Written as of June 14, 2023.
View the Nicola Wealth Investment Returns: June 2023
Highlights this Month
- Historical trends and projections for the next six months.
- A closer look at volatility trends, market dynamics, and the current bull market.
- The disappointing performance of bonds in 2023.
- Challenges in achieving target inflation with labour market tightness and wage growth dynamics.
- Investors’ anticipation and delayed economic downturn.
- Divergent views on valuations and future S&P 500 performance amid recession concerns.
- The bull market’s path: balancing resilience, inflation, and future challenges.
June in Review
Stocks ended the second quarter on a high note last month, showcasing positive performances across various indices. The S&P/TSX Composite recorded a 3.4% increase (total return in Canadian dollar terms), while the S&P 500 and NASDAQ experienced total return gains of 6.6% (total return in U.S. dollar terms) and 6.7% (total return in U.S. dollar terms) respectively. These second-quarter results were equally remarkable, mirroring the relatively strong returns observed in the first half of the year.
During the second quarter, the S&P/TSX Composite showed a 1.1% increase, bringing its year-to-date performance to a notable 5.8% rise. As for the S&P 500, it delivered returns of 8.7% and 16.9% for Q2 and the year-to-date period, respectively. The NASDAQ, however, outperformed the mentioned indices with an impressive 13.1% increase in Q2 and a significant 32.4% rise year-to-date. In 2023 so far, both the S&P 500 and the NASDAQ have displayed positive returns in five out of the six months recorded.
Historical trends and projections for the next six months.
Investors seem to be embracing the current bull market, as Carson Investment Research argues that a strong start to the year historically leads to robust returns in the final six months. The most optimal outcomes have been observed when the S&P 500 has increased between 10% and 15%. In such cases, the second half of the year has seen an average return of 10.9%, consistently staying in positive territory. However, when returns surpass 15%, things become a bit uncertain, with positive returns occurring only 60% of the time and averaging 5.7%.
Strategas provides insights into the mixed returns associated with the highest first half returns. Among the 15 best starts, Q3 returns have averaged -0.5%, while the S&P 500 has recorded an average gain of +3.2% for the entire second half of the year.
Taking a slightly different perspective, BMO assesses the strength of this new bull market over the next six months. Following a 20% gain from market lows, which happened in early June, BMO reports that the S&P 500 has averaged a 2.4% increase after three months, with positive returns occurring 71% of the time. After six months, the average gain has been +10.1%, also with positive returns observed 71% of the time.
Despite the ongoing bull market, investors remain apprehensive about its narrowness. Although there was some improvement in breadth during June, the percentage of stocks outperforming each month continues to fall below average. In June, the S&P 500 equal weight index recorded a 7.7% increase, surpassing the 6.3% return of the S&P 500 cap-weighted index. However, year-to-date, the equal weight index lags behind the cap-weighted index by almost 10%.
According to 3Fourteen Research, the recent surge in the equal-weighted S&P 500 has not kept pace with recoveries seen in other bear market bottoms. Société Générale, on the other hand, believes that the market is not excessively narrow, as the 10 worst-performing stocks have not significantly impacted the market over the past six months.
The market's future trajectory raises the question of whether the broader market will catch up, with the remaining 490 S&P 500 stocks closing the gap on the dominant ten large-cap tech leaders or if these technology frontrunners will experience a decline. Bloomberg reports that the NASDAQ achieved its strongest first-half performance ever, but this was not due to improved earnings. As highlighted by Albert Edwards from Société Générale, U.S. tech earnings have actually been lacklustre both in absolute and relative terms. The recent rally in tech stocks can be attributed to higher valuations, with the S&P 500 Information Technology sub-index diverging from real 10-year yields.
A closer look at volatility trends, market dynamics, and the current bull market.
One positive aspect of the current bull market's lack of breadth is its potential contribution to low volatility. Deutsche Bank highlights that the correlation between stocks has decreased significantly over the past three months, reaching some of the lowest levels ever recorded. Stocks and sectors are moving in distinct directions. Deutsche Bank further notes that the S&P 500 has not experienced a 3% pullback for over three months, marking one of the longest stretches since World War II. Additionally, FactSet reports that since the end of March, the S&P 500 has experienced average weekly moves of less than 1% in either direction.
Considering that July is historically a quiet month, traders do not anticipate an increase in volatility in the immediate future. However, the bond market has been the center of notable activity. While the VIX Index, which measures expected price volatility of the S&P 500, has continued to decline, the MOVE Index, an indicator of market-implied bond market volatility, remains at elevated levels.
