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18 min read

Points in Time, Q2 2024

Investors are showing more concern now for the social, political and economic direction of our world than ever before. Learn what our investment team has to say about the pause in CAD markets, the U.S. market’s resilience, French politics, and central banks’ caution with further rate cuts.

In this commentary:

Our summer of discontent | Canada | U.S. | International | Fixed Income

 

Read the issue as a digital newsletter


Our summer of discontent

Scott Blair, CFA
Chief Investment Officer

 

On a recent cross-country investment roadshow, we had the pleasure of presenting to clients and investors in five different cities. Cognizant of the diversity in such audiences, we always first seek client feedback to inform our presentation, then collaborate with our firm’s relevant subject matter experts on what’s paramount on our clients’ minds. Sometimes the topics are obvious, such as pandemic impacts on the market or our recent bout of runaway inflation. This time, the sheer number of items was too overwhelming to narrow down. In fact, it’s hard to think of a time, outside of a recession, where investors have felt so concerned about the direction of our country, economy or world in general. 

Widespread angst

Among the pre-submitted questions we received from clients prior to the events, we noted over a dozen substantial themes that had multiple questions attached to them in one way or another. Some examples are:

  • Inflation – is “normal” around the corner?
  • Exploding government debt – when will there be an impact to the economy?
  • Upcoming elections – what if Trump wins? What would a conservative government look like in Canada?
  • Interest rates – what’s the outlook and the impact on housing?
  • Artificial Intelligence – how will this impact the markets?

No doubt, there’s a lot to be concerned about these days. And widespread, non-stop access to information through seemingly unlimited sources amplifies every concern. Whatever the issue, there’s a website, video or news outlet that lets you journey down the rabbit hole to confirm your worst fears.

Stock market keeps rolling

With all the negativity out there, one might reasonably expect that global stocks would be having a difficult time. This is incorrect. In fact, returns for the first half of 2024 are outstanding in most markets (see figure 1). Going further, returns so far in the 2020s have been strong, despite a pandemic and two bear markets (a fall of more than 20% from its peak) in the last four and a half years.

 

Figure 1: Market returns in CAD$

Index 2024 YTD Total returns this decade
IndexCanada 2024 YTD6.1% Total returns this decade47.4%
IndexU.S. 2024 YTD19.4% Total returns this decade91.7%
IndexEAFE 2024 YTD9.6% Total returns this decade38.0%
IndexEM 2024 YTD11.7% Total returns this decade16.7%

All figures in Canadian dollars, December 31, 2019 to June 30, 2024
Canada = S&P/TSX Composite Index, U.S. = S&P 500 Index, EAFE = MSCI EAFE Index (Europe, Asia, and Far East), EM = MSCI Emerging Markets Index

Sources: Bloomberg, FactSet

 

The market has been able to shrug off the concerns that keep us up at night because corporate earnings expectations have remained resilient and growing. Earnings and interest rates are what drive stock markets. As individuals, we care about a lot of things that the market simply doesn’t.

 

Figure 2 shows the S&P 500 Index this decade, along with expectations for earnings over the next twelve months (NTM). The two are highly correlated. The S&P 500 fell sharply in early 2020 and again in 2022 as the outbreak of the pandemic and rising interest rates (to quell inflation) respectively hurt earnings expectations. With rates now likely having peaked and the economy still growing, investors are anticipating stronger earnings growth and bidding the market higher. Although we’ve shown the S&P 500 here, a similar correlation exists for most global markets.

 

Figure 2: Earning and stock markets move together

Figure 2: Earning and stock markets move together

Source: FactSet

All clear?

Despite the robust returns we’ve seen recently, there’s no doubt we’ll see more market corrections and bear markets in the future. The only questions are: when, and what will be the catalyst? Unfortunately for investors, most major selloffs are caused by events that are hard to predict. Of the two bear markets we’ve had so far this decade, one was unforeseen by most (inflation wasn’t transitory) and the other was unforeseen by virtually all (the global pandemic).

 

An investor with a crystal ball may well have been able to foresee both events, but would they have been better off? It depends. Getting out of the market is one thing – knowing when to get back in is another. With many major markets at or near all-time highs, you’d have needed impeccable timing to beat a strategy of just staying invested.

 

Sources: Bloomberg, FactSet

Canada

Gil Lamothe, CFA
Head of Canadian Equities, Senior Portfolio Manager

Watching

The Canadian equity market, as measured by the S&P/TSX Index, has taken a pause in Q2 this year, posting a return of -0.5% from May to June 2024. Notwithstanding the recent reduction in interest rates, signalling the beginning of an easing cycle, many sectors saw weakness recently. Technology was down 5.6%, led by Shopify, down 13.5%, which reported a good quarter, yet warned of weaker margins going forward as they spend on developing increased functionality and AI features for their online products.

