JENNIFER DOWTY, THE GLOBE & MAIL
PUBLISHED JUNE 24, 2024
The Canadian stock market has displayed two attractive characteristics this year, a positive, albeit modest, return for the overall index combined with low market volatility. In May, the S&P/TSX Composite Index closed at an all-time high. Meanwhile, there have only been around a dozen days in the first half of the year with gains or losses of 1 per cent or more in the index and just one trading session when it experienced a market move of more than 2 per cent.
To gain insights on what might be in store for investors in the second half of the year, The Globe and Mail recently spoke with Brent Joyce, chief investment strategist of BMO Private Investment Counsel. He believes investors holding a diversified portfolio of cash, fixed income and equities are positioned for success, noting that the set-up for the three asset classes is the best in at least a decade.
For the balance of the year, you see greater upside potential for the Canadian stock market compared to the U.S. stock market. You have a year-end target for the S&P/ TSX Composite index of 23,500 and a target of 5,600 for the S&P 500 Index. Why don’t see greater upside potential for the U.S. market given its higher earnings growth and its broader sector composition?
The S&P 500 is up 15 per cent on the year versus 3 per cent for the TSX so a chunk of that earnings growth expectation for the U.S. market is already reflected in the level that we’re at today.
I think the tailwind for Canadian equities is the reversal of what has been a headwind for Canadian stocks for much of the past two to three years and that would largely be the interest rate backdrop. We are at the cusp of an interest rate cutting cycle. It’ll help both markets, but the Canadian economy and the Canadian stock market are more interest rate sensitive than the U.S. economy and the U.S. stock market.
What are your thoughts on the upcoming earnings season? Will we see a strong earnings season in Canada and the U.S.?
We think about earnings growth as a more medium-term concept as opposed to quarter by quarter.
We are exiting, with the exception of some companies in the high growth technology space, we’re exiting largely what has been an earnings recession for the past one and a half to two years.
When businesses fear a slowdown, fear a recession, have to adapt to higher wage costs, have to adapt to supply chain disruptions, higher borrowing costs, all the things that corporations had to deal with over the past couple of years that impacts earnings. They get leaner and more efficient.
Now, we didn’t have full-blown recessions, it was just an earnings slump that sort of bounced around zero. We expect to see a return to normal for earnings growth at a minimum. Average earnings growth through long periods of time is 8 per cent. We expect at least that. If it approaches 10 or 12 per cent on an annual basis that wouldn’t surprise us.
To answer your question on a quarterly basis, most companies beat expectations. Analysts are subject to behavioral emotions and biases. If earnings are disappointing, they pull in their expectations a little bit. When earnings start to recover, we just talked about corporations getting leaner and more efficient and coming out of an earnings recession, the surprises then surprise everybody including analysts.
So, could your market targets be too conservative given that we could see earnings growth return to normal?
Yes. And this is where we have erred on the side of fairly conservative equity targets. It gives us a degree of comfort to be overweight equities when we’ve used not the most Pollyannish scenarios but what we think is a fairly common-sense scenario.
For the S&P 500, 5,700 wouldn’t surprise us to see. If we start to think about the end of next year, we’ve got 6,000 penciled in. That’s not a hard number to get to for 2025.
Turning to sectors, financials are a key focus within the Canadian stock market. Are Canadian bank stocks value traps. The reason why I ask is that they have low earnings growth, BMO’s real GDP growth forecast is just 1per cent for 2024 and we have an inverted yield curve.
They are value stocks. I would not describe them as value traps.
These are excellent franchises over decades that have rewarded their shareholders quite handsomely. They are well diversified businesses, never more so, as many of the Canadian banks now are making significant forays into the U.S. market and globally as well in some cases.
This is a bit of a good case study of what we just described in terms of this earnings recession. The banking sector certainly has faced an inverted curve, which is very difficult for the basic business of lending money. So, earnings growth has been weak for the past couple of years, and it looks as though that could be bottoming and starting to turn the corner.
When the yield curve becomes a little less punitive and the economy starts to pick up a bit, the housing sector activity starts to improve over the next 6,8, ten, twelve months and beyond that, they’ll be poised to see a recovery in their earnings profile.
What we’re witnessing today is what we believe is a bit of a bottoming in the ROE [Return on Equity] numbers, a bit of a bottoming in the earnings per share numbers and with a trajectory that that starts to turn higher. And from a share price perspective, they’re not expensive at all. They’re trading below their average price-to-earnings multiples.
So, do you have an overweight recommendation for bank stocks? Do you make sector recommendations?
