“Give fools their gold, and knaves their power; let fortune's bubbles rise and fall; who sows a field, or trains a flower, or plants a tree, is more than all.”
– John Greenleaf Whittier (1807 to 1892), American poet and abolitionist
The first half of 2024 has delivered solid equity market results. Bond yields have been volatile; the Canadian bond market posted a small year-to-date loss. A typical well-diversified Canadian balanced investor is sitting with a total return in the mid-single digits as of June’s end.
Overall, the global macroeconomic backdrop is in decent shape, especially considering where we’ve come from (high inflation, sluggish global growth). As always, there are some mixed signals, yet more signs point to a soft landing than anything else. This outcome is aligned with our base case and is what everyone generally hoped for. It’s the Goldilocks scenario of not-too-hot, not-too-cold economic growth that allows COVID disruptions to settle, demand and supply to realign, and inflation to fall back into an acceptable range (generally pegged at between 1% and 3%).
Given the friendly macroeconomic backdrop, major global equity markets are buoyant on the year; most are up mid- to-high single digits. The S&P 500 and NASDAQ top the list and are raising eyebrows (again) because the gains are concentrated in a handful of stocks whose valuations aren’t cheap. To us, this is a glass half full.
Let the cuts begin
Economic growth outside the U.S. is picking up. Growth isn’t rip-roaring, nor should it be after nearly three years of monetary policy tightening. At this moment, strong economic growth isn’t the goal because that could stoke an uptick in inflation, which hasn’t been totally tamed yet. In many countries, inflation is moving in the right direction: 11 of the G20 countries have inflation below 3%; more than half of the 130 countries tracked by Bloomberg globally are registering sub-3% inflation.
Although the U.S. story is more mixed, the news is still good. The U.S. economy is cooling (not collapsing). Housing activity can’t get off the ground thanks to elevated mortgage costs and limited supply (low legacy mortgage rates keep American homeowners locked in place). Consumers are fatigued by higher borrowing costs for big-ticket purchases, credit card debt, and pandemic savings now largely exhausted. Unemployment, which has been at historically low levels, is creeping up. The labour market is moving toward balance, yet wage growth remains elevated.
After an early-year scare, it looks like U.S. inflation has flipped back to a mild downward trend. The most recent monthly U.S. inflation reading was a surprising 0.0%. May’s Core PCE inflation data (the U.S. Federal Reserve’s preferred measure) resumed its decline, falling to a year-over-year 2.6% pace from 2.8% previously.
Nevertheless, two years of elevated inflation are weighing on consumers’ psyches. A more discerning consumer, unwilling or unable to chase YOLO and revenge spending, bodes well for a further decline in inflation. A similar scenario is playing out the world over.
Given that the U.S. economy has been quite resilient, and inflation has just returned to a downtrend, the U.S. Federal Reserve (the Fed) remains reluctant to begin a cycle of interest rate cuts. With the cracks in the economy mentioned above, we believe inflation will continue to fall enough, and measures of U.S. economic activity will cool enough, that the Fed will make two rate cuts of 0.25% this year. The first will probably come in September, the second in December.
Global manufacturing is trying to bottom out and turn higher. In order to pick up steam, housing activity needs relief from high interest rates, which we believe is coming. Consumers are slowing down, while wage growth and employment keep the outlook constructive. These green shoots in the global economy (ex-U.S.) should be nurtured by most non-U.S. central banks pivoting toward easing interest rates. With its June quarter-point rate cut, the Bank of Canada (BoC) is among the vanguard – the European Central Bank also cut, as did the Swiss and Swedes. The most recent Canadian Consumer Price Index reading was disappointing; the annual rate ticked slightly higher to 2.9%. However, if we strip out rent and mortgage costs, inflation is running sub-2%. We see the BoC cutting interest rates twice later this year, likely a quarter-point cut in both September and December.
The average stock has room to run
Year to date, the performance of the S&P 500 and NASDAQ indices has been stellar (up 14.5% and 18%, respectively). A handful of companies, mainly in the technology space, have posted spectacular returns that contributed heavily to this performance. Although some pundits are alarmed at the level of concentration in the returns, we’ve seen this situation before. Indeed, we discussed this concern in our 2023 mid-year commentary.
We reiterate our views from last year: 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, yet in their wake lies a vast swath of stocks with improved, attractive valuations. Simply because some U.S.-based global multinationals have powered ahead doesn’t mean that other markets can’t perform. The reality since these same concerns were raised 12 months ago stands as testament: most global equity markets outside the S&P 500 and NASDAQ, including indices of small and medium size companies, are up 10% to 14% over the last year.
We see a fertile environment for risk assets since economies are recovering or stabilizing, the worst of inflation is behind us, and easing monetary policy is either upon us or likely to begin soon.
Most significantly – recession or not – many corporations faced an earnings recession and feared an actual recession. In response, they slimmed down and got more efficient. During the last few lean years for corporate earnings, they faced rising wages, input costs and borrowing expenses. As global demand stabilizes (picking up in some places, slowing a bit in the U.S.), companies can generate recovery- style earnings growth.
Even though the earnings rebound won’t be as spectacular as it would be after an actual recession, we should at least see a return to normal or slightly better. Normal is high single-digit earnings growth, so low teens wouldn’t surprise us. Earnings growth in the low teens and respectable stock valuations across a wide swath of companies should deliver high-single to low-double digit stock market returns. Remember, if the lament is that only a handful of companies have driven performance, the corollary is that only a handful are expensive.
