Written as of June 9, 2023
View the Nicola Wealth Investment Returns: May 2023
Highlights this Month
- Concerns about market breadth and its implications
- The potential outcomes of narrow market leadership
- Earnings outlook and economic factors' impact on market dynamics
- Debating the likelihood of a soft landing for the U.S. economy
- Navigating the complex economic landscape and Fed's challenging decision
- Housing challenges, monetary policy dilemma, and market outlook
May in Review
In May, stocks experienced mixed performance, with some stocks weakening while others remained resilient. The S&P/TSX Composite Index fell by 4.9% (in Canadian dollars), contrasting the S&P 500, which saw a modest gain of 0.4% (in U.S. dollars). Meanwhile, the NASDAQ exhibited notable strength, surging by +5.9% (in U.S. dollars). This divergence showcased American exceptionalism, as Europe faced a nearly 6% decline, while China plummeted by 9%.
When looking at year-to-date figures, U.S. stocks displayed even more impressive results. The S&P 500 soared by over 9%, and the NASDAQ surged by 24%. Since reaching its lowest point in late December, the NASDAQ has been on a bullish trend, experiencing a 20% increase from its bear market low. Similarly, the S&P 500 achieved its own milestone, entering a bull market in early June after advancing by 20% from its low point on October 12.
Does this settle the debate between a bull market and a bear market rally? It might, but as highlighted by Bloomberg, 20% rallies and corrections are relatively common and don’t necessarily indicate sustained trends. Let’s not get too fixated on the technical definition of a bull market as a 20% rally from the bear market low. What truly matters is what lies ahead.
Looking back, we can recall that just last June, the S&P 500 experienced a rally of over 17%, only to reach new lows in October. Market strategist, Ed Yardeni, suggests that the current rally has the potential to become the most despised bull market in history. This sentiment stems from the skepticism of investors who haven't fully embraced it. JP Morgan highlights the narrow range of central scenarios and risks, which contribute to heightened market indecision. Among these risks are the possibility of a U.S. recession and the potential for further interest rate hikes. The contradictory nature of these two risks adds to the current environment's complexity and precariousness.
In the following section, we delve deeper into the ongoing battle between the bullish and bearish perspectives.
Concerns about market breadth and its implications
The first point likely to be raised by the bears is the issue of market breadth, specifically poor breadth. While it is true that the S&P 500 has recorded a nearly 10% year-to-date increase and has surged by over 20% from its low point on October 12th, these gains can be largely attributed to a relatively small group of technology-oriented stocks. According to Goldman Sachs, as of May 22nd, companies like Meta, Amazon, Apple, Microsoft, Alphabet, Tesla, and Nvidia collectively experienced a remarkable 44% rise.
However, if we exclude these high-flying stocks, the S&P 500's year-to-date gains diminish significantly from +10% to just +1%. In fact, the equal-weighted S&P 500 index, which assigns the same weight to every stock rather than based on market capitalization, actually declined by nearly 1% year-to-date by the end of May. Bloomberg reports that this performance gap between the equal-weighted index and the market-capitalization-weighted S&P 500 is the widest since 1999.
The overwhelming influence of these large-cap growth stocks has also impacted the overall market dynamics in other ways. Volatility has reached its lowest point in over a year, and the valuation of the S&P 500 has surged. Raymond James estimates that the price-to-earnings (P/E) multiple of the prominent seven tech stocks stands at nearly 33 times, compared to just under 16 times for the rest of the S&P 500.
One notable standout among this select group of winners is the semiconductor designer, Nvidia. In a single day (May 25th), Nvidia’s experienced a staggering increase in market capitalization of $183.8 billion, which is nearly equivalent to the entire market capitalization of companies like Adobe, Nike, Comcast, Walt Disney, or Netflix. At these levels, Nvidia is trading at a price-to-sales ratio of over 36 times.