As a global strategist, I am implicitly taking sector allocations to some extent by making regional allocations. The TSX is a much more cyclical, interest rate sensitive market. Some of that is because of the banks, but not exclusively. Energy, materials, those are very economically sensitive, if not interest rate sensitive. So, by having an overweight in Canada, we know that the market comes with certain exposures and so that has to be taken into consideration, even though we leave the sector and stock picking to our sub-advisor asset managers.
The reason we have an overweight on U.S. and Canadian markets, even though our Canadian numbers on paper point to a bit of a stronger return, is we like the differentiation that you get from each market. Canada has the better return prospects, comes with a little bit higher risk profile, has the tax advantages of dividend tax credit, at least for Canadians, and a much stronger dividend yield.
On the other hand, the S&P 500 has a more secular growth theme with the technology and health care exposures and other innovative companies in the consumer space, the “Magnificent Seven” stocks, etc. For Canadians, it’s also a defensive market, not only because those sectors tend to be a little bit more bulletproof to the economic cycle, but it’s U.S. dollar exposure for Canadians. So, if we have some events that causes a risk-off scare, stocks are going to suffer but U.S. stocks would suffer probably less than Canadian stocks. The Canadian dollar likely weakens in that environment as people get risk averse globally, and so there’s a built-in automatic buffer for Canadians by having exposure to U.S. assets.
And if you think about Europe, it’s a lot of individual specialized companies, whether that’s in health care or technology or luxury goods. Then emerging markets, it’s again a cyclical story but also generally a high growth story.
That leads me to my next question. For investors seeking international equity exposure, in terms of return potential, what are your top three international equity market recommendations?
As a global macro strategist, I make allocations between Canada, the U.S., international developed markets, which largely you have to parse out as being Europe and Japan, and then emerging markets.
We are neutral weight on developed international markets, both Europe and Japan. Japanese equities have done very well. There’s momentum behind them. They’re certainly coming off decades of disappointment and there’s some very good companies in Japan. Japanese equities are not about what’s happening with the Japanese economy very much. They’re all exporters so a weak yen certainly has been benefiting Japanese exporters. But if we do believe that the rest of the world, excluding the U.S., is exiting the slowdown or recession of the past year and a half, two years, and that the U.S. is going to continue to stay reasonably strong, albeit we want it to cool a bit, then that’s a decent global growth backdrop that would favour Japanese exporters.
It’s a similar story in Europe. I mentioned the luxury brands that you get from European markets, you get some good consumer names from there as well, interesting health-care exposure. It’s a reasonably broadly diversified basket, but a lot of them are exporters. You have to think about the European economy, but they tend to also have some outsized exposure to emerging markets, particularly China. If we think that China might be getting its feet under it rather than making allocations specifically to Chinese equities or to emerging markets, this is a bit of a gentler way to play that recovery through European exporters.
You have overweight recommendations on Canadian and U.S. stock markets, a neutral recommendation on international developed markets. What about emerging markets?
We’re slightly underweight in emerging markets but not zero.
The geopolitical shifts that are taking place that are really a bit longer term, in terms of reshoring, but also some of the political hegemony shifts that are happening in the world today does give us some caution. It’s likely that emerging markets will see a positive bounce and it could be quite significant. These markets can move up 20 or 30 per cent in a matter of weeks or months, that’s not unusual. So, it’s likely to happen eventually, which is why we don’t want to have a zero weight there. But the patience and the risk appetite that’s required in the current environment, it’s pretty steep for us at the moment.
There’s been discussion about lofty price-to-earnings multiple for some indices and stocks. For instance, some AI stocks and the U.S. equity market trading at a price-to-earnings multiple of around 21 times forward earnings. Are multiples justified?
By and large, I would say they are. Certainly, for individual stocks, we could have a debate.
The debate that we often have is with those who think that the S&P 500 fair value is something like 16- or 17-times earnings. I would push back on that and say the make-up of a stock market index is a reflection of the companies that are in it and that is not a static item. It’s fluid through time. So, 20,30, 40 years ago when Exxon Mobil was the largest stock in the S&P 500, the U.S. banks were bigger weights and industrials - like car companies, etc. - with those businesses, a 17-times multiple makes sense. For high growth businesses in the technology space, in the innovation space, in the healthcare space, they don’t trade at those kinds of multiples, and they never have, so to expect them to is foolish.
When a rate cut is announced by the U.S. Federal Reserve will this be a catalyst for stocks and lift U.S. markets to new record highs or is much of the rally in stocks typically seen ahead of the first rate cut?
The latter. So, some of the move we’ve seen in U.S. equities so far has been in anticipation.
If you think about the rally that happened in the fourth quarter of last year - a very strong market rally in November, December globally - that was excitement that the Federal Reserve was going to be cutting as many as six times this year.
