Points in Time, Q1 2024

In this commentary:

What rate cuts? | Canada | U.S. | International | Fixed Income

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What rate cuts?     

Investors who remembered the old Wall Street expression, “The trend is your friend” were well rewarded in the first quarter of 2024, as the stock market rally that started in the last three months of 2023 continued to charge forward. 

Six months to remember

The rally we’ve seen over the past six months has been noteworthy for a few reasons. First, it’s been global in nature, with only a few emerging markets left behind. Second, it’s been broad-based. Although technology stocks continue to lead, other sectors have also participated as evidenced by less tech-heavy markets like Canadian posting excellent returns. Third, it’s been powerful. Although the returns we see in figure 1 are only for six months ending March 31, they’d be considered outstanding for any 12-month period.

Of course, the original source of this rally was the belief that central banks were done raising interest rates and would start cutting them soon. Yet, six months after this belief captivated markets, the only major central bank to cut rates so far has been the Swiss National Bank. Clearly something has changed.

Figure 1: Major index total returns* in Canada, U.S., and International markets 



Source: FactSet
*Returns in CAD dollars

Good news is bad news?

Inflation rates continue to trend in the right direction globally but are not yet down to where central banks want them to be. For instance, Canada’s latest inflation reading came in at 2.8% for February which is a huge improvement over 5.3% a year ago, but still above the Bank of Canada’s (BoC) target of 2.0%. Central bankers want to be certain inflation is near their target before they cut.

But there’s another reason why rates haven’t yet been cut: the economy is stronger than anticipated. In the past couple of years, we’ve gone from debating when and how deep the next recession will be to whether there will be one at all.

In the U.S., economists are now forecasting just over 2% growth in 2024, while just six months ago the forecast was for 0.6% growth. It’s a similar story in Canada. Growth expectations are now near 1% for this year versus 0.5% at the start of 2024.

If the economy is in decent shape, unemployment is low and inflation is moving in the right direction, a reasonable person may ask why cut rates at all? For those hoping for lower rates, a resilient economy is not necessarily good news.

Canada’s conundrum

As economic forecasts have changed, so have market expectations for rate cuts. Both Canada and the U.S. are now looking at 0.75% in cuts this year, versus cuts of 1.0% and 1.5% respectively which were expected at the start of the year. The first cuts are now seen as starting late in Q2.

From our point of view, the BoC is in a tough spot. Our economy has slowed more than the U.S. and with growth expectations still relatively low, cuts are needed. But inflation still isn’t where it needs to be, and with the U.S. economy looking solid, rate cuts there could be delayed. If the BoC starts to cut first, that could hurt our dollar and stoke inflation. 

Additionally, there’s a wall of 5-year mortgages coming due in 2025 and 2026 that will need to be refinanced at much higher rates. This will cause homeowner payments to skyrocket, which will hurt economic growth. Any relief the BoC can give these homeowners will be welcome. The question, again, is when to provide that relief.

It promises to be another year of unpredictability and uncertainty, with fast-changing forecasts and expectations. Such an environment can feel unnerving. But as we’ve seen over the past several years, uncertainty doesn’t necessarily mean poor markets. In fact, it can lead to outstanding outcomes. 

Sources: FactSet, Bloomberg 

Canada

Gil Lamothe, CFA

Senior Portfolio Manager, Canadian Equities

Watching 

The Canadian equity market had a good start to 2024 as the S&P/TSX Composite Index returned 6.6%. After some volatility at the beginning of the year, the market rallied over the latter part of Q1. Longer-term bond yields increased during the quarter, as indications are that the Bank of Canada (BoC) will cut the overnight rate later than previously expected due to concerns about lingering inflation.  

As a result, interest sensitive sectors such as communication services and utilities were weak in the quarter. Higher bond yields are a positive for insurance companies as they allow them to provide for future insurance payouts with more certainty. Technology companies continued their upward momentum due to recent strong earnings results and the overall strength of the technology sector in the U.S.

Increased food and shelter costs are affecting the consumer discretionary sector. Discretionary spending has been weak in some segments of the economy as Canadian consumers have focused on essentials such as groceries and housing. Consumers are buying more in bulk, reducing spending on items that are not essential and looking for value. Reduced discretionary spending has been a headwind for companies such as Magna, Couche-Tard, Canadian Tire and Richelieu Hardware. Figure 2 shows the dramatic increase in the costs of basics over the past year, as well as the recent easing of that trend. As inflation recedes and the BoC begins decreasing the overnight rate, we expect consumer behaviour to normalize once again.

Figure 2: Consumer Price Index comparisons in Canada



Source: Statistics Canada (Seasonally Adjusted)

The communication services sector continues to be challenged, due to lower wireless (cell phone) prices from stronger than normal promotional activity. We’re watching for updates on government regulations that could affect companies such as Telus, BCE, and Rogers Communications. We’ve been cautious on the sector and reduced exposure in 2023.

Thinking

Canadian banks rebounded from lows reached last fall due to better-than-expected earnings, positive sentiment, and the expectation of lower interest rates. Canadian banks do well when interest rates are less volatile. A rapidly rising rate environment results in more loan defaults, while a low interest rate environment can put pressure on profit margins. 