The potential outcomes of narrow market leadership
Ed Yardeni recently expanded the group of large-cap tech winners to include Netflix, referring to them as the "MegaCap-8." While not particularly catchy, the term accurately highlights their significance. Bears argue that such narrow leadership leaves the market highly susceptible to a correction, drawing parallels to the demise of the Nifty Fifty in the early 1980s and the dot-com bubble of the late 1990s as cautionary examples of breadth gone awry.
However, it's important to note that this narrow leadership doesn't necessarily guarantee a negative outcome. As Strategas recently emphasized, underperformance of the equal-weighted S&P 500 index is not a rare occurrence. BMO also points out that while the top five stocks by market capitalization have outperformed the S&P 500 by 30% year-to-date, historical data shows that once the performance of these top names has peaked, subsequent returns for the overall market have been far from disastrous, albeit not spectacular. Over the following three months, average returns were -0.8%, which improved to +1.5% over six months and eventually reached +16.5% over 12 months.
It's worth mentioning that there were instances of significant drawdowns, such as in 2001 and 2008. However, in 1997, the market rallied by 19.1% in the first three months, eventually delivering a 38.7% return over the course of 12 months. These examples highlight the potential for both downside risks and substantial gains when considering the market dynamics in the aftermath of peaked performance for the top names.
The prevailing narrative within the group of large-cap winners revolves around artificial intelligence (AI). Bloomberg indicates that AI has ignited the most significant tech rally seen in the past two decades, and UBS suggests that larger companies are particularly favoured in this regard. Notably, FactSet reports that 110 companies in the S&P 500 have mentioned AI during their recent earnings conference calls, highlighting its widespread impact.
The crucial question of whether the current AI rally represents a bubble, or a sustainable trend will have a significant bearing on the future trajectory of market performance. It will determine whether the market broadens its scope and embraces a more diverse range of companies or continues to favour the select few that are leading the charge in the AI space. Monitoring this development closely is key to understanding the potential outcomes for market dynamics moving forward.
Earnings outlook and economic factors' impact on market dynamics
Earnings are expected to play a significant role in shaping the market dynamics. The market's affinity for AI stems from its potential impact on future earnings. However, for the current rally to become more inclusive and involve a broader range of companies, earnings need to show a broader improvement across various sectors.
Despite concerns about a potential economic recession and its potential adverse effects on corporate earnings, estimates for S&P 500 profits over the next 12 months have actually increased. However, market strategists, such as those at Morgan Stanley, argue that this optimism may be misplaced. They point to weak market internals as evidence to support their case. Sectors like regional banks, transportation, and retail stocks have shown poor relative performance, while indicators like copper prices, oil prices, and Chinese manufacturing have been weak.
Furthermore, 3Fourteen Research highlights that while earnings estimates for the 10 largest stocks in the S&P 500 have remained positive, earnings estimates for the remaining 490 companies have continued to decline.
The fate of corporate America is heavily influenced by the overall state of the economy. The Bank of America Global Fund Manager Survey for May reveals that the majority of institutional investors believe in the narrative of a soft landing for the economy. This sentiment is shared by Goldman Sachs, which assigns a mere 25% probability of the U.S. economy entering a recession within the next 12 months. In contrast, Bloomberg's consensus estimate remains more pessimistic at 65%. The Federal Reserve Bank of New York aligns with this perspective, assigning a nearly 58% chance of a recession occurring.
Examining asset prices, JP Morgan's analysis suggests that the current valuation of the S&P 500 implies a 55% probability of a recession. Similarly, U.S. investment-grade and high-yield credit markets are pricing in probabilities of 39% and 23%, respectively. Among these asset classes, base metals exhibit the most bearish sentiment, with prices reflecting an 89% probability of a recession.
Debating the likelihood of a soft landing for the U.S. economy
The argument for a soft landing holds some merit. Forecasters have been predicting a recession since October 2022, but the anticipated start date has continuously been postponed. This suggests a level of resilience in the economy that contradicts the recession narrative.
Furthermore, the Bloomberg U.S. Economic Surprise Index has shown recent improvement, indicating that economic data releases have been surpassing expectations. This positive surprise factor supports the notion of a potential soft landing scenario.
