November 18, 2024

Financial letter, Spring 2024, 69^th edition

Mission accomplished?

After just over 12 months of spectacular returns, it’s logical to wonder whether this trend can continue.

Chart 1, which tracks the S&P 500’s performance, shows that sharp market downturns of more than 20% (red bands) generally coincide with recessions (grey bands).

Meanwhile, chart 2 compares the earnings of S&P 500 companies with recessions (grey bands). It seems fairly clear that most earnings declines occur during economic contractions. This means that if monetary authorities manage to achieve a soft landing, earnings could keep climbing (although perhaps at a slower pace).

In a climate of still-rising earnings, as long as investor sentiment doesn’t flag and price-to-earnings ratios hold steady, stock markets could very well advance in line with earnings growth. They may move more slowly than they have over the past 12 months, but the trend would still be positive.

The global economy is affected by multiple trends that should keep shaping market expectations and economic outlooks in the coming months. China’s economic struggles were highlighted by its bond yields, which plunged to record lows even though the country’s central bank sold some of its bonds to limit the decline. Chinese exports were propped up by their low prices, but China’s economy is still being held back by the ongoing deleveraging of its property market and the resulting negative wealth effect. Meanwhile, Western countries are adopting increasingly protectionist stances, which will create more challenges for Chinese exports in the future. As for Europe, even though lending conditions are still tight, the region has experienced modest growth, partly as a result of this summer’s big sporting events. Yet persistent pressures on salaries and services inflation mean the European Central Bank should nevertheless remain cautious about normalizing its monetary policy.

In contrast, central banks in North America are now feeling a sense of urgency. The Federal Reserve (Fed) started easing its monetary policy later than the other major central banks. It is now trying to catch up, as shown by its decision to make a jumbo 50-basis-point cut at its September 18 meeting. The Bank of Canada (BoC) started cutting rates 3 months earlier, shrugging off (with good reason) overblown fears over monetary policy divergence. In fact, the Fed and the BoC are motivated by slightly different reasons: The Fed is trying to catch up after waiting a little too long to start easing, while the BoC is trying to protect Canada’s economy from major headwinds expected over the next year, namely a sharp slowdown in population growth and the impact of mortgage renewals.

Despite these differences, the US and Canadian economies share one trait: increasing labour market slack. For now, the pullback seems to be orderly. Population growth appears to be responsible for most of the rise in unemployment, while layoffs are still close to cyclical lows. Hiring has slowed, but that’s to be expected given the decrease in job postings. The 2 countries posted respectable economic growth in the first 6 months of 2024, and we expect slow but steady expansion over the next few months. This is unlikely to trigger the amount of layoffs usually seen during a recession.

But 2 big factors will affect these forecasts. The first is the outcome of the US election. Since Donald Trump’s platform depends heavily on across-the-board tariffs, it will have a net negative impact on growth, fuelling inflation in the United States and possibly other countries. The second factor is how central banks choose to normalize interest rates in an environment where their decisions will have to strike a difficult balance between growth and inflation risks.

In Canada, this challenge has been heightened by the government’s changes to and implementation of immigration policy. The BoC’s latest projections show the population increasing rapidly over the next 2 years, which suggests a certain skepticism regarding the government’s ability to fully achieve its goals. But many recent BoC forecasts have been excessively optimistic. If the government unveils a detailed, credible implementation plan when adjusting its immigration targets this fall, the economic outlook could be revised downward. This may allow the BoC to slash rates even more aggressively than markets currently expect.

Donald Trump 2.0

After many months of campaigning, Donald Trump managed to win back the White House with a solid majority. The market response was basically in line with what was expected to happen if he won. That means US stocks went up, expanding their lead over the rest of the world. It also means bond yields followed stock prices upward. In addition, the US dollar continued to soar, trading at its highest against the loonie since 2020. US politics may bring up a lot of feelings, but for stock markets, the economy reins supreme.

Basically, a Trump presidency is viewed as good for business, which explains why US stock markets welcomed his return. One of his campaign promises was to lower the corporate tax rate from 21% to 15% for companies that manufacture their products in the United States (and 20% for companies that don’t). This policy would increase the profits of S&P 500 companies.

As for the country’s trade policy, he wants to impose an across-the-board tariff of 10%, raising it to 60% on Chinese exports. This could, to a certain extent, rein in economic growth and fuel inflation in the United States.

Current economic and budget conditions have changed and are more restrictive than they were 8 years ago. Debt is now at a record high, while budget deficits are constantly making headlines. The threat of renewed inflation is a highly important variable that markets need to watch out for.
Investors will need to ignore the short-term noise and stick to their strategy over the medium and long term, regardless of the headlines or the party in power.

Asset allocation

Current conditions seem to point to a soft landing. The employment market is slackening, but job growth continues, albeit at a slower pace. Corporate earnings and household wealth are sending promising signals.

There’s another important point to consider when getting ready to adopt a defensive positioning: On average, over the long term, bull markets last longer and have a bigger impact than bear markets (see the following chart).

