Looking Back and Looking Forward
Q3 saw a rising tide lift (almost) all boats. As interest rates moved lower, bond prices rose. Major equity markets across the globe moved higher, with many finishing the quarter at or near peak levels. Money market rates of return were one of the few things that fell in the quarter.
In our Q2 newsletter, we described our concern about the lack of breadth in the U.S. equity market, as only seven stocks had accounted for more than 60% of S&P 500 returns at the year’s halfway point. What was notable in Q3 was how the equity market broadened beyond the Mag7 and AI trades. Ten of the eleven sectors that make up the S&P 500 were higher in the quarter. For the first time in a long time, small caps outperformed large caps, and value stocks outperformed growth stocks. It was a refreshing change.
Economically, however, things were not quite as rosy. In Canada, we’d seen five straight quarters of negative GDP-per-capita growth to the end of Q2. July printed GDP growth of 0.2% while August’s preliminary reading was flat. We’ll see how the quarter finished when Statistics Canada releases Q3 final numbers, but the per-capita trend continues to look poor. With the Canadian unemployment rate now ~6.5%, we’re hopeful that interest relief will stimulate an improvement in economic growth. In contrast, while showing some signs of slowing, the Atlanta GDPNow tracker predicts U.S. GDP growth of ~2.5% for Q3 – not amazing, but not recessionary either.
With equity markets trading at or near all-time highs, market bulls will point to two key trends in their favour: 1) corporate earnings, overall, remain on track and 2) inflation is falling, making way for central banks to continue cutting interest rates. Market bears, on the other hand, will point out that the S&P 500 currently trades at a rich valuation – ~21x 2025 expected earnings – which means that a “soft landing” is the base case that the market has already priced in and anything less will bring markets lower.
What might challenge the bulls? We don’t expect corporate earnings, in aggregate, to fall through the floor. We are, however, concerned that central banks might not be able to cut interest rates as quickly and/or as much as market participants currently believe. We look no farther than how Q4 has started, with port strikes on both sides of the border, industrial capacity offline in the U.S. southeast due to Hurricane Helene, and escalating tension in the Middle East. These all present supply-side shocks that could re-stoke some inflation and complicate the path to lower interest rates.
We note that the U.S. 10-year Treasury Note yield has been RISING since the Federal Reserve’s 50 basis-point cut in mid-September. We suspect bond market participants may be pricing in higher inflation in the out years, driven in part by supply-side factors like those described above. Bond markets may also be disenchanted by the Fed’s rather sharp pivot to the “maximum employment” side of the dual mandate vs. the “stable prices” side. Finally, bond market participants might be growing increasingly disillusioned by huge federal deficits and growing national debt. While not a new issue, the fact that neither U.S. presidential candidate (nor their respective parties) will even mention reigning in the deficit has to be disconcerting to bond markets. In the past year, equity markets have had some difficulty when the U.S. 10-year Treasury Note yield approaches ~4.5% (currently it’s ~3.95%) so we’re watching this carefully.
Our Core Model Portfolios
In Q3, our core model portfolios benefitted from a continued high allocation to both Canadian and global equities. Dividend-growth equities in our income-focused model did particularly well as interest rates fell.
We also added to our Canadian investment-grade bond holdings during the quarter across all core model portfolios. These positions appreciated throughout the quarter as interest rates fell, producing solid risk-adjusted returns. As mentioned earlier, we’ll continue to monitor the yield curve to determine if and when to lower exposure and/or duration on our bond holdings.
We continued to hold a small amount of gold bullion exposure in our core capital growth models, which appreciated significantly in the quarter. We also exited a small infrastructure position in our core capital growth models.