“No, no. You forced me into visiting him last year, and promised, if I went to see him, he should marry one of my daughters. But it ended in nothing, and I will not be sent on a fool’s errand again.”
– Mr. Bennet, Pride and Prejudice by Jane Austen
July saw a welcome return to normal, meaning cash, bonds and a wide variety of stocks contributed to performance. The month was a victory for the well-diversified investor – our strategy and portfolios performed handsomely.
Politics, geopolitics, inflation, economic growth, monetary policy and corporate earnings all influenced capital markets. The benefits of diversification were evident as markets reacted to the volatility of shifting, rotating and changing narratives. Globally, there was significant divergence among regional equity markets and across the size spectrum (or market capitalization) of companies.
The changing landscape of the 2024 U.S. election has dominated headlines, but it wasn’t the primary driver of shifts in capital markets. Politics and geopolitics can move markets in the short term and at the margin; however, the economy is ultimately larger than any individual or party. We see more evidence that fundamentals drove results.
Fundamentals, not politics
We hear a lot of buzz about the so-called Trump trade – a shift in market or investor behaviour in response to pro-business policies or promises from a second Trump presidency (e.g., looser regulations, greater protectionism, but perhaps higher inflation). As proof of Trump or Harris trades, some point to equity weakness in China, Japan and Europe or the rotation to small and mid-size U.S. companies. Yet, we see fundamentals more than politics driving these moves.
Non-U.S. equities may be reacting to the possibility of tariffs (Trump promises them, and Democrats generally also like them). Still, Europe has its own issues: while the eurozone is growing, Germany, the region’s economic engine, is stalled. Inflation remains sticky, leaving the European Central Bank in a tough spot – the economy needs cuts, but high inflation makes that problematic. In the U.K., economic growth surprised to the upside and the Bank of England joined the global parade of central banks cutting interest rates. For July, the European Stoxx 50 Equity Index fell 0.4%, and the U.K. FTSE 100 Index rose 2.5%.
The Bank of Japan is bucking the rate-cutting trend (of course, it’s starting from close to zero), and export-heavy Japanese stock markets are the victims of rising Japanese interest rates and a stronger yen. Japan’s Nikkei 225 Equity Index fell 1.2%. For foreign investors, the yen’s sharp appreciation flipped the Nikkei return sharply positive to 5.5% in U.S. dollars.
China’s troubles continue with little sign of relief, prompting Beijing to administer another teaspoon of monetary and fiscal stimulus. This slow-drip intravenous injection isn’t going to rev things up, but it should stabilize the economy enough so global growth isn’t threatened, a treatment course Beijing has followed for the last several years. Here, politics do feature more prominently, and tariffs on China are likely to persist or increase no matter who occupies 1600 Pennsylvania Avenue. For July, the MSCI China Equity Index fell 2.2%, and the MSCI Emerging Markets Index (USD) fell 0.1%.
Canadian equities were star performers in July, clearly untroubled by politics despite talk of broad-based U.S. tariffs or the scheduled review of the USMCA trade agreement under new Washington leadership. Canadian equities responded to the fundamentals: falling Canadian inflation, better-than-expected GDP growth and two central bank rate cuts in two months, with more in the offing. Notably, the S&P/TSX rally is broad based, the exact opposite of the S&P 500 until lately. For every stock falling on the S&P/TSX, two have advanced year to date, pointing to a strong foundation. The S&P/TSX’s 5.7% return for July doubles the year-to-date performance to a gratifying 10.3%.
Powerful small cap rotation
The standout story for equity markets was the supercharged rally in shares of small and medium-sized companies. With valuations stretched in the mega-cap tech and AI names, investors used them as a source of funds to purchase companies outside these year-to-date market darlings. Improved (cooling) U.S. inflation data ignited the rally. This raised hopes that the U.S. Federal Reserve could soon lower interest rates, possibly by as much as 0.75% this year.
The Russell 2000 surged 10.1% for July compared to a 1.1% rise for the S&P 500; the equal-weighted version of the S&P 500 that represents the market much more broadly gained 4.4%. This rotation is a constructive development that helps temper enthusiasm for the large-cap, AI-focused companies whose share prices have risen a long way in a short time. Contrast that to the small-cap Russell 2000, which has been trading at the lowest level relative to the S&P 500 since 1999.
Earnings matter
Adding to the selling pressure on the large-cap tech names were disappointing earnings outlooks from Tesla, Alphabet, Microsoft, and Amazon, where some missed expectations, but even simply meeting earnings expectations wasn’t good enough. Questions are being raised about how much companies are spending on AI research and rollout versus how much and when those investments may generate revenue.
Beyond the underwhelming earnings of selected mega-cap names and the punishment meted out to their share prices, earnings season has generally been fine. Major market earnings forecasts (that had been on an upward trend) are holding steady for this year and next. Some companies were priced for perfection and penalized for mildly disappointing results. Others whose shares offered greater value and delivered or beat expectations saw their prices rewarded appropriately – precisely how capitalism should work.