And then very quickly into February, early March that had been ratcheted down to the point where there were some whispers that the Fed might raise rates. So, we went from six to call it zero cuts. And now, we’ve landed back to where we started eight months ago, 10 months ago.
The Fed’s guidance hasn’t shifted all that much, sort of in the one to three rate cuts for this year. We lean towards two. The Fed should be cutting today as far as I’m concerned.
So, to answer your question, some of the rally has been put in but because of the uncertainty around whether cuts are even coming or not, I still think there’s upside.
Savings accounts have provided individuals with attractive interest rates in recent years. Should investors reduce their cash allocations and invest in stocks and bonds?
Allocations to cash, first and foremost, I think are very personal choices at the investor level.
As an asset class, cash is certainly attractive. It gives you lots of optionality as a macro strategist. So, to have some cash means that I have the ability to take advantage of an opportunity should it come along. So, we’re never going to run zero cash.
For the good old-fashioned foundational balanced investor who thinks about having some cash, an allocation to fixed income, and an allocation to stocks, I would say, it is a great time to be that kind of an investor. The set up that we have for those three asset classes has not been as good as it is today for at least 10 years, and I might argue for all of the opening quarter of the 21st century. We can make, call it, 4 per cent in cash, plus or minus. We certainly see an opportunity to make somewhere between four and maybe 6 per cent out of a broadly diversified basket of fixed income that includes some credit exposure. And the normal return from stock markets is in that 8 to 12 per cent range, that’s where we think earnings estimates are going to land, and valuations by and large are reasonable, certainly outside the U.S., they’re very reasonable.
You’ve been working in the financial industry for over two decades. Strategists often discuss the importance of portfolio diversification. What portfolio management advice do you have for investors that might not be as well known?
One question that I often get asked is: “Are tech stocks in a bubble?” It gets to the heart of answering your question as to what I believe is some sage advice for the average investor.
So, if we think about bubbles in stock markets, technology or otherwise, whether we’re in one or not today with artificial intelligence, only time will tell. We should probably hope that either it is a bubble or is going to form into a bubble and we shouldn’t really be afraid of that if that does happen.
Stock markets have bubbles. It’s how we engage with that as investors that’s most important. We can control our behavior. We can’t control what happens in the stock market.
When it comes to new technology and innovation, what we’re experiencing today is not unusual. In fact, it’s what stock markets are supposed to do and what society needs them to do when we’re faced with discovery and innovation and really new productivity enhancing tools. These concepts and ideas, first of all, they need money. That’s why it’s called capitalism with capital markets. The people who founded them and take the risk to get them going need to be eventually rewarded for taking on that risk. Then, we see a growing number of companies that come piling in to try and take advantage of this opportunity and those businesses they need vetting and capitalism does this and stock markets are really the arena where all of this plays out.
Like I said, this is not a new story. You go all the way back to railways, electricity, the combustion engine, telephone, TV, cell phones, internet, smartphones, and now AI, all these innovations that were game changers for quality of life, for productivity enhancement, for humanity, they all featured pockets of spectacular stock market returns for companies or individual sectors.
It’s where companies sort of duke it out for the spoils of that innovation and it’s not just the inventor, it’s the whole ecosystem around it, the suppliers, the distributors, the adopters of the innovation, they’re all involved, and can get wrapped up in that euphoria. Eventually, capital markets will reveal the winners and losers but identifying the eventual winners is very difficult, particularly in the early days. And I would argue it’s difficult even through the middle innings, which ones are going to be the survivors or not. But for the diversified, well-balanced investor, this is all okay.
As investors, we have choices. So, the first thing is you don’t have to even play this game if you don’t want to. Today, you can easily build a portfolio of cash, bonds, and good old-fashioned well-run companies with proven products and services that have good track records, pay dividends, grow the share price through time. But I think most investors can benefit from these exciting new areas of innovation and discovery.
If we understand that bubbles are a part of investing, they’re not new and we’re going to see them again, then it’s us that has to adjust our behavior and we can do that by having well diversified exposure to these areas. You don’t try to time these things, but you do trim them, you don’t get greedy, you need to take profits all the way along. We need to use common sense.
We also need to know that these things do end in tears eventually, there will be some disappointments. But if you’ve harvested a decent gain all the way along by staying disciplined for as long as the bubble may or may not last, then you’re likely going to end up having harvested some of that opportunity for your portfolio and minimizing the pain when the bubble eventually does burst.
The magic to investment success, and this is why working with investment professionals is so important, is to keep our own emotions guarded and in check. And the best way to do that is through knowledge and experience and investment professionals have that and can help individual investors make fewer mistakes.
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