Q2 2024 Strategy & Market Reviews
Each quarter, our Investment Management teams publish their key observations and portfolio updates across Global Equity and Fixed Income markets. This is a summary of our views for the Second Quarter of 2024. You can download the full reports via the links shown below.
KEY OBSERVATIONS
Market performance for the second quarter of 2024 was mixed as the S&P 500 experienced a 5.35% gain in Canadian dollar terms, while the TSX slipped -0.53%.
Inflation data recently came in much lower than expected, inching closer to the Federal Open Market Committee (FOMC) target of 2%. However, despite mounting disinflationary data, the Fed’s projection for the Fed Funds interest rate for year end 2024 went from 4.6% to 5.1%, as compared to 5.25%-5.5% today, implying one rate cut this year versus three projected in March.
The bond market has interpreted the softer inflationary data favourably, as 10-Year Treasury yields have fallen from about 4.6% at the end of May to the current level around 4.4%. Lower Treasury yields support the idea that inflationary conditions are improving, even if more slowly than anticipated by the Fed earlier in the year.
While a rate cut might incite further stock market gains in the near term, it could also lead to excessive valuation. We prefer to see market gains supported by stronger earnings growth. The good news is that positive earnings surprises during Q1 2024 and higher forward guidance have led to upward revisions to 2024, 2025 and 2026 earnings expectations.
Despite a generally positive outlook, market pullbacks of 5%-10% in the third quarter of U.S. presidential election years have been the historical norm for the past 75 years. If history repeats itself, we can’t rule out some market turbulence in the July through September period.
Having said that, historical data show that secular bull markets last 16 years on average, and cyclical bull markets within those larger bull runs last about 30 months and produce a gain of 86%. The S&P 500 is now up about 53% from its October 2022 low roughly 20 months ago. We believe we are likely only part way through a cyclical bull market, suggesting that any pullback will be temporary.
Putting everything together, we see an economy that can sustain moderate economic growth with lower inflation, which should eventually allow for market-friendly monetary policy. Furthermore, stronger earnings growth should support stock valuations.
NORTH AMERICAN EQUITY UPDATE
Peter Jackson, HBSc, MBA, CFA
Chief Investment Officer
Portfolio Manager, North American Equities
Our overall equity exposure remains high, having increased by 1% to 96%, with cash decreasing to 4%. Our U.S. equity exposure increased from 52% to 56% while our Canadian exposure decreased from 43% to 40%. For portfolios invested in our North American plus International Equity strategy, the US and Canada weights will be proportionately less than this given the current 20% allocation to international companies.
During the quarter, we continued to shift our allocation in favour of US equities (+4%) over Canadian equities (-3%). US earnings growth continues to outpace Canadian earnings growth where recent F12M earnings for the TSX turned negative. This was largely driven by energy resource sector downgrades, which is a sector in which we maintain minimal exposure. Our Canadian companies have growing earnings, and many are globally diversified in terms of revenue sources despite their Canadian headquarters.
We added one new investment during the quarter:
Cadence Designs Systems is often referred to as one of the most important companies you have never heard of. It is a leader in Electronic Design Automation (EDA) software, a critical tool that turns complex chip designs into manufacturing blueprints. The EDA market has a near-duopoly structure dominated by Cadence and one other player ensuring stability and pricing power. This specialized software commands high returns on invested capital and less cyclicality than the semiconductor industry overall. Cadence is poised to benefit from the growing trend of companies designing their own chips.
A detailed review of this company can be found in the full report per the link above.
GLOBAL EQUITY UPDATE
Phil D’Iorio, MBA, CFA
Portfolio Manager, Global Equities
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.
In terms of the economy, Macroeconomic Surprise indexes turned negative during the month of June for major economies around the world. This phenomenon was particularly pronounced in the US. In our view, what’s really happening is that the economy is slowing, not shrinking. A slowdown in the economy strengthens the case for interest rate cuts and that’s a good thing as it would help stimulate the economy.
Technology stocks have continued to dominate. On a year-to-date basis, Nvidia alone has contributed 30% of the gain generated by the S&P 500. Microsoft, Amazon, Alphabet, Meta, and Apple have collectively generated another 30%. When you add it all up, six companies have generated more than 60% of the upside in the S&P 500 for the first six months of 2024.
We continue to focus on companies with strong fundamentals, competitive advantages, and exposure to secular growth themes. Some of these themes include artificial intelligence, electrification of global infrastructure, decarbonization of the global economy, and healthcare innovation. We would argue that many of the large Technology stocks deserve to trade at above-average valuations given their attractive growth profiles, their robust free cash flow generation, and their pristine balance sheets.
Our current outlook is cautiously optimistic. The global economy remains resilient and inflation has fallen enough to set the stage for interest rate cuts.
During the second quarter, we established several new positions in our Global and International portfolios. In our Global strategy, we established new positions in ASML, Broadcom, and Wolters Kluwer. In the International strategy, we initiated new positions in Arch Capital and Tokyo Electron.
A detailed review of each company can be found in the full report per the link above.
Owen Morgan, MBA, CFA
Portfolio Manager, Fixed Income
Following a challenging Q1 for interest rates, Q2 saw fixed income investments perform more positively. The tone of the interest rate cycle changed in June. First, the Bank of Canada cut rates by 25 bps on June 5th, to bring the overnight rate to 4.75%. This was the first cut by the Bank since the outset of the pandemic. The European Central Bank followed suit the next day, cutting rates by 25 bps as well, to bring its headline rate to 3.75% (its first rate cut since early 2016).
Very short-term interest rates (from 3 month to 2 years) are heavily influenced by the Bank of Canada overnight lending rate trend, and by the market’s expectations of the timing of any changes to that rate. These all gapped downwards on with the June 5th rate cut, but have not changed to a significant degree since.
We believe we are at the beginning of a rate cut cycle by the Bank of Canada, although how deep the cuts and the length of time the bank will take to complete the phase is unclear. Current data suggest that the market is expecting two or three more cuts.
Looking at the Canadian Yield Curve, it flattened a little in Q2, with the short end rates declining, and the longer-dated ones remaining relatively static. The curve slope remains inverted, with short term rates higher than long term rates, which is often cited as an indication the economy may be headed into a recession in the near term.
Another driver of fixed income returns are credit spreads, or the additional yield provided by corporate bonds over that of federal government bonds. Credit spreads narrowed very modestly over Q2, and remain well below year-end 2023 levels, which is positive for returns (as spreads narrow, it means yields decrease, and as yields decrease, bond prices increase).
In terms of the Cumberland Income Fund investment portfolio, as we anticipate interest rate cuts in the near term, it makes sense for us to continue to extend the fund’s duration, which will positively impact valuations as rates fall. We also anticipate modest increases in our exposure to federal, provincial, and/or investment-grade corporate bonds over the coming quarters.
We expect that the remainder of calendar 2024 will provide a positive outcome for fixed income investors.
