Market Perspective - Fall 2024

Guide to the markets

Sifting through financial information online is becoming quite onerous with so many opinions out there, so we've consolidated what we believe to be informative and insightful into one Market Commentary.

The U.S. economy (the largest economy in the world, and our largest trading partner) demonstrated surprising resilience over the summer, with consumer spending driving growth despite slowing data in other sectors. After a sluggish start to the year, GDP grew at an annualized rate of 3.0% in Q2, largely fueled by a 2.8% rise in consumer demand. However, softer data from purchasing managers' indexes (PMIs) and employment indicators have sparked concerns about a potential economic slowdown. Even so, with few signs of overextension in the key cyclical sectors—such as residential investment, vehicle sales, and business inventories—a near-term recession remains unlikely.

Inflation, meanwhile, continues its path downward, bringing it closer to the Federal Reserve’s 2% target. Headline CPI reached 2.5% year-over-year in August, its lowest since early 2021. Supply chains have stabilized, and the prices of core goods have steadily declined for six months. While shelter and auto insurance inflation remain stubbornly high, broader disinflationary forces, including easing wage pressures and moderated energy prices, seem likely to push inflation lower into 2025.

The labor market, while still healthy, is starting to cool. After reaching a cycle-low unemployment rate of 3.4% in April 2023, it has since climbed to 4.2% in August. Job openings have fallen significantly from their March 2022 peak, and wage growth has slowed to 4.1% year-over-year. This moderation suggests that labor market pressures are easing, which should help reduce inflation further. Despite these softening indicators, layoffs remain historically low, indicating that the labor market is stabilizing rather than deteriorating sharply.

In response to cooling inflation, the Federal Reserve shifted its focus to employment, cutting rates by 50 basis points in September. This marked the beginning of what could be a series of rate cuts, though the pace will depend on future data. Fed projections indicate two more cuts this year, but the central bank remains cautious, as any missteps in policy could destabilize the economy. Rates are expected to settle at a structurally higher level compared to the last decade, barring any major economic shocks.

Financial markets have experienced heightened volatility, particularly in August, as lackluster corporate earnings guidance and weaker economic data unsettled investors. However, as inflation eased and rate cut bets increased, markets rebounded. The broadening of earnings growth beyond the top tech stocks helped push equities higher, though valuations remain stretched. With elevated geopolitical risks and the U.S. election on the horizon, market volatility is likely to persist, prompting investors to consider active management and diversification across global assets.

Global markets are similarly in flux. While U.S. equities have outperformed international markets for much of the past decade, valuation gaps are widening. Non-U.S. markets, particularly in Europe and Japan, offer more attractive entry points and higher yields. As central banks around the world continue to normalize policy and inflation trends lower, investors may find opportunities in international equities and bonds that have been overlooked in favor of the heavily concentrated U.S. market.

I have included below an economic & market update from J.P. Morgan Asset Management that I would like to share. This Guide to the Markets provides concise insights into economic trends globally, emphasizing growth, employment, and inflation. The commentary, and its many supporting charts, are presented by JP Morgan's Chief Global Strategist Dr. David Kelly, and they highlight the major themes and concerns impacting investors today.

From JP Morgan’s Dr. David Kelly:

The U.S. economy appears to have maintained a solid growth pace over the summer, fueled by resilient consumer spending. At the same time, inflation continued on a path back toward the Federal Reserve’s 2% target, while a rising unemployment rate sparked fears the labor market is cooling too quickly. Moving forward, resilient consumer spending should support trend-like economic growth into 2025, and, with few excesses building across the cyclical sectors of the economy, a near-term recession seems unlikely.

Meanwhile, cooling inflation has allowed the Federal Reserve to put more focus on the labor market, prompting it to join other global central banks in easing policy and deliver a 50-basis point rate cut in September. While the Fed’s updated economic projections forecast two more rate cuts this year, the pace of cuts will depend heavily on the incoming data. It does appear, however, that rates will settle at a structurally higher level relative to the past decade barring any economic shocks.

