Global Markets Commentary: Normal Uncertainty

“Democracy is the worst form of government, except for all those other forms that have been tried from time to time.”
– Winston Churchill, British statesman and former Prime Minister

 

The clouds hovering over much of the global macroeconomic landscape appear to be clearing, suggesting a return to normal could lie ahead. But when it comes to investing, normal always brings a “normal” level of uncertainty. 

Major economic themes remain unchanged. The U.S. economy and U.S. stock markets continue to perform well. China’s economy and stock markets continue to suffer from lingering malaise. Otherwise, the rest of the world muddles along.

Thankfully, inflation is still trending downward across the globe despite pockets of concern. The primary worry is elevated wage growth in many countries; central bankers view this as a threat to reaching their 2% inflation targets. In addition, escalating conflict in the Middle East, especially hostilities in the Red Sea, has stirred up familiar worries that supply-chain disruptions will reignite inflation.

Capital markets

In January, most developed equity markets added to December’s gains and the S&P 500 Index crested to an all-time high. All told, the combined results of the nine-month slump to open 2022 and the last 16 months of recovery averaged out to remarkably similar but unspectacular overall performance for many equity markets. Measuring back to the beginning of the decline for stocks in January 2022, the S&P 500 tops the list with an 11% cumulative total return in Canadian dollars. The S&P/TSX Composite and MSCI EAFE Index (international developed markets) are in positive territory, posting 5.8% and 8.7% cumulative total returns, respectively. While the NASDAQ’s recent roaring returns are impressive (up 45% in 13 months), many people might be surprised to learn that the total return in Canadian dollars since 2022 is just 4.7%, falling short of the S&P/TSX and MSCI EAFE markets.

There are two investment takeaways here. First, diversification works. Second, it’s wise to look at the big picture before jumping to conclusions. For example, some observers might think that we must now be on the precipice of a significant decline because stocks have been on a tear and are hitting new all-time highs. However, the top performing S&P 500 has compounded an annualized total return of only 2.4% over the last 25 months, far below long-term expected returns from stocks. That said, some stock markets may be ahead of themselves in the near term. But stepping back, we continue to see equities in a favourable light.

The bond market did get ahead of itself in December as the U.S. Federal Reserve (the Fed) signalled that it would shift from rate hikes to rate cuts in 2024. Acting as though cuts would be imminent and deep, the bond market ran with this idea, which drove yields down sharply. Inflation, employment, and wage data for January (not just in the U.S., but Canada and elsewhere) prompted a rethink of how fast the rate cuts will come and how big the cuts will be. This resulted in a recalibration in the bond market, with bond yields rising. Early February’s stellar, blowout U.S. employment report brought a further recalibration. Predictions that the Fed would cut six times, potentially starting in March, have now shifted to five cuts, starting in May (at the earliest). For Canada, the original prediction was between four and five cuts, starting in April; that has been chopped to three or four cuts, starting in July. We are sticking with our projection of four cuts for the U.S. and three for Canada, with both starting in June.

The timing is less significant than the fact that cuts are expected, even by central bankers. Consensus that 2024 remains a year of rate cuts is the most significant factor for stock and bond markets.

Bond market implications

Across the spectrum, Canadian bond yields rose by roughly 0.20% in January, sending the FTSE Canada Universe Bond Index down 1.4%. In our view, the whopping 7.4% return to close out Q4 2023 encroached on the return potential for 2024. With January’s move up for bond yields (price down), we see bond markets capable of delivering a return in the 4% to 6% range for the remainder of the year.

Equity market implications

Finessing the timing and extent of central bank rate cuts involves a balancing act among economic growth, inflation, and wage growth. This has implications for stocks. With fair-to-elevated equity market valuations, earnings growth must do the heavy lifting if we are to see gains in share prices.

If economic growth is stronger than expected, earnings growth expectations will rise – that’s good for stocks. But then central bankers won’t cut rates as deeply, which will temper some enthusiasm in the stock market.

Conversely, if economic growth is weaker, earnings expectations will need to soften – that’s bad for stocks. But under weaker growth, we would expect slower wage growth and lower inflation expectations. In this scenario, central banks will likely chop interest rates more, which is a plus for stocks.

So, it’s earnings growth on one side and interest rate levels on the other. How this teeter-totter plays out on share prices depends on how closely each variable matches current expectations. The good news is that many of these variables are returning to normal as the bullwhip effect from COVID-era shake-ups continues to fade.

Today’s debate over possible outcomes is much narrower and more focused than it has been over the last four years. Investors are trying to parse how much the economy will grow, not whether there will be a recession. They are wondering if inflation will land between 2% and 4% versus the 6% to 9% we’ve seen in the last two years. It’s a similar situation for earnings growth. The question is whether earnings will grow 6% or 10%, not how much they will contract. In other words, normal levels of uncertainty are back.

Uncertainty is a constant in capital markets and investing. However, the pandemic kicked up historic levels of ambiguity. We’ve seen extraordinary fog and gyrations around many key data points that are fundamental to how investors value assets. We are finally approaching a stage where we can say things are returning to normal. Weighing the probabilities, we continue to be constructive on the outlook for 2024 and see an environment where investors are rewarded across the risk spectrum. Our base case lays out favourable risk-adjusted returns from cash, bonds, stocks and selected alternative strategies.

Regional recap

Most global equity markets managed gains, except for the U.K., China, and emerging markets.

