Market Perspective - Summer 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 biggest economy in the world and our largest trading partner) remained strong in the first half of the year with solid consumer spending and a normalizing labor market. However, inflation has been slow to decrease, prompting the Federal Reserve to maintain a cautious stance with plans for only one rate cut this year. Globally, other central banks are easing their policies, potentially keeping the U.S. dollar strong.

Bonds bounced back after a tough start, and stocks hit new highs. Expected earnings growth should make the stock market rally more inclusively than what has mostly been concentrated into the Magnificent 7. The high interest rate environment offers opportunities to secure attractive yields in fixed income investments. Additionally, alternative investments like real estate and private equity can provide better income, returns, and diversification.

Economic growth slowed from 3.4% in late 2023 to just over 1% in early 2024, but the labor market stayed strong with low unemployment. Increased immigration boosted the labor supply, helping control wages and inflation. However, core inflation remains stuck between 3.1% and 3.5%, with high shelter and auto insurance costs.

Globally, the economic outlook is improving, with positive signs in Europe and strong demand in Asia, especially India. Bonds now offer higher yields, potentially presenting an opportunity to secure income amounts. International markets also look attractive, despite recent gains.

Traditional portfolios may face challenges due to positive stock-bond correlations and low historical yields. The addition of alternative investments in a portfolio can enhance income, diversification, and returns.

Overall, the U.S. economy seems likely to achieve a soft landing into next year, supported by a strong labor market and consumer spending. However, risks from geopolitical tensions, the upcoming U.S. election, and high policy rates remain, so investors should stay vigilant and consider a diversified approach.

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:

Despite some weakness at the headline level, underlying U.S. economic momentum remained solid in the first half of the year. At the same time, progress on inflation has been very slow, while the labor market has continued its gradual normalization. Moving forward, a resilient consumer should allow the U.S. economy to sustain a soft landing into next year. However, with still elevated geopolitical tensions and an upcoming U.S. election, risks remain that are worth monitoring.

Meanwhile, sticky inflation has forced the Federal Reserve to reassert its hawkish tone. At its June meeting, the Fed’s updated dot plot showed that it expects to deliver just one rate cut this year, down from the three cuts they projected in March. That being said, while they have delayed rate cuts, the Fed has begun to slow the pace of quantitative tightening. Elsewhere, other global central banks have begun to ease policy and a widening gap in short-term interest rates between the U.S. and other major developed economies could maintain the U.S. dollar in an elevated position for some time to come.

Bonds have rebounded after a challenging start to the year, while equities have maintained their upward trajectory and notched multiple new all-time highs during the second quarter. Moving forward, broadening earnings growth should support a more inclusive stock market rally, while investors may want to use this extended period of higher rates to lock in attractive yields in fixed income. Outside of traditional markets, alternatives can help better prepare portfolios for challenges that may lie ahead, whether it be through enhanced income, alpha or diversification.

In this edition of the Guide to the Markets, 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. Finally, we consider the implications of all of this for those investing across asset classes and highlight the importance of getting invested, even with markets near all-time highs, and actively engaging with opportunities in alternative assets.

At first glance, the U.S. economy appeared to slow sharply during the first quarter, with real GDP growth falling from 3.4% annualized in the fourth quarter to just over 1%. However, after stripping out net exports and inventories, which are the most volatile major components of GDP, underlying economic momentum still looks solid, and the U.S. economy should maintain a soft-landing into 2025. Consumers have displayed impressive strength, supported by a tight labor market.

That said, we do see some signs of stress. Sentiment remains suppressed, while spending on nondurable goods has slowed in recent months, a sign of mounting stress on lower income households. Moreover, auto and credit card loan delinquencies have risen above their pre-pandemic levels. Despite this, a still tight labor market and rising real wages should continue to offset dwindling excess savings and tighter credit conditions, and consumers should help extend this economic expansion into next year. Business spending has been surprisingly resilient over the past year, largely due to healthy corporate balance sheets, government incentives and surging demand for AI-related technologies.

Tailwinds from AI spending and the federal government should continue to partially offset the impact of higher interest rates, although any slowdown in corporate profits could constrain growth in capital expenditures. The housing market has stabilized but remains depressed, and while elevated mortgage rates will limit any significant reacceleration in the sector, tight supply suggests a recovery in activity is more likely than another meaningful decline.

International trade may be a slight drag on the economy as a still-strong dollar weighs on exports, although prospects for global growth are improving. Meanwhile, increased spending on public infrastructure and stronger hiring should continue to support government spending. Overall, the U.S. economy looks set to maintain its soft landing trajectory into next year. That said, with an upcoming U.S. election, high policy rates, and elevated geopolitical tension, plenty of risks remain that could cause the U.S. economy to falter.

While the labor market has normalized from its postpandemic boom, job growth remained solid in the first half of 2024. The unemployment rate edged up to 4% in May but still marked the 30th consecutive month of unemployment at or below 4% – the longest such streak of low unemployment since the late 1960s. Despite fears of an economic slowdown, strong growth in the U.S. labor supply has allowed employers to hire workers and narrow the gap between supply and demand.

