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First Quarter 2024 Global Equity and International Review

After delivering robust returns in 2023, global equity markets started off 2024 with a bang. Some of the key factors driving the returns included strong corporate earnings, an expectation of interest rate cuts in 2024, and a turn in investor sentiment with investors abandoning their recession calls. Given this backdrop, stock market returns were not only strong, but also widespread across geographic regions.

Should we worry about the narrow breadth and market concentration in the S&P 500?

Over the last several years a lot has been written about the increasing power and concentration of Mega Cap stocks in the S&P 500. Media articles on this subject exploded in 2023 as Technology stocks skyrocketed and a new moniker was born when Bank of America analyst Michael Hartnett coined the term ‘Magnificent Seven’. For the record, the Magnificent Seven includes Alphabet, Amazon, Apple, Meta Platforms, Microsoft, NVIDIA, and Tesla. Apparently this term is a nod to a Western film from the 1960’s, which starred Steve McQueen as depicted in the picture below.

Does this exclusive group of seven stocks deserve all of the attention that it has received? In our opinion, the attention given to the Magnificent Seven is warranted when one considers the magnitude of the returns generated and the significant size that these stocks represent in the S&P 500 index.   

As seen in the chart below, the Magnificent Seven generated huge returns in 2023 including 3 stocks that increased in value by over 100%.

In terms of its contribution, the Magnificent Seven accounted for 62.2% of the S&P 500’s total return of 26.3% (in U.S. dollars) during 2023. Excluding the Magnificent Seven, the total return for the S&P 500 would have been significantly lower with the remaining companies in the index collectively generating a total return of 9.9% in U.S. dollars.

After the stellar performance of the Magnificent Seven in 2023, several concerns about market concentration have arisen. As you can see in the chart below, the Magnificent Seven collectively represent approximately 29% of the market capitalization of the S&P 500. This is the highest level for the largest 7 stocks in the S&P 500 over the last 45 years!

Given the magnitude of the market returns and the significant market concentration, a number of strategists have suggested that the recent returns of the Magnificent Seven are unsustainable. Some have even suggested that these stocks are in a bubble. We will only know the answers to these questions several years into the future with the benefit of hindsight. But for now, we ask ourselves the following question…is it unusual for a small group of stocks to generate the lion’s share of stock market returns? To put some numbers on this, let’s use 2023 as a starting point. During 2023, 1.4% of the stocks in the S&P 500 (The Magnificent Seven) generated 62.2% of the total return for the S&P 500. Fortunately, there are some academic studies that can help us compare the stock market returns generated in 2023 with market returns generated in the past.

According to a study by Hendrik Bessembinder, history has shown that a narrow group of stocks has driven the majority of equity market returns over a long period of time. For the purposes of his study, equity market returns were defined as the excess returns generated by stocks over and above what could have been generated by investing in U.S. treasury bills. The study also refers to these excess returns as net wealth creation. The study included data from 1926 to 2022 and it included 28,114 publicly traded companies in the United States over this period. The output from this study confirmed that a very narrow group of stocks has generated the vast majority of net wealth creation over the period. To be more specific, 317 companies (or 1.1% of the stocks in the study) generated 80% of the total net wealth creation; 528 companies (or 1.9% of the stocks in the study) generated 90% of the total net wealth creation; and 966 stocks or (3.4% of the stocks in the study) generated 100% of the net wealth creation. These figures can be seen in the chart below.

When the results of this study are compared to 2023, the returns from the Magnificent Seven do not appear to be abnormal. In 2023, 1.4% of the stocks in the S&P 500 generated 62.2% of the total return for the S&P 500. Over 96 years (1926 to 2022), 1.9% of the stocks in the United States have generated 90% of the net wealth creation.

In conclusion, we don’t believe that there is anything unusual about the returns generated by the Magnificent Seven when taken in a historical context. There is no question that the Magnificent Seven generated spectacular returns in 2023 and it wouldn’t be surprising if this exclusive group of stocks experienced a period of weakness after generating supernormal returns in 2023. Having said that, we believe that it’s likely that some of these Magnificent Seven stocks will continue to create more value in the years ahead. 

Year End 2023 Global Equity and International Review

After a tumultuous year in 2022, a year in which both stocks and bonds fell by double digits, stocks came roaring back in 2023. There are several factors that drove global equities higher in 2023 including low expectations, the absence of a global recession, and a faster than expected decline in the rate of inflation. Going into 2023 there was widespread fear about a recession on the back of surging inflation that had not been seen in decades. In response to this inflationary phenomenon, most central banks around the world raised interest rates aggressively during 2023. Given this backdrop, the consensus view was that the global economy was going to tip into a recession. The United States was front and centre as part of this recession call. In fact, the U.S. Conference Board’s recession probability model called for a 99% chance of a U.S. recession at the beginning of 2023. However, and as we all know, a recession did not materialize. Not only did a recession not occur, but inflation started falling at a very rapid pace towards the end of the year. Given these developments, global equity market generated attractive gains in 2023 as seen in the chart below.

