Macro & Strategy - June 2024

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The equity rally broadens out

We’re approaching the mid-point of 2024, and the markets have been kind to equity investors so far. In fact, the latest fund manager surveys show that institutional investors are the most bullish they have been since November 2021, when the markets were going straight up, and central banks were still holding their key rates at the zero lower bound.

Fast forward to today, and we see that although monetary policy is at the tightest levels in decades, along with persistent worries of a hard landing and geopolitical turmoil around the world, global investors’ largest overweights are in equities and commodities. Even though consumer confidence has remained subdued recently, the hard economic data are still robust, leading investors to say we’re in a “vibecession”.

Our positioning has also favoured equities and commodities in 2024, and we think investors should be rewarded for taking on risk in the coming months. This month, we’re discussing the opportunities emerging outside the mighty U.S. market.

The story so far in equity land

Earlier this year, the airwaves were dominated by talk of artificial intelligence, NVIDIA and Big Tech in general. But surprisingly, Japan and Europe have provided the best equity returns so far this year. Even Canada is keeping pace.

As shown by the chart below, the 3-month (63 trading days) momentum leadership has already seen a few changes in 2024. The tech-fuelled U.S. stock market roared out of the gate and led the pack through February, before giving way to Japan, where investor-friendly structural reforms and hints of reflation made the Nikkei one of the best performers on the equity score card, right up with the Nasdaq. In fact, we recently added a tactical overweight on a dip in Japanese equities, and we think this positive story will continue in the coming quarters.

Interestingly, when Japan was becoming ripe for a consolidation phase, Canada and Europe regained equity market leadership.

With most of the major developed equity markets participating, we have a broader rally that isn’t U S centric.

One important reason is that, as we have pointed out in previous months, the global manufacturing cycle is recovering and getting broader.

More and more countries are seeing their manufacturing PMIs rise above the threshold of 50 with emerging countries leading the way In short, the macro environment has recently become more supportive of cyclicals, with investors getting more bang for their buck outside the United States This development is beneficial in that cyclicals and other value oriented indexes are finally attracting investor attention after largely being out of favour in recent years.

Looking deeper into market valuations, we see that forward price earnings ratios have expanded in synchronized fashion since the start of the year, proportionately the most in Canada and Europe, where the cyclical sectors have more weight The discount to the U S market remains an important feature, as it has been over the past 10 years, given that it’s the home of Big Tech.

Earnings expectations on all markets shown below have also been revised higher through the year, much more so in the United States ( data centres, no landing, etc but the trend is to the upside in every region.

With U S earnings growth forecasts remaining lofty, we think the market could be expecting something too close to perfection U S exceptionalism has been a dominant theme in the COVID era, and betting against it has been a losing strategy since the bear market of 2022 But, looking at valuations and earnings forecasts across regions, we see the potential for higher multiples and positive earnings revisions outside the United States as manufacturing continues to reaccelerate.

Is sector breakdown finally benefitting Canada and Europe?

One of our core macro views is that commodities are entering a new bull market, led by copper, which plays a key role in the electrification of transport, and the AI data centre theme If we’re right, and the manufacturing cycle continues to accelerate, the markets could be supported by multiple dominant themes.

One of the drawbacks of many global ex U S indexes over the past 10 or more years has been the low weight of tech and the tilt toward cyclical sectors Well, the combination of progressively less tight monetary policy and manufacturing resurgence should increase demand for Canadian and European equities Prospects of lower interest rates should act as a catalyst for businesses to ramp up investments in capital intensive projects, and stronger demand for commodities and manufactured products should benefit the most cyclically inclined indexes.

China could also play a role Non official numbers, such as Chinese electricity consumption and air pollution, are indicating a sharp rebound of manufacturing activity in the Middle Kingdom Moreover, Germany’s latest ZEW survey has noted accelerating demand from China in recent months Another story gaining traction is that China is stockpiling commodities, such as copper and iron ore, to reduce its reliance on foreign sources, and is moving instead to natural resources as a store of value on a global scale.

In this light, the sector composition of non U S stock indexes could become a tailwind once again Looking at the table below, we see how heavy the Canadian and European indexes are in cyclicals (consumer discretionary, energy, financials, industrials and materials) in relation to the U S where non cyclicals tend to dominate The S&P/TSX Index has a whopping 79 2 of its weight in non tech cyclicals, and the Euro Stoxx 50 Index comes second with a weight of 65 3 The picture is pretty much flipped in the U S indexes, where tech and non cyclicals tend to dominate.

In a nutshell, although we don’t recommend standing in the way of the U S stock market in a world that will increasingly be dominated by Big Tech and AI, we think the macro tailwinds that have started blowing over the world in recent quarters will continue to support cyclical heavy markets.

Over all, the macro environment is turning supportive for cyclicals, and investors are looking beyond the U S market for opportunities, as reacceleration of manufacturing, interest rate cuts, stockpiling of commodities and broader economic growth trends become dominant themes.

The equity markets are stronger when they are broader After being a weakness for more than a decade, the cyclical tilt of the Canadian and European equity indexes could become a strength once again.

Current views

Our positioning is little changed from last month’s We are still moderately optimistic about the outlook for the equity markets Even though we acknowledge that significant ground has been covered since 2023 the environment for equities remains supportive With first quarter earnings largely in the rear view mirror, it is clear that corporate earnings growth and guidance remain solid The largest U S companies, and the big equity index movers, have continued to post strong results and to make shareholder friendly moves, such as increased buyback programs and dividends.

In line with the broadening of the economic expansion described above, we are also beginning to witness improved returns outside the United States, which has dominated equity market performance of late European, Canadian and even beleaguered Chinese equities are waking up from a long slumber, as markets start to price in better growth outcomes for these regions We think there is further room for improvement on this front and, therefore, remain optimistic about equities.

We have maintained our position in Japanese equities, which we continue to think will benefit from relatively easy monetary policy from the Bank of Japan, as well as positive earnings from Japanese corporates Interestingly, Japan seems to have fallen off the radar screen of most investors, with the consensus no longer really paying attention We continue to think Japan offers one of the more compelling equity market stories.

Last month, we initiated a position in the U S utility sector When interest rates peak, defensive, dividend paying companies, such as utilities, typically see a tailwind Moreover, several utility companies are starting to benefit from the insatiable power demand created by investment in data centres, electrification of the power grid, decarbonization and AI related power demand We think this environment is favourable to the sector.

On the fixed income front, we firmly believe that Bank of Canada rate cuts are coming, but our view is that the U S Federal Reserve will remain a bit more cautious when it comes to easing monetary policy Even though Jerome Powell removed the “right tail” of the interest rate probability distribution in his recent communications, by indicating a very high bar for further interest rate increases he also suggested that more evidence of disinflation is needed before the Fed can move decisively to reduce interest rates We generally agree with this assessment and think there is a risk that the Fed will disappoint the markets by not delivering as many cuts as investors expect or desire In this context, along with a persistently inverted yield curve, we hold a slightly negative view of fixed income.

Finally, we have maintained our positions in gold and copper Although both metals have experienced wild gyrations lately, as investor positioning apparently shifted more to the long side, we continue to think both commodities are in secular uptrends.

Gold is benefitting from a potential peak in real interest rates as well as diversification purchases by central banks We expect this story will continue to play out over the medium term Meanwhile, the copper supply demand balance remains very tight especially because the Chinese economy seems to have found a bottom in terms of growth momentum.