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Global equity markets were generally weak in May, with two standout exceptions: the NASDAQ Index in the U.S. and the Japanese Nikkei 225 Index broke out of the sideways trading range where they had been stuck with other global stock markets for many months. Bond yields rose, driving a negative performance in bond prices (yields and prices move in opposite directions). However, this did not erase year-to-date gains for bond investors. Capital markets continue to weigh incoming data, searching for direction but not finding it in the mixed evidence.
There are as many reasons to be optimistic as there are reasons for worry. Markets are rudderless because they don’t see a dominant theme – good or bad. Every new piece of economic data changes the narrative, swinging the zeitgeist one way or the other depending on the day.
A year's worth of central-bank tightening is impacting some parts of the economy, and the concern is that more slowing will come as higher borrowing costs hit consumer and corporate pocketbooks with a lag. Commodity prices, which are a sign from markets on the prospects for growth, are soft on fears of global recession (that has yet to materialize), and a China reopening that is progressing less robustly than anticipated.
On the plus side, inflation generally continues to fall slowly, despite some stubborn pockets. Canadian and U.S. housing markets perked up and employment remains solid. Corporations delivered better-than-expected earnings and improved their forward guidance. In response, analysts are upgrading their outlooks. A soft landing (rather than a recession) is possible. In some corners, resilience is progressing to reacceleration of the economy.
Yet, reacceleration is double-sided. It suggests that efforts to slow the economy in order to tame inflation haven’t worked yet. We have what feels like a race to the finish line. Can inflation fall far and fast enough to stop central banks from raising interest rates too high, forcing a harder landing? We believe inflation will eventually cool. However, getting inflation from 9% to 4% was the easy part. Getting from 4% back down to 2% will be tougher and could bring economic consequences. Despite claims that 2% is the target, we believe central banks can live with 2%-3% inflation. North of 4% remains unacceptable, so the mission is not yet accomplished.
May saw some significant changes in outlook. Expectations are fading that central banks are done raising rates. Banking stress in the U.S. appears contained and U.S. debt ceiling woes are vanquished. This has North American bond yields up from the bottom of their recent trading range. As a result, bond yields that had dropped too low are now back to levels that reflect stubborn inflation and the potential of higher-for-longer interest rates. Bond yields heading lower were inconsistent with a soft landing; they were actually a sign that the bond market feared a recession. Higher bond yields (especially real yields, which we currently have) are a healthier sign, and drive more income to bond investors.
Stocks may need to roll along sideways for some time before the next rally can get going. The U.S. Federal Reserve’s (the Fed) signal that it will pause in June is being called into question. Either way, the Fed is near a peak Fed funds rate, which has historically benefitted stocks. For the S&P 500, since 1990 average annualized returns have been around 9% during periods when the Fed was on hold after raising rates. Similarly, in the last 75 years, periods of disinflation (when core inflation was above 3% and falling) have been among the most equity friendly – S&P 500 annualized returns averaged nearly 10%. Note that we are not yet in either of these situations: inflation sits above 4%, and the Fed may not yet be on hold. Herein lies the crux of the problem.
Canada – Un-Pause
For May, the S&P/TSX Composite tumbled 5.2%, leaving the index up just 1% on the year. Canada’s main stock index has little exposure to tech, the month’s only winning sector. Prices slumped for energy and base metals on fears of slow growth and recession. West Texas Intermediate oil fell 11% to US$68.09 a barrel. Our loonie eased just 0.2% to US$0.737, or C$1.357 per U.S. dollar, supported by the big advance in Canadian bond yields. Canadian 2-year yields rose from 3.65% to 4.22%, and 10-year yields rose from 2.84% to 3.19%. Rising bond yields equate to falling bond prices; the FTSE Canada Universe Bond Index gave back 1.7%, remaining up 2.5% on the year.
Bond yields were responding to a surprise uptick in Canada’s headline inflation rate. Annual Consumer Price Index (CPI) inflation edged higher to 4.4% in April, above expectations and marked the first increase since last June. Thankfully, core inflation cooled, as did average hourly wage growth. The job market remains tight. In April, home prices climbed 1.6%; this second straight monthly increase signals a stabilizing housing market.
All told, Canada’s economy has been surprisingly resilient. Real GDP grew 3.1% annualized in Q1, more than expected. April and May also look stronger than anticipated – despite a public-sector strike and wildfires. This resiliency forced the Bank of Canada (BoC) to hike rates again on June 7 by 0.25% to 4.75%. With the bank rate above inflation, financial conditions in Canada are tight; we continue to believe that the BoC rate-hiking cycle is close to being done.
United States – A pause or just a skip?
For May, the S&P 500 rose 0.25% on the back of a sharp rally in the technology and communications sectors – two sectors that contain some of the index’s largest companies. They were up 9.3% and 6.2%, respectively. Technology companies are even more heavily weighted in the NASDAQ, which jumped 5.8%.
Year to date, the five largest stocks by market capitalization are eclipsing the other S&P 500 companies by roughly 30%. This can be a glass-half-empty or glass-half-full scenario. More stocks participating in the rally suggests broader economic health. What we have now is a handful of very expensive stocks, and a huge swath of stocks with potential to move higher. Despite abundant handwringing over this phenomenon, there isn’t much evidence that narrow market breadth is a bad omen for future S&P 500 performance. This situation has happened before. Historically speaking, once these mega-caps settled down, the broader market held up just fine.
