Moving On Up
Fresh off a positive year for equity returns in 2023, global stock markets continued their march higher in the first quarter (Q1) of 2024. The S&P 500 rose 10.6% in USD terms, or 13.5% in CAD in Q1. This strong performance continues to be driven by a subset of the dominant Magnificent Seven (M7), comprising of Nvidia, Meta, Amazon, Microsoft, Alphabet, Apple, and Tesla. While share price weakness from Tesla (-29% YTD) and Apple (-11% YTD) were a drag on the group, the M7 collectively still appreciated 13% in Q1, double that of the other 493 stocks in the S&P 500, which rose just 6%. This mid-single digit return is more in line with the S&P/TSX Composite’s return of 6.6%. Regardless, these are solid equity returns over a short three-month period. Both stock market indices made new highs at quarter end, climbing the proverbial wall of worry and adding to the market’s optimism that an economic slowdown is likely to be very mild in nature, if there is one at all.
Source: FactSet, Standard & Poor’s, J.P. Morgan Asset Management
Cuts Like a Knife
North American bond markets were volatile during the first quarter. As the central bank narrative progressed from policy rate hikes to policy rate cuts, the market got ahead of itself and by year end 2023, had priced in six rate cuts (25bps each) by the U.S. Federal Reserve (Fed) and five cuts in total by the Bank of Canada (BoC) for the 2024 calendar year. Fast forward three months and a combination of resilient economic data and ‘higher for longer’ guidance from central banks led to the market revising its 2024 rate cut expectations down to just three. In response, the U.S. Treasury 10-year yield rose from 3.9% to 4.2% and the Canadian Government 10-year yield rose from 3.1% to 3.5% by the end of March. As higher bond yields lead to lower bond prices, U.S. and Canadian bond markets both posted a -1% return in the quarter.
Spread Too Thin
Corporate bonds outperformed government bonds in the quarter. The additional yield that investors demand for investing in riskier corporate bonds is called the credit premium, as our colleague discussed two weeks ago. The credit premium compensates investors for taking on additional risk such as default risk and liquidity risk. The market’s current confidence in the economy and corporate balance sheets help explain strong current demand for corporate debentures. Along with an attractive all-in yield for investment grade and non-investment grade bonds, robust fund flows into fixed income have compressed credit premiums as a result. This can be observed in the credit premium between BB rated (non-investment grade) bonds and BBB rated (investment grade) bonds, otherwise known as the crossover spread. It is a good indicator to show market optimism, and the very narrow spread suggests that investors are being thinly compensated for owning lower credit quality relative to higher credit quality at this juncture.
Source: Bloomberg, QV Investors
North and South of the River
The South
The U.S. economy has been surprisingly resilient under the weight of restrictive interest rates. Most market forecasters predicted some economic weakness by this point, but we have just not seen the level of deterioration that would be consistent with a recession. Real gross domestic product grew a robust 3.1% y/y for the fourth quarter of 2023. Relative to the 30-year median growth rate of 2.6%, U.S. growth remains at an above-trend pace.
Source: Bloomberg, QV Investors
U.S. businesses have not slowed their capital spending. Private non-residential fixed investment, which measures spending on essential assets that drive economic production, growth, and innovation rose 7% y/y in Q4 2023. This pace of growth is consistent with the level observed during the mid-1990s, when the U.S. last achieved a soft landing in the face of restrictive policy rates. That said, it is uncertain whether business spending will remain as persistent as it did during the 90’s which was fueled by the aggressive deployment of IT equipment in the internet era. Today, both heightened investments in infrastructure and artificial intelligence seem likely to support the persistency of capital spending in coming years. Any material weakening in this measure, however, may portend economic weakness ahead.
Source: St Louis FRED, QV Investors
The labour market is also showing some tenacity with an unemployment rate of 3.8% as of March. It has edged higher from the low of 3.4% last April but remains at the low end of its historic range, indicating a strong labour market. Wage growth also remains hot at 4.1% y/y as of March. While it has been moderating, it will continue to challenge the Fed’s inflation targeting mandate as long as it is elevated.
