocks have been laggards on the year, while Japanese equities have soared. Chinese equity markets continue to suffer from negative sentiment based on geopolitical concerns and tit-for-tat economic restrictions the U.S. and China continue to impose on each other's commerce. The expected post-COVID consumption splurge has been disappointing.
Japan’s Nikkei stock index is dominated by exporting companies; thus, sentiment has improved as fears of a global recession receded. These companies’ export profits are juiced by a depreciating yen, and domestic earnings are getting a boost from pricing power thanks to Japan’s first real inflation in decades. An ultra-accommodative central bank is stock-market friendly but is allowing the yen to fall. The 2023 return from Japanese stocks is effectively cut in half when translated to U.S. dollars.
Here are the equity market results for Q2 and year to date: MSCI China Equity Index, ‑10.8%, and ‑6.1%; Nikkei 225 Stock Index, 18.4%, and 27.2%.
Our strategy – Balanced, with an equity bias
Our portfolios remain well balanced, with a modest tilt toward equities. After harvesting some gains earlier in the year, the continued outperformance of U.S. stocks is nudging our exposure up. We are watching this situation closely but allowing the drift to persist so our equity overweight has grown a little (from slight to modest).
We are now overweight both Canadian and U.S. equities in many portfolios. As we trimmed galloping positions in U.S. equities throughout the year's first half, we closed our underweight in international developed markets (Europe and Japan). Additionally, in portfolios with exposure, we rotated some Canadian and U.S. large-cap equity exposure into small- and mid-caps. Overall, these trades at the margin move our positioning toward our strategic benchmarks and increase diversification.
Our well-diversified exposure to bonds is delivering a solid running yield. Coupon income and maturity proceeds are being reinvested at higher yields. While this is not our base-case scenario, if the economy slows too much we believe our bond positions will provide a level of safety.
The last word – Measuring our calls
Discipline and process are terms we use to describe how we manage our clients’ assets. Measurement is a significant part of discipline and process. In December 2022, we published our 2023 Market Outlook: The End of Free Everything? Could Simply be a Return to Normal. At the halfway mark, let’s evaluate where we stand.
Our overarching theme is that capital markets must adjust to higher inflation, higher interest rates, less easy money, slowing growth, and increased geopolitical tensions. We continue to see this as the main underlying narrative, with significant progress toward this adjustment. Inflation is falling, interest rates are close to a peak, and credit flow is tightening (less easy money). Geopolitics remain a factor; testy U.S.-Sino tensions have become the norm and, sadly, capital markets have become inured to the horror in Ukraine.
Specifically, we identified three factors that could impact equities: complacency toward risk, adjustment to higher bond yields, and the future path for earnings growth. In some areas, we see complacency returning. We aren’t glossing over the rapid, spectacular gains driven by the promise of AI and have taken steps to reduce risk there. A relationship exists between bond yields and share prices – all else being equal, higher bond yields put downward pressure on stocks. Bond yields are up substantially, so we see this adjustment as largely complete. While uncertainty remains around inflation in the short term, long-term bond yields settling into a comfort zone around 3.5% indicates that bond investors believe central bankers will eventually tame inflation.
Some equity markets are close to reaching our full-year forecasts. We called for equity returns in the neighbourhood of 8% to 12%, seeing targets of 22,000 for the S&P/TSX Composite and 4,400 for the S&P 500. We are comfortable with our TSX target but grant it may take into 2024 for the TSX to hit 22,000. While it’s still early, we are penciling in 5,000 as reasonable for the S&P 500 next year; there may well be progress toward this level in the back half of 2023. The most important factor in our analysis is earnings growth, which is improving against an improving economic backdrop. This progress underpins our continued enthusiasm for equities.
We are in the ballpark when it comes to the fixed-income scorecard. Inflation is proving stubborn in some areas. Central banks are emboldened by the healthy economy. Currently, they can focus on using rate hikes to fight inflation without the headache of deteriorating economic conditions – a luxury we hope they don’t take for granted. We called for a U.S. Fed funds rate of 5% and a BoC rate of 4.5%. Both are currently 0.25% above these levels and are expected to go a little higher. Our 3.25% forecast for 2-year yields is offside – the current yield is 4.58%. However, our 10-year bond yield call of 3.25% still makes sense as the current yield sits at 3.27%. We are sticking with our call for 10-year yields and are increasing our 2-year call by half a point to 3.75%. Overall, we have held an underweight to fixed income that has served us well.
The second half of 2023 will undoubtedly bring more surprises: the future always does. Rest assured that we will use our expertise and experience to navigate the path forward – employing rigour, discipline, and processes that are measured and reported.
Please contact your Investment Counsellor if you have any questions or would like to discuss your investments.
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