That means that when in doubt, it’s normally a better idea to be optimistic rather than pessimistic, even though pessimists may look like geniuses over the short term. In investing, success is measured over the long term.

As Peter Lynch put it, “far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in the corrections themselves.”

Investing during an economic slump requires caution. We’re maintaining a reasonable strategic position that’s tactically aligned with our target so we can seize opportunities as they arise.
We’re taking into account the outcome of the US election and the market response.

Tactically, we’re recommending a neutral position in cash, stocks and bonds.

Equities | Neutral

Challenging valuations

In September, the MSCI World Index held steady at the 93rd percentile of its historical distribution, the highest it’s been since the end of 2021. Valuations are challenging, which has led us to invest in an equal-weighted S&P 500 index so we can take advantage of the US’s sustained economic growth, but at a lower, more appealing price. In addition, the equal-weight index offers more upside potential given the prospect of a manufacturing recovery, which aligns with our “value” approach to Canada.

The Canadian market is increasingly costly, rising from the 83rd to the 87th percentile in September. That said, Canada’s relative valuation compared to the United States is still highly attractive.

The S&P 500 moved up a notch from the 96th to 97th percentile. The US market remains pricey compared to all other regions of the world.

We’re maintaining a conservative balance between defensive and offensive strategies so we can try to take advantage of opportunities during market dips as soon as confidence indicators start flashing green.
In terms of stock selection, we’re focusing on good businesses that offer attractive earnings growth, are well positioned for an economic slowdown and perform well in an environment of falling rates.

Fixed income | Neutral

After peaking last fall, Canadian 5-year yields plummeted from nearly 4.50% to just under 3.00%. Assuming Canada’s policy rate goes down to 2.25% at the end of 2025, as we expect, it seems the 5-year yield has already fully priced in a scenario where the policy rate continues to fall, but medium- and long-term yields are expected to remain more stable.

Until now, high unemployment has been the result of population growth and a slowdown in hiring, rather than more layoffs, which means we can be a little optimistic. But it’s clear that the Fed needs to act quickly if it wants to stick a soft landing.

As for bigger movements in the Canadian bond market, we expect one of 2 scenarios to come to pass. First, the economy could prove resilient enough for inflation to remain unchanged, forcing the BoC to pause its easing cycle at least once. This would keep rates high and limit returns on bonds. The second scenario would arise if rate cuts aren’t enough to keep the economy from losing momentum. This would result in disappointing data on multiple fronts, prompting the BoC to cut rates faster and farther than expected. Such a scenario would buoy the bond market, but it wouldn’t be so great for the Canadian dollar.

Conclusion

The market is currently at a crossroads. The economic climate remains cloudy, but interest rates are falling fast. Sooner or later, an environment like this should boost the economy and give rise to attractive investment opportunities.

Unlike Canada and Europe, the US economy has so far held up against monetary tightening, but demand could still be affected by interest rate hikes putting a damper on activity in the United States. In the meantime, we can’t help but notice that US growth has confounded all forecasts.
In fact, the consensus is still betting on a US economic contraction, but not till 2025. This outlook is pretty much in line with a longer—but not abnormal—lag between when central banks start hiking rates and when the economy starts feeling the full effect of those rate hikes.

Even with the best models, economic forecasting can be tricky. The scenario that’s currently baked into equity markets doesn’t leave much room for disappointment. The main valuation metrics of the MSCI World Index are in the 95th percentile of their historical distribution, which means expectations are high. High prices are no longer limited to a few US mega-cap stocks with strong balance sheets. In recent months, they’ve expanded into other regions and market segments that were expecting a significant slowdown just a few quarters ago.

In closing, the latest data paints a sunny picture of the US economy. The employment market is stabilizing, consumers aren’t showing many signs of fatigue, and corporate earnings are growing. This buildup of strong data has raised the bar for stock markets, which have delivered outstanding returns over the past 12 months. It’s worth noting that risk appetite is still very high among both institutional and retail investors. History has shown that this kind of exuberance can last for many, many months. Patience is therefore in order.

We hope this provides you with additional market insight. We’re always available to discuss our investment strategies with you at greater length. We remain committed to working even harder to identify promising market opportunities to help you achieve your long-term goals.

Index		Level	3 months	6 months	1 year
S&P/TSX		24,156.87	5.30%	12.94%	32.06%
S&P 500 (USD)		5,705.45	3.66%	14.07%	37.99%
MSCI Emerging Markets (USD)		1,119.52	3.77%	8.96%	25.88%
MSCI World (USD)		3,647.14	2.55%	11.36%	34.31%
CAD/USD Exchange Rate		$0.72	$0.72	$0.73	-0.42%
FTSE TMX Short-Term		805.95	1.52%	4.78%	8.16%
FTSE TMX Mid-Term		1,274.66	1.02%	6.84%	11.72%
Oil (US$)		$69.26	$77.91	$81.93	-14.51%
Gold (US$))		$2,743.97	$2,658.24	$2,286.25	38.31%