The industrials sector had a good Q1 due to the continued strength of the North American economy. One notable in the sector was CCL Industries. CCL Industries produces complex labels for a variety of products. The company was severely impacted by COVID-19, first negatively with very soft demand, and then positively with supply chain imbalances and excess ordering. The business has strong momentum and should have good earnings growth over the medium term. On the trend of nearshoring, CCL continues to expand production in Mexico, and are nearing the competition of a large manufacturing plant which will significantly expand capacity in one of their segments and reduce their exposure to Asia.  

Doing

During the quarter we rebalanced several positions within our strategies, which had moved materially away from their target weights. In our core Canadian equity strategy, we’ve reduced the weight of Stantec, as we feel the company is fairly valued after being a strong performer over the past few years. We have also increased the weights of Canadian Pacific and Waste Connections due to their demonstrated management quality and consistent growth.

Another adjustment involves transitioning out of Bank of Nova Scotia and into EQ Bank. EQ Bank is growing faster than the large Canadian banks, and due to its smaller size has significant room to increase market share.  EQ Bank has strong capital ratios and a track record of low credit losses.

It’s been a strong start to the year for Canadian equities. We’re cautiously optimistic that eventual rate relief should be a tailwind, though getting there may be a somewhat volatile ride.    

Sources: Bloomberg, Statistics Canada, FactSet

U.S.

Watching

Thinking

We note this quarter that despite recent fears over an impending recession, corporate earnings were strong overall. Earnings for Q4 2023 exceeded consensus expectations by 4%, aligning well with the broader soft-landing narrative echoed by many companies. Other positive trends noted by companies’ management teams include the revenue and cost opportunities from AI, other ongoing operational and productivity initiatives, and relatively strong demand despite post-pandemic demand normalizations. 

Despite the relatively good news so far this year, there are still concerns over high inflation, as evidenced in figure 3 which shows CPI still running well above the Fed’s 2% target.

Figure 3: U.S. Consumer Price Index fluctuations, Jan 2021 – Jan 2024



Source: FactSet

Combined with signs of softening consumer spending and industrial activity, there are some valid concerns about the ability of many companies to sustain margins amid the potential weakening of pricing power. These fears were compounded by some negative trends in Q1 earnings guidance. 

Against this backdrop, our thought process has remained steadfast on trying to identify which businesses can not only weather different types of economic environments, but also thrive and emerge stronger. While virtually every business will eventually encounter challenging periods, such as weaker consumer spending or temporary dips in product demand, our attention lies in discerning which companies’ stocks are priced as if these near-term headwinds are permanent, despite our analysis indicating their long-term potential remains intact.  

Doing

During the quarter, our U.S. portfolio showed a slight outperformance compared with the S&P 500, primarily driven by strong performance of our holdings in NVIDIA and AutoZone. Our decision to abstain from holding Tesla, a weak performer in the index this quarter, also contributed to this outperformance. However, these gains were partially offset by our holding in Intel, which underperformed. We also added three new holdings – Nike, Cheniere Energy, and Elevance Health – and trimmed our holdings in Costco, Fabrinet, Microsoft, NVIDIA, and Johnson & Johnson.

Despite these favourable results, we emphasize our commitment to not fixate on short-term results, whether they’re positive or negative. We continue to invest in high-quality companies with promising growth prospects, competent management teams, strong balance sheets, and consistent cash flows, while ensuring they’re valued at levels offering attractive risk/reward potentials.

Sources: FactSet

International

Ric Palombi, CFA

Senior Portfolio Manager, International Equities and Alternative Income

Watching

We watch with interest – and amusement – at the almost insatiable investor interest in everything AI. The epicenter has been U.S. tech companies, but given the level of interest in this topic, we decided to focus on it from a not-so-well understood global perspective. We believe that AI has the potential to significantly change how the world operates, but we’re also cognizant of the pitfalls and challenges that will come from deploying it. 

As everything from digital chips to natural gas is being promoted as benefiting from AI, it’s important to seek the truth and separate the hype from investment theses. To judge the risks and opportunities for our portfolio and frame our discussion, we classified our holdings into different buckets to help provide a better understand of the AI value chain.

Thinking

Along with the AI chip developers, the first order impact is being felt by some of our biggest holdings in the portfolio (7% combined weight) – ASML Holdings and Infineon Technologies. 

From its monopolistic position, ASML supplies the extreme ultraviolet lithography (EUV) machines that are necessary to manufacture the advanced chips that are designed by NVIDIA, Intel, or AMD. To be competitive and cost-effective, these chips must be made in factories that use ASML’s latest $300+ million lithography machines. Increasing demand for AI chips is, therefore, directly geared to higher demand for these EUV machines.

Infineon designs and manufactures the power electronic chips that are used to generate, transmit, convert, and deliver the power to data centers. These chips are thus used in the broader electrical grid, the power system inside a building, and the digital power system within the various servers. So, Infineon benefits from the rapid increase in both the number of servers, data centers, and their increasing power consumption.

