The bulls keep running: Why markets remain upbeat

CIO STRATEGY NOTE

As winter turns to spring, the bulls keep running.

The most recent round of earnings generally delivered good results, with the biggest story being Nvidia continuing to beat analysts’ high expectations. There’s no question that the Tech giant has been an outlier, but it’s an outlier that fits the overarching theme of artificial intelligence (A.I.)—demand for Nvidia’s microchips is there, margins are excellent, and we see no sign of an imminent slowdown. This tells us that American corporations continue to spend and the U.S. remains a very strong market. Quality companies continue to dominate, growing their earnings based on products that are in-demand. That, along with a strong consumer, ultimately why we remain overweight U.S. equities.

American corporations continue to spend and the U.S. remains a very strong market.

Looking ahead, unless the job picture dramatically changes or markets experience an unforeseen shock that affects consumer spending, we expect to remain positive on markets. Even the deferral of interest rate cuts hasn’t slowed investors’ enthusiasm, as many thought it would. Our focus is on the U.S.—the forthcoming elections could shake things up, but they’re still months away. For now, optimism reigns, and Quality—a category that includes some key Tech names—is still king.

ECONOMIC OUTLOOK

Second verse, same as the first

Trends from 2023 continue into 2024, with expectations of interest rate cuts from the U.S. Federal Reserve (Fed) getting pushed back further. Meanwhile, the Canadian economy continues to cool and China’s growth struggles persist.

U.S. outlook

U.S. markets continue to cope with seasonality in the data; January and February jobs were strong and inflation numbers have been higher than expected, similar to what happened in January 2023. It is possible that this trend will continue into the Q1 data, which would likely pare back interest rate cut expectations even further, but we would not take that as a signal that the economy is necessarily reheating. Rather, we’re looking further out into the second half of the year—we think there’s a good chance inflation will be lower by then, helped by a further loosening of the labour market. That would give the Fed the justification to lower rates at least a few times before year-end.

Canada outlook

Canada’s outlook remains largely the same as recent months. Weak growth continues, with Q4 gross domestic product (GDP) growth clocking in at a subpar 1%. Private sector job growth has also disappointed in recent months. At the same time, a technical recession has been avoided, and growth is tracking positive for Q1. This likely reflects Canada’s economic linkages to the U.S.—a resilient U.S. economy is underpinning Canadian growth. Inflation is still elevated, but the latest report was much more constructive than previous months. We think weak growth and a loosening labour market are important reasons why the Bank of Canada (BoC) will likely cut rates this year. In the near term, however, they’re likely to stay on the sidelines and take their cues from the Fed. If they were to cut before their American counterparts, it would probably be the result of especially ugly growth numbers or bearish developments in the labour market.

International outlook

In general, we’re seeing early signs that global growth is bottoming, including a greater share of Purchasing Managers’ Indexes (PMIs) rising above 50 (indicating expansion rather than contraction) and trade flows picking up. In particular, leading indicators in the Eurozone and U.K. continue to improve, with both regions also primed for rate cuts given that inflation data is likely to show more meaningful progress beginning in the second quarter.

Weak Chinese growth continues to weigh on the outlook for Emerging Markets (EM). On the macro side, China’s economic outlook remains dour, particularly because there are not yet any signs that its housing market is bottoming. That’s particularly concerning given that stimulus aimed at stemming the bleeding has already been deployed.

Summary

PORTFOLIO POSITIONING

Asset Classes

Stocks are back in favour and look poised for a sustained run. Should the market be worried about valuations? To an extent, but Growth stocks, which typically command higher multiples, are an increasing proportion of total global market capitalization. This is one reason among several that have us bullish on equities.

Our view is that the market is still looking at three to four cuts from the Fed this year. The one observation to make right now is: if you look at the spread between forecasters who think we’re going to have no cuts to those who believe the economy will decline steeply without five to six cuts, it is probably as wide as it has ever been. Indicators are still pointing to a strong economic environment and we are caught in the middle ground of wanting strong-but-not-too-strong conditions. The market might want rate cuts to come sooner, but be careful what you wish for—if we need more than three or four cuts, it is because something has gone wrong.