After falling sharply during the pandemic, labor supply in the U.S. staged an impressive recovery over the last two years, largely due to increased immigration. In fact, in fiscal year 2023, Immigration Services approved over 2 million initial applications for employment authorization, a 70% increase from a record 1.2 million in fiscal 2022. With this surge in migrant workers, employers were able to fill open job openings without applying upwards pressure to wages, helping to explain why strong job creation hasn’t sparked higher inflation. Importantly, a strong recovery in the labor force participation rate has also boosted labor supply. While continued aging of baby boomers into their retirement years has left the overall labor force participation rate below prepandemic levels, participation amongst the working age population, or those aged 18-64, has fully recovered its pandemic losses.

Moving forward, tighter labor supply, falling job openings and solid productivity growth could slow the pace of job gains. That said, a backlog of migrant workers waiting to be integrated into the U.S. economy suggest that employment growth should remain solid, and the unemployment rate should stay low.

Inflation has made meaningful progress toward the Federal Reserve’s 2% target. However, that progress has stalled in 2024, and headline CPI has been rangebound between 3.1% and 3.5% since last October. While the journey back to 2% may take longer than expected, there are still disinflationary forces that should allow inflation to resume its downward path in the back half of the year.

Core goods prices have continued to trend lower in 2024 as supply chains have remained well managed, even with recent conflict in the Middle East, and should remain well behaved. On the more volatile components, energy prices have rebounded in recent months due to higher gasoline prices while food inflation has remained mild. Moving forward, slow 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. In fact, the measure has grown by 0.4% or above month-to-month for 7 consecutive months. That said, shelter inflation should follow real-time measures of market rent back to more normal levels. Auto insurance has been another source of hot inflation and is currently rising by over 20% year-over-year. Fortunately, prices here actually fell on a monthly basis in May, suggesting that pressures are improving, not worsening. As the rollover in vehicle and auto prices feed through the data, this trend lower should continue.

Overall, inflation should continue to ease through the balance of 2024 and into 2025. While the ride down may take longer than anticipated, the Fed should feel reasonably confident that inflation can fall close to their 2% target by the middle of next year without further policy tightening.

The resilience of the U.S. equity market in 2024 has been very impressive. Despite a sharp hawkish repricing in policy expectations, stocks showed few signs of slowing, and the S&P 500 is up about 15% this year. That said, as we show on the left of slide 12 from the Guide, this rally has remained narrow in nature, and the “Magnificent 7” continue to lead the charge higher. In fact, this cohort of stocks is already up over 30% this year whereas the rest of the index is up just 5%.

That said, strong performance from the “Magnificent 7” isn’t without reason. These companies were large beneficiaries of excitement around artificial intelligence and were responsible for all the S&P’s earnings growth in 2023. While this dynamic continued to play out during the 1Q24 earnings season, other companies across sectors are expected to see earnings improve in the coming quarters. As 2024 progresses, earnings growth should broaden out to the rest of the index, supporting a more inclusive, and sustainable, equity market rally.

Stalling progress on disinflation has forced the Federal Reserve to reassert its hawkish tone in recent months. While the Fed continues to have a bias towards easing policy, it needs more evidence that inflation is trending in the right direction before cutting rates.

At its June meeting, the Federal Reserve left rates unchanged in a range of 5.25% to 5.50% and reduced the number of expected rate cuts in 2024 from three to just one, although they added one cut to the 2025 forecast. In its updated projections, the committee increased its headline and core inflation forecasts for 2024 by 20bps and left its growth forecasts unchanged. This suggests that the committee still expects a soft-landing, but also a slower path down to its 2% inflation target.

While the Fed didn’t deliver rate cuts in the first half of the year, it did slow the pace of quantitative tightening. The Federal Reserve is now only letting $25bn in Treasuries mature off its balance sheet each month, down from $60bn, while they left the mortgage-backed securities cap unchanged at $35bn. This should leave the Fed with much larger Treasury holdings than before the pandemic and help hold long-term interest rates down.

Moving forward, with market expectations and Fed messaging very much in sync, it would likely take a meaningful change in the economic outlook to trigger any sharp movement in long-term interest rates in the months ahead.

After a sluggish ending to 2023, prospects for the global economy appear to be turning a corner in 2024. Countries that have done well, like the U.S. and India, should continue to do so, while those that have lagged, like Europe, should see better times ahead.

Economic surprises in Europe have turned positive in recent months, a sign of too much pessimism toward the region. Activity has been supported by higher consumer confidence due to rising real wages and stabilizing manufacturing activity. In China, the real estate slump continues to hamper growth, and while activity has gained momentum in recent months, incoming data on employment and inflation continue to look weak. That said, as fiscal support turns to focus on housing, growth should stabilize around 5%. Elsewhere in Asia, Taiwan and Korea should benefit from renewed global demand for tech-related exports, while favorable demographics and economic reforms should continue to feed momentum in India.

Overall, this year should mark a turning point for the global economy, and while the recovery may not be even across countries, brighter times are ahead. With U.S consumer activity expected to slow, narrowing growth differentials should highlight plenty of attractive opportunities across global markets.