Goldilocks is still in the house
July’s market activity supports our base case: we’re most likely to see a soft-landing, Goldilocks scenario, meaning the economy is neither too hot (inflationary) nor too cold (in recession). The strongest outperformance of small caps relative to large caps since 2001 was a twofold affair. The large-cap stocks were trimmed on overvaluation and a reality check on earnings. At the same time, the small caps rallied on the prospect the Goldilocks economy would bring them interest rate relief without a significant economic slowdown. The takeaway is if Goldilocks was in question, the riskier, smaller companies wouldn’t be rallying. July’s rotation trade and broadening out of participation across geographies and market capitalization reinforces our constructive view on risk assets in the medium term.
Bumpy start to August
With inflation resuming its descent, it is natural to see bond yields falling as expectations for central bank rate cuts increase. However, bond yields were falling fast and furious at the end of July and the opening days of August. While there are plenty of signs Goldilocks is still in the house, when central banks have been deliberately trying to slow economies for two years to quell inflation, it naturally begs the question of when is weak data too weak?
Early August reports on the outlook for global manufacturing disappointed, and the U.S. labour market is cooling quicker than previously thought. Bond yields are approaching levels where it is natural to ask if the bond market is worried about inflation falling or growth slowing too much. We continue to see enough evidence that U.S. growth is slowing, not collapsing, and growth outside the U.S. is weak but rebounding, yet there are risks.
Corrections in equity markets are a normal part of investing. It’s good news that pockets of overvaluation saw weakness and other areas saw strength. However, we are in the volatile, low attendance, and low liquidity part of the calendar year, so more rocking and rolling may lie ahead. Indeed, August opened with a sea of red across global stock markets. Given how far equities have come, the seasonally weak part of the calendar, and cracks showing in the juggernaut U.S. economy, some downside isn’t unusual or unexpected – stay calm and avoid knee-jerk overreactions.
Our strategy: Balanced, with an equity bias
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.
Throughout the year, our discipline saw us selling stocks into strength to add to bonds in the event a growth scare might arise. That growth scare may be upon us now. The 2.4% return in July for the FTSE Canada Universe Bond Index is proof that our approach is prudent.
In portfolios where market movements drifted regional equity allocations away from desired targets, we have realigned by selling U.S. equities and buying Canadian equities. Noteworthy trading in July focused on our more growth-oriented portfolios, where we trimmed U.S. small caps on their recent strength while remaining solidly exposed. Small caps can add value over time but are inherently a more volatile asset class. Additionally, while valuations are compelling in small caps, they aren’t universally cheap. There is an argument small-cap stocks have underperformed and are cheap for a reason. In aggregate, earnings growth in small caps is weaker than in large caps, small caps have weaker profit margins, and the universe is littered with unprofitable, heavily indebted companies.
Consider small caps as the minor leagues: some players are rising in their careers, and some are on their way down. Thus, the small-cap arena is ripe for active stock picking. We rely exclusively on specialized, dedicated, active small-cap money managers who focus on quality for our small-cap exposure. A quality focus in an area where the index contains a lot of junk does mean that when all-things small cap go on a tear, our managers will tend to lag. This is by design and delivers an element of risk control.
The last word: Keep your politics out of your portfolio
Factoring politics into an investment process is dangerous. Politics can matter to some companies and may favour or hinder specific sectors, but the overwhelming weight of evidence says U.S. and global economies forge ahead no matter who occupies the Oval Office.
Going back to Teddy Roosevelt in 1901, the 28 positive-return presidential terms were split almost evenly between Democrats (15) and Republicans (13). In just seven presidential terms the U.S. stock market total return wasn’t positive – a 20% failure rate. Democrats own two, Republicans five. The 20% failure rate mirrors long-term equity market behaviour – the U.S. equity market’s annual return is positive more than 70% of the time. Stock markets are driven longer term by economic, not political, events.
Although polls are notoriously unreliable, the presidential race appears to be a dead heat. Promises from any politician, especially those made on the hustings, must be taken with a big grain of salt. Neither candidate has articulated a coherent policy agenda. Rhetoric is what a candidate would like to do; it often bears little relation to what is actually achievable. Beware of those making connections between political rhetoric and movements in capital markets.
Many of the policy projections depend on the complexion of Congress. Both candidates have pockets of resistance within their party, and moderate voices exist. Both candidates face the highest peace-time deficit as a percent of GDP in history and the highest debt servicing costs as a percentage of government revenue in over 40 years. These realities will limit what they can get done. Market responses are often short-lived and are overwhelmed by the broader economic cycle.
Political events are binary outcomes where you must get multiple predictions correct to potentially benefit. You need to predict the outcome and predict the market reaction. Recent history is rife with examples where the majority would have got it wrong. Brexit happened, but U.K. stocks rallied post-Brexit. Trump beat Hillary Clinton and Democrats said Trump 1.0 would be a disaster for the economy and the stock market; Republicans said the same about Obama and Biden. For all these presidents, the economy grew; the stock market had typical wobbles, but went up.
Trying to predict political outcomes brings risks but yields little benefit. We are not naïve and we won’t abandon our experience, process, and discipline. We will go with Jane Austen’s Mr. Bennet and avoid embarking on a fool’s errand.
Please contact your Investment Counsellor if you have any questions or would like to discuss your investments.
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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