Portfolio Perspectives – April 2024

Market review

Global equity markets finished strong for the month of March and wrapped up one of the most positive quarters since the beginning of the pandemic. Monthly and quarterly gains were largely driven by optimism over artificial intelligence (AI) related stocks and expectations that monetary policy will soon be relaxed.

U.S. Treasury yields fell, fuelled by an upbeat sentiment as the U.S. Federal Reserve elected to keep three policy rate cuts pencilled in for this calendar year. In Canada, bond yields fell following lower-than-expected inflation for February.

Canadian and U.S. equities finished higher, returning 4.1% and 3.2% (US$), respectively. International equities were also higher, rising 3.4% (US$), while emerging markets finished positively, rising 1.9% (US$). The ICE BofA Canada Broad Market Index was slightly higher, rising 0.5%. On the currency front, the Canadian dollar appreciated against the U.S. dollar, increasing 0.3%.

Economics

Canada – Canada’s gross domestic product (GDP) rebounded in January, exceeding expectations, and February’s preliminary estimate points to another expansion. The economy grew 0.6% in January, its fastest growth rate in a year, which Statistics Canada called a broad-based expansion led by a bounce back in education services. February’s GDP is also likely to have grown 0.4% with main contributions from mining, quarrying and oil-and-gas extraction. The strong start to the year and the forecast for February show that the GDP is likely to close the first quarter better than the Bank of Canada’s 0.5% projection. Growth in January was broad-based, with 18 out of 20 sectors expanding output in the month.

U.S. – Home sales rose in February from the month prior, marking the first time in more than two years that sales increased for two consecutive months. Sales of existing homes, the majority of purchases, surged 9.5% to a seasonally adjusted annual rate of 4.38 million, the National Association of Realtors reported. The momentum in sales over the past two months comes just ahead of the spring selling season and follows one of the most sluggish periods for the housing market in recent history. Home sales in 2023 fell to the lowest levels in nearly 30 years. Since 2022, higher mortgage rates, high home prices and limited inventory have stifled sales, which were still down 3.3% from a year earlier in February.

Eurozone –  The European Central Bank will be able to lower its key interest rate in June if forthcoming data on inflation and wages come in line with its projections, President Christine Lagarde said. Lagarde’s comments in a speech to economists and investors are the strongest indication yet that the eurozone’s central bank is preparing to lower borrowing costs as early as June, providing inflation continues to ease. “If these data reveal a sufficient degree of alignment between the path of underlying inflation and our projections, and assuming transmission remains strong, we will be able to move into the dialling back phase of our policy cycle and make policy less restrictive,” she said.

Asia – China’s youth unemployment rate rose in February, another data point signalling weakness in the country’s economic recovery. The youth unemployment rate rose to 15.3% for February, compared with 14.6% for January, the National Bureau of Statistics reported. The country’s overall jobless rate was 5.3% for February. China’s statistics bureau suspended the release of the jobless rate among 16- to 24-year-olds after the figure climbed for six straight months to a record high of 21.3% last June. It resumed releasing the data in January with a new methodology that excludes students in schools, reporting the youth unemployment rate at 14.9% for December.

Current outlook

Equity markets have continued to move higher since the fourth quarter of 2023, leading bearish investors to make comparisons to the dot-com era and bulls to suggest there could be more upside ahead. Those optimistic about the market point to the S&P 500 trading at 24.6x trailing 12-month earnings, significantly below the ~30x peak observed during the dot-com era (December 1999)¹. The current macroeconomic environment, characterized by low unemployment rates and healthy consumer spending patterns, lends credence to the bullish scenario.

Conversely, the bearish perspective urges investors to look past the index-level trailing price-to-earnings (P/E) multiple. Currently, the 20% most expensive stocks (by P/E) in the S&P 500 have a collective index weight of 28%. While that is lower than the dot-com era’s 47%, it exceeds the 10-year pre-pandemic average of 18%.² Assuming high-P/E stocks are most vulnerable to multiple-contraction-related declines, investors should exercise a higher-than-normal degree of caution.

Household allocation to equities is also significantly higher today than in the dotcom era, which may reduce the number of marginal buyers left to sustain further price increases. Additionally, volatility is subdued, driven by extremely low correlation among individual stocks. In prior instances, when stock correlations dipped to current levels, this was followed by a spike in volatility. Given our concerns about the macroeconomic backdrop, we believe a slightly cautious stance on equities is warranted.

Looking at fixed income, a cross-sector analysis of credit rating agencies’ potential actions reveals that most U.S. investment-grade (IG) sectors are poised for upgrades. According to data compiled by Bloomberg, the energy sector is expected to lead the pack, with about 10% of IG and 20% of high-yield (HY) debt expected to climb the credit rating ladder.³

IG companies in the technology and communications sectors are distinctively better than their HY counterparts, with net IG upgrades of 5% and 7%, respectively. Conversely, HY technology and communication businesses are expected to see net downgrades of 20% and 10%, respectively. Meanwhile, major credit rating agencies have singled out the consumer staples sector as having no upside credit potential, with 12% of IG and 5% of HY debt set to move lower in credit quality.⁴

While this analysis is helpful for top-down credit selection, it also shows that speculative-grade issuers are more likely to face credit downgrades. At the same time, investment-grade firms are more likely to move up the credit quality ladder and hold their value in the face of rising financial costs. This underpins our preference for high-quality credits, whose issuers are better positioned to weather challenging financial conditions than their HY counterparts.

Monetary policy will likely remain front and centre this year as investors look for falling inflation and looser monetary policy to whet risk appetite. At the same time, we think that once central banks begin to cut rates, they will do so gradually. As such, risks pertaining to excess indebtedness could linger and weigh on consumption and investment. In this context, we advocate for a high-quality bias in portfolios and diversification across multiple regions and asset classes.

^{1 2 3 4} Scotia Wealth Management, Bloomberg.

Indices

Commodities

Currencies

Source: Bloomberg. As at March 31, 2024.