Riding the tailwinds of September storms

CIO STRATEGY NOTE

Riding the tailwinds of September storms

Over the past year, Nvidia’s earnings announcements have become major market milestones—more similar in some ways to macroeconomic events like interest rate decisions than to your average corporate results release.

In late August, the artificial intelligence (A.I.) leader marginally beat analysts’ estimates but nonetheless failed to meet the market’s sky-high expectations (which were based on several consecutive quarters of massive outperformance), prompting a sharp decline in its stock price the following week. This tells us something about market dynamics and the psychology of the investor: sometimes, even ‘very good’ isn’t good enough.

There’s no question that a lot of positive news has been priced into the valuations and earnings expectations for some of the top names—but that doesn’t mean investors should head for the hills. Our approach is to stay the course while expecting more volatility.¹ September is a notoriously choppy month historically for markets, while economically, it’s fair to say that consumers are still adjusting their spending habits as higher interest rates take their intended effect, so a pullback is certainly possible. But we would view such a dip as a potential long-term buying opportunity. A rotation to other sectors—and potentially even other geographies—is likely, and we’re currently tilting toward the Value segment of the market. It’s not that Growth companies aren’t strong; rather, they’ve over-delivered all year, and the bar keeps getting raised. Given how resilient Equity markets have been and the fact that the interest rate-cutting cycle is set to begin in the U.S., we don’t think sitting on the sidelines is the best strategy.

There’s no question a lot of positive news is priced into valuations for some of the top names—that doesn’t mean investors should head for the hills.

Looking ahead, we’ll be closely monitoring the unemployment story. As my colleague Fred Demers so succinctly puts it: if people lose their jobs, they’re just not going to spend. So far, layoffs have largely been offset by new hiring, so spending has continued, albeit on staples-type items rather than luxury goods. We’ll continue to watch retail results to track any further shifts in spending patterns, as well as any demand-side headwinds that companies like Walmart and Target might identify. That would be a signal for investors to proceed with greater caution.

ECONOMIC OUTLOOK

A faltering job market forces the Fed’s hand

The seemingly indefatigable U.S. labour market suddenly finds itself running on fumes, leaving monetary policymakers no choice but to commence a cutting cycle. Size and scope are the only remaining questions.

U.S. outlook

The U.S. data has steadily become more mixed with labour market prints being the most obvious. The August payroll additions of 142,000 followed an even weaker July number. It amplifies the cooling trend we’ve seen developing, notably in the wake of significant negative revisions—800,000-plus jobs vanishing from previous months’ payrolls. Suddenly the narrative around a tight U.S. labour market is fraying. Equally as sudden, in terms of the second focus of the U.S. Federal Reserve’s (Fed) dual mandate (the first being stable inflation, and second, maximizing employment) it is very much time to get going. We are done speculating on the timing of when interest rate cuts will commence. The question is depth and pace; will they trim 25 basis points or 50 going forward? Will it be serial 25 bps cuts or will they speed things up? The market has done a lot of repricing as we have removed potential inflation catalysts that were built into assumptions in April and May. That said, there is no need for alarm—the tried-and-true consumer is still spending. Gross domestic product (GDP) data and consumer spending reports indicate there is good underlying momentum leading into the third quarter. A recession is not imminent. But on balance, the Fed must rid its cautious bias. It is indeed time to move.

Canada outlook

Canada is lucky to have one of the fullest employment industries in the world in our public sector. All joking aside, second quarter growth north of 2% looks pretty good on the surface, but the bad news is most of that growth (75%) is attributable to the public sector. Private economic activity remains weak. Per capita growth in fact contracted for the fifth consecutive quarter in Q2—nothing to celebrate. The silver lining, if we are in need of one, is that we are discussing a sluggish growth backdrop, not full-blown recession when you look at the aggregate level. But again, measuring per capita, Canada has in fact been in a recession for a while. Migration flows will continue to help at the margin, with the assumption that population growth will remain strong for the foreseeable future, spurring growth with public money helping support a rising population.

Consensus estimates for 2024 read GDP growth: Tough to bet against the U.S.

Source: BMO Global Asset Management/Bloomberg.

