Global Markets Commentary: Goldilocks Rally

“Perhaps the safest prediction we can make about the future is that it will surprise us.”
– George Leonard (1923–2010), American writer, editor and educator

 

 

It was tempting to title this month’s commentary “The Everything Rally” since the list of assets that advanced (many significantly) during the third quarter is long.

Only a handful of the more than 100 global equity, bond, currencies, commodities, industrial sectors and bellwether company share prices we track regularly are down on the quarter. Everything else is in the green. The year-to-date performance for major equity and bond markets is the same. Of the dozens of equity and bond markets we track, only South Korean and Brazilian equity markets and the Japanese bond market are down on the year.

So far, 2024 is shaping up as a rewarding year for investors. It’s a Goldilocks rally in Q3 because even the few asset prices that have dipped (mainly energy and foodstuffs-related assets, the U.S. dollar against all major currencies, and shares of four of the Magnificent Seven) are in sync with the not-too-hot, not-too-cold theme driving capital markets.

The term “soft landing” has served its purpose

The idea of a landing was always about inflation. Nobody wants the economy to land, but the accepted doctrine postulates that the best way to bring down inflation is to slow the economy. There are exceptions, however. Economic growth can remain healthy alongside retreating inflation if the economy experiences increased supply or productivity gains.

It has been more than two years since the COVID-induced global supply shock to goods, services, and labour – we’ve seen great improvement on these fronts. Additionally, many economies have slowed, and so has inflation. While the U.S. economy continues to run above potential, this isn’t too inflationary because the country is in the throes of a productivity boom.

Capital markets are responding to this friendly backdrop. They are looking at a powerful alignment of falling inflation and smooth-sailing economies (U.S.), or economies that are holding up better than feared (Canada, U.K., and a good chunk of Europe). At the same time,  central banks are reversing course and lowering interest rates.

Let’s not forget that the quarter experienced a growth scare. In mid-summer, the S&P 500 swooned by 9% and the S&P/TSX fell 5%. Markets tumbled in response to weakness in the U.S. labour market, earnings disappointments from some of the Magnificent Seven tech stocks, sluggish readings in the interest-rate-sensitive global manufacturing and housing sectors, plus economic malaise in China.

But it was just a scare. Markets rebounded based on improved or even revised data along with surprisingly forceful actions from the central banks of the world’s two largest economies. The U.S. Federal Reserve has finally joined the rate-cutting parade, jump-starting its easing cycle by lowering the fed funds rate a supersized half percentage point. China’s central bank significantly stepped up its stimulus measures by lowering interest rates while easing lending policies and bank reserve requirements. Other fiscal measures are also being brought to bear.

The Chinese economy has slowed to the point where authorities have ditched the piecemeal approach, turning to more significant economic stimulus measures including targeting the real estate sector, equity markets, and lower income households. Historically, sizeable bouts of stimulus in China haven’t helped just the Chinese economy and stock markets – the impact has been measurable on Western stock markets, too.

It matters why central banks are cutting rates

We can’t overstate the significance of the fact that global inflation is easing nicely, allowing central banks to cut interest rates.

Roughly half the global rate-cutting episodes of the last 50 years were due to an external crisis (1970s energy shock, 1980s Latin American debt crisis, the 2000 dotcom bubble bust, the 2008 financial crisis, COVID). The economy was headed for recession because of these upheavals. Central banks were fighting the external shocks by slashing rates to help the economy cope. Rate-cutting was a tangential solution. Under these circumstances, stock markets had already declined significantly and continued to fall.

This is not what’s happening today; China aside, central banks aren’t lowering interest rates to stave off a crisis.

If central banks are lowering interest rates because inflation is ebbing enough to allow them to do so in an orderly fashion, and there isn’t a crisis, then the problem and the solution are the same. The problematic areas in the global economy today largely stem from the drag of higher borrowing costs. Lowering interest rates isn’t tangential support: it directly addresses the problem. In past situations when this occurred, stock and bond markets performed well above their long-run averages. Case in point: 2024.

Is this it, then? Time to sell?

Aha: the age-old question. If you need to raise some cash and intend to spend it, then yes, it is a great time to harvest some gains. Good financial planning contemplates inflows and outflows. For most investors and most of their investments, the focus is on the long term. Just as capital markets can retreat more than they should when things are bad, they can run up higher than expected when times are good. Mountains of research corroborate that trying to time these cycles is impossible.

Being a prudent and pragmatic investor is our objective. We look at the situation from that angle and ask if the current fundamentals support asset prices, or are we simply running on emotions?

Our conclusion is that the fundamentals of economic growth, corporate earnings, inflation, bond yields, sentiment, and valuations remain supportive. We see a path to further gains, albeit more modest ones and always with the caveat that we could face another “growth scare” at any time. We also aren’t naïve; we know and remind investors that Goldilocks conditions won’t last forever.

Fundamentals remain supportive

Economic growth remains solid in the U.S. Earlier this year, there was chatter on Wall Street that U.S. inflation would remain sticky, that consumers would run out of steam and savings, and that economic growth would cool, threatening the strength of corporate earnings growth.