The disappointing performance of bonds in 2023.
Not only have bonds exhibited higher volatility in 2023, but they have also delivered below-average benchmark returns through the end of June, as reported by Bloomberg. At the beginning of the year, investors held optimistic expectations for fixed income portfolios, anticipating strong returns due to high coupon rates and a potential pivot by the Federal Reserve. While coupon rates have performed reasonably well, there have been no indications of a Fed pivot, and bond yields have started to trend upwards.
In June, 2-year Treasury yields surged by 49 basis points to reach 4.90%, while 10-year Treasury yields rose by 19 basis points to 3.83%. Traders are engaged in ongoing debates regarding the potential extent of further yield increases. According to Torsten Slok from Apollo, forecasters, for the first time in 20 years, no longer anticipate an increase in 10-year rates from their current levels. Surprisingly, despite this, Bloomberg reports that investors still do not demand additional income on 10-year bonds to compensate for the risk associated with lending for a longer duration. The absence of the so-called "term premium" may have been tolerable when inflation remained below 2%, but now it raises concerns.
Insights from The Official Monetary and Financial Institutions Forum's annual report revealed that 75 reserve managers worldwide consider inflation, global economic slowdown, and rising policy rates (in that order) as the most significant economic challenges expected in the next 12-24 months. This sentiment aligns with Bank of America's June Fund Manager survey, which reached a similar conclusion. However, stock markets do not seem to share the same concerns, while bond markets appear more inclined to factor in the possibility of an extended period of higher interest rates.
The S&P 500, for instance, has managed to recover all its losses since the Federal Reserve began raising rates in March of the previous year and continues to trade at higher levels, in line with positive economic surprises in the United States. This raises the question of why the market doesn't share the same level of worry as the forecasters, especially considering the ongoing rise in yields. Below, we delve into some potential explanations for this discrepancy.
Central banks in "wealthy" countries have generally pursued aggressive rate increases, sparking debates among market analysts about how much further they will go. However, not every country faces the same situation. Britain and other European countries have taken a more assertive approach to raising rates over the past 12 months, as inflation has been slower to subside in those regions. Canada has trailed behind the U.S. in raising rates but has recently started to catch up, benefiting from a more moderate inflation environment compared to Europe, albeit still behind the progress made by the U.S. Federal Reserve. Japan remains an outlier, as inflation is beginning to show signs of life after decades of low levels, yet the Bank of Japan continues to adhere to its highly accommodating negative interest rate monetary policy. On the other hand, China has been among the few central banks globally to implement rate cuts, responding to market demands.
Market expectations suggest that the European Central Bank (ECB) and the Bank of England will continue raising rates, while Canada and the U.S. are nearing the end of their rate-hiking cycles. Pressure is mounting on the Bank of Japan to abandon its yield curve control policy and allow rates to normalize, particularly evidenced by the recent weakness in the Yen. Conversely, in China, market sentiment calls for and anticipates more fiscal and monetary stimulus.
Taking a closer look at U.S. interest rates, market expectations have undergone a significant shift. In May, there were anticipations of rate cuts of up to 75 basis points in the Fed funds rate by the year-end. However, the current belief is that the Fed will not initiate any cuts until sometime in 2024. This change in sentiment has led to an increase in U.S. Treasury yields, particularly the more sensitive 2-year yields influenced by the Fed's monetary policy. As a result, the yield curve has become more inverted, with 2-year yields rising more than 10-year yields. The yield curve is often seen as a traditional predictor of an impending economic recession.
Despite the apparent tightening of monetary conditions, the S&P 500 has continued to climb higher. One possible explanation for this is that while the Fed has been actively raising rates, financial conditions have actually become more accommodating. According to Bloomberg, the Chicago Fed's National Financial Conditions Index has recently eased and is currently lower than the level observed when the Fed Chairman delivered his hawkish speech at the Jackson Hole Economic Symposium in August of the previous year. Even the Fed funds rate itself is not overly restrictive when compared to inflation. Bloomberg reports that while the real Fed funds rate is positive when considering 10-year TIPS (Treasury Inflation-Protected Securities) and 1-year breakeven rates as a proxy for inflation, it remains negative based on Core CPI (Consumer Price Index).