In addition, MRB Partners has highlighted a turnaround in key indicators such as real GDP, PMI (Purchasing Managers' Index), ISM Manufacturing, and Homebuilder Housing Market Index. These positive developments raise doubts about the validity of recession predictions and further strengthen the case for a more optimistic outlook.
Considering these factors, it becomes evident that there are indications of economic stability and a potential avoidance of a recessionary phase.
Indeed, there is a counter argument that challenges the notion of a soft landing for the U.S. economy. One key aspect is the continuous decline in U.S. Leading Indicators, with various components signaling a weakening economy. Factors such as credit conditions, the inverted yield curve, consumer expectations for business conditions, building permits, and initial jobless claims all point towards a slowdown in economic growth.
Furthermore, as Stifel points out, the ISM Manufacturing Index has fallen to 46.9, indicating contraction in the sector. The ISM Services Index, at 50.3, is also dangerously close to following suit. These figures raise concerns about the broader health of the economy.
Taking into account the current ISM Manufacturing Index, Morgan Stanley suggests that the S&P 500 may be overvalued by approximately 15%. This implies that the market may be pricing in a more positive outlook than the economic indicators currently suggest.
As Strategas highlighted last month, lower corporate earnings can lead to layoffs and a deterioration in the job market. Despite some indications of a potential weakening in the job market, it has demonstrated remarkable resilience thus far.
In May, the U.S. Bureau of Labor Statistics (BLS), announced a surprising upside in non-farm payrolls, with the addition of 339,000 jobs. However, it is important to note that the separate household survey indicated a decline of 330,000 jobs and an increase in the unemployment rate from 3.4% to 3.7%. It's worth mentioning that historically, the current unemployment rate remains very low.
According to BLS, approximately 60.2% of U.S. industries are still experiencing job growth. Additionally, the Labor Department reported a reversal of a three-month slide, with job openings rising above 10 million. Industries such as retail, warehouses, healthcare, and transportation have actively been seeking more workers.
When it comes to wages, there are indications of a slowdown, although wage increases still remain higher compared to the post-Global Financial Crisis period. It is important to monitor the metric of worker mobility as it provides insights into wage trends. Typically, job switchers experience higher wage increases.
According to BLS, there has been a decrease in the number of U.S. workers quitting their jobs, which is a concerning trend. ADP's report for May indicates a broad-based slowdown in wage increases. Job switchers saw a 12.1% increase, a decline of 1% from April. For workers who remain in their current jobs, wage increases decelerated to +6.5% from 6.7%.
There is a concern that robust wage growth could create a floor for inflation, meaning that inflation may not decrease significantly. While global inflation appears to have reached its peak, achieving a target rate of 2% may present challenges. There are signs of progress, such as the Cleveland Fed's trimmed mean CPI showing a decline and commodity prices suggesting disinflation in the future.
According to a recent Financial Times article, the drivers of inflation have shifted from components like energy and goods to services and housing. Inflation in services continues to show stickiness, meaning it remains relatively high and resistant to downward pressure. However, there may be some positive developments in the housing sector that could provide better news regarding inflation.
The Federal Reserve is closely monitoring "supercore" inflation, which excludes housing or shelter prices from services prices. In April, while core CPI dipped to 5.5% from 5.6%, supercore inflation reached an eight-month low on a month-on-month basis. This suggests that the so-called sticky inflation, which has been persistent, is starting to recede.
The Atlanta Fed's core sticky CPI also supports the notion of diminishing sticky inflation. However, housing, which remains a significant component of the overall CPI index, is yet to show signs of decline. Housing's impact on inflation is crucial for the Federal Reserve's objective of bringing inflation back to its target range. According to Bloomberg, rents, which have a lagged effect on CPI, have been declining for almost a year. Bloomberg believes that falling rents are consistent with a decrease in headline CPI by the end of the summer.
