Market Commentary: May 2024

Written as of June 10, 2024.

Highlights this Month

• U.S. equity market breadth is at its weakest since 2009.
• The Fed's timing and magnitude of rate cuts spark intense debate on Wall Street.
• Signs of strain are emerging.
• Worsening geopolitics has become the top concern for markets.
• What if Trump secures another victory?
• Canada is facing its own challenges.

Executive Summary

Most asset classes delivered positive returns, with the S&P 500 outperforming due to its heavy exposure to large-cap technology stocks - the "Magnificent 7." The U.S. equity market's narrow breadth, driven by these few tech giants, contrasts with broader market indices.  

Despite the Federal Reserve's hawkish tone on inflation, financial conditions remain relatively stimulative, and the U.S. economy continues to defy recession forecasts.  

Political uncertainties, particularly the upcoming U.S. presidential election, are adding to market concerns, with contrasting economic perceptions between Republicans and Democrats influencing voter expectations. The outcome of the election, especially a potential Trump victory, could significantly impact market policies, particularly regarding the Federal Reserve's independence and regulatory landscape. 

May in Review

In May, markets rebounded, with most asset classes posting positive returns. According to a Deutsche Bank chart, oil was the only major global financial asset to decline. U.S. stocks fully recovered from April's correction, with the S&P 500 up 5.0% (total return in U.S. dollars). Although the Dow Jones Industrial Average briefly reached an all-time high of 40,000 on May 17th, it closed the month at 38,686, marking a 2.6% gain for May. However, the Dow lagged behind the S&P 500 year-to-date, with a 3.5% gain compared to the S&P 500's 11.3%. The S&P/TSX performed slightly better than the Dow, recording a 2.8% increase (total return in Canadian dollars) in May and a 7.6% increase year-to-date in 2024.

U.S. equity market breadth is at its weakest since 2009.

The Dow, like many other indices, has lagged behind the S&P 500 due to insufficient exposure to large-cap tech stocks. Bloomberg reports that U.S. equity market breadth is at its weakest since 2009, with the equal-weighted S&P 500 index at its lowest relative to the market-weighted S&P 500 index in over 14 years. Year-to-date, the S&P 500 has outperformed both the equal-weighted S&P 500 index and the small-cap Russell 2000. Nvidia, Amazon, Alphabet, and Meta have driven this outperformance, causing Wall Street strategists to miss their marks. The average year-end forecast for the S&P 500 was 5,095, but it hit an all-time high of 5,321 on May 21st before closing the month slightly lower at 5,278.

The outperformance of a small number of large-cap technology-related stocks is not a new phenomenon. According to a recent chart by Strategas, the Magnificent 7 stocks have outperformed the S&P 500 2.7 times since early 2020. While this hot streak might seem poised for a correction, the earnings growth of these companies suggests otherwise.

Illustratively, a recent chart from The Wall Street Journal demonstrates Nvidia's share price ascent mirroring its 12-month forward earnings growth, despite its seemingly exponential trajectory. Strategas forecasts a moderation in net income growth for the Magnificent 7 by the latter half of 2024, bringing it more in line with the broader S&P 500. However, these companies seem to be currently riding an exceptional wave of earnings growth, largely propelled by advancements in artificial intelligence.

While speculation surrounding AI may diminish over time, the underlying momentum driving these tech giants remains robust.

The fixed-income market has presented significant challenges in forecasting.

The yield curve persists in an inverted state, a condition where 1-year Treasury yields surpass 10-year yields, maintaining the longest stretch on record since mid-2022. Although the yield curve has begun to flatten since July 2023, this adjustment is primarily due to the rise in long-term yields, while short-term yields remain tethered to the Fed Funds rate.

Traditionally, an inverted yield curve foreshadows a recession within nine to 24 months, prompting rate cuts by the Fed to lower 1-year yields. However, none of these anticipated events have materialized yet. Strong job growth persists, the Fed has refrained from rate cuts, and 1-year yields have remained stagnant. Consequently, the inverted yield curve appears either ineffective or prematurely signaling a recession.

The Fed's timing and magnitude of rate cuts spark intense debate on Wall Street.

Over the past year, expectations of rate cuts have been volatile, initially projecting six cuts in 2024, but dwindling to just 1.5 cuts by May's end. Forecasting long-term yields has proved equally challenging. Since mid-2023, 10-year yields have closely followed Fed Funds expectations and correlated strongly with Citigroup’s U.S. Economic Surprise Index, dropping with negative economic surprises.

Despite expectations for higher Fed Funds rates, the recent decline in the Citi Economic Surprise Index suggests lower 10-year yields. This conflicting data leaves the Fed in a precarious position, navigating uncertain economic signals with caution.

