“Sell in May and go away, come back on St. Leger’s Day.”
– adage born from 18th century U.K. stock traders escaping London’s summer heat and returning for the St. Leger Stakes, the final leg of the English Triple Crown run mid-September.
April brought shaking to the equity markets and rattling to the bond market, with tandem declines for both asset classes. However, we saw continued rolling recoveries in housing, manufacturing and non-U.S. global economic growth, all of which support our positive outlook for capital markets.
We have been warning that equity markets were ripe for a consolidation of recent gains. A smooth, uninterrupted five-month advance for equity markets was certainly welcome, but was always due to come to an end. A pause was in order, which is also welcome and healthy. Investors need reminding that risky assets deliver premium returns because they are risky. Remove the uncertainty (i.e., markets only go up), and complacency will drive the premium opportunity away.
Capital markets had plenty to digest in April: warm U.S. inflation, chilled U.S. GDP numbers, heated political wrangling over Western aid to allies, and geopolitical flare-ups that escalated the ongoing misery in a number of global hotspots. For now, tensions have eased; aid is beginning to flow. In our view, April’s equity market slides of 3% to 5% were run-of-the-mill volatility. We are encouraged that markets held up in the face of gloomy headlines. Much of April’s real story was not so plainly visible. If we look deeper, some of the data reveal silver linings.
Inflation redux
Among the adverse developments that shook markets, the worst was a familiar culprit – U.S. inflation. After surprise upticks in January and February, March’s high reading couldn’t be ignored. These two months could have been considered anomalies. But a third consecutive month makes a trend; U.S. inflation has stalled out at an elevated level.
The inflation measure preferred by the U.S. Federal Reserve (the Fed) is core Personal Consumption Expenditures (PCE), which now sits at 2.8% year over year. The annual increase for headline Consumer Price Index (CPI) reads 3.5%. While these levels are much less alarming than the 5.5% and 9% readings at their peak, they also aren’t close enough to the Fed’s 2% target to justify all the rate cuts that investors have been expecting. Adding insult to injury, the Fed’s second key metric, the Employment Cost Index (ECI), generated its first quarterly uptick in a year. That marked the end of a steady downward trend. At a year-over-year 4.2% increase, the index is paused flat (a small silver lining over an increase). However, ECI at 4.2% is a little too high to jibe with 2% core inflation. Rising labour costs risk seeing businesses raise prices (inflation) unless labour productivity rises substantially to offset the wage gains. Unfortunately, productivity that had been running along very nicely above 3% for several quarters suffered a setback in Q1, falling to just 0.3%.
The one-two punch of higher inflation and employment costs dealt a body blow to (already shrinking) expectations for the number of Fed interest rate cuts in 2024. This adjustment requires a repricing of both stocks and bonds: yields higher, prices lower for bonds; prices lower for stocks. Yet, in the face of earnings growth, the silver lining is lower equity valuations.
Numbers continue to seesaw. A surprisingly weak U.S. jobs report on May 3 plus cooler wage growth bolstered the chances of a soft landing and central bank rate cuts. Bonds and stocks posted solid gains to open the month.
At the start of the year, optimism about Fed rate cuts was unreasonably high. Markets priced in up to six quarter-point cuts in 2024. We were never in this camp, but given recent data and considering the U.S. election may impact the timing of cuts, we now see the Fed making three 0.25% cuts by the end of January 2025. If pushed, we’d say there is a greater chance of more than three versus fewer. Canada’s better inflation dynamics and lower growth profile could still bring a June cut. Between two and three cuts are still expected for 2024.
There are good reasons to think that U.S. economic growth will moderate, which will loosen the labour market, moderate wage gains and open the door for rate cuts. Waiting for this situation to unfold will require patience. Central bankers are still talking about rate cuts; the debate is not if, but when and how many. We don’t buy into the whispers of possible U.S. rate increases – the bar for that is very high and would require several inflation upticks, not just a stall. For the record, there is no talk of rate hikes for Canada.
GDP – It doesn’t stand for Gross Domestic Problem
Adding to the bad vibes from U.S. data was a seemingly weak Q1 GDP number. U.S. economic growth slowed to 1.6% annualized quarterly growth, below the consensus forecast of 2.5%. Hot inflation and weaker growth prompted the usual naysayers to suggest the possibility of dreaded stagflation. Fed Chair Jerome Powell downplayed that idea at the May Fed meeting, saying “I don’t see the ‘stag’ or the ‘flation.’” The numbers simply don’t support this conclusion.
A silver lining is hiding inside the GDP report, which showed less government spending and more imports than exports. Consumers and businesses, the heart of the U.S. economy, remain in good shape. If this is a lousy GDP report, I’ll have a second helping. Given profligate government spending and ballooning deficits, a slightly tighter-fisted Uncle Sam is more than good news to us. With a strong U.S. dollar (thanks to higher U.S. interest rates, robust GDP growth and higher for longer monetary policy), we should expect more imports and fewer exports. This, too, is a silver lining. Cheaper imports bring lower inflation and transfer demand (economic growth) to U.S. trading partners. We want U.S. growth to slow somewhat to ease inflation and we want the rest of the world, where weak growth has trampled inflation concerns, to accelerate. That’s part of a global soft landing.
