Investment Strategy - March 2024

Productivity acceleration – The holy grail for investors

Global stock markets continued to defy various bearish accounts in 2023, and so far in 2024. With the notable exception of China, which is mired in a painful growth slowdown, major stock markets around the world, notably Europe (EURO STOXX 50), North America (Dow and S&P 500), and Japan (Nikkei) have made new all-time highs. Given equity markets are among the best leading economic indicators, this, at the very least, does not portend a global recession in the next few quarters.

History tells us that market strength begets more strength. As noted by our colleague Brent Joyce, Chief Investment Strategist, BMO Private Investment Counsel, “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.” This also appears to be the path of least resistance this time. In the near term, inflation expectations continue to be very well grounded, around 2%, which should allow central banks to cut rates around mid-year. The BMO Economics team continues to believe the Bank of Canada will begin trimming in June, ahead of the U.S. Federal Reserve (“Fed”). This has clear, positive implications since – as noted by our research partners at NDR – bond yields have always fallen going into the first cut. This would clearly be a positive for laggard interest rate-sensitive, defensive, and “value” stocks and the relative performance of the S&P/TSX vs. the S&P 500. Furthermore, stocks almost always post good gains during easing cycles. Going back to 1970, the median S&P 500 return during easing cycles has been over 25% annualized. The lone exception was in the 2001 to 2003 period which followed the bursting of the tech bubble.

Longer term, the key will be continued productivity growth led by the U.S. (as usual), but we also see Canada benefitting from this in time, assuming better policies and incentives to increase capital investments (particularly in technology). While productivity acceleration gets less attention than other major macro variables (because it moves slowly and with a considerable lag following investments), we believe it is crucial as it increases long-term economic and corporate margin growth potential, without creating dangerous inflationary pressures. In the current context, we believe enormous investments in artificial intelligence, cloud computing, autonomous vehicles, etc., is bound to have a real-world impact. As an example, The Economist recently stated that artificial intelligence is raising productivity for salespeople and coders by a third at tech startups. This is far from trivial for companies that typically burn cash and are racing to generate positive cash flow.

The nineties parallel

We have seen some bearish narratives which argue we may fall into a 1970s-type stagflationary cycle which would clearly be very painful for investors (U.S. stocks had negligible returns in that decade). Our own view is that a more likely and constructive scenario for the North American economy and markets is something akin to the 1990s. Back then, investments in computing (PCs and laptops), wireless communications and the internet really took off in the 1980s/early 90s. It took time, however, for employees to truly harness the power of these “new” technology tools, but eventually – in the mid-90s – productivity really started accelerating. The Federal Reserve of St. Louis stated that the acceleration of labour productivity growth that began during the mid-1990s was the defining economic event of the decade.

The high-tech manufacturing sector experienced rapid growth in output on a per hour basis throughout the 1990s and the rate of growth accelerated sharply in the second half of the decade. We believe this was a major contributing factor to the epic bull market we witnessed in that period. It is also worth noting that productivity also accelerated strongly in Canada in the 1990s, but we lagged the U.S. This is a plausible scenario for this cycle as well, in our view, and BMO Chief Economist Doug Porter concurs.

Current cycle

As recently reported, Q4 U.S. productivity came in at 2.7% year-over-year, the fastest pace since Q1 2021. As a result, unit labor costs (“ULC”), or labor costs in excess of productivity, rose only 2.3% year-over-year, near the slowest pace since Q2 2021 (falling inflationary pressure), and well below its five-year average rate. This is a tailwind for margin growth and is historically consistent with above-average stock market gains. It is supportive of the current upswing in equity prices. The slowdown in ULC growth also implies falling underlying inflation pressures. The productivity proxies of our research partners NDR show gains across the majority of industries, which argues for sustainability.

Technical analysis

We never like to use the word “guarantee” in our research, but a pullback in the third quarter of U.S. presidential election years is just about as consistent as you’ll ever see in this business.

If you ignore 2008 as an extreme outlier, the average Q3 pullback since 1980 is -8.28% (It’s -10.27% if you include 2008.) The good news is that if you’re looking at historical averages, we’re still only in the “middle innings” with respect to how an average cyclical bull market plays out within bigger secular bull markets. Historically, they tend to last about 30 months with an average gain of 86%. If you apply that to the October 2022 low, that would give a 2025 target of 6,493 for the S&P 500.

Of course, that target seems a bit too ambitious at this point, but history shows a high likelihood of further all-time highs following any mid-year correction, and we probably won’t run into any significant turbulence until sometime in 2025. In addition, while mega-cap Tech stocks have been getting all the press by carrying the weight for U.S. indexes, global stock markets have actually been doing pretty great themselves. In late February, Germany, France, Switzerland, South Korea (one of our key market-based measures of economic activity), Taiwan, India, and Japan either made 52-week or all-time highs. In fact, on February 22, Japan made its first, new all-time high since 1989, which is fantastic. As a more general barometer of global stock market activity, the MSCI World Ex. U.S. Index also made a new 52-week high in late February, so it’s not just an AI craze, it’s steady improvement in the global economy.

Last but not least, the “canaries in the coal mine” that typically pre-warn of major sell offs (think 10-15%+) all look great right now as well. This includes key “risk on/risk off” metrics such as the performance of Discretionary vs. Staples stocks, Financials vs. Utilities, and the continued outperformance of economically sensitive sectors such as Technology and Industrials, which all reflect a healthy economy.

Bond market sentiment gauges also remain sedated: both corporate/treasury credit spreads and credit default swap indexes remain at/near 52-week new lows, which is a good thing (i.e., the bond guys are not worried). Historically, these indicators tend to roll over and go negative anywhere from 6-12 months ahead of real bear markets, so until we see a more defensive shift in those indicators, it’s still “game on” for equities.

 

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