Inflationary trends are unlikely to follow a linear path, as evidenced by the acceleration in Personal Consumption Expenditures (PCE) prices in April, reaching their highest level since January. Housing continues to be a significant contributor to inflation, but even when excluding housing, core services prices in PCE remain persistently high. Deutsche Bank highlights that cyclical core PCE prices are currently at their highest level on record dating back to 1985.
Deutsche Bank also notes that consumer inflation expectations for the future have started to rise, with the University of Michigan reporting 5 to 10-year consumer inflationary expectations reaching 3.2%, which is a 12-year high. However, it is worth noting that 5-year break-even rates, which reflect market expectations for future inflation, have been moving lower. This indicates a disconnect between the market's inflation outlook and consumer expectations.
Despite the concerns about higher inflation, consumer satisfaction levels remain relatively high. According to a recent poll by the Conference Board, workers' overall job satisfaction has reached a 36-year high in 2022, with 62.3% expressing satisfaction with their current roles. This indicates that employees are happier in their jobs than they have been in decades.
The biggest year-over-year increases in job satisfaction came from factors such as work-life balance and workload. The implementation of hybrid and work-from-home policies likely played a significant role in improving these aspects of work. These policies have provided employees with more flexibility and autonomy, contributing to their overall satisfaction.
Furthermore, with participation rates at near all-time highs, there are ample job opportunities available for those seeking employment, and workers have the opportunity to choose where they want to work. According to Challenger, Gray & Christmas, the number of workers relocating is at record lows. This suggests that individuals are finding job opportunities in their preferred locations, reducing the need for relocation.
Consumer confidence and its impact on retail sales and spending patterns
While there have been positive indicators regarding job satisfaction and employment opportunities, it is true that consumer confidence has been showing signs of decline. Both the University of Michigan and the Conference Board have reported decreases in consumer confidence levels. Furthermore, political affiliation seems to play a role in shaping consumer sentiment, with Republicans expressing higher levels of pessimism.
Additionally, it is worth noting that retail sales have been lacklustre, suggesting a slowdown in consumer spending. This could be reflective of the waning consumer confidence and a more cautious approach to spending.
Determining the near-term outlook for the U.S. consumer may hinge on the remaining amount of pandemic savings they have. Apollo suggests that while consumers have been drawing down their savings, they still have a substantial $1.2 trillion remaining, which indicates a healthy level of reserves. However, Longview Economics presents a more conservative view, stating that U.S. household "excess cash" amounted to only $500 billion in Q1. Even considering Apollo's more optimistic estimate, it is important to note the growing concern over increasing credit card delinquencies.
Navigating the complex economic landscape and Fed's challenging decision
The current economic landscape presents a complex and uncertain situation. The prevailing belief is that the U.S. is on the path towards a recession, although the timing of its occurrence remains uncertain. The job market, while showing signs of aging, continues to exhibit relative tightness. Inflation, although showing improvement, is still considered too high. The consumer, while appearing content, also harbors a sense of pessimism.
Given this backdrop, the Federal Reserve faces a challenging decision. Market expectations point towards a continued decline in inflation and anticipation of rate cuts, although projections for rate cuts in 2023 are being pushed further into 2024. The market is currently pricing in the likelihood of one more 25 basis point rate hike, potentially in July, followed by another in September, before the Fed finally pauses. As the Fed aims to avoid surprising market participants, it is likely that they will adhere to their communicated pause in June and potentially wait until July to make any adjustments.
It is worth noting that recent Gallup polling indicates a decline in confidence in the Fed and its Chairman, reaching levels not seen in decades.
We feel the Federal Reserve has the ability to tighten financial conditions even without raising interest rates. With Congress reaching an agreement to increase the debt ceiling, the Treasury Department will need to issue bonds to replenish their general account. Concurrently, the Fed's quantitative tightening program is expected to continue. These factors combined are likely to result in a decrease in market liquidity, leading to higher yields and tighter financial conditions.
In line with a global trend, yields have been experiencing upward movement, particularly in shorter-term rates. This increase in yields is reflective of changing market conditions and expectations. Additionally, credit spreads have also seen a slight increase, although they are not yet indicating an imminent recession.
