Global Markets Commentary: Rolling Recessions and No Landings

“Buy not on optimism, but on arithmetic.”
– Benjamin Graham, noted as the father of value investing, author of Security Analysis (1934) with David Dodd, and The Intelligent Investor (1949)

 

 

February brought more positive macroeconomic data, which ranged from largely good to Goldilocks (not too hot, not too cold). The global economy continues to improve. Fewer investment gurus are predicting recession and the holdouts are finding it tougher to justify their position.

In fact, those calling for a recession might have missed one right under their noses. It’s been our view that the last two years weathered recession-like, or recession-light, conditions in many places.

Early in 2024, it became apparent that many countries were closer to recession than we thought. Germany, France, the U.K., Japan, Canada and China all delivered weak showings during the back half of 2023, with Germany, Japan and the U.K. meeting the technical definition of recession – consecutive quarters of declining GDP.

Fortunately, not all countries and sectors slowed or became sluggish at once, thus avoiding a full-blown recession. Excess savings plus strong business and household balance sheets propped up spending, while governments continued to aggressively dole out funds. Pandemic disruptions injected chaos into certain industries (semi-conductors, autos, most services businesses) to such an extent that, post-pandemic, they were exceptionally strong while other areas were weak (housing, manufacturing, business investment, for example).

We could still see some give-back. Growth in government spending can and should slow. Household consumption may slacken a bit, but perhaps not that much, given wage growth and easing inflation. If these two areas cool off, the economy can pass the baton to other areas. Sectors that were sluggish are exiting their rolling recessions. Ebbing inflation and lower borrowing costs will fan the embers of growth as long as inflation continues to decline toward central bank targets. In 2023, the global economy threaded a needle; now it has to stitch everything together.

Equity market insights

Most global markets are posting gains, some sizeable in February (Japan and China up 8% and 9%, respectively, Europe and the U.S. up 5%).

Stock markets lead the economy; they are forward looking. Stocks are off to a good start in 2024 because many positives are on the horizon. Housing is finding a bottom, manufacturing indicators are positive, credit conditions are improving, borrowing costs are off their highs, and global trade is picking up (highly sensitive indicators like Japanese and South Korean exports are running at 12% and 18% year-over-year growth, respectively). Expectations are being revised higher for global growth and corporate earnings growth.

In the U.S., from six months ago, 2024 consensus forecasts for real economic growth have more than doubled (now at 2.5%), while inflation expectations have nudged up only slightly from 2.55% to 2.7%. This kind of no-landing drives stock markets higher. Six months ago, if you had offered central banks inflation settling in at sub-3% with no recession, let alone solid economic growth, they would have jumped at it.

All of this means we are in a good place. When we’re in a good place, with lots of cash on the sidelines, stock markets go up.

February saw more new highs. The S&P 500 Index flirted with the 5,100 level (up about 7% for the year), but it isn’t alone. Equity indices that measure European stocks (EuroStoxx 600) and Japanese stocks (Nikkei 225) also hit new all-time highs. The combined strength of U.S., European and Japanese stocks drove the broad global benchmark (MSCI World Index) past its previous high reached in January 2022. Not far behind, the S&P/TSX Index is just 3.4% away from a new record high.

This rapid rise of equity markets continues to bring out the Chicken Littles. They are sounding the alarm that stock markets are well ahead of themselves, citing comparisons to 1999 or 2007. We believe these are false alarms – we don’t think such comparisons are valid.

No bubbles detected

Walking through a checklist of conditions that prevailed in the last two bubble peaks, we find scant evidence of a repeat.

For example, the 2008 financial crisis was born from a decade of excess in the U.S. housing market. Excesses in the real economy today are nowhere close to that situation. In 1999, hype ruled the tech bubble. Dotcoms were helmed by newly minted, 20-something MBAs touting nothing but a business plan, juicing a classic mania where fundamentals didn’t matter. Speculative demand rather than earnings and assets fuelled inflated share prices. Rename your company XYZ.com, and its share price skyrocketed. Today’s environment is very different.

Second, we have not had extended and excessive equity market gains, a situation that is often referred to as a “market melt-up” or “blow-off top.” Currently, stocks are simply hitting new all-time highs. By definition, that means most have gone nowhere for two or more years (34 years in Japan’s case). Can you really have a blow-off top when you have only just recovered from a slump and are now rallying to the previous market peak? We say no.

Those pointing to 1999’s tech bubble collapse should also note that the S&P 500 rose over 230%, compounding at more than 25% annually for the five years leading up to that peak. Now consider today’s situation. Using the most favourable starting point (in December 2018, just over five years ago after the market dropped 19%) puts the S&P 500 up 117%, or 16% compounded; the bang-on five-year number is not even a doubling at 12.3% annualized. Above average – yes. Outside the norm – no.

It is important to remember that equity market returns come in a lumpy fashion.

