“Uncertainty is the only certainty there is, and knowing how to live with insecurity is the only security.”
– John Allen Paulos, American professor of mathematics
After April’s disappointing performance in capital markets, the bulls bounced back in May with solid gains for stocks and bonds. A balanced investor with 60% diversified global equity and 40% Canadian bonds enjoyed a monthly gain of 2.5% – enough to recoup April’s 1.7% decline and then some.
Four key developments unfolded in May.
April’s mild cleansing of some over exuberance set the stage for markets to return to rally mode.
Economic data continued to show that the U.S. economy is cooling (a good thing when inflation is the problem). Economic activity elsewhere, especially in China and Europe, continued to warm up; Canada’s performance has been so-so.
U.S. inflation fell slightly after four months of high-side surprises. Annual U.S. Consumer Price Index (CPI) inflation fell from 3.5% to 3.4% as expected. Inflation elsewhere is falling quickly enough to warrant the possibility of inflation being too low in some countries (not our base case, but it’s creeping onto our radar). Geopolitics also saw some thawing, especially on the China file.
Lastly and always most important, corporate earnings remained a bright spot.
All these factors encouraged equity markets to take off, with many markets recapturing all-time highs.
Canada
Canada’s economy opened the year in fine form, but mixed signals are emerging. Job creation remains buoyant, but is just keeping pace with population growth. The unemployment rate held at 6.1%, a more than two-year high. This slack in the labour market is starting to cool wage growth, which is important as the Bank of Canada (BoC) is watching wage growth closely and needs to see it cool as one pre-condition to cutting interest rates.
The Canadian economy is showing signs of fatigue under the weight of higher borrowing costs. Retail sales have flatlined for seven months, manufacturing activity is weak, and Canada's housing market isn't revving up despite the arrival of spring and some easing of mortgage rates. Combined, all these elements point toward a BoC rate cut.
On top of that, inflation is finally in the green zone conducive to rate cuts. All three of the BoC’s inflation measures now sit below 3% as of April. Strip out mortgage interest costs, and inflation would be below 2%. Markets are pricing in two or three rate cuts in 2024; we lean toward three.
Loonie over rate cuts
If the BoC begins cutting before the U.S. Federal Reserve (the Fed), what will this mean for our loonie? At sub-74¢, the loonie has already started to price in expectations that Canada’s central bank will move first and more aggressively. We don’t see a lot of currency downside to a Canada-goes-first scenario.
However, the tone of the BoC statement and press conference can make a difference. Longer term, there is a gravitational pull toward the 76¢ level, but that may take some time. History shows central bank rate divergence can range from Canada being 2% above the Fed to 1% below. A weaker loonie is akin to some monetary policy easing for Canada, so in practice we see a limit to divergence in this cycle. With Canada’s rate already a third of a percent lower than that of the U.S., we think the BoC could make two quarter-point cuts before a Fed rate cut. Beyond that (and to get the third cut in our forecast), the Fed would have to close ranks with Canada. We believe the Fed will cut twice in the latter half of this year.
United States
The desired outcome is a cooling U.S. economy that cements the continued ebbing of inflation. This scenario allows the Fed to lower interest rates by 0.25% once or twice in 2024.
Wishing for slower economic growth plus robust corporate earnings is a fine needle to thread. Several factors could create this Goldilocks situation. Slower U.S. economic growth isn’t a recession – it’s merely a less hot economy. Profit margins and productivity can bridge solid earnings on less economic growth; both are in good shape.
S&P 500 earnings growth is more than a U.S. story. Many S&P 500 companies are multinationals, so about 40% of S&P 500 revenue comes from outside the U.S. This matters as economic growth outside the U.S. shows signs of improvement (after many places experienced recession) and helps supplant what might be lower U.S. revenues.
The bottom line is that we are seeing a mix of data – no surprise when the economy is coming off disruption from the pandemic, a bout of inflation, and a steep Fed tightening cycle. On the whole, May’s narrative tipped toward the soft-landing scenario. Markets have moved to price in some of this scenario, but we see further gains for stocks and bonds should this come to pass.
International
Overall, the general improvement in economic growth and cooling inflation continues. British Prime Minister Rishi Sunak’s snap election announcement took some wind out of the sails of U.K. stocks and bonds. An election mothballs any possible near-term Bank of England interest rate cut.
Many of the headlines were China-related. Although mixed, they were mostly positive. U.S. President Joe Biden imposed new tariffs on key Chinese imports while China staged military exercises near Taiwan. Then again, these aren't new stories, and Taiwan's President Lai Ching-te’s conciliatory remarks aimed to calm the waters.
Offsetting these moves were the first China/Japan/South Korean trade discussions in four years. Beijing continued to add targeted stimulus to the economy, propping up the besieged property sector, and announced more financial support for key industrial sectors (semiconductors) in an ongoing effort to achieve self-sufficiency as the U.S. seeks to restrict China’s growth.