The Fed is adopting a more hawkish tone, indicating concerns about inflation and suggesting that interest rates will need to remain higher for longer. However, Apollo notes that financial conditions are currently easier than when the Fed began tightening in March 2022. Alpine Macro supports this, highlighting that the Kansas City Fed’s U.S. Financial Stress Index indicates a relatively benign environment. This is further evidenced by U.S. junk bond spreads, which are at historically tight levels.

The inconsistency between the Fed's statements and actions can be partly attributed to disparities in the U.S. economy. The IMF notes that the U.S. is among the few countries surpassing its pre-pandemic economic projections. Despite sharp increases in inflation and interest rates, the U.S. economy continues to defy predictions of a recession. For instance, last month, U.S. Jobless Claims decreased for the second consecutive month, alongside a decline in U.S. consumer inflation expectations. This convergence of factors presents a formidable challenge for market forecasters.

Signs of strain are emerging.

Although jobless claims decreased last month, job openings in April also declined, hitting a three-year low and signaling a potential cooling of the job market. The drop in the Citi Economic Surprise Index corresponds to a recent decline in the Atlanta Fed’s GDP Now forecast for Q2 economic growth, suggesting that the U.S. economy may be facing challenges.

Consumer spending is the driving force behind the U.S. economy. Strong real disposable income growth has been a key factor in sustaining consumer resilience, according to Bloomberg. However, the Bureau of Economic Analysis reported that real disposable income growth slowed to just 1% year-over-year growth in April. Consequently, American consumers are increasingly relying on credit to maintain their spending levels. Oxford Economics suggests that declining inflation could alleviate this burden for consumers in the future.

Although inflation previously eroded the positive gains in wage growth for nearly two years, this trend reversed in early 2023 and is expected to continue improving. Lower inflation coupled with stronger wage growth is likely contributing to the recent rebound in U.S. Consumer Confidence. The Conference Board’s index bounced back in May after three consecutive months of decline.

Worsening geopolitics has become the top concern for markets.

The U.S. economy presents a mixed picture. While we believe the Fed is inclined to cut rates, it remains cautious, particularly regarding inflation. Financial conditions continue to be accommodative, and the Biden administration is taking significant fiscal measures to support the economy ahead of the November 6th election. This is reassuring for investors, allowing them to shift their focus elsewhere, like to geopolitical concerns.

Recent polls by Bank of America indicate that worsening geopolitics has become the top concern for markets. While global events are significant, the upcoming U.S. election, especially the race for the presidency, has the potential to impact markets. Historically, elections have had limited market impact. However, Gallup highlights substantial partisan divides between the Republican and Democratic parties. The policy differences between the candidates could have significant economic and geopolitical consequences.

To external observers, many aspects of this situation are confounding, particularly the lack of confidence in President Biden's handling of the economy. Despite robust economic growth during his tenure, Biden appears to be underappreciated in this regard, according to a recent analysis by Strategas. The prevailing concern likely revolves around inflation, as annual CPI figures during Biden's presidency have exceeded those of any president since the Carter administration. The Financial Times underscores that rising prices are the primary source of financial stress for U.S. voters. President Biden must either stem inflation before the November 5th election or persuade voters that prices would rise even further under a Trump administration. However, based on past performance, Biden faces an uphill battle. Bloomberg and the U.S. Bureau of Economic Analysis report that living standards improved at a faster rate during Trump's tenure, accompanied by lower inflation. Nonetheless, Biden's presidency has seen superior economic growth and job creation.

Partisan politics influence perceptions. Varying exposures to information sources lead to divergent perspectives. According to the Financial Times, Republicans and Independents encounter more narratives on inflation compared to Democrats. Consequently, Republican expectations regarding inflation for the upcoming year surpass those of Independents and Democrats by a significant margin. However, this discrepancy might also stem from a genuine disparity in inflation rates. The Wall Street Journal recently noted that states won by Trump in 2020 have witnessed higher inflation rates than those won by Biden. Trump supporters speculate that this discrepancy reflects stronger economic growth and demand in red states, which are experiencing a positive net migration trend.

The presidential race is tight, with Trump currently holding momentum and possibly a slight advantage. Real Clear Politics reports a significant shift in betting odds in favour of Trump, mirrored by positive movements in equity markets. Strategas notes that a portfolio favouring stocks aligned with a Trump victory has recently outpaced a Biden-biased portfolio, indicating the market's perception of the candidates' chances. However, the outcome hinges on seven swing states, with Trump leading in six of them according to polls. Yet, polling accuracy remains uncertain. While surveys may show Trump ahead, his lead is precarious, largely reliant on voters disengaged from politics and traditional news sources, who may not turn out to vote. Conversely, recent polling by Times/Siena, focusing on 2020 election voters, suggests Biden leads, despite trailing in overall eligible voter polls.