We’ve seen no massive inflows to equity market mutual funds and ETFs that signal recklessness, FOMO (fear of missing out), or manic buying that you would typically see in the run up to a bubble. What we have seen are solid inflows to stocks, but they are eclipsed by money pouring into money market funds. Plenty of cash remains on the sidelines, with the potential to fuel further equity (or bond market) gains.

How about a mania of mergers and acquisitions? Nope. M&A activity is picking up, but we’re not seeing buyers going after any company at any price, pursuing deals that are no cash, all stock with pumped-up prices. Nor are we seeing a rush of initial public offerings. Some will argue that private equity masks this activity today. Alas, activity in private equity is relatively muted, with many raising funds but being very selective in making acquisitions.

Manias and bubbles happen after earnings have been strong and analysts have been raising their forecasts for a long time. Currently, forecasts for corporate earnings revisions are just starting to turn higher.

Today, lots of ink is being spilt over a handful of mega-cap companies driving the market. However, the Magnificent Seven is now the Super Six after Tesla faltered. Furthermore, Apple and Alphabet shares haven’t gone anywhere for six months, but the broad equity market has advanced. Nvidia is a big part of this – and for good reason. It is delivering spectacular earnings and earnings growth. The reality is that a healthy number of stocks, over 70% by one measure, are demonstrating positive momentum, up from 25% in October. This is evidence that the breadth of the market rally is much greater than the headlines suggest.

Similarly, the bond market isn’t signalling weakness ahead. Bond yields have risen, and the corporate debt market remains stable. Even shudders in commercial real estate that rocked New York Community Bank did not produce contagion.

A stumble maybe, but not a fall

We are not suggesting that today’s markets can’t stumble; that can happen anytime for any number of reasons. Experienced investors know stock market corrections in the 10% range generally happen every eight to 18 months. After the substantial and uninterrupted gains since October, it would be neither surprising nor unhealthy if we saw some consolidation of recent gains. We don’t see harbingers of the colossal declines that marked the 2000 and 2008 episodes.

Stocks aren’t cheap, nor should they be. Interest rates, earnings growth and sentiment can all drive stock prices from time to time. Valuations are a mixture of these ingredients. The most powerful driver of the three is earnings growth. We may not like paying up for stocks. But paying up for earnings is a much more comfortable place than paying up based solely on the hope that interest rates will fall or sentiment will remain ebullient. We are very constructive on earnings growth. We also think interest rates and sentiment have the potential to support stocks in 2024.

Bond market insights

After five sluggish months, the Canadian economy has been showing signs of life since November. January’s annual CPI inflation reading meaningfully surprised to the downside, falling from 3.4% to 2.9%. Both developments are welcome. Canadian bond yields rose by roughly 0.20% in February, boosted by U.S. bond yields that were up twice as much on upward surprises for both U.S. growth and inflation. The FTSE Canada Universe Bond Index fell 0.3%. This is normal recalibration in the bond market. We continue to like the overall yield environment as a contributor to returns through time. The bond market is also poised to provide an element of downside protection should the economy falter.

Our strategy – Balanced with an equity bias

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. We remain underweight fixed income. Within fixed income, we have substantial exposure to high-quality, investment-grade corporate credit and are underweight lower-rated high yield bonds.

The last word – New S&P 500 target of 5,400

The S&P 500 is flirting with our year-end target of 5,100. It’s notable that the forward price-earnings multiple (P/E) of the S&P 500 is lower today than it was at the beginning of the year (so is Nvidia’s, by the way). That’s because expectations for earnings growth have risen more than share prices.

One way we forecast markets focuses on earnings growth, interest rates and an equity risk premium framework. By combining earnings growth with our forecast for bond yields and a market-derived estimate of prevailing risk appetite, we solve for a reasonable price-earnings multiple and build out an array of scenarios.

We formulated our January base-case S&P 500 call for 5,100 by using a conservative estimate of risk appetite and a forecast U.S. 10-year bond yield of 3.75%. However, with our starting pitcher nearing the pitch-count limit, we can turn to our bullpen scenarios. They point to 5,350 and 5,600 as plausible destinations for the S&P 500. These require the P/E to stay in the range of 21 to 22, where it sits now, or a modest 5% upside to earnings growth. Neither of these are Herculean tasks.

New all-time highs are bullish. Since 1950, after marking a new high, the S&P 500 has been positive more than half the time over the next three, six and 12 months. And since 1960, after reaching a new all-time high following a bear market (which we had in 2022), the S&P 500 has been positive 88% of the time over the next three, six and 12 months. If the S&P 500 reaches 5,600, that equates to a 17.3% annual gain for 2024 – well within one standard deviation of the average 12-month forward return after a new all-time high.

Probability-weighting these outcomes, we are upping our year-end forecast for the S&P 500 to 5,400. This represents a 6% gain from February 29 and would add up to a 2024 calendar-year gain of 13.2%.

Like Ben Graham, we buy on arithmetic.

 

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