Taking a longer-term perspective, Gavekal's Will Denyer argues that financial conditions are actually quite tight, even tighter than they were during the 2008 credit crisis. Supporting Denyer's viewpoint is the performance of regional bank stocks, which faced pressure following the default of Silicon Valley Bank (SVB) and have struggled to recover. Many traders are concerned that the Federal Reserve will persistently raise rates until some breaking point is reached, be it more bank failures or other yet-to-be-determined consequences. There are apprehensions about the potential impact on the stock market as well. Bloomberg recently highlighted that in 2007, when 2-year bond yields surpassed 5% (a level that bond markets were rapidly approaching in early July), stocks experienced a significant decline.
Despite the concerns raised by the inverted yield curve and the Federal Reserve's aggressive actions, credit spreads seem to provide a contrasting signal. While spreads have slightly increased, they are still far from the levels typically associated with an impending recession. This observation is puzzling, especially considering the rise in bankruptcies as noted by Zero Hedge. Refinitiv data reveals that even riskier credits, such as CCC-rated corporate bonds, have been outperforming investment-grade bonds this year, with returns approaching 10% year-to-date.
Traders currently seem satisfied to overlook the recent increase in interest rates, as they maintain the belief that a pivot from the Federal Reserve is still on the horizon, albeit delayed. However, taking a stance on inflation becomes crucial when forming an opinion either in agreement or disagreement with this perspective. Inflation serves as the battleground between the bullish and bearish sentiments on Wall Street at present.
It is challenging to ignore the fact that inflation is showing signs of decline. In May, the headline Consumer Price Index (CPI) dropped to 4%, the lowest level since March 2021. The Fed's preferred inflation measure, the Personal Consumption Expenditures (PCE) inflation, also experienced a decrease, although core PCE, which excludes volatile components, has remained relatively stable, with a 4.6% year-over-year increase in May. This level is consistent with the past year. According to Torsten Slok from Apollo, demand-driven inflation is responsible for maintaining the elevated level of Core PCE.
According to the NY Fed's Underlying Inflation Index, inflationary pressures are decreasing rapidly, with the index recently dropping below 3%. Bloomberg highlights that financial markets have never priced in a significant surge in inflation expectations, as evidenced by breakeven rates remaining within a narrow range of 2.15% to 2.25%. However, caution is necessary when considering consumer inflation expectations. Although they have also remained stable, BCA Research suggests that expected inflation is closely correlated with historical inflation, implying that people expect the future to resemble the recent past.
Regarding financial market expectations of inflation, Bloomberg suggests that 10-year breakeven rates are influenced by oil prices. This relationship is likely due to TIPS traders using oil futures to hedge their positions.
While inflation is anticipated to continue decreasing, reaching the Federal Reserve's 2% target is expected to become increasingly challenging. Bank of America's June Fund Manager Survey reveals that only 2% of respondents expect inflation to rise from its current levels. According to Bloomberg's June 5-9 MLIV Pulse survey, 45.8% of respondents believe it will take five years or more for the Consumer Price Index (CPI) to reach the 2% mark. Moreover, the Official Monetary and Financial Institutions Forum (OMFIF) found that none of the 75 reserve managers surveyed from around the world believed that inflation in most global economies would be 2% or less within the next one to two years.
Challenges in achieving target inflation with labour market tightness and wage growth dynamics.
One of the significant hurdles in achieving the target inflation rate is the tightness of the labour market. According to Goldman Sachs, there are still more job openings than available workers, creating a gap. Goldman suggests that this gap needs to decrease to 2 million, compared to the current range of 2.5 to 4 million, in order for wage growth to stabilize at 3.5 to 4% and for core inflation to decline to the target level. Goldman already believes that wage growth has fallen to 4.5 to 5%.
However, Morgan Stanley holds a different perspective, suggesting that wage shocks no longer have a significant impact on inflation, as they did between 1970 and 1999. This view is supported by a study conducted by the San Francisco Fed, which found that the recent increase in the Employment Cost Index (ECI) only accounted for 0.1% of the 3% increase in the core Consumer Price Index (CPI). While it is possible that high wage growth could be a consequence of inflation rather than the cause, the two factors remain closely correlated. The Federal Reserve has highlighted the tight labour market as a concern, and the link between wage growth and general inflation seems intuitive. When consumers have more disposable income, they tend to purchase more goods, which can drive up prices. It is important to remember the perspective of Apollo's Torsten Slok, who states that inflation is now demand-driven.
Inflation holds significant importance because the Fed displays determination in ensuring a return to the target level, even if it means risking a recession. An inverted yield curve serves as a warning from the market, indicating that this outcome may indeed be on the horizon. According to James Mackintosh from the Wall Street Journal, an inverted yield curve signifies that investors lack confidence in the sustainability of current interest rates. This inversion can contribute to a recession in two ways: firstly, by creating a self-fulfilling prophecy as companies interpret the inversion as a signal to reduce risk-taking, and secondly, by negatively impacting bank business models, leading to a reduction in lending.