International outlook

Within EAFE, we continue to see some green shoots, with a caveat for Germany where we are seeing some challenges. The U.K. is definitely looking better, even though that economy has not had the benefit of interest rate cuts, it is managing quite nicely—not booming, but certainly moving in the right direction. In Japan, after some pockets of weakness, the economy is again improving. The news that Volkswagen intends to close auto-manufacturing plants in its home country is a surprise, in what is turning into a perfect storm for Germany’s industrial sector. The development speaks to the very challenging conditions there. The energy crunch has caused a lot of inflation on the old industrial base—anything that consumes energy has been penalized. And then there is the energy transition, which has perhaps been a little too aggressive, while competition from China is making it tough to compete in the electric vehicle (EV) landscape. In Emerging Markets (EM) and China specifically, indicators are not very bullish. We are seeing a continuation of domestic weakness. It is a challenging backdrop for that economy.

Summary

PORTFOLIO POSITIONING

Asset classes

The research shows buying opportunities abound during a typically volatile stretch, setting the market up for what is also usually the best quarter of the year for returns.

September is not a great month for Equity markets, or credit for that matter. You can look at any number of studies ranging from 10 or 20 years ago and they all consistently come to two conclusions: September is more often than not a dicey stretch for risk assets, but the fourth quarter more often than not tends to be the best three-month period of the year. There are always exceptions to the rule, i.e., one study will say it depends if the market is positive year-to-date in August or not, or whether or not it is an election year, or which direction interest rates are moving in—factors that affect magnitude but not the overarching outcome: the early fall usually equates to volatility. The good news is that those studies also uniformly indicate that Q4 tends to deliver the best returns. We absorbed a short correction in August and have bounced back very quickly, but we are not prepared to give the “all clear” yet, hence we remain neutral (0) on Equities. If we do see more downside in September and into October, our view is, that may be a pretty good buying opportunity.

On Fixed Income, the clarity around Fed Chairman Jerome Powell’s intentions is a lot better now than what it was a year ago at this time. Powell’s recent comments have indicated two things: there is a pivot underway in policy, while the Fed has changed the North Star it is guiding toward, from getting inflation down to now keeping employment up. The shift has us increasingly bullish on bonds. How bullish will depend on how quickly policy moves. It’s expected that the U.S. and Canada will have 100 bps taken off benchmark rates by year-end, and probably another 100 next year (if not more in Canada). It makes sense to start moving cash onto the yield curve—if you’re not there already.

PORTFOLIO POSITIONING

Equity

The gulf between Technology earnings growth and the rest of the U.S. market is narrowing, rather vividly illustrated by Nvidia’s relatively pedestrian outperformance last quarter.

Earnings season has wrapped and, in general, it was a positive one overall. Profits among S&P 500 companies topped estimates by approximately 5%, which is in line with historical averages. A big difference in this earnings season compared to recent history was composition. Earnings growth wasn’t simply Tech stocks generating huge beats, and everything else missing forecasts. Upside surprises for the Technology sector and the rest of the market were in line with one another. Tech beats were around 5% on average, while the remaining names in the index also surprised by about 5%. Growth was much more broad-based. Drilling into the details, three sectors we have grown more bullish on—U.S. Health Care, Financials and North American Utilities—all had more upside surprises than Technology. And in what’s become “must-see TV” for investors, Nvidia earnings similarly topped estimates, but the market reaction was negative because it beat by less than previous quarters (about 5% this quarter vs. double digits previously). Nvidia’s results underscore a convergence in earnings growth across sectors, and a broadening out of that growth. Tech names continue to be the strongest overall, with earnings growth still a whopping 29% this quarter, but the upside surprises are moderating. We still see Tech continuing to be the strongest sector for profit gains but the lead is narrowing.

Regionally, the U.S. still has the strongest earnings growth, which is a function of stronger economic growth relative to the rest of the world, led by better productivity. That is why that market is our largest weight on an absolute basis. In other regions, like Canada, where we’re funding our U.S. overweight positions from, we see slowing activity. One development on EAFE that bears comment is the huge drawdown taken in Japan, given the volatility around the Yen carry trade. While it was a wild month, we have largely ended where we started and we continue to hold a neutral (0) view.

PORTFOLIO POSITIONING

Fixed Income

Shorter-term government bonds are likely to benefit from a deeper cutting cycle than is currently expected. Our recent deep dive on EM Debt also reveals potential outperformance over High Yield—and even U.S. Treasuries.