A Soft Landing for the U.S. Economy is in the Realm of Possibility

One of the biggest debates in the market today is whether the U.S. economy is headed for a recession or a soft landing. Given that the United States is the world’s largest economy, the outcome of this debate matters a lot given the implications it would have for the rest of the world. One of the key factors that will impact the outcome of the debate is the rate of inflation. The bears argue that inflation remains far too high and that the U.S. Federal Reserve will need to keep hiking interest rates which will eventually tip the U.S. economy into a recession. Recent inflation data over the last few weeks is not the type of fodder that the bears were hoping for given that both the Consumer Price Index (CPI) and the Producer Price index (PPI) declined more than consensus expectations.

As seen in the chart below, the consumer price index for the month of October increased by 3.2% compared to one year ago. This was better than consensus, which called for an increase of 3.3%. The consumer price index is a measure of the average change over time in the prices paid by urban consumers for a broad basket of consumer goods and services.

On a month over month basis, the CPI for October was flat versus September. This is fueling hope that stubbornly high prices are easing their grip on the U.S. economy and that the U.S. Federal Reserve is in a better position to stop raising interest rates. And eventually cut interest rates.

The Producer Price Index (PPI) also delivered results that were better than consensus expectations. During the month of October, the PPI declined by 0.5%. This marked the biggest monthly decline since April of 2020. Consensus was expecting an increase of 0.1% so this result was much better than consensus.

The Producer Price Index measures the average change over time in selling prices received by domestic producers of goods and services. The PPI index measures the price change from the perspective of the seller, which is different than the Consumer Price Index that measures price change from the purchaser’s perspective. It’s good to see that both the CPI and PPI data was better than consensus as it provides more evidence that inflation is falling faster than expected.

In addition to the favourable inflation readings, there was also a positive economic data point with the recent release of the Chicago PMI Index. The Chicago PMI captures manufacturing and non-manufacturing business conditions across Illinois, Indiana, and Michigan. A reading below 50 signals contraction in the economy while a reading above 50 signals expansion in the economy. The Chicago PMI has been in contraction mode for 14 consecutive months. However, November’s reading put an end to the streak as the Chicago PMI surged past consensus expectations. The November reading of 55.8 was well ahead of October’s reading of 44, and ahead of consensus at 46. While 1 month of data is a small sample size, it is encouraging especially given the magnitude of the difference between the actual reading versus consensus.

There is one data point that will encourage the bears and that is the recent release of the Beige Book from the Federal Reserve. According to the Beige Book the economy has slowed in recent weeks as consumers are keeping a closer eye on their spending.

From our perspective, falling inflation and a sudden turn in the Chicago PMI increases the probability of a soft landing in the U.S. economy despite the slowdown that was highlighted in the Beige Book. While nothing is for certain and there are no guarantees in our industry, we are encouraged by the recent data points and believe the likelihood of a soft landing has increased. 

Have a good weekend.

Phil

Third Quarter 2023 Fixed Income Strategy Review

Heading into the third quarter of 2023, the outlook for the economy gave investors a few reasons for a little optimism. Inflation had fallen very consistently for a year and measured 2.8% by the end June, not all that far off from the Bank of Canada’s 2% target. The economy, although slowing (GDP growth decreased to 1.8% for the prior 12 months by the end of Q1, and to 1.1% by the end of Q2) was still producing positive output. In addition, the unemployment figures remained surprisingly robust, with the unemployment rate at 5.5%, the net change in the labour force remaining positive (employers were adding to their payrolls), and average hourly earnings measured above 5% (meaning wages grew at a rate greater than 5%).

Third Quarter 2023 Global Equity and International Review

After a strong first half of the year, global stock markets took a breather during the third quarter. Equity market indexes were down across the board during Q3 with the S&P 500 returning -3.7%, the STOXX Europe 600 index returning -2.5%, and the Nikkei 225 returning -4.0%. Despite the weakness experienced in Q3, global stock markets have generated respectable gains throughout the first nine months of the year. On a year-to-date basis through September 30, the Nikkei 225 has returned +22.1%, the S&P 500 has returned +11.7% and the STOXX Europe 600 index has returned +6%.

Is the Artificial Intelligence hype creating a bubble in Technology stocks?