 

Industrials was also weaker. Transportation was the theme here, with the rails, CPKC and CNR, being down 8.9% and 9.6% respectively. Volumes have weakened slightly across the transportation spectrum and there’s concern of a possible strike at both railroads. Labour issues will likely be sorted out, but uncertainty may linger until the end of July.

 

Both the communications and consumer discretionary sectors continue to face challenges. Telcos are competing with one another on wireless pricing, while the CRTC is deciding how fiber-to-the-home will be priced to allow or promote competition within that space. Both are headwinds that will slow the growth in these sectors. Magna, a consumer discretionary stock, was down a further 21.5% in the quarter as weakness continues in the auto industry globally. Higher interest rates have certainly affected consumer spending behaviour.

 

Conversely, consumer staples saw a positive return of 4.2%, with Saputo leading the way with a 16.0% return. The company, a global cheesemaker, announced the sale of some milk producing facilities in Australia, which was an important part of a wider plan to improve efficiencies. The market clearly liked the news. Another sector which stood out was materials, or more specifically, gold stocks. Many of them were up between 10% and 30%, helping the overall sector to come in at 7.4% in the quarter. The yellow metal traded through $2,300 USD per ounce in April and has managed to hold that level.

 

Thinking

Since April, the S&P/TSX Composite Index has become somewhat directionless (see figure 3). Now that the long-anticipated rate easing cycle has begun, market participants are focused more on fundamentals, and perhaps concerned about valuations. This is also in part due to interest rate reductions being somewhat slower than many had hoped, which delays or attenuates the growth that was anticipated to be fuelled by the rate cuts.

 

Figure 3: Directionless CAD Equity market - S&P/TSX Composite

Figure 3: Directionless CAD Equity market - S&P/TSX Composite

Source: Bloomberg

 

We’ve seen a number of dividend increases this year, but are also concerned with the prospect for continued dividend growth in some sectors. With heated price competition among the incumbent telcos, we’ve already seen a slowdown in BCE’s dividend growth and expect more of the same from the sector overall going forward. In utilities, Emera has announced that its dividend growth will slow to around 1%, as it focuses its capital resources on new investments.

 

Doing

Element Fleet Management is a company we’ve owned for some time within our Core Canadian Equity strategy, where capital appreciation is the focus. They’re a global leader in managing fleets of cars and small trucks for companies who want to outsource their fleet management needs. Element generates significant cash flow and has been returning that to shareholders through dividends. We’ve recently added it to our dividend strategy, having noted that they’ve been growing their dividend at over 25% for the past three years and are poised to continue growing it in the high teens going forward. We funded that purchase by selling our Canadian Utilities position, whose dividend growth is 1-2%, with little prospect of improving.

 

Sources: Bloomberg, Statistics Canada, FactSet

Q2 2024 Dividend performance summary
 Canadian Dividend Portfolio
Number of companies in the equity portfolio 31
Number of companies that declared an increased dividend 16
% of companies that declared an increased dividend 51.5%
Weighted average of dividend increase 2.63%
Consumer Price Index increase (YoY*) 2.90%
Equity portfolio dividend yield** 4.75%
S&P/TSX dividend yield 3.39%

*Estimate from Statistics Canada May 31, 2024

**The dividend yield is based on the Leon Frazer Canadian Dividend Fund using the target weight for cash. Dividend performance numbers are year to date and express growth statistics only. These are not rates of return (as with the other portfolios).

 Top 10 dividend growers
Brookfield Asset Management 18.8%
Intact Financial Corp 10.0%
Manulife Financial Corp 9.6%
CCL Industries 9.4%
Canadian National Railway 7.0%
Brookfield Renewable Corp 5.2%
Canadian Natural Resources 5.0%
Russel Metals 5.0%
Sun Life Financial Inc 3.8%
Telus Corp 3.5%

Source: CWB Wealth

U.S.

Liliana Tzvetkova, CFA
Co-Head of U.S. Equities, Senior Portfolio Manager

Saket Mundra, CFA, MBA
Co-Head of U.S. Equities, Senior Portfolio Manager

 

Watching

The S&P 500 Index continued its upward trajectory in the second quarter, finishing with a total year-to-date return of approx. 15%. While concerns around the impact of higher rates, health of the consumer and the upcoming presidential election have continued to remain in the news, the U.S. market’s resilience has surprised many. Many of the prevalent narratives, such as Artificial Intelligence and obesity drugs, continued in the second quarter which led to a persistent rally in a handful of names exposed to these themes . With returns being driven by a handful of stocks, naysayers have found comfort in how narrow the rally has been.