Equity market insights
We described the market retreat in April as healthy and warranted. Since equity markets have retraced all those declines, it is natural to ask what has changed. Aren't we simply back where we started? The answer is no. Healthy equity market check-backs are necessary to wring out complacency and separate investors from speculators. April's swoon did a bit of that. But frenzied meme stocks (like GameStop or AMC, pumped up on the internet) are back in the headlines, which has us wondering if more volatility lies ahead. Lighter trading volumes in summer and U.S. election noise could be catalysts.
However, there have also been positive changes since the beginning of the year. The degree of economic uncertainty is waning. Economic growth in Europe and China is picking up steam. Corporate earnings growth is delivering, and the earnings outlook across the globe is seeing upgrades. This is causing the rally in stocks to broaden out to embrace more sectors and geographies – all healthy signs.
For May, the S&P/TSX Composite rose 2.6%, the S&P 500 rose 4.8%, the EuroStoxx 50 rose 1.3%, and the U.K. FTSE 100 rose 1.6%. The MSCI China Index added 2.1% for the month. Japan's Nikkei rose 0.2%, and the MSCI Emerging Markets Index (USD) eked out a 0.3% gain.
We continue to see a positive backdrop for stocks through the end of 2024. We are upgrading our S&P/TSX end-of-year target to 23,500 and reiterate our S&P 500 target of 5,400, but we see the prospect of 5,700 as a plausible scenario.
Bond market insights
We are more constructive on fixed income at this juncture than at the start of the year. A return to slowing inflation and cooling U.S. economic growth saw a mild retreat for North American bond yields. The FTSE Canada Universe Bond Index advanced 1.8%. Equity investors welcomed the mild retreat in yields, but because the back-up was mild, bond investors are left in a good place, too. A diversified basket of fixed income delivers a yield well north of 4% and is poised to offer portfolio safety should a risk-off environment pop up.
Our strategy – Balanced with an equity overweight
The return of the prospect for a soft-landing U.S. economy and the growth pick-up/ebbing inflation narrative outside the U.S. continue to be favourable for our stocks-over-bonds asset mix.
The no-landing scenario (where economic growth is higher but inflation may remain elevated) strengthens the case for stocks over bonds. Equities benefit from a more robust economic backdrop. Owning shares of corporations that are part of the inflation machine delivers a form of inflation hedge (companies raising prices to defend profit margins is central to the concept of inflation).
A soft-landing scenario, where economic growth lands between 1% and 2% and allows some room for interest rate cuts, is also a decent environment for stocks. As well, it opens the door for bond positions to contribute more to overall portfolio performance.
Hence, we remain overweight equities, specifically Canadian and U.S. equities. We are neutral weight to international developed markets (Europe and Japan) and underweight Emerging Markets equities.
We have maintained varying degrees of overweight exposure to equities for the last two years, including carrying an equity overweight throughout the current strong equity market rally that started in October 2023. Developed markets in Canada, the U.S. and internationally are all up over 20% total return in Canadian dollars since October 31, 2023. This has resulted in some of our solutions becoming overweight equities beyond our comfort zone. In May, we moved to rebalance by selling U.S. and Canadian equities and purchasing fixed income.
Seeing opportunity in both U.S. and Canadian equities, we rebalanced some of our U.S. and Canadian large-cap equity allocations to move toward a more equal North American equity overweight.
This trading impacted many but not all of our clients. Although there is an overall asset-mix profile, each client situation is unique. Your Investment Counsellor may have tailored an approach to your individual circumstances.
We emphasize that our purchase of bonds is driven by a desire to trim our U.S. and Canadian equity from being overweight to still overweight – just less so.
Although our trading activity was entirely an investment decision, we are also tax aware and chose to execute these trades sooner rather than later, given the proposed capital gains tax changes.
The last word – Some thoughts on our “risk-budget” approach
We take a risk-budget approach to asset allocation. That means if we take risk in one area, we consider that when allocating to other assets. The overall portfolio asset mix is a blend of all the risk and reward trade-offs. Given that we are spending the risk budget on a healthy equity overweight, we choose to balance that risk with the relative safety offered through core fixed income (and cash, which we have also topped up this year in some instances). We believe these are the best solutions for downside protection should the economy, politics, geopolitics, or capital markets deliver a curveball.
Our recent trading sold stocks and purchased core fixed income, a mix of government and high-quality corporate bonds. Within certain of our Canadian bond solutions, we reduced the exposure to investment-grade corporate bonds in favour of government securities.
Our decision to sell riskier assets and buy safer ones in no way reflects a change of heart in our outlook. We remain optimistic about the near-term prospects in an environment where we see opportunities to make fair risk-adjusted returns across cash, bonds, stocks and selected alternative investments.
We simply believe, like mathematician John Allen Paulos, that uncertainty is a constant. We must accept it and turn it into a strength, allowing us to see that all things are possible. Our trading activity embraces uncertainty as part of our normal, prudent, well-diversified, and balanced approach to money management.