For markets, this summer was anything but calm. Equity market volatility spiked in August due to lackluster guidance from the Magnificent 7, weaker economic data and policy action from the Bank of Japan. However, market jitters have faded in recent weeks, with broadening earnings growth and rate cut bets pushing markets higher and leaving valuations elevated. Expectations for dovish policy action have helped bonds rally too, and yields are lower now than at the start of the year. With the U.S. election quickly approaching, geopolitical tensions still elevated and the Federal Reserve keen on normalizing policy without sending gloomy signals, risks remain that could keep markets volatile and tip the U.S. into recession.  Against this backdrop, investors may want to lean into active managers to access attractive opportunities in an environment of rich-index level valuations, while diversifying across global stocks, bonds and alternatives.

What we've done here is boil it down to 10 slides. In particular, we assess the recent performance of the markets and economy, considering trends in growth, jobs and inflation in the U.S, and how these trends are shaping the outlook for monetary policy. This is followed by comments on growth from around the globe, and finally, a discussion of the global opportunity set across stocks, bonds and alternative assets.

After a sluggish start to the year, the U.S. economy accelerated during the second quarter, growing at a 3.0% annualized pace. While inventory accumulation was a large contributor, underlying demand was robust with consumer spending rising by an impressive 2.8%. However, other economic data, ranging from PMIs to employment indicators, have begun to slow, sparking fears that the economy may be closing in on a recession. However, with few excesses building across the cyclical sectors of the economy, a recession seems unlikely.

We aim to assess the health of the economy by looking at key cyclical sectors, including residential investment, business fixed investment, light vehicle sales and the business inventory-to-sales ratio. We often refer to these as the 'Four Horsemen of a Recession' because, across these cyclical economic sectors, there is usually one or more that becomes overextended, suggesting that a bubble, which could precipitate a recession, is forming. Currently, none of these sectors look overextended. Residential investment and vehicle sales are near average levels, signaling that excessive homebuilding is not an issue and consumers are in decent shape. Moreover, business spending is still in check, even with recent AI enthusiasm, and businesses are not accumulating excessive amounts of inventory.

Overall, none of these cyclical sectors look overextended now, suggesting the risk of some endogenous shock inducing a recession is low. That said, with the U.S. election just over a month away, monetary policy at a critical turning point and geopolitical tensions still elevated, external risks remain that could tip the U.S. into recession, albeit a mild one.

Coming out of the pandemic, strong demand for labor clashed with a limited supply of workers, creating one of the tightest labor markets ever seen. However, that labor demand has largely normalized from its post-pandemic boom.

One way to gauge labor demand is by examining job openings measured in the JOLTS Report. After peaking at 12.2mn in March 2022, job openings have steadily fallen over the past two years, with just 7.7mn job openings reported in July 2024. This print lowered the ratio of job openings per unemployed workers to 1.07x, well below 2019 levels. Quits have normalized also as loosening labor market conditions have made employees more wary about leaving their current posts. That said, other data, while softening, suggest the labor market is still on solid footing. Layoffs remain historically low while initial claims for unemployment benefits have settled down after disruptive weather conditions and larger-than-expected auto plant shutdowns caused them to spike this summer. In fact, they are lower than they have been more than 80% of the time this century.

While labor demand has normalized, it hasn’t deteriorated to the point of concern. Job openings are still higher than in any month prior to the pandemic, and subdued layoffs indicate that businesses have enough confidence in their current prospects to retain their workforce. Overall, while certainly softer than it was relative to the past two years, the labor market still looks healthy, and resilient economic growth in the coming quarters should facilitate plenty of hiring.

Within the broader labor market mosaic, investors have found themselves paying particular attention to one measure: the unemployment rate. After reaching a cycle low of 3.4% in April 2023, unemployment has steadily ticked higher, reaching 4.3% in July before easing slightly to 4.2% in August. While this is still lower than it has been almost 88% of the time over the last 50 years, the July jobs report spooked investors. With unemployment jumping to 4.3%, this report triggered the Sahmrule, which states that if the unemployment rate’s three-month moving average exceeds its prior 12-month low by 0.5%, a recession might already be underway.