 

Not surprisingly, technology and communication services remained the best performing sectors during the quarter and on a year-to-date basis. Many of last quarter’s winning sectors, like industrials, energy, financials and materials, took a breather during the quarter and ended up on the losing side.

 

Thinking

As usual, many theories are being circulated to explain the existing market dynamics. We believe that, ultimately, corporate earnings and investors’ expectations dictate price movements and returns. As seen in figure 4, analyst expectations have been fairly low over the last several quarters, while the actual results have been far ahead. For the upcoming quarter, the bar is much higher. Though the markets continue to make new all-time highs, upcoming election uncertainty and these higher expectations could result in increased volatility.

 

Figure 4: Actual earnings vs expectations - S&P 500 Index

Figure 4: Actual earnings vs expectations

Source: Bloomberg

 

While volatility may scare typical market participants, it provides opportunities for long-term fundamental investors. Needless to say, a volatile environment preceded by one of the narrowest market rallies, makes security selection paramount. Our investment process and fundamental research approach make us ready to take advantage of any such scenario.

 

Doing

We continue to be prudent in balancing varied and unpredictable risks, while seeking incremental returns for our U.S. equity strategies portfolio. This has been done by introducing new securities in the portfolio at smaller weights over the past several quarters. This quarter, we initiated a small position in Disney which we deem to offer a good risk-reward proposition. We sold Disney at the peak of streaming euphoria a few years ago and have followed the business since. We believe that under the current management, Disney is on a path to becoming a better managed company with purposeful investments, in rejuvenating its creative core and brands.

 

If we had a crystal ball that predicted stock prices, it would have made our jobs easier in managing portfolio holdings such as NVIDIA, which is up 600% since our initial purchase in early 2022. The question now becomes what to do with our position in the stock after such a dramatic rise. On the one hand, the company has performed well beyond most investors’ expectations and the upside from here is more limited. On the other, we are likely just at the beginning of a super cycle for AI and an optimistic view supports further upside. As stewards of our clients’ capital, we use various frameworks to deal with all investment opportunities in front of us and allocate appropriately. Accordingly, we still see upside in NVIDIA but have been trimming our holdings after this phenomenal run, as we see attractive risk-reward in other opportunities.

 

With our long time horizon and focus on understanding the companies we invest in, we believe we can meet the risk and return thresholds that our clients expect of us.

 

Sources: FactSet, Bloomberg

International

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

 

Watching

The U.S. presidential debate isn’t the only political drama grabbing headlines. In France, President Macron surprised everyone on June 9 by calling snap elections after his party’s poor performance in the European Parliament elections. French markets reacted negatively on concerns that Marine Le Pen’s right-wing party, running on a platform of higher public spending, may win.

 

The event again highlighted France’s challenging fiscal position. Concerns around unsustainable public finances has led to capital outflows, resulting in higher bond yields and asset price deflation. In the last month, the yield spread between French and German 10-year bonds widened by approx. 30 basis points to approx. 77 basis points while the CAC 40 Index, the benchmark for French stocks, is down about 6% since June 10 (after the snap election was announced) (see figure 5).

 

Figure 5: Politics weighs on the French stock market

Figure 5: Politics weighs on the French stock market

Source: FactSet

 

Thinking

The decline in the CAC 40 indicates that the market is pricing in some political risk. Additional uncertainty or poor policies can lead to further declines. Financials, utilities, and infrastructure stocks have been most impacted as these would be the most prone to policy impacts.

 

While uncertainty often causes market volatility in the short term, our strategy remains apolitical and focused on long-term fundamentals. Corrections are an opportunity for us to take advantage of dislocations between the price and value of businesses that meet our investment process. A quote that well reflects our mindset during such times is to “never let a good crisis go to waste”.

 

Our experience in Europe has taught us that no matter which party wins, left or right, markets force governments to gravitate towards the centre. A vivid recent example of this was when former U.K. Prime Minister Liz Truss presented her budget with a large deficit. This created a lot of stress within financial markets as the Pound fell to its lowest level against the Dollar while U.K. gilt (government bonds) prices collapsed driving yields significantly higher. This eventually led to a reversal of the policies and ended Truss’ political career. She resigned after only seven weeks on the job.

 

French politicians would be well-advised to learn from the mistakes of their U.K. counterparts and respect fiscal discipline and the financial markets.