Another straightforward explanation is that an inversion occurs when short-term interest rates surpass the economy's neutral interest rate, thereby slowing down economic growth until a recession materializes. The Financial Times reports that the 10-year-3-month Treasury Yield Curve Spread has accurately predicted recessions in the past 40 years, and it is presently more inverted than prior instances that successfully predicted recessions. However, timing plays a crucial role. Credit Suisse's Jonathon Golub suggests that the countdown to a recession begins when the yield curve reverts to normal, which, according to the futures market, is not expected to occur until June 2026.
When considering the stock market, Strategas draws attention to examples like 1979 and mid-2006 to mid-2007, where the yield curve was inverted, but stocks still managed to achieve substantial gains, at least for a period. However, both instances ended in a recession, and the rally of 2006-2007 concluded particularly poorly, culminating in the 2008 financial crisis.
Investors’ anticipation and delayed economic downturn.
Investors are currently fixated on the impending recession, which has become highly anticipated and widely expected. Some even refer to it as the most eagerly awaited economic downturn in history. This scenario is reminiscent of Samuel Beckett's renowned play, "Waiting for Godot," which we might remember from our English 100 classes (thanks to Coles Notes!). Similar to the characters in the play waiting endlessly for Godot's arrival, investors seem to be waiting for a recession that never materializes. More accurately, investors have been bracing themselves for a slowdown in economic growth.
Economists have continuously revised their recession forecasts, now anticipating positive growth in both Q1 and Q2, with expectations for a decline in GDP limited to Q4. Bloomberg's U.S. Economic Surprise Index has recently shown an upward turn, aligning with the ongoing rally in the stock market. This suggests that economic data has been exceeding expectations, which is reflected in the positive market sentiment.
To be fair, recessions have become less frequent compared to the past. As highlighted in a recent Bloomberg report, many investors have not experienced numerous recessions and may be out of practice in anticipating and navigating them. However, as of mid-May, economists still hold the belief that there is a greater likelihood of a recession occurring within the next year, surpassing the median historical probability of 36% according to ASR Ltd.
During a recent Deutsche Bank conference, 65% of attendees expressed their belief that the recession would materialize by the end of Q2 2024. Interestingly, 28% of participants did not anticipate any impact from the recession on the market. This disparity in perspectives suggests that some individuals may indeed be out of practice when it comes to understanding the potential consequences of a recession.
Economic indicators present a mixed picture, with both positive and negative aspects. The Leading Economic Indicators are currently experiencing their longest period of decline since the Great Recession. However, there are indications of resilience in the housing market, factory orders, and consumer confidence, which provide rays of sunshine amidst uncertainties.
The degree of disagreement regarding the future path of the economy is best exemplified by the Federal Reserve itself. The St. Louis Fed predicts that Q2 GDP will be either flat or negative, implying a potential economic slowdown. In contrast, the Atlanta Fed forecasts positive GDP growth for the same period, suggesting a more optimistic outlook.
Unlike Deutsche Bank's clients, we recognize the significance of economic growth as it strongly influences corporate earnings. The direction of earnings, alongside valuations, plays a crucial role in shaping the future returns of investments. In a Bank of America survey, fund managers expressed slightly higher optimism in June, with the most probable outcome being global earnings growth ranging from 0% to 5% over the next 12 months.
According to Factset, the second quarter of 2023 has witnessed the highest number of S&P 500 companies revising their earnings per share guidance upwards since the third quarter of 2021. Société Générale recently emphasized that analyst upgrades in earnings per share have been a driving force behind the recent market rally. RBC shares this sentiment, believing that the current market is factoring in the anticipated recovery in earnings later in the year. In contrast, the market correction experienced last year was a reflection of the market anticipating the current period of subdued earnings.
Truist Advisory Services recently highlighted a contradictory situation where analysts anticipate corporate earnings growth in the third and fourth quarters while GDP is projected to contract. This inconsistency raises questions about the alignment between macroeconomic indicators and corporate performance. Bank of America reports that 75% of earnings growth since January 2022 can be attributed to inflation, which is expected to decrease in the future. Additionally, MRB Partners points out that while revenue growth is anticipated to stagnate at around 5%, analyst optimism regarding profit margins is currently reflected in forward earnings estimates.
