“Part of being optimistic is keeping one’s head pointed toward the sun, one’s feet moving forward.”
– Nelson Mandela
Equity markets saw substantial gains in the first quarter of 2024 – many were up more than 5% on the year. The list of markets posting fresh all-time highs is long. Fixed income endured a mildly negative Q1, giving back some of Q4 2023’s outsized gains. No surprise, considering the shifting macroeconomic narratives.
The major themes continue to be inflation, economic growth, and central bank policy actions, all with a side order of politics and geopolitics. However, many economic themes are looking better (but for politics and geopolitics not so much). Worries are surfacing about excessive exuberance creeping into the stock market. There are questions about the limits to U.S. equity outperformance and where we go from here.
Inflation – Bumpy but favourable
Overall, inflation is falling in most global economies. In the U.S., inflation moved in the wrong direction, stalling out after December’s unexpectedly low readings. January and February each saw small consecutive upticks. Canada fared better. It’s worth celebrating that Canadian inflation for January and February registered the first back-to-back sub-3% readings in almost three years. Even better that this came alongside surprisingly strong GDP growth to start the year. Canada’s economy looks to have grown 1.0% for the opening two months of 2024; that’s as much growth in two months as in all of 2023.
While the battle against inflation isn’t over, the worst may be behind us. Today’s most worrying inflation dynamics are in wages and housing, which could be viewed as “less bad” than the burden of higher food and energy prices. Wage growth and rising rents deliver an upside. Wage growth puts money in peoples’ wallets, boosting overall demand. Rising rents are a cost for tenants, but income for landlords. Both are essential price signals that incentivize a greater supply of workers and houses. In other words, they’re positive supply responses.
However, these responses take time to unfold, which central banks understand and thus are hinting that this kind of inflation is more tolerable. Considering their significant progress toward corralling inflation, central banks are unlikely to create a painful recession just to squeeze the last few decimal points to hit their 2% inflation targets.
Central banks – Hold or fold
Now that inflation is retreating and growth is stabilizing, most central banks are looking to lower rates.
Remember higher for longer? We’ve had both. The U.S. Federal Reserve (the Fed) has held the Fed Funds Rate at 5.5% for eight months. That marks the second-longest rate pause since 1990 at one of the highest levels (the highest is 6.5% in 1999 to 2000). Similarly, the Bank of Canada (BoC) has kept the bank rate at 5% for eight months, which is also rare.
We think the Fed will make a 0.25% rate cut in July, followed by two more quarter-point cuts later in 2024. Canadian inflation numbers may greenlight the BoC to cut sooner, but spring’s housing market could come into play: if prices heat up, cuts may be delayed. In our view, the BoC will behave like the Fed and cut three times at 0.25% each, starting in July.
Equity market insights
Most global markets posted gains in Q1. The S&P/TSX Composite Index rose 5.8%, the S&P 500 rose 10.2%, the EuroStoxx 600 rose 7%, Japan’s Nikkei rose 20.6%, China’s CSI 300 rose 3.1%, and the MSCI Emerging Markets Index (USD) rose 1.6%.
If equity markets rallied in late 2023 at the prospect of lower bond yields, why are stocks continuing to rally against a backdrop of higher bond yields in 2024? The answer lies in whether bond yields are rising due to growth or inflation. As we noted above, if we face “less bad” inflation dynamics, it means there is work to do (increase supply, hire workers, build homes) so economic growth can be above average. In that context, within reason, inflation can also be a bit above average. Historically, economies characterized by tight labour markets and high wage growth have bred higher productivity. Higher productivity is the heart of capitalism and nourishes everyone: shareholders, employees, government and society.
For equity investors, earnings growth is the touchstone, the crucial factor in determining a company’s valuation and the stimulus for rising share prices, dividends, and dividend growth.
Earnings aren’t just about economic growth: costs and efficiency matter. Over the last two years, companies feared we were headed for a recession. So, they acted as if we were in a recession – even though we weren’t. In recessions, corporations get lean; the animal spirits of capitalism are survival first and feast second. After two years of cost containment, rising borrowing costs, recession fears, and supply-chain disruption, corporations are poised to make hay, and the sun is starting to come out (eclipse aside). For five quarters, profit margins fell as they normalized from the post-COVID demand spike (greedflation). Many feared profit margins would continue to decay. Instead, because corporations got lean, their profit margins have been rebounding for the last three quarters.
The future looks bright: surveys of business outlook, sentiment and spending intentions are improving. With stable inflation and good profit margins, solid-to-better economic growth fuels earnings growth. Corporations are primed to shine.
To this we can add the allure of anticipated productivity gains from artificial intelligence (AI). While AI’s benefits haven’t fully materialized yet, excitement is fuelling exuberance. In some areas, this exuberance may be over the top or premature, but historically that is how all new technologies have been built out and tested before they ultimately advance humanity’s interests. In the here and now, we are seeing investments in innovation and technology. While it’s early days for AI, digital implementation, robotics and cloud computing are all integrated into our reality.