 

Doing

Dealing with numerous European political crises over the years has taught us that “history doesn’t repeat but it often rhymes”. We have hence developed a playbook to take advantage of the market volatility that inevitably follows political upheaval.

 

Banks are often the canary in the macro volatility coal mine and we saw once again that bank stocks were down twice as much as the broader market. This happens because major changes to economic policies, interest rates, government bond yields, and economic activity have a direct impact on a bank’s profitability. Additionally, widening spreads on government bonds have an outsized negative impact on bank balance sheets.

 

When to buy?

With BNP Paribas (BNP) down over 12% at one point since the snap election announcement, we believe the market overreacted as the valuation reflected a dire outcome. For a bank that generates a respectable ROE of 15%, a valuation of 0.6x price-to-book and a P/E ratio of 6x is simply too low.

 

Often called the JP Morgan of Europe because of the similarity in their business models, only 25% of BNP’s revenue and 8% of pre-tax profit come from France. Additionally, less than 2% of its total assets are exposed to French bonds, making higher interest rates and higher spreads between French and German bonds negligible. The strength of the bank’s balance sheet is evident with a Common Equity Tier 1 (CET1) ratio of 13.1%, which allows BNP to reward its shareholders with an 8% dividend yield, plus an extra 10% via buy backs.

 

All points considered, we felt this correction was a great opportunity to add to our position.

 

Source: FactSet

Fixed Income

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

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

 

Watching

In Q2, benchmark bonds, as measured by the FTSE Canada Universe Bond Index, produced a return that was more in line with expectations. This reflects how market expectations of bank rate cuts are more aligned with thoughts from central banks. The Bank of Canada (BoC) did cut its bank rate in June, as did the European Central Bank (ECB). Canadian inflation continues to move towards the target of 2%. The U.S. Fed and Bank of England remain on hold waiting for more supportive economic data. Central banks’ discussions emphasize the need for caution in proceeding with further rate cuts. They note that prior actions need time for the impact to flow through the economy, while also noting that rate cuts cannot be overly delayed as that could lead to a recession.

 

Credit spreads are virtually unchanged on a quarter-on-quarter basis despite continued day-to-day volatility, and credit spreads are at the lower end of their historical range. Similarly, longer-term yields are largely unchanged for the quarter, while shorter-term rates have declined in line with the bank rate cut announced by the BoC.

 

Thinking

Central banks remain on alert for a potential resurgence of inflation. While the general direction is for further cuts over the next 18 to 24 months, it’s reasonable to expect the cuts to be punctuated by a meeting calling for a pause. The stated goal of central banks is to return the bank rate to “neutral”, that is, a rate that neither stimulates nor contracts the economy. This gives us comfort in saying that shorter-term yields have room to decline, while longer-term rates may show minimal movement.

 

Should the BoC make multiple cuts before the U.S. Fed starts to, there could be an effect on the exchange rate. At this point, we don’t feel there’s sufficient disparity between Canada and the U.S. to make this exchange rate effect any more than “something to watch”. It’s worth noting that a national election in both the U.K. and U.S. suggest that the respective central banks may delay changing policy until after the election to avoid any appearance of political influence.

 

We feel there’s still value in holding credit bonds, but note that credit spreads are at low levels. Opportunities for outsized gains will become less prevalent. At this point, we don’t see evidence of any significant recession. This, combined with an observation that corporate balance sheets are in reasonable shape, tells us that spreads likely won’t widen quickly in the near term (see figure 6).

 

These developments have made us more selective in adding corporate bonds as, anecdotally, we’ve seen some froth beginning to appear in some areas of the credit markets. For example, the demand for new issues has been strong leading to issues being highly oversubscribed, causing concessions to existing bonds to be negligible and – in some instances – negative.

 

Figure 6: Canada 10-year Corporate A spread

Figure 6: Canada 10-year Corporate A spread

Source: Bloomberg

 

Doing

We’re holding both longer-term bonds for good coupon income, and shorter-term bonds for potential capital gains. We continue to be overweight credit. There are fewer opportunities for outsized gains in credit bonds, but we still see reasonable returns from this sector.

 

In keeping with our mantra to be selective on corporate bonds, we purchased an Alibaba convertible bond this quarter in one of our strategies. It’s an A-rated bond maturing in 2031 and pays a modest 0.5% coupon. We leverage our International Equity team’s positive view on BABA stock (based on improving fundamentals, depressed valuation and negative sentiment) and see favorable risk-reward for this convertible bond, while diversifying away from more traditional spread product and exhibiting less interest rate sensitivity.

 

Source: Bloomberg

 

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