An increase in unemployment due to layoffs would indeed be concerning. However, with layoffs and initial jobless claims still historically low, this hasn’t been the case thus far. Instead, the trend higher in the unemployment rate likely reflects a healthy normalization of a labor market that was operating above full employment as opposed to something more sinister.

Nonetheless, loosening labor market slack has also led to a moderation in wage growth. After peaking at 7.0% in March 2022, growth has continued to slow back to trend. Wages rose 4.1% year over year in August, just above the 50-year average of 3.9%. While this is likely slightly above what is consistent with the Federal Reserve’s 2% inflation target, softening labor market conditions should help wage growth ease, bringing inflation down with it.

After a bumpy start to the year, inflation has made meaningful progress lower in recent months, giving the Federal Reserve “greater confidence” that it is on a sustainable path back to 2%. Disinflationary tailwinds remained intact during the third quarter, with headline CPI inflation falling to 2.5% y/y in August, its lowest print since early 2021.

Core goods prices have trended lower for sixth consecutive months as supply chains have remained well-managed, even with elevated geopolitical tensions, and should remain well-behaved. On the more volatile components, lower gasoline prices throughout the summer have weighed on energy prices while food inflation has remained mild. Moving forward, sluggish global demand limits the likelihood of a surge in either of these categories.

That brings us to the stickier segments of inflation, shelter and auto insurance. Shelter inflation accounts for over a third of the CPI basket and has held stubbornly above its pre-pandemic trend. That said, real-time measures of market rent point to more normal levels of shelter inflation ahead. Auto insurance, a consistent hot spot of inflation, has eased slightly in recent months but is still rising by over 16% year-over-year. Fortunately, as the rollover in vehicle prices feed through the data, this trend lower should continue.

Overall, inflation should continue to ease into 2025. While price gains in shelter and auto insurance remain elevated, real-time data continue to point to easing price pressures ahead, and with broader disinflationary tailwinds, such as easing wage pressures and stable supply chains, inflation could reach the Federal Reserve’s 2% target by the end of this year.

With inflation on a steady path back to 2%, the Federal Reserve has turned its focus to the employment side of its dual mandate. At the Jackson Hole Economic Symposium, Chair Powell noted the committee does not “seek or welcome further cooling in the labor market conditions,” opening the door for the Fed to join other global central banks easing policy.

At its highly anticipated September meeting, the Federal Reserve opted to kick off its rate cutting cycle with a 50-basis point cut, reducing the federal funds rate to a range of 4.75% to 5.00%.  Although some may see the larger move as a sign of the Fed’s concern about the economy, its updated economic projections still predict a soft-landing. Over the next four years, the committee expects steady growth of 2%, and while unemployment rate forecasts rose by 40 bps and 20 bps for 2024 and 2025, respectively, inflation forecasts for the same periods moved lower. With an eye on the labor market, the Fed pulled forward rate cuts in its updated dot plot, penciling in two more cuts for this year but still four cuts in 2025, while the neutral federal funds rate ticked higher to 2.9%.

Today, markets expectations are more dovish compared to the Fed’s forecast, and interest rates could rise modestly from here should somerate cuts fail to materialize. Nonetheless, the long-awaited rate cutting cycle is finally here, and while the pace of cuts hinges on the incoming data, interest rates should settle at a structurally higher level compared to the last decade barring any economic shocks.

Bonds rallied over 5% during the third quarter as cooling economic data and dovish Fed commentary caused markets to double down on rate cut bets. Even after this rally, yields across many fixed income sectors still look attractive relative to recent history.

Yields across fixed income sectors relative to the last 10 years, and nearly all sectors, are trading above their 10-year median yields. Simply sticking with core fixed income provides attractive yields of almost 5%, while leaning into riskier asset classes like high yield can provide yields of about 7%. Credit spreads across investment grade and high yield do look tight. However, corporate fundamentals are still in solid shape and in a trend-like growth environment, spreads can remain tight. All to say, tighter spreads shouldn’t deter investors from taking advantage of attractive all-in yields.

