August 15, 2024

Financial letter, Summer 2024, 68^th edition

This summer, the heat is on

Despite geopolitical tensions and uncertainty surrounding the economic outlook, enthusiasm for the stock market is here to stay! One new height followed the other at the beginning of the year, defying expectations and forcing Wall Street strategists to up their year-end targets. With each new record, returns were concentrated in fewer market sectors. Although investor enthusiasm for artificial intelligence is high, there are also some signs of market complacency. Given the astronomical valuation gains, results that fall short in any way could be severely punished by investors. Expectations are high … and hard to meet!

Last year, there was a consensus that a recession was looming. Although a recession is still expected, it looks like fewer people are expecting such a scenario. The reality of recessions is that they usually become obvious long after they've started.

After a streak of fast and steady interest rate hikes, consumers are starting to take a breather as some central banks recently announced their first key interest rate cuts. Advanced economies such as Canada and the eurozone have started loosening their monetary policy. On June 5, Canada lowered the target for the overnight rate from 5.00% to 4.75%. At the time of writing, we're also anticipating another rate cut after the July meeting. Despite this first cut, Canadian monetary policy remains very restrictive, and more gradual cuts will be necessary to bring key rates back to neutral territory (around 2.75%). If inflation continues to move in the right direction, we expect 3 more cuts to Canadian key rates by the end of the year, followed by more cuts in 2025 and 2026. We expect the Bank of Canada's overnight rate target to drop to about 2.25% in early 2026.

In the US, the Federal Reserve will have to be more patient before starting to cut its key interest rates. On top of greater resilience in demand, some upward pressure on inflation remains. Moreover, per-person growth in consumer spending is significantly more robust in the US than in most other industrialized countries. This is probably because mortgage terms are longer in the US than in other countries, such as Canada or the UK, which limits the immediate impact of interest rate hikes. Investment continues to grow, particularly in the manufacturing sector, as some US companies begin repatriating production to reduce their dependence on the vagaries of global trade, particularly in microchip manufacturing. In light of this, we expect the Fed to wait until November, after the election campaign, before it follows the global lead and makes its first key rate cut.

Index		Level	3 months	6 months	1 year
S&P/TSX		21 875.79	-0.52%	6.06%	12.14%
S&P 500 (USD)		5 460.48	4.28%	15.29%	24.54%
MSCI Emerging Markets (USD)		1 086.25	5.03%	7.60%	12.86%
MSCI World (USD)		3 511.78	2.77%	12.04%	20.78%
CAD/USD Exchange Rate		$0.73	$0.74	$0.76	-3.20%
FTSE TMX Short-Term		781.85	1.24%	1.57%	5.61%
FTSE TMX Mid-Term		1,226.95	0.83%	-0.30%	3.89%
Oil (US$)		$81.54	$83.17	$71.65	15.43%
Gold (US$))		$2,326.75	$2,229.87	$2,062.98	21.23%

 

Asset allocation

The relative low interest rate environment of the past 15 years has led us to generally overweight the equity portion of the portfolio, primarily in US equities. The fight against inflation that started in 2022 and the current astronomical valuations have turned things around. Put simply, bonds are once again a viable alternative to equities!

Investing during an economic slowdown requires prudence. We're maintaining a slightly cautious position in the short term to seize opportunities as they arise. We're recommending a slightly underweight position in equities and an overweight position in bonds.

In early 2022, our long-term return expectations for a balanced 50/50 portfolio were diminished by very low interest rates, minimal bond market protection and equity valuations above historical averages.

Since then, the fight against inflation and rising rates have helped restore the bond market's current yield, and perhaps more importantly, re-establish the ability of bonds to protect a portfolio.

This restoration of a 50/50 portfolio makes it possible to approach investment with a dose of confidence. If the economy dips more than expected, or stock markets see significant fluctuations, our bond exposure should at least be able to partially offset these pressures.

What's more, the expected gains/losses for major asset classes don't entail much risk taking.

If interest rates aren't moving much, at least the current yield has been brought back to a level that's historically high and relatively attractive to equities. If rates go down, the upside potential could go up 10%–15% depending on bond maturities.

On the equity side, if the economic momentum continues and the price-to-earnings ratio remains constant, equities could generate gains of up to 5%–8%. Conversely, if economic or other difficulties were to disrupt the markets, earnings could fall along with the price-to-earnings ratio, which could lead to a sharp stock market downturn.

Is this worthwhile?

Fixed income | Overweight

Following 3 difficult years, the bond market is becoming attractive again in absolute terms and relative to other asset classes. With inflation expected to continue trending down, economies slowing—or in some cases, even tipping into recession—the opportunity to add bonds is still worth considering.

We're maintaining our recommendation for an overweight position in government bonds as a refuge in the event of a recession.

Equities | Underweight

In June, the aggregate percentile of valuation for the MSCI World Index rose by 2 percentile to reach a score of 92 percentile. This slight increase is due to the S&P 500, which rose from 93 percentile to 95 percentile in a month. In other words, the US stock market (S&P 500) has been more expensive than it is now only 5% of the time.

A slowing US economy, a Canadian economy that continues to perform below its potential, the start of a rate cut cycle and uneven inflationary outlooks across different economic zones call for nuance in sector decisions.

We recommend focusing efforts on sectors and equities that offer significantly higher earnings growth than the market and perform well in a context of weak economic growth, high interest rates and persistent inflation. We favour the industrial, consumer staples and health care sectors in particular. With the expectation that rate cuts will materialize in the second half of 2024, we will prioritize utilities and communications stocks.

Conclusion

Unlike the Canadian and European economies, the US economy has so far resisted monetary tightening. But demand is not immune to interest rate hikes in the US. This will eventually dampen activity. The consensus forecast hasn't abandoned the scenario of a US slowdown—it's just been postponed to 2025. This outlook is fairly consistent with a longer—but not abnormal—lag between the start of interest rate hikes and their full impact on economic activity.

Even with the best models, economic forecasting can be tricky. The current stock market scenario leaves very little room for disappointment. The main valuation metrics of the MSCI World Index are in the 95th percentile of their historical distribution, reflecting nothing less than a highly positive outlook. 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 calling for a significant slowdown just a few quarters ago.

In the end, adopting a marginally cautious positioning would seem to be the right approach, even if the momentum continues to push the markets to new heights.

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.