This is evident in the decent yet not extravagant returns from most markets outside the U.S. For the opening six months of 2024, the S&P/TSX Composite Index rose 4.4%. The European Stoxx 50 Equity Index rose 8.2%. The U.K. FTSE 100 Index rose 5.6%. Japan’s Nikkei 225 Equity Index rose 18.3%. Adjusting for the Japanese yen’s 14% slide, this return shrinks dramatically to 3.6% in U.S. dollars. The MSCI Emerging Markets Index (USD) rose 6.1%. Even in the U.S., while the S&P 500 and NASDAQ were up double digits, an equal-weighted version of the S&P 500 rose 4.1%, and the Dow Jones Industrial Average gained 3.8%.
The largest U.S. companies are stellar franchises delivering exceptional earnings growth; opportunities also abound outside of these names. All of this has us overweight equities.
Our strategy – Balanced, with an equity bias
Revisiting our base case, which we’ve held since December when we published the 2024 Outlook, cash should yield a low 4% (annualized) at the end of 2024, unchanged from our December view.
We called for a 6% return from the bond market. The FTSE Canada Universe Bond Index is down 0.4% for the year. The running yield is north of 4% and we can see small price gains that could deliver another 1%, which leaves the back half of the year at 3.5% for a full-year return of 4%. This is somewhat lighter than our original forecast but is decent nonetheless. Should some risk event develop that prompts a flight to safety, our highest-quality bond positions can provide ballast since returns in the 8% to 10% range are entirely possible.
For equity markets, our full-year total return estimates published in December called for 10% to 12% in Canadian equities. We’ve booked 4%, so we have 6% to 8% to go. We remain comfortable with our forecast. To get all that return, however, we need the Fed to cut rates so the BoC can keep leaning toward cuts.
For the S&P 500, most analysts’ forecasts from December have landed in the trash bin. We started at 4,900, and we were among the more bullish. We upped it to 5,100 in January and again to 5,400 in March. We hold that view now, but our bullish scenario can get us to 5,600 easily; we’ll be looking at 6,000 in 2025.
With all three major asset classes poised to deliver solid, risk-adjusted returns, we believe it is a good time to be an investor, especially a balanced one.
Our asset mix stance and trading activity reflect that the world has unfolded more along the lines of our December Capital Markets Outlook than any other scenario. We are overweight equities, specifically Canadian and U.S. equities. We are neutral weight to international developed markets (Europe and Japan) and underweight Emerging Markets equities. Within fixed income, we are overweight investment-grade corporate bonds and underweight the lowest-quality borrowers in high yield.
In portfolios where market movements pushed equity weights beyond our risk tolerance, we have harvested gains as part of our well-balanced, disciplined process. Those trimmed positions were deployed into cash and fixed income, taking advantage of the solid income available and ensuring a level of safety should the backdrop sour for any reason.
The last word: Are we in a bubble?
Bubbles have been documented (always after the fact) for hundreds of years. The earliest verified – probably not the first – was Dutch tulip mania in the 1630s. Stock markets develop bubbles from time to time (as do other assets); that’s the nature of the beast. The question shouldn’t be “are we in a bubble?” Rather, the key question is what should we do about it?
Stock markets are doing what they have always done and what society needs them to do when faced with discovery, innovation and productivity-enhancing tools. These ideas require money and rewards for the risk-takers who launched them. As Whittier says, “let fortune’s bubbles rise and fall; who sows a field, or trains a flower, or plants a tree, is more than all.”
Every innovation (e.g., railways, electricity, the combustion engine, TV, the internet, AI) has enjoyed pockets of spectacular returns. Identifying the eventual winners in the early days and even in the middle innings is very hard. The companies that over time become involved (e.g., competitors, the supply chain, distributors) need vetting. That’s capitalism’s role, and stock markets are the arena where it plays out.
For the diversified, well-balanced investor, that is okay. Investors have choices and can decide to shy away from areas that might be bubbling – the whole market is not in a bubble. Today, we can build portfolios of cash and bonds, plus good old-fashioned, well-run companies with long track records that pay dividends and grow share prices modestly through time. That’s why we say it’s a good time to be an investor. This foundational, balanced option hasn’t looked this attractive for at least 10 years.
However, most investors can benefit from new areas of innovation and discovery. Understanding that bubbles are a part of investing, savvy investors adjust their behaviour and opt for portfolios that provide well-diversified exposure to these areas. You don’t try to time the market; you trim and take profits all the way along.
All bubbles end with some tears and disappointments. By staying disciplined and rebalancing regularly for as long as the bubble lasts, you’ll harvest some of the opportunity and minimize the pain when the bubble does eventually burst.
Please contact your Investment Counsellor if you have any questions or would like to discuss your investments.
You can read my recent interview with The Globe and Mail for further discussion on the current market landscape available on the BMO Private Wealth BMO Private Wealth website.
Information contained in this publication is based on sources such as issuer reports, statistical services and industry communications, which we believe are reliable but are not represented as accurate or complete. Opinions expressed in this publication are current opinions only and are subject to change. BMO Private Wealth accepts no liability whatsoever for any loss arising from any use of this commentary or its contents. The information, opinions, estimates, projections and other materials contained herein are not to be construed as an offer to sell, a solicitation for or an offer to buy, any products or services referenced herein (including, without limitation, any commodities, securities or other financial instruments), nor shall such information, opinions, estimates, projections and other materials be considered as investment advice, tax advice, a recommendation to enter into any transaction or an assurance or guarantee as to the expected results of any transaction.
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