While it’s difficult to make any outsized bets on duration after the recent rally, bonds should help diversify portfolios if lower rates coincide with recession. Moreover, even if rates hold steady, bonds can generate strong returns via attractive coupons, and current yields still offer an attractive “yield cushion” that can help offset losses if rates move higher. As the Federal Reserve moves deeper into its rate cutting cycle, the potential for asymmetric returns in bonds may fade, underscoring the importance of locking in attractive levels of income while they are still here.

Though U.S. equities have returned roughly 50% since the start of 2023, the concentration of these gains among just a few stocks is concerning. Excluding the largest 10 stocks in the S&P 500, the return falls to around 20% during the same period. The outperformance of this group has increased their share of index market capitalization as well. Consequently, future returns, particularly within passive instruments, will be highly sensitive to the performance of this group.

The left-hand side shows that these same names are also the most expensive with a forward price-to-earnings ratio of over 30x. So not only do the top 10 have an outsized sway on index level returns, but elevated valuations could also make for a steep tumble should earnings growth not keep pace with expectations.

But it’s important to remember that membership in the top 10 is not arbitrary; it’s a reflection of the strength of these businesses. We added the chart on the bottom right this quarter to highlight that index concentration is also a matter of economic concentration. These companies capture a disproportionate share of free cash flow and operating income and spend significantly more on R&D, suggesting their large competitive moats may be set to expand rather than erode.

Importantly, the rally has begun to extend to a broader cohort of stocks already, and earnings growth outside of the most dominant companies inflected positive in 2Q24. If economic growth remains steady through the rest of 2024, as we expect, gains should continue to broaden out as the market grinds higher. In this environment, an active approach can reduce concentration risk by taking some chips off the table in favor of less-appreciated opportunities.

The global economy has held up better than expected despite some pockets of weakness. The U.S. and emerging markets excluding China have shown robust growth while Europe, given its manufacturing-centric economy, may continue to face challenges.

The manufacturing sector in Germany, Europe's largest economy, is facing structural issues as policies are driving up energy costs and competition from other vehicle makers. However, strength in the services-oriented economies of Southern Europe, including Italy and Spain, is partially offsetting this manufacturing weakness. Moving forward, rate cuts from the European Central Bank could alleviate pressure on both business and personal lending, helping to spur activity.

In China, the real estate slump continues to hamper growth, inflation remains near zero and domestic demand remains suppressed. However, stimulative policies and government intervention could improve sentiment and stabilize growth around the government's 5% target. Elsewhere in Asia, Taiwan and Korea have benefited from renewed momentum in the electronics sector, while favorable demographics and business policies are expected to sustain India's growth trajectory.

Overall, this year is poised to be a solid one for the global economy, which has thus far managed to avoid recession. As global central banks continue to normalize policy and inflation gradually returns to more manageable levels without a meaningful slowdown in economic activity, global risk assets should continue to trend higher.

A long cycle of U.S. equity market outperformance over international markets has left many U.S. based investors nervous about allocating abroad. While U.S. equity performance has been impressive, it has also driven U.S. concentration in global equity indices to an unprecedented high of 64%. This heavy concentration exposes passive investors to risks specific to U.S. markets, including elevated equity valuations.

In contrast, valuations in most other major markets are in line with, or below, their 25-year averages, with the notable exceptions being the U.S. and India. Enthusiasm for these markets, coupled with robust earnings growth, has resulted in their higher valuations relative to peers. India has experienced over 6% annual economic growth over the past three fiscal years, fueled by strong investment and domestic consumption. Elsewhere, there is significant potential for earnings growth to accelerate. Japan stands out, especially with the return of inflation leading to higher nominal growth, creating a favorable environment for stronger corporate earnings. Additionally, Japan's ongoing focus on improving corporate governance could drive further multiple expansion. In emerging markets excluding China, Taiwan and Korea are witnessing sharp earnings rebound as the tech cycle gains momentum.