Since October, the S&P 500 is up 24.5% and small caps have actually outperformed—up 26%. Other liquidity indicators have turned bullish, as well. Bitcoin has topped US$65,000; Consumer Discretionary versus Staples, cyclicals versus defensive stocks—virtually everywhere you look, markets appear relatively healthy. Should we be worried about valuations with price-to-earnings multiples where they are? Consider the market has more Growth stocks that make up a bigger part of the index than we’ve ever had before, and they command a higher P/E.

When you look at the economy, it is hard to argue that the situation is anything but good. GDP expectations are up, consensus expectations of a recession in the next 12 months have fallen to 45%, and job growth continues to support consumer spending.

Bottom line, we’re bullish on equities. We are cognizant that we’ve had 16 out of 18 weeks of rallies on the S&P 500. It may indeed be time for a little bit of a tactical pull-back, but looking out over the next 12 months, stocks look poised to continue their upward trend.

PORTFOLIO POSITIONING

Equity

World-leading earnings growth and an extended tailwind from Technology stocks keeps the U.S. stock market as the clear frontrunner globally. In Canada, we have likely seen recession risks peak, with odds of a downturn fading the further we get into 2024.

The market remains the domain of the Magnificent 7 (Apple, Meta Platforms, Alphabet, Microsoft, Tesla, Nvidia and Amazon). They have very fast revenue growth and very high profitability, and those two things put together translates into greater earnings. That has been the case for last 12 months, and the most recent quarter was no different. Our view is that this momentum will eventually fade but it will not be anytime soon. There are going to be pullbacks but the group’s outperformance is a secular theme with staying power—Nvidia, in particular. Other companies may eventually catch up, but for now they have chips that no one else has. We are still in the early innings for AI products. The first wave now is coming from cloud applications and things like ChatGPT. The next is going to be the AI applications for individuals and retail.

That is why regionally we are most constructive on the U.S. market—it is where the Technology-fueled earnings growth is, underpinned by strong GDP growth. A third leg is the policy support. We may see a smaller deficit than last year but we’re still seeing fiscal stimulus. You put all of that together and the U.S. appears to be the most attractive market.

In Canada, we continue to see an economic cooling (but not crashing) which has meant stocks have held up. But on a relative basis, the domestic market is less attractive than that of our U.S. neighbors. Part of that is sector composition; the TSX has a much smaller Technology universe (8.7% vs 30.1% in the S&P 500) and a heavier weight to Materials (10.5% vs 2.3%),¹ which is a sector we are less bullish on. We still hold our Canadian bank position. With loan loss provisions probably at a peak, our view is that we are now seeing declining recession risk, a trend we expect to continue throughout 2024.

Internationally, Japanese stocks just passed their 1989 highs, and we are still bullish on that market. There remains strong earnings momentum, valuations relative to other markets are still attractive on a historical basis, and there is still scope for continued improvement of corporate return-on-equity as excess cash is either deployed through capex, or returned to shareholders via buybacks or dividends. In China, we have seen a small uptick in sentiment and fund flows, creating a bounce in the markets. So, while we are still neutral on EM, we have been gaining an exposure to this short-term upward move through call options.

PORTFOLIO POSITIONING

Fixed Income

We are constructive on Duration² over the balance of the year, but with a more uncertain interest rate outlook in the near term, we remain neutral (0) across the board on fixed income. We continue to monitor central bank policy divergence dynamics, as well.

In general, bonds historically outperform equities and cash in the quarters following the peak of a monetary tightening cycle. But that outperformance is accompanied by—and is, in part, the result of—a slowdown in the economy and equity sell-off. If we are headed into a ‘soft to no landing’ scenario, there will not be the big crunch where you see a very rapid decline in rates. That is in part why we remain neutral (0) on fixed income at the moment.

