Looking Back and Looking Forward
The first half of 2024 is firmly in the books. Investment-grade bonds on both sides of the border are down year-to-date by about 2% on a price basis, though it’s notable that today they are paying a respectable level of interest and hold the potential for material capital gains once central banks cut interest rates in earnest.
The Canadian equity market, as measured by the S&P/TSX Composite Index, was up 4.4% in H1, while the U.S. equity market, as measured by the S&P 500, was up 14.5% in H1. It is, however, necessary to temper one’s enthusiasm over the U.S. market, as the average stock in the S&P 500 is only up 4.1%. It’s only because of the index heavyweights known as the Mag 7 that the U.S. equity market can boast double-digit H1 returns.
In prior newsletters, we’ve argued the Canadian economy has been receding for quite some time (at least on a per capita basis). Given the recent string of data showing a cooling off in inflation, the Bank of Canada cut its overnight rate 25 basis points in June. A recent hotter-than-expected inflation print has put a second 25bp rate cut for July into question, but we do believe another is forthcoming in the near-term. With a wave of mortgages coming due in the next couple years, we believe the BoC would like to cut rates further, but they remain somewhat constrained by rate differentials with the U.S. and the corresponding effect of comparatively low Canadian interest rates on the Canadian dollar (as a weak Canadian dollar would only add to inflation pressures).
We’ve also discussed U.S. economic resilience in our prior newsletters, though we’re starting to see weakness in U.S. economic data, particularly as it relates to the U.S. consumer. Unlike Canada, U.S. inflation data has been more mixed, though the last PCE print was favorable for those yearning for a rate cut. If forthcoming inflation data provides greater confidence to the Fed that inflation is trending toward their 2% inflation target, we could see a rate cut as early as September. Barring that, it’s likely only to come after the U.S. election, either at the Nov or Dec scheduled Fed meetings, provided inflation does not reignite.
The seasonally weaker period from August through October is just ahead, and an equity market correction, particularly in the U.S., is entirely plausible. We’ve become very concerned about the lack of breadth in the U.S. market. In H1, only seven stocks accounted for more than 60% of the total return of the S&P 500. Magnificent though they may be, a very concentrated equity market that lacks broad participation across companies and sectors does not bode well in the near term, particularly with the Mag 7 trading at a forward P/E of 37x. If you remove these seven stocks, the remaining 493 companies in the S&P 500 still trade at 18-19x P/E multiples, which is high by historical standards. With the Mag 7 priced to near-perfection, and the other 493 valued at anything but depressed levels, one precondition for a correction is in place. Unlike the U.S. market, the Canadian market has a materially lower valuation, and it’s not coming off a blistering result over the last 18 months, making the likelihood of a large market drop in Canada much lower.
The high valuation of the U.S. market, alone, is not a sufficient reason for a market sell-off; it would take one or more catalysts, often those that investors don’t see coming, to ignite a market correction. As an example, a Republican party win in November, which has historically been perceived as positive for capital markets, might manifest negatively if market expectations form that their policy agenda would be inflationary (thereby putting significant upward pressure on interest rates and the economy). It will be interesting to see what, if anything, breaks market momentum for U.S. equities, particularly the Mag 7.
Our Core Model Portfolios
In Q2, we maintained a high level of exposure to equities across our core models, and our clients benefitted therefrom, given positive Q2 performance across major global equity markets. We did add some investment-grade bond exposure, as well as gold bullion exposure, to our core models during the quarter.
As mentioned, the U.S. equity market looks frothy to us, having moved up 15% in 6 months and priced at ~21x forward earnings. High market valuation, slowing economic activity and uncertainty around the forthcoming election make us increasingly cautious on U.S. equities in the near term. After a strong run, we are reviewing geographic equity exposures in our core capital growth model portfolios, in particular.