One potential crisis that was successfully averted was the failure of Congress and President Biden to reach a deal on increasing the debt ceiling, which could have resulted in a U.S. government debt default. However, while this crisis was averted, an opportunity to address the unsustainable trajectory of U.S. debt levels was missed.
Although Republicans have advocated for lower spending and fiscal restraint, the reality is that high levels of debt have become a bipartisan concern in Washington. The debt ceiling, originally intended to provide fiscal discipline, has proven ineffective in curbing the increase in U.S. indebtedness, as highlighted in a recent Financial Times article.
According to the Congressional Budget Office, U.S. debt levels continue to follow an unprecedented upward trajectory, and the recent debt deal reached by policymakers only has a limited impact on the long-term forecasts.
Averting the debt ceiling crisis but failing to address rising debt levels
The issue of rising debt levels is not unique to the United States but is a global concern, with Canada being particularly vulnerable. As highlighted by Bridgewater, Canada has experienced a significant increase in both Private Sector Debt/GDP and Government Debt/GDP since 2009. Private Sector Debt/GDP has risen by 36%, while Government Debt/GDP has increased by 29%.
One notable aspect is that Canadian households have been slower to deleverage compared to many other countries following the Global Financial Crisis.
The situation indeed poses a challenging dilemma for the Bank of Canada in its efforts to address inflationary pressures. Despite strong real Canadian GDP growth and positive surprises in the job market, the persistence of sticky inflation likely influenced the Bank of Canada's decision to step off the sidelines and raise interest rates in early June.
Housing challenges, monetary policy dilemma, and market outlook
The Canadian housing market presents a challenge for the Bank of Canada. Despite the increase in interest and mortgage rates, house prices have shown signs of resuming their upward trajectory in April. Affordability remains a concern, but strong demand driven by immigration has helped keep the supply of housing low and the market tight.
Rosenberg Research's observation that the population-to-housing stock ratio is 40% above historical norms highlights the imbalance in the market. This imbalance raises concerns about the vulnerability of Canadian homeowners, given the high household debt levels and increased exposure to floating rates. The International Monetary Fund (IMF) has expressed similar concerns about the potential impact of higher mortgage rates on Canadian households.
The Bank of Canada faces a difficult choice: raising rates to address inflationary pressures could risk a collapse in the housing market as homeowners struggle to meet their mortgage obligations, potentially leading to defaults and broader financial instability. On the other hand, staying on the sidelines and keeping rates low risks allowing inflation to become more entrenched, which could have its own negative consequences for the economy.
Central banks and investors face a daunting task of navigating through conflicting information to make decisions about interest rates and market conditions. This situation is far from what investors had anticipated at the beginning of the year. A recent Bloomberg article highlights how investors initially leaned towards fixed income investments, but stocks have outperformed them significantly. Carson Investment Research suggests that this upward trend in stocks might just be the beginning. Historically, when the S&P 500 has rallied 20% from its bear market low, the market has only retested the low successfully three out of thirteen times. New bull markets have typically rewarded investors with an average return of nearly 18% over the following 12 months.
However, amidst the positive signals, conflicting information persists. Monetary policy takes time to have an impact, and signs of weakness are emerging in corporate earnings, the job market, and consumer spending. The same is true for inflation, although it is unfolding at a slower pace than central banks would prefer. The risk lies in central banks maintaining high interest rates until the economy significantly weakens, which could be too late from the market's perspective. Although there is a possibility that central banks manage to engineer a soft landing, given the current lack of confidence in the Federal Reserve, it seems peculiar that markets would favour this scenario. Bloomberg highlights that markets seldom hit their lowest point before the onset of a recession. Consequently, we maintain a cautious stance and perhaps lean slightly towards a bearish outlook.
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 Management Ltd. (Nicola Wealth) is registered as a Portfolio Manager, Exempt Market Dealer, and Investment Fund Manager with the required securities commissions. All values sourced through Bloomberg.