There has been a lot of excitement about Artificial Intelligence (AI) recently and this is being reflected in the Technology sector, which has led the stock market thus far in 2023. AI is a transformative technology for consumers and enterprises, and one that will create new opportunities that will enhance productivity. Although AI has been around for a long time, it has only been used to perform narrow tasks such as voice recognition. However, the more recent excitement around AI is related to the opportunities related to Generative AI. One of the key attractions of Generative AI is the Large Language Models that are being developed. One of the distinguishing factors of Large Language Models is their deep understanding of language, allowing them to perform a wide range of language-based tasks. By utilizing Large Language Models, businesses will have access to state-of-the-art models that can be customized to leverage their own data.

We believe that AI technology is for real and that it will create significant opportunities for organizations around the world. While it is still early days for Generative AI, it won’t take long for the benefits to impact the global economy. Technology research company Gartner predicts that by 2025, more than 30% of new drugs and materials will be systematically discovered using Generative AI techniques, up from 0% today. Gartner also predicts that by 2025, 30% of outbound marketing messages from large organizations will be synthetically generated, up from less than 2% during 2022. Generative AI is expected to have an impact on a wide range of industries including pharmaceuticals, manufacturing, media, interior design, engineering, automotive, aerospace, defense, medical, electronics and energy. One of the key benefits of Generative AI is that it will enable enterprises to create new products more quickly. As companies incorporate AI models into their core processes, they will be able to improve the productivity of their marketing, design, and corporate communications activities.

Given the huge run in AI related stocks, there are concerns that a Technology bubble is starting to form. And there is some data that one can point to if one wants to make an argument that a bubble is on the horizon. According to Goldman Sachs, hedge funds have increased their exposure to the seven biggest Technology stocks to the highest level ever seen. These 7 stocks include Tesla, Apple, Nvidia, Microsoft, Amazon, Meta and Alphabet. They have collectively been nicknamed the Magnificent Seven and they now make up more than 50% of the Nasdaq 100 as seen in the chart below.

For those concerned about an AI bubble, one can also point to the outsized year-to-date returns generated by the Magnificent Seven compared to the rest of the S&P 500 as seen in the chart below.

In the first 7 months of the year, the Magnificent Seven soared by 65.6% as a group while the remaining 493 stocks in the S&P 500 gained 7.3% as a group. This implies that the Magnificent Seven have accounted for $4.5 trillion (or nearly 70%) of the S&P 500’s $6.5 trillion increase in market capitalization so far this year through to the end of July.

So are we in an AI bubble?

This is a good question, especially since many of us can remember the Dot.com boom in the late 1990’s, which ended with a 70% crash in the Nasdaq index. To address this question, we believe it makes sense to look at the individual stocks that make up the Magnificent Seven. Although some of the stocks in this group look expensive, some of them look very reasonably valued. On the expensive side, Tesla, and Amazon trade at a price-to-earnings (P/E) ratio of 54x and 43x, respectively, based on 2024 consensus estimates. While these multiples are lofty, they are lower than the 80x P/E ratio that was seen at the Dot.com peak in the late 1990’s. For the record, we don’t own Tesla and Amazon in our portfolios. On the more reasonable side, Alphabet (AKA Google) and Meta trade at a price-to-earnings (P/E) ratio of 20.0x and 17.5x, respectively, based on 2024 consensus estimates. These valuations appear attractive to us given the double-digit earnings profile of both companies. For the record we do own Alphabet and Meta in our portfolios. By looking at the individual stocks within the Magnificent Seven, we think it’s safe to say that some of the stocks within the Magnificent Seven are nowhere close to being in bubble territory.

So how are we playing the AI theme?

We own a number of stocks across our portfolios that will benefit from AI including language model developers, cloud service providers, and semiconductors. Meta has built a number of AI tools for developers including their open-sourced Large Language Models. Meta will also benefit directly from using their own models in their family of applications. Microsoft and Alphabet will also benefit from large language models and have much to gain from their cloud service offerings. Both Microsoft and Alphabet are building their platforms to enable their customers to train and deploy their models in the cloud. This will lead to an explosion of customized Large Language Models (LLM’s). Given their complexity and their size, these LLM’s will need to be stored and run in the cloud. We believe this puts Microsoft and Alphabet in a very favourable position. Within the semiconductor industry, we own several companies including ASML and Applied Materials. Given the large wave of data and computational power that will be required in the years ahead, we believe that the semiconductor industry is very well positioned to benefit from AI. In order to develop AI models, very large sets of data will be utilized in the training phase. The initial sets of data as well as the subsequent generation of new information will require semiconductor chips to perform computations and to store information. As demand for AI models grows exponentially, it will require significant gains in power efficiency. All of this will drive demand for the leading-edge chips, which is why we view the semiconductor industry as critical enabler for AI.

