“It’s tough to make predictions, especially about the future.”
– Yogi Berra (1925-2015)
July saw global equity markets heat up even further and extend their year-to-date gains. They were fuelled by more Goldilocks (not too hot, not too cold) data on the global economy, inflation, and some better news from China at last. The once-long list of economists and market watchers forecasting a recession continues to shrink. Yes, Yogi, predicting the future is tough.
All major global equity markets made gains except Japan’s Nikkei. Notably, the gains were broad-based across geographies, markets and company size. All 11 sectors of the S&P 500 rose, the S&P 500 equal-weighted index outpaced its mainstream S&P 500 market-cap counterpart, and stocks of smaller companies were among the best performers in the U.S. and Canada. Earlier this year, some pointed to this lack of broad participation as problematic; like many elements on the scorecard, this situation has changed from a negative to a positive.
Global inflation continues to cool, and the European and Chinese economies continue to lag, but these factors are expected to encourage major central banks to stop increasing interest rates. For now, though, July’s additional rate increases and monetary policy actions in North America, Europe and Japan sent bond yields higher on the month, leaving fixed-income investors with a slight monthly loss.
Inflation remains the most important variable in the near term. The recent downward trajectory of global inflation, especially in North America, is encouraging and is forecast to fall further in the months ahead. Where it lands a year from now is uncertain, but currently odds are that central banks (excluding England) will not need to raise interest rates any further.
While corporate earnings are down year over year in many markets (but are much better than feared), this quarter or next is expected to mark the bottom. As a result, higher equity market valuations are responsible for much of this year’s gains. We can reconcile this accounting as one part recovery from last year’s pessimistic view toward 2023, and one part optimism over next year’s outlook.
There is a downside to so many things coming in better than expected: When everyone is in the pool and the water's warm, capital markets have likely already priced in some of the more optimistic outcomes. Yet, mountains of cash still remain on the sidelines. There is an old adage that says equity markets climb a wall of worry. Climb they have, and worries have diminished.
Valuations outside the U.S. (especially Canada) and within parts of the U.S. market leave room for additional gains. At this juncture, it will increasingly come down to earnings growth to generate sustainable further gains for equity markets. We continue to see room for earnings to grow into 2024 and stock markets to make additional advances. But we also remind clients that short-term setbacks are a common and healthy part of stock investing.
Canada – Fires and strikes
The S&P/TSX Composite rose 2.3% for July. The Bank of Canada (BoC) raised the overnight interest rate to 5%, the highest it’s been since 2001, and continues to lean hawkish. This is despite softening inflation (CPI fell to 2.8%, while core inflation remains just below 4%) and signs that the Canadian economy is cooling, albeit modestly. GDP growth increased 0.3% in May. The strong result would have been even stronger, but wildfires impeded resource extraction and likely travel and tourism as well. However, the early reading for June disappointed with a 0.2% contraction, and the B.C. port strike will weigh on July. Canada’s unemployment rate is also up 0.5% from a year ago, and wage growth is elevated but not sprinting higher. We believe the BoC will pause from here.
The price of West Texas Intermediate oil rose 16% to US$81.80 a barrel, helping the loonie advance 0.4% to US$0.758, or C$1.319 per U.S. dollar. Canadian 2-year yields rose from 4.58% to 4.67%, and 10-year yields rose from 3.27% to 3.50%, sending the FTSE Canada Universe Bond Index down 1.1%.
United States – Goldilocks sighting
All major U.S. equity market indices made gains in July on signs that the economy is holding firm as inflation continues to ebb, creating the so-called Goldilocks scenario. This is despite ongoing rate hikes from the U.S. Federal Reserve (the Fed).
The Fed raised interest rates by 0.25% to 5.5%, taking the Fed Funds rate to its highest level since early 2001. U.S. 2-year government bond yields fell slightly from 4.90% to 4.88%, and 10-year yields rose from 3.84% to 3.96%. Despite 11 rate hikes in a year-and-a-half, the U.S. economy is powering ahead. Real GDP growth came in at a better-than-expected 2.4% annualized in Q2, which marks four consecutive quarters above 2%.
Alongside this resilience comes additional positive news that inflation continues to ease. The Fed’s preferred inflation gauge, core PCE inflation, slowed to 4.1% year over year, or 3.4% annualized over the latest three months (2% annualized in June alone). Even though inflation is higher than the Fed wants it to be, sturdy growth and falling inflation make a good combo for stocks. In the race between inflation and the economy, the economy is winning. We think the Fed is finished raising rates for this cycle.
In July, the S&P 500 and the NASDAQ rose 3.1% and 4.1%, respectively, but both were topped by the small-company Russell 2000 Index, which leapt 6.1%. Smaller companies are more dependent on the U.S. economy alone and are sensitive to borrowing costs and higher wages. Strength in their share prices reflects the improved backdrop for all these factors.
Europe – Stagflation
While many economies are seeing surprisingly good growth and falling inflation, Europe’s economy isn’t one of them. The eurozone economy did exit recession in Q2, growing by 0.3% and unemployment remains historically low. However, inflation remains stubbornly high. In July, CPI inflation slowed to 5.3% year over year, but the core price index held at 5.5% year over year for the second straight month.