Equity market insights
Despite April’s declines, year-to-date percentage gains for all major equity market indices that we track remain higher by mid-single digits (with the exception of U.S. small-mid caps, specifically the Russell 2000 Index).
Stocks had many encouraging developments to celebrate. By month’s end, geopolitical tensions eased slightly. Inflation outside the U.S. remains on a downward path, while economic growth outside the U.S. continues to perk up. Europe and China posted better-than-expected economic results, garnering investors’ attention as these markets outperformed. In Europe, after years of malaise when only the largest countries shouldered most of the weight, it was encouraging to see the peripheral countries contribute handsomely to growing the European pie.
For April, the S&P/TSX Composite fell 2%, the S&P 500 fell 4.2%, the EuroStoxx 50 fell 3.2%, and the U.K. FTSE 100 rose 2.4%. The MSCI China Index finally caught a break, rebounding 6.4% for the month. Japan’s Nikkei fell 5%, and the MSCI Emerging Markets Index (USD) eked out a 0.3% gain.
Earnings growth to the rescue
Corporate earnings are of the utmost importance to investors. First-quarter 2024 earnings growth is coming in better than expected, helping to stem the equity market declines. Earnings growth is key to our outlook and our pro-equities stance. The fact that earnings were the bright spot in April is very encouraging.
Better earnings growth is also spreading; earnings are beating analyst estimates in the U.S., Europe, Japan and Canada. In the U.S., solid earnings reports are broadening beyond the largest companies. Improving global growth and a solid U.S. consumer are reviving commodity prices (except for oil, which was down on the month despite Middle East tensions). This helped buoy the commodity side of the S&P/TSX (and produced a slight positive return for Canadian small-cap stocks). While our index was down on the month, its peak-to-trough decline was only 3.6% versus 5.5% for the S&P 500.
For several months, we have been concerned about overly bullish expectations, stretched valuations, and complacency. April’s events moderated these factors to a certain extent, which we think is healthy for equity markets. In the near term, it is impossible to know if this correction has run its course or if additional weakness lies ahead. However, we continue to see the backdrop as positive for stocks through the end of the year. The silver linings aren’t peripheral – many are the fundamental shifts we hope to see and that must happen to extend the cycle. At this point, it appears April is nothing more than an overdue breather following a robust five-month rally for global stocks.
Bond market insights
Bonds faced headwinds in April, but the retracement in yields back toward their October 2023 highs is making them more enticing. April saw the FTSE Canada Universe Bond Index post a nasty 2% decline. It has given back 3.2% this year, but is still up 3.5% from six months ago, which is in line with our expectations.
U.S. bond yields are wagging the tail for the rest of the world. Now that markets are anticipating fewer rate cuts from the Fed, the U.S. and, by extension, global bond yields have backed-up to retrace about three-quarters of their October 2023 highs (which were decade highs). Central banks outside the U.S., including Canada, have a green light to cut rates in the coming months. On May 1, the Fed reiterated that some cuts remain their base case for 2024.
Fixed income delivers returns in two ways: income or capital gains. Canadian bond yields are between 3.8% and 4.9%, so the income is there, plus room for yields to fall and also drive price gains. We see late April’s Canadian bond yield levels near the upper end of the range we expect for 2024.
Our strategy – Balanced with an equity overweight
If inflation remains elevated on stronger U.S. and global growth, stocks are a more attractive choice than bonds. 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 market equities.
We remain underweight fixed income. We have substantial exposure to high-quality, investment-grade corporate credit within fixed income and are underweight lower-rated high-yield bonds. This stance has served us well in the rising yield environment thus far in 2024. We are more constructive on fixed income at this juncture than at the start of the year.
April brought validation that our well-diversified approach remains prudent. For quite some time, U.S. equites have been outperforming. April saw our allocations to Canadian, international and emerging market equities out-perform U.S. equities.
One reason we hold a U.S. equity overweight is for the currency exposure. This benefit was evident in April. The S&P 500 fell 4.2% in U.S. dollars, but strength for the greenback against our loonie saw that decline nearly cut in half to -2.6%.
The last word – Don’t sell in May and go away
As long-term fundamental investors, we rely on sophisticated research and market experience to guide our trading strategies. However, spring has sprung, which will inevitably prompt some investors to wonder if they should follow the age-old maxim – sell their equity holdings this month, then get back into the market in September. We remind clients that staying invested is a much better strategy than making decisions based on an urban legend.
A quick Google search will turn up reams of data that debunk this theory across numerous periods and various markets, including the Dow, S&P 500, not to mention the U.K. stock market where these shenanigans started nearly 250 years ago. While some seasonality to market returns indicates stocks do better from November through April versus May through October, performance varies dramatically from year to year. The overwhelming evidence points to the wisdom of staying invested. Tempting though it may be, don’t follow the folklore. Instead, rely on the impressive weight of solid historical proof – take a well-diversified approach and “stay and play.”
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.
You should not act or rely on the information contained in this publication without seeking the advice of an appropriate professional advisor.