Annual U.S. CPI moderated to 4.9% in April, the first sub-5% figure in two years. Core prices, which exclude food and energy, also cooled slightly. However, Personal Consumption Expenditures (PCE) prices – the Fed’s preferred inflation gauge – accelerated. They jumped 0.4% in April, which kept the annual figure stubbornly above 4%. The bond market moved aggressively from pricing-in a paused Fed to pricing-in a Fed that may skip a June hike but follow up with a July hike. The debt-ceiling deal calmed default fears but left the much-less-scary prospect of slightly restrictive fiscal policy. Combined with tightening monetary policy, this is a double dampener to growth that should help on the inflation front. U.S. 2-year government bond yields rose from 4.01% to 4.4%, and 10-year yields rose from 3.42% to 3.64%.
Europe – Not pausing
European equity markets were weak in May, plagued by the same lack of exposure to technology darlings as the Canadian market. For all the predictions of looming recession across the globe, we now have one economy that’s officially in this category. German real GDP shrank over the last two quarters.
For May, European inflation fell to 6.1% above year-ago levels, down from 7.0% in April. This isn’t dissuading the European Central Bank (ECB), which raised rates 0.25% to 3.75%. Although this is its smallest increase since July 2022, these central bankers remain very concerned about inflation. “We are not pausing," and “still have ground to cover on rates,” said ECB President Christine Lagarde.
The Euro STOXX 50, German DAX, and U.K. FTSE 100 stock market indices all declined in May, posting returns of -3.2%, -1.6%, and -5.4%, respectively.
Asia – China down, Japan up
Despite high-profile and encouraging meetings between U.S. and Chinese politicians, as well as trips to China by U.S. business leaders Jamie Dimon of JPMorgan Chase and Elon Musk of Tesla, Chinese equity markets continue to suffer from heavy negative sentiment. Adding to the difficulties for Chinese equities, China's reopening recovery is less robust than expected. The MSCI China Equity Index fell 9% in May.
The standout performer for May was Japan’s Nikkei 225 stock index, which vaulted 7% to a 33-year high. The Nikkei is dominated by exporting companies whose earnings are juiced by a depreciating yen, pricing power thanks to Japan’s first real inflation in decades, and an ultra-accommodative central bank.
Our strategy – Balanced, with a dash more equity
Our portfolios remain well balanced, with a moderate tilt toward equities. After harvesting some gains earlier in the year, the continued outperformance of U.S. stocks is nudging our exposure up. We are watching this situation closely but allowing the drift to persist so that our equity overweight has grown a little (from slight to modest).
We are now overweight both Canadian and U.S. equities in many portfolios. Our multi-strategy approach to U.S. and Canadian stock selection is well positioned to navigate the current divergence within the U.S. and Canadian equity markets. This approach combines active and passive stock selection. The active managers weigh valuations as an integral part of their investment process. The passive allocation provides exposure to the current momentum, which is dominating at the moment. We remain neutral weight to international and emerging market equities.
Our well-diversified exposure to bonds is delivering a solid running yield. Coupon income and maturity proceeds are being reinvested at higher yields. While this is not our base-case scenario, if the economy slows too much, we believe our bond positions will provide a level of safety.
The last word – AI: Artificially Inflated?
For centuries, financial bubbles have been associated with the introduction of new technologies: railroads, cars, computers, the internet, and maybe AI. This is a feature, not a bug of capitalism and one of its essential roles in directing resources to new ideas. The tradeoff for the many companies that fail is spectacular returns for the ones that succeed, and the proliferation of productivity-enhancing technologies.
There are good bubbles and bad. Good bubbles are financed by equity, resulting in many companies pursuing a common innovation. In the end, funding many ideas fuels competition that leads to better, faster innovation and adoption of productivity-enhancing technology. The fruits of this exercise snowball for decades across society. Bad bubbles are generally financed by debt and fuel unproductive assets like tulips or too many houses for people who can't afford them. These bubbles end in misery for all but a few and create enduring scars versus ongoing improvements.
If AI stocks are in a bubble, so far it has the hallmarks of the good kind. It is playing out in the stock market and appears to have the potential to increase productivity across a wide swath of applications. However, the AI story has multiple layers, and we are very early in the game. It remains to be seen where the lasting money will be made and who will reap the lion's share of the reward. Inventors? Suppliers like semiconductor companies? The distributors and enablers like Google, Microsoft, Meta, and Amazon? Or will it be the world at large as monetizing the innovation proves difficult, and consumers of the service end up enjoying most of the benefits?
Bubbles are a fact of life for investors; invest long enough and you'll see many. The key to investing longevity is avoiding the frenzy, keeping greed in check, and sticking to a disciplined investment framework. Ask ChatGPT how to avoid financial bubbles; it tells you the same thing (less eloquently, IMO). Ask ChatGPT who will win the AI revolution, and it humbly defers. It says it can't predict the future but instead lists companies that have seen their share prices rise sharply based on the hope that they will reap the AI revolution rewards. Only time will tell.
This commentary was 100% created by humans.
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