The European Central Bank (ECB) raised rates by 0.25%, going from 0.0% to 4.25% in one year, the largest and fastest credit tightening since the euro’s launch in 1999. Some central bank members are now leaning dovish. As we did with the Fed and BoC, we are calling for the ECB to halt rate increases. This dovish shift, retreating global recession fears, and improved prospects for China caused European bourses to gain alongside their global peers. The Euro Stoxx 50, German Dax, and U.K. FTSE 100 rose 1.6%, 1.9%, and 2.2%, respectively.
Asia – Switching places
Chinese and Japanese equity markets switched places in July. Chinese shares that have lagged all year rebounded sharply; the MSCI China Index beat all other major markets, advancing 9.3%. Japanese equities fell from grace; the Nikkei 225 Stock Index came in flat at -0.1%. The changes stem from politics. China's weak growth and potential deflation mean that its economy continues to disappoint. However, the situation may have become bad enough to prompt policymakers to adopt more aggressive economic stimulus. On the geopolitical front, China welcomed several senior U.S. diplomats, including a heavily symbolic surprise visit by the 100-year-old Henry Kissinger, the OG U.S.-China diplomat. Investors cheered the thaw.
Japan's CPI inflation rate rose to 3.3% in June, yet the Bank of Japan (BoJ) has stubbornly stuck to its accommodative policy stance – until now. While the BoJ made no change to its policy rates, it did loosen the cap it has been defending on 10-year Japanese bond yields (JGBs), allowing the range to drift from 0.5% to 1%. Japan has a vast pool of savings and is therefore a major provider of capital to the rest of the world. Changes in Japan’s interest rates matter beyond Japan’s shores. JGB yields are much lower than the rest of the world’s bond yields, so they provide some anchoring for global bond yields. Allowing them to drift higher not only raises Japanese borrowing costs but also puts upward pressure on global bond yields, too.
Our strategy – Balanced, with an equity bias
Our portfolios remain well-balanced. We let our equity winners run in July, but we remain vigilant on the regional make-up of our equity exposure and the overall balance with fixed income. For July, most global equity markets posted similar low-single-digit results. Within markets, the number of stocks participating in the rally broadened out.
Additionally, our relative Canadian overweight is perking up due to improved performance from Canadian equities, including our recently increased allocation to smaller companies in Canada (the S&P/TSX Small Cap Index jumped 6% in July). Currency movements are also helping to keep portfolios balanced. Recent strength in the loonie supports Canadian positions against non-Canadian exposure. Altogether, July’s relative portfolio movements remain within acceptable tolerance levels to meet our medium-term asset mix targets.
In our broadest representative portfolios, our target weights are overweight equities and underweight fixed income. The equity overweight is positioned in Canada and the U.S. Canadian equities continue to offer very attractive valuations, a high dividend yield, favourable currency positioning (we forecast a stronger loonie) and are well positioned for the soft-landing/better-than-feared global economic scenario that is unfolding. U.S. equities are enjoying strong momentum. We maintain neutral weights to international developed markets (Europe and Japan) and emerging markets.
The current yield from our well-diversified bond positions is increasing as yields rise. There is now enough income coursing through portfolios that the latest increases in bond yields dent rather than crush total fixed-income returns. The higher yields go, the greater protection they offer if the economy slows, or stock markets encounter a short-term setback.
The last word – Beware the fear of heights
The pace of gains in U.S. equity markets has surprised most market watchers; many pundits have backtracked on their cautious prognostications for 2023. However, plenty of analysts are still issuing cautions about the economy and investing in stocks. Of course, it’s a good idea to check your personal fear-and-greed gauge regularly and question whether everything is all too good to be true (or lasting). The stock market gains we have seen recently are no reason to be overly concerned.
Historical records remind us that what we are seeing in 2023 is a very normal state of affairs. Stock market rallies of 30% and 40% within the first year after bear market lows are not unusual. The 28% advance for the S&P 500, and the 40% for the NASDAQ from their December 2022 lows are both below the 38% and 50% averages, respectively, of all the similar instances for the NASDAQ and S&P 500 going back decades.
We understand the pushback from those who are saying, “This time it’s different; look how much interest rates have gone up.” Here, too, we must follow the science – not our emotions. U.S. stocks can fare just fine after rate hikes. The average return for the S&P 500 measured 250 trading days after the last Fed rate hike is 12.2%. Then the pushback becomes, “Yes, but central banks are going to hold rates higher for longer.” Similarly, stocks have tended to enjoy their best returns when interest rates were stable, whatever the prevailing level of interest rates happened to be. Going back to the early 1980s, the S&P 500 and TSX enjoyed strong double-digit median returns when central banks held rates relatively steady.
Bottom line: Stock market rallies of 30% and 40% within the first year after bear market lows are not unusual. Equity markets are doing what equity markets usually do. Their overwhelming tendency over the long term is to go up.
These statistics aren’t a story of doing nothing. Trimming positions, maintaining appropriate weights, and taking profits are all part of prudent, active management. We have been adjusting portfolios where warranted. Disciplined, goals-aligned investing is our mantra. Neither fear of heights nor fear of missing out (FOMO) will factor into our decisions.
Please contact your Investment Counsellor if you have any questions or would like to discuss your investments.
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