Looking Back and Looking Forward
Q1 was stellar for equites. The S&P/TSX Composite Index, for example, was up 6.6% in Q1, while the S&P 500 was up an even better 10.6% – moves that would be fine for a full year, let alone a single quarter. However, results were not so stellar for bonds in Q1. The Government of Canada 10-year bond yield, for example, backed up 51 basis points in Q1, while the yield on the 10-year U.S. Treasury backed up 32 basis points. Those moves pressured bond prices yet again, after the bond price weakness we witnessed from 2021 to 2023. Even though Canada and the U.S saw directionally similar moves in capital markets, the two economies continue to behave quite differently.
In Canada, data continues to show economic activity is slowing. Unemployment, for example, has risen more than a full percentage point over the past year. For quite some time, our view has been that Canada is currently in recession, even though headline GDP growth would contradict this assertion. Our reasoning is that headline GDP growth numbers mask the effect of Canada’s massive population growth in recent years. In Q4 of 2023, for example, Canadian real GDP grew at a 1.0% annual rate. However, on a per capita basis, Canadian real GDP growth was actually down 2.3% – a print that has only been worse on four other occasions in the past eighty years.
The combination of economic weakness and declining inflation open the door for the Bank of Canada to initiate a rate cut this summer, though it wouldn’t surprise us if they wait a bit longer to avoid re-igniting an under-supplied Canadian residential housing market. If and when they move, we would expect both the Canadian economy and capital markets to respond positively.
In contrast, the U.S. economy keeps posting resilient GDP and employment data, yet inflation in the U.S. remains stickier and could very well keep the Federal Reserve on the sidelines until much later this year. Recall that at the start of 2024, futures markets were implying the Fed would cut rates 6-7 times in calendar 2024. Those expectations have now fallen to about 2 rate cuts by year-end, on the back of this continued economic strength.
It’s becoming increasingly probable that the U.S. realizes a “no landing” scenario, meaning the economy continues to grow (in real GDP terms) with no recession. The longer-term, low-interest-rate lockups secured by both U.S. households and corporations during the pandemic years (together with excess savings from fiscal stimulus and other factors) have made the U.S. economy less interest-rate sensitive vs. prior cycles. When we hear U.S. central bankers speaking about today’s restrictive monetary policy, we can’t help but wonder what they’re looking at, as the economy is showing few signs of restriction. That could change quickly, but for now it seems a “no landing” is very possible.
What about market valuation? We struggle with a U.S. equity market trading in excess of 20x forward earnings, particularly in the context of a 10-year Treasury that today yields 4.5%. With an earnings yield on the S&P 500 of ~5%, the equity risk premium today is only marginally positive. In short, investors today are being compensated little for taking on equity risk vs. owning a “risk-free” U.S. Treasury bond. With consensus forecasts showing only 3.2% earnings growth for the S&P 500 in Q1, and 11% for all of 2024, the U.S. equity market does not look compelling to us in the short term. We may very well be setting up a “sell in May and go away” scenario, with the caveat that market momentum can persist longer than may appear rational.
As a final point, we emphasize that we are anything but complacent in the current environment. While a material re-acceleration of inflation is not our base case, we would not rule it out, given recent increases in commodity prices and the potential for sustained wage pressure. We don’t believe the recent rapid rise in the price of gold bullion portends a re-escalation of inflation – after all, gold did not act well as an inflation hedge during the 2022-2023 period of elevated inflation. Central banks, particularly the PBOC, have been buying gold in larger quantities as of late, but we can’t help but wonder if it’s only that, or if the gold market is sniffing out some bad outcome that few investors see today. We’re watching closely.
Our Core Model Portfolios
As we entered 2024, we were surprised at the sheer number of market pundits declaring that bonds were a screaming buy for 2024. While that made some degree of sense to us (weak bond markets the prior three years, central banks looking like their next rate move was down), we felt it appropriate to apply Bob Farrell’s Rule #9: “When all the experts and forecasts agree – something else is going to happen.” In retrospect, it did.
We materially re-allocated from bonds to equities relatively early in the quarter, particularly in our capital growth core models. We also re-allocated some assets from money markets to equities. These two re-allocations proved fruitful given the quarter that equities enjoyed relative to these other asset classes. Our gold exposure across all models benefitted from the rapid rise in the price of bullion, while our infrastructure exposure appreciated modestly while generating solid income for all models.