While there has been a tremendous amount of hype around Artificial Intelligence, we don’t view it as a bubble. We believe that AI will create significant productivity gains for the global economy in the years ahead so we don’t believe this is a fad that will disappear over time. In terms of getting exposure to the AI theme, the companies we own have very strong core businesses that were growing and highly profitable before the recent hype around Generative AI came along. While we believe the above-mentioned companies are very well positioned to benefit from AI, they have multiple avenues for growth outside of Artificial Intelligence.

Phil

Second Quarter 2023 Global Equity and International Review

After generating strong gains during the first quarter, global equity markets continued their upward climb during the second quarter. On a total return basis, the S&P 500 was +8.7%, the STOXX Europe 600 index returned +2.7 %, and the Nikkei 225 index was +18.5%. The Nasdaq was particularly strong with the index generating a total return of +13.1% during the second quarter. For the first six months of the year, the Technology-heavy Nasdaq index soared by more than 32%, which marks the best first half for the Nasdaq since 1983 when it rose by 37%. The strong gains in the Nasdaq have largely been driven by the excitement surrounding artificial intelligence (AI) and the potential productivity gains that AI could generate for the global economy.

Climbing the Wall of Worry _ May 2023

Global equity markets have been very strong thus far in 2023 with broad based strength across geographic regions. Year-to-date returns up to the closing price on May 26th are up approximately +9.5% for the S&P 500, up +8.5% for the Stoxx Europe 600 Index, and up +18.5% in Japan as measured by the Nikkei 225 Index. This might be surprising to some investors given all of the concerns including sticky inflation, the ongoing war in Ukraine, recent bank failures, the debt ceiling fiasco in the United States, and the potential for an economic recession. Despite these headwinds, global stock markets have continued to rise in 2023. This concept is often referred to as Climbing the Wall of Worry. The Wall of Worry refers to a tendency in financial markets for stocks to rise in the face of seemingly insurmountable problems. However, it usually turns out that the problems are temporary and that they are eventually resolved. As seen in the illustration below, there has been and always will be a rotating cast of things to worry about in the stock market.

Source: https://berkshiremm.com/markets-climb-wall-of-worry/

Of all the concerns that exist today, we believe the possibility of an economic recession is the one that is causing the most anxiety for investors. And we believe this is justified because the potential for a recession is a realistic concern. Bond market yield curves are currently inverted and that has historically been a sign that a recession is on the horizon. In addition, the dislocation that has occurred in the banking sector also increases the probability of a recession. One of the consequences from the recent bank failures is that lending standards in the banking industry have tightened. This is very likely to create a drag on economic growth. If the economic drag is too big, the economy will fall into a recession. However, if a recession does materialize, we believe it will be a milder, garden variety type recession. Our rationale for saying this is that global banks have robust levels of capital, while corporates and consumers are significantly less exposed to credit risk and leverage risk than they have been historically. In terms of the stock market, it appears that investors are already bracing for a recession based on market positioning. As seen in the chart below, the recent Bank of America Global Fund Manager Survey showed that global fund managers are the most underweight in equities relative to bonds since March of 2009.

The current positioning by Global Fund Managers does not mean that the stock market won’t go down if the economy falls into a recession. And it doesn’t mean that markets won’t go down if we avoid a recession. Stock market corrections are part of the cycle and they occur frequently. According to Cornerstone Macro, there have been more than 230 corrections of 5% or more for the S&P 500 since 1928. The average duration of these corrections was approximately 1.8 months and the average decline of these corrections was about 12%. The complicating factor about market corrections and economic recessions is that nobody can predict when they will happen, nor can anybody predict how long they will last. We think that with the many factors considered, the best course of action for investors at this time is to accept that they will occur from time to time and that eventually the stock market will recover. Despite the uncertainty that exists at this time, we are comforted by the types of companies we own across our portfolios. Companies with robust free cash flow generation and strong balance sheets are the types of companies that are best positioned to weather the storm should we be headed for a recession.

First Quarter 2023 Global Equity and International Review

After a challenging year in 2022, global equity markets generated positive returns during the first quarter of 2023 with all major geographic regions in the green. The S&P 500 was up 7%, the STOXX Europe 600 index climbed by 7.8%, the Nikkei 225 increased by 7.5%, and the Emerging Markets collectively generated a positive return of 4%. Some of the factors driving these returns include falling inflation, better than expected economic data in the U.S. and Europe, as well as enthusiasm related to the reopening of China’s economy.