For the year as a whole, we are bullish on duration²—however, it is not going to be a straight line down for interest rates. Markets are presently pricing in three to four rate cuts from the Fed, which we think is very plausible. But as of now we are still seeing inflation and growth surprise to the upside. It does not make sense to go overweight duration at this point in time but we’re still strategically bullish. Cuts may come eventually, benefitting long bonds.

We remain neutral (0) on High Yield and Investment Grade bonds as well. Spreads are tight by historical standards, keeping us from going overweight, while we are seeing resilient economic growth. So, we do not see a catalyst for spreads to widen anytime soon—without material spread widening in our in our forecast, we remain neutral (0) on credit across the board.

One theme to watch is the divergence between Canada and U.S. economies, which could eventually create a divergence between the Fed and the BoC. The Canadian central bank historically likes to wait on the Fed to cut first, but if this bifurcation in growth continues, we could see the BoC cut first later this year, and more frequently— especially given the more vulnerable nature of the relatively more indebted Canadian businesses and consumers.

PORTFOLIO POSITIONING

Style & factor

With rate cuts on hold, the focus has changed from multiple expansion to future earnings growth estimates. That, and the comfort afforded from ample free cash flows, are reasons why we favour Quality. From a sector view, we have also shifted to overweight in Healthcare and Industrials.

Given the volatility of markets so far this year, we have seen modest changes in the Style and Factor lens of our house view. In terms of Value versus Growth, there is at present no real driver because we have yet to see an expected impact from a change in interest rate trajectory—if we thought that all of a sudden the market was to reprice to estimates of five to six rate cuts again, we would favour Growth, because of the favourable effect on those multiples. But at this point, we’re not focusing as much on multiples as we are on earnings growth. We like Quality because there is a ton of free cash flow in some of these mega caps. That provides a certain level of downside security, which allows us to stay overweight equities overall.

We typically discuss factors in this space, but sectors are the more relevant focus in how we are expressing our current view, and we are growing more cyclically oriented. We still like Technology, but in addition to that, we have shifted to overweight on Industrials and Healthcare. The latter had probably been one of the hardest-hit sectors this earnings season but is now showing strong potential earnings growth for the coming year. It’s timely with the rising awareness of weight loss drugs— but there is a lot more to healthcare than just pharma. It is an attractive sector on a valuation basis, showing a forward price/earnings-to-growth ratio³ below that of Technology. It is a very healthy industry on a global basis that has been punished over the past 12 months because of a rollover in earnings growth following the pandemic, but it is expected to have higher-than-market earnings growth for 2024 and 2025.

Looking forward, as we get deeper into this rally, the market is likely to start looking at Value names (in addition to Growth) because of dividends, which typically tend to outperform in a falling rate environment—although we probably prefer to stick with bonds for that play. But dividends are a good hedge in case something goes wrong—you rarely have to apologize for owning dividend-paying stocks. It is this notion that endorses patience with our tilt towards Canadian banks.

PORTFOLIO POSITIONING

Implementation

Gold is up but a sustained rally will likely require a monetary policy shift to lower interest rates. We have taken positions in derivatives and options to drive returns this month, as well as provide downside protection.

Gold has popped past US$2,100⁴ but it will likely take actual rate cuts for bullion to catch sustained bids—and of course, it now has Bitcoin to compete against once again. We maintain a position in most funds, but are hesitant to add to it following so sharp a rally.Our use of derivatives and options from a tactical opportunity standpoint is benefiting the portfolios—in particular, ETF call options related to the Chinese Technology sector. We have also made use of protective puts⁵ both against the Nasdaq and S&P 500, the former as a tactical hedge around earnings season and the latter for a longer- term hedge against seasonality and valuation risk. It underscores the fact that while our scores may not change each month, we are making tactical adjustments that reflect more granular moves within the market on a week-to-week basis.