The next set of beneficiaries are companies that deploy AI. Naturally, these are software-led companies, and in our portfolio, these include SAP, Adyen, Alibaba, and Tencent (7.3% combined weight). These companies already sit at the crossroads of commerce and have unfathomable amounts of data that has been collected over the years. By applying advanced analytics and AI to this data, they can help deliver increases in efficiency, improve productivity, and reduce fraud, among other things, for their clients. All these AI-enhanced services and products are naturally priced at a premium for customers and are expected to improve sales. 

Finally, the tangential beneficiaries include companies further up in the value chain such as Vestas or utilities like E.ON, Enel, and RWE (6.4% combined weight). Data centers are already driving a huge uplift in power consumption, and we’ve already seen regions like Ireland rejecting new data center capacity as there’s insufficient supply. 

In Ireland, existing data centers already account for 25% of national electricity demand and this is expected to grow to 32% by 2026 (source: IEA via FT). Figure 4 shows the expected growth in power demand in the U.S. from data centers. By 2027, the share of power consumed by these facilities is expected to triple from the current 2.5% to 7.5% of total U.S. generation (source: Bernstein Research). Similar dynamics are expected in other countries in Europe and Asia. 

Figure 4: Data center power consumption (GW)



Source: McKinsey & Co estimates, Bernstein analysis 

As many of the computing companies have self-imposed mandates to purchase renewable energy for their data centers, we expect this to drive an incremental uplift in demand for Vestas’ wind turbines. Utilities are expected to benefit too from higher power generation and utilization of their infrastructure. The additional investments needed to support incremental demand will also drive a higher rate base, which should translate into higher earnings. 

Doing

We continue to execute in line with our investment process and make suitable changes as necessary. To that end, as we assess the risk/reward of the entire AI value chain we maintain that there are investment opportunities that have yet to be fully exploited. In particular, we view companies like RWE and Vestas in the utility space as having very favorable risk/reward with AI benefits underestimated by investors.

Sources: FactSet, McKinsey & Co. estimates

Fixed Income

Malcolm Jones, MBA, CFA
Senior Portfolio Manager, Fixed Income 

Ric Palombi, CFA
Senior Portfolio Manager, International Equities & Alternative Income

Watching

Over the first quarter of 2024, we continued to see a lot of near-term volatility in the yield curve. At the same time, this volatility washes out when looked at over longer time periods. Over three months, the yield curve has only moved up marginally, but has shown a good deal of day-to-day movement. This can mostly be attributed to the market trying to interpret where central banks will move the bank rate. The market started the year expecting five to six cuts over the year, possibly beginning in February. The market now expects two to three cuts over the year, with the first coming in the summer.

Credit spreads declined in the quarter, continuing a trend from the fourth quarter of 2023, as seen on figure 5. Interestingly, the decline seems to be more pronounced the lower the quality of the bond. Currently, BBB bonds (the lowest investment grade bond) have a spread close to the bottom of its historical range. BB bonds (the highest non-investment grade bond) have a spread that’s actually below its historical range. CCC bonds (very high risk of default) have seen steady gains for 14 straight sessions, the longest winning streak in more than three years, while yields hit a 10-week low at 11.92% and spreads plunged to a fresh two-year low of 726 bps. The breakout for CCCs, and continued compression in the spread gaps between ratings tiers, highlight aggressive risk taking in the lowest-quality borrowers.

Figure 5: Credit spreads to U.S. Treasury

 

Source: Bloomberg

Markets seem to be discounting the possibility of any kind of significant slowdown. Expectations are for a mild recession at worst, and likely just a slowdown.

Thinking

We have increased confidence that long-term inflation will return to around 2%. Applying an historical premium over inflation, we feel that the current long-term yield of 3.5% is quite reasonable, and do not anticipate much change in this yield. Conversely, bank rate cuts are expected to contribute to a decrease in short rates. Over the next few years, short rates could decline up to 200 basis points. 

This improved inflation outlook is consistent across Canada, U.S., and ECB. This consistency gives us comfort that there should not be excessive pressure on exchange rates.

Improved economic data suggest that the economy is more resilient that some thought. But lower credit spreads argue that some of the outsized returns from credit exposure may be behind us. There are still good opportunities in credit, but not to the same extent as we saw last year at this time. 

Thinking specifically about the sharp decline in non-investment grade bond spreads reminds us of the importance of doing appropriate due diligence and fully understanding the bonds that we hold. There’s less cushion for error. An improved economy may decrease the probability of a non-investment grade bond going into distress. However, changes in covenants and changing market dynamics have meant that should a bond go into distress, recovery rates have declined. For those companies that do not default, there are buyers willing to buy bonds and allow companies to extend their maturity dates.

We continue to watch national debt levels. It’s an interesting phenomenon where many economists will point to debt levels being an issue, but governments won’t do anything until it becomes a critical issue. Note the upcoming U.S. election, in which fiscal restraint is not an item (so far, at least) on anyone’s platform.

Doing

We continue to be overweight credit. There’s still opportunity here, but not to the same extent as last year. We’re slightly longer in duration than the benchmark. We are holding a barbell approach with some long-dated bonds providing solid income, and some short-dated bonds proving opportunities for capital gains as bank rates decline.

Source: Bloomberg

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