Welcome to summer. We hope you are getting to enjoy it!
It is indeed always a wonder how we are halfway through the year already and yet after a year like the last, markets and the economy remain uncertain.
In this months’ e:Newsletter we are going to do our best to put in lay terms, either side of what we are seeing in both the fundamentals and news of the economy and markets as well as what is being confirmed by the technical “Price action” charts that we are watching very closely. We are in the Green Zone in our longer term indicators. Although our shorter term “technical” signals are still in the Yellow Zone, the technicals are again improving and could see us put cash to work. But as the topics below point out, there are still many concerns, what ifs and buts, that if not well managed by the central banks of the world, could push us into a recessionary environment and the need to become defensive again.
Markets, and particularly the Growth Stocks, have been buzzing over artificial intelligence (AI) technology. This has been good for growth indexes and we have been making sure to have some exposure to them. Investor excitement over the rise of artificial intelligence may be obscuring some serious risks facing the US economy today. The world of business and finance has been abuzz with hype over the ground-breaking technology following the sensational debut of OpenAI's ChatGPT - and that has fueled a sizzling rally in tech stocks, seen valuations of AI-friendly companies surge sky-high, and inflated the wealth of Big-Tech CEOs. But underneath it all is a US economy faced with some bleak realities, painting a picture of stark contrast with the bullishness of the stock market.
This recent move in the markets had been heavily weighted in the top 10 capitalized size companies (in the U.S.). Not exactly diversification. Back those out and most markets are in rather low single digits year to date.
When we look at the rest of the broader market, it has not been necessarily the same. Financials, including Canadian banks, as we have discussed in past letters, are still well lagging the market. The technical charts are still in a downtrend and have been unable to break out. For Small to Mid size companies, the backbone of any economy, it has been much the same. If these sectors of the economy cannot get traction to the upside, the longer term outlook for the economy and market dims.
On the positive side, in the last few weeks, we are finally seeing at least the beginnings of a broadening of the market. More players are indeed taking part in the recent rise in the market. A perfect example is the U.S. Industrials which have broken out and hit new highs. This trend needs to continue expanding for markets to return to their prior highs.
The quantitative Easing or stimulus that the Central banks around the world pushed into the economy after 2008 and even more so during covid was designed to boost the economy after the great recession and the covid shutdowns. That certainly did the job. All too well. To the point that we began to see serious signs of inflation. In the past year, they began to reduce stimulus as well as increase rates to reduce inflation. In fact, in the U.S. the Federal Reserve raised interest rates by 500 basis points in the past 15 months - the steepest surge in four decades - to tame historically high inflation. Benchmark rates in the US are currently the highest since 2007, just before the global financial crisis erupted.
And while the Fed has succeeded in lowering inflation significantly and left rates unchanged this month, it still signaled at least two more 25-basis-point increases by year-end. The notes from the June meeting, where they skipped raising rates, has since reaffirmed the commitment to higher rates at the next meeting on July 26th and thereafter. As such markets as of writing, particularly those growth stocks that rely on stable or declining rates are amidst a potential pullback. Likewise, Canada, New Zealand and other central banks are expected to announce higher rates next week.
Not only do higher rates effect the consumer and homebuyers, it also makes it more expensive to do business putting pressure on corporate profit margins. Stocks become less attractive and such a scenario will likely trim corporates' budgets, including the recent driver of the markets in the demand for technology hardware and software upgrades. The result could put a dampening effect on the current bout of AI optimism.
We are still hopeful that the feds of the world will be able to reduce stimulus and raise rates at a pace that can be absorbed by the economy. If they are able to do this, corporations may still be in a position to manage their expenses and continue to grow.
Given the prospects of higher rates and sticky inflation, market commentators including economist Nouriel Roubini and Elon Musk, as well as Wall Street banks such as JPMorgan, have warned of a looming US recession. According to the Fed itself, its recession probability model shows there's a 70% chance the US economy will experience an economic downturn by May 2024. The expectation of “higher for longer interest-rates” is likely to further increase the costs of funding and the likelihood for a global recession.
Recession bets are rising in Canada and globally. Inflation everywhere is sticky pointing to the need for higher rates and potential for a difficult “hard landing”.
The fact that we have not already officially fallen into a recession is positive. The central banks of the world have so far managed this surprisingly well. It is a fine line they are walking.
A commercial real-estate crisis may also be brewing, with tens of billions of dollars worth of assets slipping into distressed category as high interest rates squeeze borrowers. The amount of troubled commercial real estate assets, meaning properties that are forced to be sold as owners can't afford to pay their mortgages, jumped by 10% in the first quarter to about $64 billion in the U.S. as cited by Bloomberg. Another $155 billion of assets may be at risk of turning bad, according to the outlet.
CRE mortgage delinquencies rose to 3% in the first three months of 2023, according to the Mortgage Bankers Association. US commercial property owners have struggled over the past year as steep interest-rate increases by the Federal Reserve - aimed at cooling inflation - chipped away at their ability to meet mortgage payments. At the same time, tightening credit conditions and work-from-home trends are adding pressure on the industry. It's sparked widespread concern that commercial property could be the next industry to slip into turmoil, following the banking-sector chaos of recent months.
These higher rates could aggravate the risk of an economic downturn, according to multiple market experts. Higher borrowing costs have already hurt interest-rate sensitive sectors of the US economy, including the banking industry and especially the commercial real-estate market. Many corporations have leases coming due, and with less people going into office still, and with rents and costs rising, many companies will be looking to reduce rental expenses or even opt out together, leaving the owners of these buildings, especially the towers in the downtowns, stuck with empty floors and rising interest costs on their mortgage debts.
More and more companies, banks included, are however returning to work. More are mandating and requiring in office on a full-time basis. This is a positive development for commercial real estate and could lead to a strengthening of the sector.
While the Canadian, U.S. and European economies are all grappling with internal economic problems, they also face external risks: predominantly, slowing growth in China. After years of lockdown under Beijing's strict zero-COVID policy, economists were hopeful that the Asian economy would experience a strong rebound after it reopened this year. But that's far from what's happened. China is currently growing their GDP at about 5-6%. They need however 12% to sustain. China's economy may be in more trouble than anyone thought, with trade slowing, weak industrial production numbers, and piling debt – and that's a problem for Wall Street and Bay Street.
China has become less dependent on the U.S. alone. They are involved in and trading on every continent in the world. That fact could help provide the external growth China needs to get back on track.
In the shorter term, the technical Price Action charts did see us increase our cash and defense exposure. Should however markets hold here, we expect to be quickly and fully invested for the next move to the market upside.
Longer term, although we are still in the Green Zone, but as we outlined above, there are potential pitfalls that could occur later into the summer and fall. The fundamentals such as the macro and micro-economics, the earnings outlooks and market breadth all certainly highlight those – again potential concerns. We will see it first in the price movement and we will be watching our charts for any breakdown. We are well prepared to move to defense. We must be aware of the outlook, but we cannot anticipate what can happen; we can only act on what IS happening. Fundamentals tell us what is going on overall and what to consider owning. Price however tells us WHEN to buy and WHEN to sell. The bias for now, remains on the buy side.
Have a great summer and we look forward to speaking with you soon.
~ John and Megan