After delivering robust returns during the first quarter, global equity markets continued their upward climb during
the second quarter of 2024. Some of the key factors driving the returns included strong corporate earnings, reduced
fears about a global economic recession, and enthusiasm over artificial intelligence that powered massive gains in
Technology stocks. Given this backdrop, stock market returns during Q2 2024 were positive on a total return basis
across major developed market regions.

Over the past year, the bear market narrative has transitioned from fears about a recession to renewed concerns about interest rates. The reason why interest rates concerns have re-emerged is due to several inflationary data points that were worse than expected. These hotter than expected inflation reports have shifted investor expectations regarding interest rate cuts from the U.S. Federal Reserve. As a result of this, the bond market is now only pricing in 1 interest rate cut by year-end, which compares with expectations for 7 interest rate cuts at the at the beginning of 2024. Given this shift in sentiment, the U.S. 10-year Treasury yield has jumped from 3.9% at the end of 2023 to 4.5% currently.

Just over a year ago, most investment banks on Wall Street were forecasting a U.S. recession due to the impact of stubborn inflation and high interest rates. In March of 2023, 65% of economists polled by Bloomberg believed that the U.S. economy was headed for a serious downturn within the next 12 months. However, Wall Street has largely abandoned its recession call given the resilience of the U.S. economy over the last 12 months. This shift in sentiment regarding a recession was evident in the Deutsche Bank Global Markets Survey that was conducted in March of 2024. The results from that survey showed that only 17% of respondents expected a recession or a hard landing for the U.S. economy. Although many of the bears have abandoned their call for a U.S. recession, many of them have moved on to a different narrative. The new narrative is that high interest rates are bad for stocks. The argument basically says that the even though the economy will avoid a recession, stocks will perform poorly due to high interest rates. The interesting thing about this new narrative is that history tells us that investors should not fear higher rates. In fact, some of the strongest periods of performance for the S&P 500 over the last few decades have coincided with rising interest rates or higher levels of interest rates.

Since 1990, periods of rising interest rates have been associated with stronger stock market returns than periods with falling interest rates. As seen in the chart below, the S&P 500 has posted an average annual price return of 13.9% during periods of rising interest rates, which compares with just a 6.5% average annual gain during periods of falling interest rates.
Not only have stocks done better during periods of rising interest rates, but stocks have also generated higher returns during periods when interest rates were at higher levels as seen in the chart below.

Since 1990, the S&P 500 has performed better when interest rates were higher, as measured by the U.S. 10-Year Treasury Yield. When the 10-Year Yield was less than 4%, the average annual return was 7.7%. This compares with an annual return of 9.1% when the 10-Year Yield was between 4-6%, and an annual return of 14.5% when the 10-Year Yield was above 6%.

The data outlined in this note suggests that the current bear market narrative is somewhat flawed. The argument that higher interest rates is bad for stocks is not consistent with the historical data since 1990. This does not mean that there aren’t any risks because there are always going to be risks for the stock market. When we take everything into consideration, we continue to have a cautiously optimistic view for global equity markets. First, the global economy continues to demonstrate resilience which has significantly reduced concerns about an economic recession. Second, while inflation remains above the targeted threshold for many central banks, it is moving in the right direction. This is setting the stage for interest rate cuts in Europe in the months ahead and rate cuts in the U.S. later in 2024 and into 2025 Finally, corporate earnings have been steady and have surprised to the upside across several markets around the world.

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.

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. 

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.

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

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%).

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%.

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

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.