We’re maintaining our modest overweight to Duration² to take advantage of ongoing curve normalization, as we anticipate further moves down in yields across the curve. A second means with which we’re positioning ourselves is by favouring short-end government bonds over cash or cash equivalents to get some yield pick up without much risk trade-off. We are using our shorter-term bond ETFs over cash to express that view. The reasoning is: let’s suppose we see 200 bps of cuts. That simply brings us back to the neutral rate (assuming that is 3-3.5%). Our view is they likely cut deeper than the market expects—we don’t think they’re going to rush into 50-bps cuts, but at the end of the day, they probably are going to ease more than what’s currently expected. On the Bank of Canada (BoC), the market right now is pricing in effectively sequential 25-bps reductions through the end of the year and well into next. We think there is a real risk for an outsized cut in the next six months because the economy, and employment in particular, is moderating more quickly.

We should note that the MAST team has recently completed a deep dive on EM Debt and how it can better assist our portfolio construction. What we’ve learned is that EM issuers are fiscally in a better position than they have been historically. Governments are in stronger fiscal positions than they have been in previous decades, as well. They have far greater central bank reserves. In periods of currency tumult and/or capital flight, central banks can tap those reserves to better deal with a crisis. While there have been some high-profile defaults, overall, the EM default rate is similar to High Yield issuers (~4%). Those are the structural things we learned. Tactically, we discovered EM debt has outperformed High Yield bonds in almost all Fed cutting cycles. Moreover, outside of recession—i.e., soft landings—emerging market bonds have actually beat U.S. Treasuries. We remain neutral (0) for now, but are building a positive view.

PORTFOLIO POSITIONING

Sector & factor (tactical)

A broadening of market participation doesn’t mean wide index exposures are necessarily warranted. Selectivity is the watchword as we look to remain risk-on, but tilt towards more defensive and Value-oriented holdings.

When we are talking about September seasonality, we certainly want some defensiveness. In addition, it has been a concentrated rally and a long bull market. Easing off the throttle and undertaking some de-risking of positions makes sense. We’ve expressed that view in a number of ways vis-à-vis our market lenses. That question that is most important to us is: which Equities and sectors are favourable over the balance of the year? We are biased toward viewing September seasonality as a buying opportunity, but with the caveat that adding to or establishing new positions requires a lot more selectivity compared to buying a broader index simply because of the broadening of the market. We’ve already seen some softening within the Technology sector in terms of the number of names sustaining momentum (i.e., Microsoft appears to be going nowhere despite very solid earnings, while Apple has sold off pretty aggressively). What we’re looking for is ways to still be risk-on, but a little bit safer.

Financials are a clear consensus favourite among our team, specifically U.S. banks. A steeper yield curve and lower short-end rates are going to help bank earnings, while market volatility should help with capital markets divisions’ trading revenues. Several portfolios have an active tilt toward Health Care, using global fund allocations. In the U.S., the sector experienced the highest upside surprises relative to estimates this past earnings season. The consensus tilts to underweight positions are led by Consumer Discretionary, which is a very concentrated sector (Amazon and Tesla make up much of the sub-index), and the macro data of discretionary purchases versus staples shows discretionary clearly lagging. Another underweighted sector is Infotech, mostly on valuation concerns and waning momentum in the A.I. theme.

PORTFOLIO POSITIONING

Implementation

We have pared our score on Gold on a tactical basis, taking out some insurance on the positions we have added to during the metal’s recent surge. We remain, however, slightly bullish (+1) over the longer term.

The U.S. dollar has softened a bit, but we’re not prepared to say the Canadian dollar (CAD) is going to roar ahead. There are still a fair number of shorts against the CAD—not as many as there were, but it is really not of interest to us at this point. Looking out, the market is pricing in the BoC to cut more deeply than the Fed, which would also mean a softer CAD.

We increased our score on Gold to bullish (+2) not long ago, and executed on adding to our positions in a number of portfolios, either directly or synthetically through options. Upon seeing the metal almost crack US$2,600/ounce we have cut our score back to slightly bullish (+1). Gold is overbought on a technical basis, so while we do not think the price will meaningfully reverse course, it is probably going to take a breather. While we increased our direct positions, we also added some insurance by buying some puts on a gold ETF. It costs us a couple of basis points, but it puts a floor under the value. When you buy a motorcycle, you better save $100 to buy a helmet… it may not make you look cooler, but you’re going to want it if things get tricky. That’s our feeling on gold right now. Longer term, Gold is another way to express a longer duration bias, given its lack of yield.