U.S. job growth remains robust. But labour demand, as measured by several indicators such as job openings, temporary employment, average weekly hours, the private sector quits rate, is normalizing and may suggest a rebalancing of the labour market to come. However, we are simply seeing more job hires than we are seeing layoffs, further fueling the market’s confidence that a recession can be avoided. Indeed, if the Fed can cool labour demand without tripping the economy into recession, wage growth should technically cool, helping normalize inflation and engineering the soft landing scenario that risk markets have priced in.
Inflation remains stubbornly high however and has not shown sufficient evidence to prove that it is time for the Fed to lower its policy rate. The most recent headline inflation print, as measured by the consumer price index (CPI), was 3.2% y/y in February, with services accounting for most of the upward pressure. The below chart illustrates that core goods have rapidly corrected, while core services remain persistently above trend, propping up core CPI and preventing it from normalizing back to the Federal Reserve’s 2% target. Within core services, the shelter component of the calculation remains the largest and most stubborn contributor to overall services inflation.
Source: TD Securities
The U.S. will require some normalization in shelter costs and wage growth to achieve a sustainable path for inflation to return to the Fed’s 2% target. Shelter costs, as measured by owners’ equivalent rent (OER), is moderating (see below) but at a painfully slow rate. If shelter cannot be corrected via restrictive policy, then the Fed may need to weaken the labour market more aggressively to generate further relief. The Fed sees rate cuts ahead, but if these key pressures have not softened in time, the U.S. may have to endure higher interest rates for longer.
Source: BLS, TD Securities
The North
Canada, on the other hand, is not showing the same degree of strength as in the United States. Canada’s real GDP grew just 0.9% y/y in Q4 2023. Canadian households have a higher interest rate sensitivity due to our elevated level of indebtedness and conventional mortgages with shorter contracts terms (~5 years) compared to the U.S. (~30 years). Slowing mortgage and non-mortgage credit growth as well as rising mortgage delinquencies suggest Canadian consumers are being increasingly pressured by the restrictive level of current interest rates. If these trends deteriorate further, and if employment begins to weaken, Canada may have a difficult time dodging a balance sheet recession.
Source: Statistics Canada, TransUnion, CIBC
The explosive population growth in Canada is having a direct effect on some key economic metrics and confusing what is an already fragile time. The population in Canada has grown 1.25M over the last 12 months, a rare feat and much larger than the year when Newfoundland was added to the Canadian Confederation in 1949. This large population influx is not only intensifying Canada’s housing supply-demand imbalance but is also affecting the unemployment rate. Shown in the charts below, you can see that the rise in both Canada’s population and the labour force is outpacing that of job gains, as measured by the employment rate. This slowing in labour demand, in addition to layoffs, are resulting in a weakening unemployment rate which rose to 6.1% in March. Labour market rebalancing is unfolding in Canada despite the resilience shown in the U.S.
Source: NBF, Statistics Canada
In recent communications, the Bank of Canada acknowledged some signs suggesting that wage pressures may be easing. Indeed, different measures of wage gains are cooling from their pandemic peaks but remains well above the BoC comfort zone. Inflationary pressures have softened in Canada with the headline measure now within the BoC’s 1% to 3% target range. February’s CPI growth rate of 2.8% y/y has normalized considerably from the 8.1% y/y peak in June 2022.