Canada eked out a small gain to start 2024; the S&P/TSX Composite Index rose 0.3%. Our economy delivered a surprisingly solid economic performance powered by spillover from U.S. economic strength. Unfortunately, inflation and wage growth also came in above expectations. WTI oil rose 6% to US$75.85 per barrel. Canada’s larger increase in bond yields and the rise in oil prices drove our loonie up 1.5% to US$0.744 or C$1.344.

Japanese equities were the top performers; the Nikkei 225 Equity Index rose 8.4% for the month. Adjusting for continued weakness in the Japanese yen, the return is cut in half to 4.4% in U.S. dollars.

U.K. equity market performance rounds out the bottom. The Bank of England has less leeway to cut interest rates thanks to stubborn inflation (the annual rate rose to 4% in December). In January, the U.K. FTSE 100 Stock Index fell 1.3%.

U.S. equities posted a gain; the S&P 500 was up 1.6% in January. Real GDP jumped 3.3% (annualized) in Q4, well above expectations for 2% growth and piling on to Q3’s 4.9% pace. Annual CPI inflation ran a little hot in December at 3.4%, up from 3.1%. However, the Fed’s preferred measure of inflation, the core PCE deflator, came in at 2.9% year over year, and the six-month measure is running below the Fed’s 2% target at 1.85% annualized. Employment growth remains solid, the moribund housing market is showing signs of life, and upbeat consumers are spending their wage increases. All in all, it’s a rosy scenario.

The European Stoxx 50 Equity Index rose 2.8%. Defying expectations, the eurozone narrowly skirted a recession in 2023, with growth flat in Q4. The labour market is holding up, inflation is falling, and rate cuts are expected from the European Central Bank. Geopolitics plus Red Sea bottlenecks pose a more acute upside risk to European goods inflation.

In emerging markets, the Shanghai Shenzhen CSI 300 Index fell 6.3% (measured in renminbi) and the MSCI Emerging Market Index (USD) fell 4.7%.

Our Strategy – balanced with an equity bias

Overall, in our broadest representative portfolios, we remain overweight specifically in Canadian and U.S. equities. We are neutral weight to international developed markets (Europe and Japan).

We have let our emerging markets weight drift lower on relative performance but are watching it closely as valuations are extremely low. Various Chinese equity markets have fallen between 45% to 60% over the last three years, which accounts for a lot of bad news. Investors far and wide are selling in droves, and the government is stepping in more aggressively to shore up markets, all signs the tide may eventually shift. Let’s not forget that China remains the world’s second-largest economy.

Our overweight North American equity positioning combines opportunity and risk mitigation. On the opportunity side, Canadian equities are most compelling from a valuation standpoint and our models point to a better upside. The S&P/TSX should outperform if we get a soft landing or a late-2024 global economic acceleration, U.S. aside (the U.S. needs to cool, not collapse).

On the risk mitigation side, U.S. equities remain attractive given their defensive qualities within equity allocations (we also have bonds for defence). While risk of a global recession has receded, it isn’t eliminated. Given how much monetary policy has tightened and the risk that inflation might prove stubborn, a risk-off event remains a plausible scenario. Under a risk-off event, the S&P/TSX would likely underperform. Even though U.S. stocks are slightly expensive (not universally – a handful of stocks standout as richly valued), if a risk-off event unfolds, U.S. stocks will likely outperform (downside here, too, but less negative). While shares of mega-cap U.S. companies sit among the most expensive, their fortress-like balance sheets and secular growth offer an element of safety. In this scenario, the greenback would remain strong or strengthen, providing additional protection to Canadian-dollar-based investors.

The last word – It’s a global election year

Nearly half the planet’s population in more than 50 countries will see elections this year (some less democratic than others). Election noise can be a major distraction for investors. While the outcomes matter for many reasons, longer-term investors know that macroeconomic fundamentals are the main market drivers, with politics and geopolitics sometimes intervening in the short run.

The U.S. election will garner the lion’s share of attention. Remaining levelheaded will be a challenge as the world’s largest election machine fuels the world’s largest media machine. Canadians will pay close attention, but we must stay cool and focused on the bigger picture.

Since WWII, the average performance of the S&P 500 in an election year has been positive – albeit at 6.8%, it’s below the long-run average. When a sitting president seeks re-election, the return average jumps to 12.1%. Results are positive regardless of which party is seeking re-election. However, Democrat incumbents outperformed Republican incumbents, with average election year returns of 16.8% versus 9.6%.

The last 15 years have seen a financial crisis, four different U.S. presidents (two from each party), Brexit, Crimea, broad U.S. tariff increases, NAFTA to USMCA, trade wars with China, a pandemic, plus wars in Ukraine and Gaza to name a few significant developments. Volatility accompanied all of it, yet global equity markets remained an excellent place to grow wealth. From December 31, 2008, to January 31, 2024, the total return of the MSCI World Index in Canadian dollars was 458% or a 12.1% compound annual return.

Churchill was being glib when he said that democracy may be the worst form of government except for all the others. Fortunately, allowing capitalism to thrive is among its numerous benefits.

 

Information contained in this publication is based on sources such as issuer reports, statistical services and industry communications, which we believe are reliable but are not represented as accurate or complete. Opinions expressed in this publication are current opinions only and are subject to change. BMO Private Wealth accepts no liability whatsoever for any loss arising from any use of this commentary or its contents. The information, opinions, estimates, projections and other materials contained herein are not to be construed as an offer to sell, a solicitation for or an offer to buy, any products or services referenced herein (including, without limitation, any commodities, securities or other financial instruments), nor shall such information, opinions, estimates, projections and other materials be considered as investment advice, tax advice, a recommendation to enter into any transaction or an assurance or guarantee as to the expected results of any transaction.

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