Revised statistics released in September show the U.S. economy has grown faster since exiting COVID, and U.S. households have been saving more than we thought – all positive surprises. At the same time, inflation has been retreating. The net result is rising real incomes that allow consumers to both save and spend. This explains the puzzle of how profit margins and corporate earnings growth have held up so well when it looked like the economy was running more slowly. Shocker: it wasn’t.

The story in Canada is similar albeit not as strong; economic growth is running below cruising altitude but not collapsing. Interest-rate relief is underway and more Bank of Canada rate cuts are set to come. Despite a soft labour market, incomes in Canada have been catching up quickly (witness recent settlements to avoid strike action). Canadians are saving a chunk of these increases (the savings rate is a healthy 5.6%), and the height of the so-called mortgage renewal wall isn’t nearly as daunting, with 5-year bond yields down to 2.7% versus last year’s 4.4% peak. The combined effect leaves more money in Canadian consumers’ pockets. Spending in Canada has been anemic, especially in light of sizeable population growth. Consumer spending could be primed to pick up some steam, or at the very least be able to hold up if the labour market remains sluggish.

Valuations aren’t a big headwind

The third quarter brought a string of very solid returns for global equity markets. The S&P/TSX was a top performer, rising 9.7%, bringing year-to-date performance to 14.5%. This narrows the gap with the S&P 500’s 20.8% year-to-date return on a 5.5% rise in Q3.

Encouragingly, the U.S. stock market rally is broadening beyond a handful of mega-sized companies. Share prices of four of the Magnificent Seven mega-cap U.S. companies were down slightly for the quarter as money rotated to other areas of the market. The Russell 2000 Index of small and mediumsized companies rose 8.9%, and the equal-weighted version of the S&P 500 rose 9.1%, bringing the year-to-date tallies to 10% and 13.5%, respectively.

Other markets for the quarter and year to date look solid as well. The European Stoxx 50 Equity Index rose 2.2% in Q3 and 10.6% on the year, while the U.K. FTSE 100 Index is up 0.9% in Q3 and 6.5% for the year. The MSCI China Equity Index vaulted 21.3% in Q3 and is now up 25.5% for the year. The MSCI Emerging Markets Index (USD) quarterly jump of 7.8% brings year-to-date performance to 14.4%.

Given these results, it is fair to ask whether valuations are ahead of reality. In fact, many markets remain reasonably priced on a combination of higher earnings growth expectations or previous undervaluation. The commonly cited valuation metric of price-to forward-earnings ratio sits at or below the longer-term averages for the main equity indices in Canada, Europe, the U.K., Japan, and China. The S&P 500 is elevated at 24 times forward earnings, but the equally-weighted version of the S&P (representative of the average stock) is only slightly elevated at 19.4 times versus 18.8 times longer term. With 2025 corporate earnings growth expectations in the 10% to 15% range globally, valuations have some wiggle room to fall (not necessary for most, just insurance), and equity markets can deliver further high-single, low-double-digit returns into next year.

Bonds doing their job

With central banks telegraphing future rate cuts, and some now playing catch-up with oversized cuts of half a percent, bond markets have moved to price in a lot of future easing. The FTSE Canada Universe Bond Index gained 4.7% for the quarter, pulling the year-to-date number up by about as much to 4.3%. The bond market looks fully valued but still delivers a reasonable running yield of 3.5%, and the weighted yield in our core fixed income solution remains north of 4%. If a growth scare or unpleasant surprise comes along, bonds have plenty of room to deliver the safety we expect under those circumstances.

Our strategy: Balanced, with an equity bias We are well positioned for the current environment. We have been disciplined and patient throughout the year, trimming pockets of strength and adding to areas we felt were poised to benefit. Market movements in the third quarter favoured those positions.

With a broad-based rally across assets and geographies, there was limited need to trade in Q3. We remain overweight equities, specifically Canadian and U.S. equities. We are neutral weight to international developed markets (Europe and Japan) and underweight emerging market equities. Within fixed income, we are overweight investment-grade corporate bonds and underweight the lowest-quality borrowers in high yield.

 

The last word: Surprises

The third quarter was full of surprises – an integral part of investing. Prices don’t move on what happens; they move on what happens versus expectations. Various outfits keep score of how many data points hit, miss, or beat economists’ consensus expectations. Unsurprisingly, they are called economic surprise indices.

High readings in these indices make us especially watchful; expectations are elevated, and prices probably reflect that optimism. Low readings give us comfort; they indicate that expectations – and likely prices – are currently modest.

Given the run of good news lately, it might be reasonable to think that expectations have risen to the point where further positive surprises might be scarce. Surprise! That’s not the case. Readings across the U.S., Canada, U.K., China, Europe, Australia, and Japan aren’t deeply depressed but aren’t off the charts either. Of course, many feel November’s U.S. election could bring a myriad of surprises. For our take, you can read our special U.S. election comments, Politics and Your Portfolio, available through BMO Wealth Insights (https:// privatewealth-insights.bmo.com/).

George Leonard was right: the safest prediction is that we will likely be surprised. For now, the way those surprises could play out isn’t leaning heavily toward good or bad. Like many things, they are demure and Goldilocks.

 

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