Source: NBF Economics and Strategy (data via Statistics Canada)
However, inflation’s final mile back down to 2% may take longer than originally expected and will be contingent on lower wage pressure and a normalization in shelter inflation. Shelter costs account for 28% of the CPI basket so it is a major input to Canada’s inflation measure. But Canada’s population growth has exacerbated its housing supply demand imbalance, in turn pushing shelter costs stubbornly higher (6.5% y/y in February). In its January Monetary Policy Report, the BoC expects shelter costs to persist and contribute to half of overall inflation over the next couple of years. Excluding shelter, CPI is already at or below the BoC’s 2% target across all regions. As shelter is a necessity however, it is arguably misleading to strip out the shelter component just because it is stubbornly above target. But the exercise is interesting as it illustrates that the majority of the CPI basket has indeed already normalized.
Source: NBF Economics and Strategy (data via Statistics Canada)
The BoC is in a precarious position as it deliberates the timing of its first interest rate cut. On the one hand, rising early-stage delinquencies and normalized ex-shelter costs do not support such a restrictive policy rate. On the other hand, elevated shelter inflation may persist if the lower cost of financing leads to a snapback in housing activity. The BoC’s wait-and-see approach has resulted in a choppy push-pull dynamic within government bond yields over the past three quarters as new information has forced investors to rapidly recalibrate expectations for the overnight rate.
There Must Be a Better World Somewhere
The economic divergence between the U.S. and Canada has widened. Meanwhile the distribution of outcomes for both economies remain wide given the complexities of the current environment.
Similar to the divergences in economic trends, valuations of stocks and bonds show varying disparities. As shown below, the current year estimated price-to-earnings multiple of the S&P 500 has continued to rise further above that of the S&P/TSX Composite, compliments of the Magnificent 7. At 22.1x P/E the S&P’s valuation is pricing in optimistic growth expectations and not a lot of safety margin should the U.S. economy begin to disappoint. However, at 15.3x earnings, the TSX’s valuation implies lower growth expectations and potentially a better safety margin. Consensus earnings per share growth is expected to be 11% for the S&P 500 versus 6.5% for the TSX Composite, quite a notable difference.
Our equity strategies offer an attractive valuation advantage with an attractive rate of compounding. Consider the QV Canadian Equity Strategy with a CYE P/E of 14.1x, comprised of businesses that collectively earn a return on equity of 14.3% versus the TSX’s 12.7%. Our strategies are not the market. Our risk management discipline ensures that.
Source: QV Investors & Capital IQ
| Price to Earnings Ratio | 31-Mar-24 |
| S&P 500 | 22.1x |
| S&P/TSX Composite | 15.3x |
| QV Canadian Small Cap Fund | 12.8x |
| QV Canadian Equity Fund | 14.1x |
| QV Global Small Cap Fund | 14.3x |
| QV Global Equity Fund | 14.9x |
| Yield to Maturity | |
| QV Canadian Bond Fund | 4.4% |
Source: QV Investors & Capital IQ
Shelter from the Storm
Markets are emotional. Confidence can turn into excessive optimism, pushing valuations to levels that offer a slim margin of error. Treading carefully and taking a defensive approach when optimism is at extremes has helped our clients avoid setbacks in prior cycles. Risk and return are joined at the hip. As long-term investors we want to be taking on risk when we are being compensated for it and avoiding it when we are not. It is a helpful reminder to avoid potential pitfalls from pockets of high market valuation, helping put the odds in our favour.
Our equity strategies offer a collection of businesses with superior compounding abilities, stronger balance sheets, greater income potential, and a wider margin of safety than their respective benchmarks. Our bond strategy offers an attractive yield that we have not seen in fixed income markets for over a decade, with defensive characteristics to offset equity volatility should the outlook turn out to not be as rosy as is priced in. Our balanced strategy is positioned with a defensive bias because of our risk management discipline within our component strategies, but also from a slightly more conservative mix to bonds given market uncertainty at this stage in the cycle.
Risk management starts from the bottom up. It starts with the businesses and management teams we align ourselves with and the valuations we choose to invest in. Staying disciplined to this philosophy over all phases of the business cycle helps us navigate the extreme inflection points and all the time in between. We have seen this movie before, when risk management is no longer in vogue, it is these very times when investors need it most.