The degree of optimism in these estimates is considered aggressive, especially considering the present circumstances. Strategas suggests that there is still room for earnings to decline further, drawing on historical evidence from the past four economic downturns. This highlights the potential vulnerability of earnings projections and the importance of closely monitoring economic conditions and their impact on corporate profitability.
Divergent views on valuations and future S&P 500 performance amid recession concerns.
There is a wide range of opinions regarding the potential direction of valuations during a recession. Bank of America suggests that an average multiple of 20 times trough earnings has been observed over the past 50 years. Conversely, Goldman Sachs predicts that the S&P 500 price-to-earnings (P/E) multiple could reach a trough of 15 times the next twelve months' earnings in the event of a recession.
Given these varying perspectives, it is no surprise that Wall Street analysts are sharply divided on the future trajectory of the S&P 500. Currently, there exists a significant gap between the highest and lowest target price for the year-end S&P 500 target price, which is a record deviation. It is worth noting that the average year-end target price implies negative returns for the second half of the year.
One factor that likely contributes to this negative view is the anticipation of declining liquidity in the coming months. This expectation stems from the Federal Reserve's plans to gradually remove some of the emergency measures that were implemented during recent banking defaults. Additionally, the Federal Reserve aims to reduce its extensive balance sheet, which will further impact liquidity levels.
Furthermore, liquidity is expected to decrease as the U.S. Treasury Department replenishes its general account following its near depletion during the debt ceiling standoff. As the Treasury resumes issuing Treasury Bills, banks are expected to utilize their reserves to purchase these bills. However, the Federal Reserve hopes that most of the funding will come from Reverse Repos, which are financial transactions where the Fed sells securities and agrees to buy them back at a later date. To encourage banks to hold Treasury Bills rather than engaging in Reverse Repos, T-Bill rates need to be higher than Reverse Repo rates, thereby exerting additional pressure on short-term yields.
While these concepts may be technical, the key point is that liquidity has been a supportive force for markets but is expected to become a challenging factor in the months ahead.
Regarding Canada, the country's economic growth has been consistently exceeding expectations and is projected to outpace other G-7 nations in the coming year. One of the contributing factors to this growth is the increase in population driven by immigration. However, there are concerns about the sustainability of this growth, particularly due to declining productivity and less robust GDP per capita.
Rising productivity is crucial for an economy to expand without triggering inflation. While immigration can help address labour shortages in a globally constrained workforce, it also poses challenges related to inflation and monetary policy. Given the current high levels of consumer debt in Canada, the economy is expected to be more sensitive to changes in interest rates. This sensitivity may potentially limit the Bank of Canada's flexibility in managing inflationary pressures should the need arise.
The bull market’s path: balancing resilience, inflation, and future challenges.
Overall, the bull market continues, but it is important for it to stay within its boundaries, which are currently quite narrow. Inflation is gradually moderating while the economy demonstrates resilience, keeping the possibility of a smooth landing alive. For the bull market to continue running in its lane, it requires resilient economic growth alongside a decline in inflation towards the Federal Reserve's 2% target. However, the Fed seems inclined to maintain higher interest rates for a longer duration, and while some inflationary pressures may be temporary, the battle is not yet won. This is especially relevant considering the tightness in the labour market. The impact of higher rates on companies and consumers is expected to become more noticeable in the coming months, particularly as debt is refinanced at higher interest rates and pandemic savings are depleted.
One's perspective may depend on their time horizon. The challenge for the bull market, confined to its narrow lane, is the likelihood of the Fed reducing rates without being prompted by a sudden drop in economic growth or a financial crisis. Maintaining rates at these levels for an extended period can eventually harm the economy. If growth and inflation persist, the Fed may raise rates further. When considering historical comparisons, RBC draws attention to the 71% correlation between the S&P 500's daily performance during the post-dot-com bubble years of 2002-2003 and the current market in 2022-2023, suggesting this is not just a bear market rally. RBC also notes that the S&P 500 disregarded the post-World War II recession in 1945 after substantial government stimulus was withdrawn, a situation we feel is similar to the current economy. However, according to Morgan Stanley, the story doesn't end there. Following the 1945 stock market boom, there were several downturns before reaching a new bear market low in 1949. Jonathan Golub emphasizes that investors should be concerned not only about an inverted yield curve but also about when the yield curve turns positive again. The bull market has performed well so far, but the question remains whether it is a sprint or a marathon.
Disclaimer
This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information presented here has been obtained from sources believed to be reliable, but not guaranteed. Nicola Wealth is registered as a Portfolio Manager, Exempt Market Dealer, and Investment Fund Manager with the required provincial securities commissions. All values sourced through Bloomberg.