What impact might Trump's legal challenges, particularly his recent felony conviction, have on his political prospects? Among the four major trials Trump faces, the New York falsified business records case appears to pose the least legal risk for him. The legal intricacies of this case are not widely understood by the public, and it's unlikely Trump will face jail time upon sentencing. The other pending cases are unlikely to reach trial before the election. Ipsos polling suggests that 10% of eligible voters who previously supported Trump now indicate they would not vote for him following his conviction. However, it's doubtful whether these numbers will significantly sway the election outcome. Before the conviction, New York Times/Siena College polling showed Trump leading 48% to 45%. Post-conviction, his lead narrowed slightly to 47% versus 46%. While not insignificant, by November, the impact of this event may have diminished, particularly in comparison to the upcoming June 27 Presidential debate, which is likely to wield greater influence.

What if Trump secures another victory?

While this may seem unfathomable to many worldwide, approximately half of Americans, including Wall Street, support him. A JP Morgan Research survey found that 12% of respondents consider U.S. elections the biggest threat to markets, although it's unclear whether they refer to a potential Trump win or the potential turmoil if he loses. Bloomberg notes that the S&P 500 has historically risen after an incumbent President's victory, and it's currently performing better than in previous years under incumbents. Does this reflect confidence in a Biden win, or does the market view a Trump victory favourably? It's too early to discern, but some incline towards the latter interpretation.

Regardless of the election outcome, markets historically perform well in a President's first year and term. Both Trump and Biden presided over stock surges, with Biden slightly outperforming cumulatively thus far. However, it's worth noting that this term marks the second for both candidates. According to Strategas, the S&P 500 has yielded the highest returns under a Republican President and Republican Congress, though outcomes under a Republican Congress and Democratic President are nearly identical. There's a possibility that Republicans could secure control of both the Senate and House, though a Democratic sweep remains challenging. The most likely scenario is a split Congress, with the Senate potentially returning to Republican control and Democrats regaining the House—a closely contested outcome.

Some of the pivotal policy decisions at stake revolve around taxation and globalization. In the event of a Trump victory with Republican control of Congress, we anticipate tax cuts, including for high-income earners, and potentially higher tariffs. Bloomberg suggests that logistics stocks might face challenges under a Trump presidency, as evidenced by a recent comparison chart showing the decline in FedEx's share price alongside diminishing betting odds of a Biden victory. Trump has proposed broad tariffs ranging from 10% to as high as 60% on Chinese imports. While Biden is less likely to advocate for such sweeping tariffs, he has indicated support for targeted tariffs on specific Chinese products.

From the perspective of a Trump victory, one of the market's main concerns revolves around the Federal Reserve and any potential efforts by Trump to undermine its independence. According to a Bloomberg MLIV Pulse survey conducted at the end of May, over 44% of respondents believe Trump will attempt to weaken the Fed's independence or authority. In contrast, only 5% anticipate similar measures from Biden. Furthermore, 54% believe Biden will refrain from interfering with the Fed, compared to just 6% if Trump is re-elected. Bridgewater suggests that while Trump may publicly criticize the Fed or appoint more compliant candidates to key positions upon their terms' expiration, direct pressure or removal of members is less probable.

According to Strategas, certain industries may face challenges under Trump's presidency, including European automakers and Mexico, while India could benefit from the ongoing shift in trade dynamics away from China. Sectors that thrived during Trump’s tenure included technology, consumer discretionary, healthcare, and materials. Interestingly, despite recent rhetoric promoting increased energy production, the energy sector was the only one to decline during his presidency. PIMCO recently provided a helpful chart outlining sectors expected to benefit from either a Trump or Biden victory. Banks and energy are anticipated to perform well under Trump compared to Biden, while renewables and possibly healthcare are seen as beneficiaries of a Biden victory. The defense sector is expected to perform strongly regardless of the election outcome.

Canada is facing its own challenges.

Amid concerns about a potential surge in American immigrants fleeing to Canada in the event of a Trump victory, it's important to recognize that Canada faces its own challenges. Recent data from the CBC indicates that emigration from Canada to the U.S. hit a 10-year high in 2022, with over 126,000 individuals leaving Canada—a significant increase from 2012. This exodus included over 53,000 Canadian-born individuals, nearly 43,000 Americans returning home, and over 30,000 foreign-born immigrants opting to move to the U.S. instead of staying in Canada.

A recent report from RBC Economics Research shed light on Canada's economic landscape, highlighting softening productivity gains and slowing economic growth. Canada's high corporate taxes, among the highest in the developed world, are cited as a major factor contributing to sluggish investment and productivity growth. Despite these challenges, Canada possesses valuable assets such as an educated workforce and abundant natural resources, and benefits from its proximity to the world's largest economy. Perhaps we need to take a closer look at our toolbox.