On sentiment, stocks aren’t cheap. Given the backdrop, it isn’t reasonable to expect them to be. But they aren’t over their skis as far as some might think. Benchmark equity indices in Canada, Europe and China, an equal-weighted version of the S&P 500, and the Russell 2000 Index of smaller U.S. companies are all trading below their 10-year average, 12-month forward-price-to-earnings ratios. Once driven primarily by a handful of mega-cap U.S. companies, the equity market rally is broadening out to more corners of the earth and segments of the market.
A lot has been made of the fact that the S&P 500 is up over 25% since its low last October. In fact, other major stock market indices, including those in Germany, Japan and Taiwan, are also up over 25%. Nor is the rebound confined to large companies. The Russell 2000, the U.S. small-cap index, is also in the plus 25% club. Canada remains a relative laggard, but an 18% return off October’s low is not too shabby.
We remind investors that equity markets do stumble. Experienced investors know stock market corrections in the 10% range generally occur every eight to 18 months. After substantial and uninterrupted gains since October, some consolidation might be in order.
While these post-October equity market gains are impressive, they are not unprecedented. Technological advances in the 1920s – automobiles, airplanes, radio, assembly lines, refrigeration and more – significantly contributed to five years of plus 20% equity-market returns in that decade. The internet revolution of the 1990s saw the most spectacular rise of the S&P 500 ever: five consecutive years of annual returns in excess of 20%.
This is the zeitgeist as 2024 begins. Consumer prices will still go up, but way less than before, and people are getting raises. In places where productivity is rising (productivity is especially resilient in the U.S.), higher wages aren’t a problem: they drive demand, but not inflation. Globally, economic growth ranges from strong (U.S., India) to okay, but improving (and better than expected) most everywhere else. Stock prices can work with higher bond yields when yields are rising due to more robust growth. This narrative has bond yields stabilizing at moderate levels and stocks setting new records. If economic growth is better than expected, earnings growth should be as well, keeping us constructive on the outlook for stocks.
Bond market insights
Bonds faced headwinds in Q1 thanks to stronger economic growth, mixed inflation results, and the possibility of fewer central bank rate cuts in 2024. The -1.2% Q1 2024 total return for the FTSE Canada Universe Bond Index should be viewed alongside Q4 2023’s outsized 8.3% return.
The combined six-month total return is a handsome 6.5%. We don’t see fixed income repeating that outsized performance (and don’t wish for it, either, as that likely means something has gone awry in the economy). However, bond yields at current levels make sense to us. They continue to deliver decent income and offer downside protection should the economy stumble.
Our Strategy – Balanced with an equity bias
We remain overweight equities, specifically Canadian and U.S. equities. We are neutral weight to international developed markets (Europe and Japan) and underweight emerging market equities.
We remain underweight to fixed income. Within fixed income, we have substantial exposure to high-quality, investment-grade corporate credit and are underweight lower-rated high-yield bonds.
Given that U.S. equities have outperformed, our relative regional equity weights have drifted. We are employing several strategies. We are letting the U.S. winners run a bit, while also ensuring our exposure to the most expensive areas of the U.S. market remains reasonable. In cases where the out-of-balance breaches our tolerance, we are rebalancing.
We continue to see good value in Canadian equities, which are more sensitive to interest rates and global growth. The headwinds of slow growth and higher rates in the last few years appear to be waning as the global economy perks up and central banks ponder interest rate cuts. Former headwinds for Canada are poised to become tailwinds.
The last word – U.S. exceptionalism
As we noted above, U.S. equity performance has exceeded expectations. An improving backdrop prompted us to raise our S&P 500 target twice in the last four months – from 4,900 to 5,100 and then up to 5,400. Although this is not yet an official call, we have an upside scenario that points to 5,600.
Equity market outperformance and the U.S. market’s sheer size have been described as U.S. exceptionalism. We don’t see this as U.S. exceptionalism; we’d call it global exceptionalism, which happens to locate itself in the most favourable geography available.
The Magnificent Seven (Apple, Microsoft, Nvidia, Alphabet, Amazon, Meta, and Tesla), along with many more companies that make up the S&P 500, aren’t just U.S. companies: they are global companies that are U.S. based. Consider that four of the seven Mag-7 CEOs are non-U.S. born (two Indian, a Taiwanese and a South African). For the wealthy and talented, North America – and the U.S. in particular – is an attractive place to live. The lure is generally nice weather, relatively low taxes and lots of ways to spend your money.
Beyond this, for all the U.S. is and isn’t these days, it still offers plenty of what companies need to thrive. Factor in access to the world’s deepest pool of capital (largest stock and bond markets) in the world’s most accepted currency, in English, the world’s most spoken and primary business language. It offers sound infrastructure, both physical and social (democracy, a trusted legal system, healthcare), that supports growth, productivity and innovation. World-class higher education provides access to labour, which increasingly needs to be highly skilled.
The U.S. isn’t the only place businesses can thrive, and it isn’t that other countries aren’t suitable or that the U.S. is perfect – far from it. However, we shouldn’t really be surprised that so many of the world’s largest companies choose to call the U.S. – and the S&P 500 – home.
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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