Bonds struggled in the early 2024 as investors reconsidered the outlook for rate cuts. That said, as market and Fed expectations have converged, bonds have rebounded, and recent performance has stabilized. Still, the move higher in rates has dramatically improved the income offered by fixed income, and investors now have an extended opportunity to lock in higher yields.

Slide 37 shows yields across fixed income sectors relative to the last 10 years, and nearly all sectors are trading well above their 10-year median yields. Simply sticking with core fixed income provides attractive yields above 5%, while leaning into riskier asset classes like high yield can provide yields of almost 8%.

While bonds may not provide meaningful capital appreciation without any major shock, they should help diversify portfolios if lower rates coincide with recession. Moreover, higher yields offer an attractive “yield cushion” that can help offset losses if rates move in the other direction. This potential for asymmetric return in bonds won’t last forever, underscoring the importance of leaning into fixed income while yields are at these elevated levels.

U.S. equities have been on a tear over the last year and a half, gaining more than 40% since the start of 2023. However, the concentrated nature of this rally has created divergence beneath the surface. While valuations at 21 times forward earnings look concerning, there are still plenty of attractive opportunities outside of the select few Mega Cap stocks that have dominated this rally.

On the left of slide 11, we compare the price-to-earnings ratio of the top 10 stocks in the S&P to that of the broader index. The historically narrow nature of the recent rally has left the top 10 stocks significantly more expensive than the broader index, while the remaining stocks look cheap comparatively and are trading closer to their long-term average.

Indeed, index concentration is not a new phenomenon as the weight of the top 10 stocks in the S&P 500 has been rising since 2016. However, while the top 10 stocks dominated earnings growth last year, their earnings contribution hasn’t kept pace over the long run. With the top 10 stocks now representing a roughly a third of the index but only a fourth of the earnings, there appears to be a strong case for investing in the rest of the index.

If economic growth remains steady through the rest of 2024, as we expect, gains should broaden out beyond the largest names as the market grinds higher. In this environment, an active approach can help identify those companies with high quality earnings and attractive valuations that are being overlooked by the market.

A long cycle of U.S. equity market outperformance over international markets has left many U.S. based investors nervous about allocating abroad. However, there are attractive fundamental tailwinds around the world that are difficult to ignore. In fact, well over half of the 50 top performing companies this year are located outside of the U.S. Slide 47 of the Guide aims to highlight opportunities that investors may be missing.

In terms of earnings growth, the U.S. has been the standout market, although prospects in other countries are improving. For example, higher wage growth in Japan could create a positive wage-price spiral, which should boost company revenues and improve Japan's sleepy economy. Moreover, continued focus on improving corporate governance could generate additional multiple expansion. In Europe, stabilizing manufacturing activity and an improving economic backdrop should support earnings. Peak pessimism towards China appears to be behind us, and Emerging Market earnings estimates have improved on the back of AI tailwinds and optimism for a turn in the electronics cycle.

Strong performance across international markets has pushed valuations higher over the last 6 months. However, in both absolute terms and relative to their own histories, international markets continue to look attractively priced compared to the U.S. Importantly, given that some global central banks have begun easing policy while the Fed is likely to remain on pause, a strong U.S. dollar could weigh on returns for U.S based investors. Even still, favorable valuations, an improving economic backdrop and positive fundamentals should highlight plenty of opportunities around the globe.

The first half of 2024 underscored the challenges facing the traditional 60/40 portfolio. Stocks and bonds remained positively correlated and continued 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, as we show on slide 56 of the Guide, alternative assets can offer low correlations to public markets, diversified income streams and enhanced long-run returns.

Real assets shown towards the left, 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, towards the right, 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.

Resilient economic activity and solid earnings growth have powered the S&P 500 past over 30 new all-time highs so far this year. Many investors may feel like they missed the boat, leaving them on the sidelines waiting for a pullback. While investing at all-time highs can be daunting, page 64 of the Guide shows that even at all-time highs, markets can still be attractive.

On the left, we show the S&P 500 price index in gray and mark each all-time high that set a “market floor,” or an all-time high from which the market has never fallen more than 5%, in green. If an investor had planned to wait for markets to retreat from all-time highs before investing, there would have been many instances since 1950 in which an investor would have missed the boat and never seen a better entry point.

On the right, we show the average cumulative total return for the S&P 500 over different time horizons when investing at new highs versus investing on any given day. Importantly, returns generated from investing on any day are similar to returns from investing at alltime highs. In fact, for most of these time horizons, returns were more favorable when investing at all-time highs. With momentum playing an increasingly important role in today’s market, investors sitting on the sidelines should remember that strong performance usually begets more strong performance.

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Your portfolio

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

"Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas." — Paul Samuelson

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, then increase them in July of 2022, and then reduce them again in July of 2023. Note that we recently made a systematic shift to reduce our equity exposure in April 2024.

A graphical representation of what I describe above, contrasted against the S&P 500 index (just one of several market factors) over the past 4+ 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) and 2023.

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.