In aggregate, international equities present attractive discounts and higher dividend yields compared to their U.S. counterparts. In fact, international equity valuations are trading more than two standard deviations below those in the U.S. Not only that, but international stocks also offer 170 bps of more income. With interest rates likely to settle at a structurally higher level compared to the last decade, there is increased potential for international markets to outperform given their higher exposure to value-oriented sectors. Moreover, with favorable valuations and a range of fundamental tailwinds emerging across markets, investors should find plenty of attractive opportunities abroad.

As stocks climbed higher and bond yields fell during the third quarter, the challenges facing the traditional 60/40 portfolio became even more pronounced. Stocks and bonds remain positively correlated and continue to offer mediocre levels of income. Moreover, elevated equity valuations and low bond yields relative to history point to less impressive returns from the 60/40 moving forward. Against this backdrop, investors may have to look elsewhere for consistent outcomes across alpha, income and diversification.

Investors willing to venture outside of the public markets can leverage a range of different alternative assets to reach their desired outcomes. Indeed, alternative assets can offer low correlations to public markets, diversified income streams and enhanced long-run returns.

Real assets, such as real estate, infrastructure and transport, tend to be less correlated to a traditional 60/40 portfolio while providing robust income. Private equity and venture capital could provide much higher total returns but come with higher correlations to public markets and less income generation.

The classic 60/40 stock-bond portfolio still looks attractive, but adding a sleeve of alternatives can help long-term investors achieve strategic goals through higher alpha, better diversification and enhanced income.

The Market Insights program provides comprehensive data and commentary on global markets without reference to products. Designed as a tool to help clients understand the markets and support investment decision-making, the program explores the implications of current economic data and changing market conditions.

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Your portfolio

I try my absolute best to ensure my human outlook does not spill into your investment strategy.

“Waiting helps you as an investor and a lot of people just can’t stand to wait. If you didn’t get the deferred-gratification gene, you’ve got to work very hard to overcome that.”

-Charlie Munger

As a strategic asset allocator (decisions made based on past outcomes) versus a tactical asset allocator (decisions made based on future outlook), my belief is that future short-term outcomes are not yet known, and that past outcomes are a matter of fact.

Based on this framework, we make systematic determinations for portfolio shifts every quarter. The end result of these determinations was to reduce your overall equity/stock holdings in July of 2021, increase them in July of 2022, reduce them in July of 2023, and then again in April 2024. Note that we are not making a systematic allocation change this quarter.

A graphical representation of what I describe above, contrasted against the S&P 500 index (just one of several market factors) over the past 5 years, can be found below, whereby green dots represent slight shifts into equity, and red dots represent slight shifts out.

From a historical perspective, you may find that this strategy has yielded results that had your portfolio overperform in 2020, underperform in 2021 (shifting out as stocks went up), and overperform in 2022 (despite the down year), 2023 and so far in 2024.

Google and the Google logo are registered trademarks of Google LLC. Used with permission.

We continue to monitor any potential new holdings on an almost daily basis, and continue to evaluate your existing holdings to determine if the reasons we bought them in the first place remain true today.

I hope you find this both interesting and informative in keeping pace with the events of today’s financial world.

This publication contains the opinions of the writer. The information contained herein was obtained from sources believed to be reliable, but no representation or warranty, express or implied, is made by the writer, Designed Securities Ltd. or any other person as to its accuracy, completeness or correctness. This publication is not an offer to sell or a solicitation of an offer to buy any securities. The information in this publication is intended for informational purposes only and is not intended to constitute investment, financial, legal, tax or accounting advice. Many factors unknown to us may affect the applicability of any statement or comment made in this publication to your particular circumstances. Hence, you should not rely on the information in this publication for investment, financial, legal, tax or accounting advice. You should consult your financial advisor or other professionals before acting on any information in this communication.

Embark Wealth is an investments trade name of Designed Securities Ltd (DSL). DSL is regulated by the Canadian Investment Regulatory Organization (www.ciro.ca) and Member of the Canadian Investor Protection Fund (www.cipf.ca ). Investment products are provided by Designed Securities Ltd. and include, but are not limited to, mutual funds, stocks, and bonds. Adam Schacter is registered to provide investment advice and solutions to clients residing in the provinces of British Columbia, Alberta, Manitoba, Ontario, Quebec, and Nova Scotia.