It was quite the remarkable summer. There is a common saying among investors, “sell in May and go away.” While not entirely accurate, the belief is that equity markets underperform between May and October. This year, the philosophy would have spared investors the June swoon, but immediately following, investors would have missed the July pop. In the end, the closing price on the last trading day of April for the S&P 500 Index was 4,131, within one percent of the close on August 24 of 4,140. Of course, since then the S&P 500 Index has given up some of the gains following Jerome Powell’s speech in Jackson Hole, Wyoming. Sometimes it works, sometimes it doesn’t. Which goes to show that trying to time the market is often a fool’s errand.
Market participants who closed the books for the summer are back from vacation with a lot of data to digest. From inflation to shifting consumer trends, and real estate to energy prices, much has happened in just a few months with much more still to come. We have the Bank of Canada and U.S. Federal Reserve each with a policy meeting in September along with the U.S. midterm elections in November.
From the economic perspective we are reminded that consumption represents a whopping 70% of the U.S. economy. Inflation, therefore, is certainly impacting the consumer. But to what extent? Prodco is a company that measures in-store traffic via door sensors. For the week ending August 19, which reflects back-to-school spending, there was a 15% year-over-year increase in traffic in apparel stores.
While consumption remains strong, we have noticed a shift in consumption habits. For example, McDonalds’s and Walmart are reporting a higher share of high-income customers in their traffic, and lower shares of low-income families.
This seems to point towards an economy where high inflation and higher interest rates are starting to impact the consumer. At the same time however, the labour market is holding in quite strong. Wages, while not growing as quickly as inflation, are nonetheless increasing at the strongest pace in 25 years (according to the Federal Reserve Bank of Atlanta). Employed people still spend. And there are still shortages of just about every durable good. Demand is not dead.
That said, the question on everybody’s mind is: are we heading towards recession? As the year has progressed, there are more signs that seemingly point to an increased risk of the dreaded “R” word. With the Fed willing to risk economic growth to tame inflation, the question should really be: what would a recession look like if we have one at all?
The worst recessions have usually been tied with financial disasters – for example the sub-prime crisis of 2007-2009. So far, the financial system doesn’t look especially compromised. High unemployment is also a staple of a bad recession. The labour market seems to be holding up quite well. The latest job openings data in America are coming up higher than anticipated at above 11 million.
We are not certain if we are headed towards recession, but if we are, the signs lean more towards a small ‘r’ and not a big ‘R’ recession. In that context, we believe certain asset classes may be better positioned than others.
While Canada is at risk of a housing recession, we like to remind investors that the Canadian economy is not the stock market. Canadian equities are much more levered towards global growth. We believe the strength in commodity demand will continue to bode well for the S&P/TSX Composite Index. Furthermore, equity valuation in Canada remains very attractive relative to historical levels. These factors put Canadian equites in a positive light.
U.S. markets are another story, where you will still find the best companies in the world, yet valuation for the S&P 500 Index appears full. There are pockets of value showing up in some sectors, but overall, the price is still above average. Despite this, earnings growth remains favourable and corporate guidance encouraging. As such, we remain cautiously optimistic and aware that valuation may bring about headwinds.
This is somewhat the opposite of what is happening in Europe, where the general business conditions are much more difficult but are also reflected in equity valuations. The spread between the relative valuations of the MSCI EAFE Index versus the S&P 500 Index is now historically wide. This may present opportunities for international equities as this valuation gap narrows.
As far as fixed income is concerned, we believe much of the downside is behind us. With rising interest rates, the long-term prospects for bonds have dramatically improved. Historically, the correlation between the 10-year government bond yield and the eight-year forward return is extremely strong. In this regard, current yields suggest forward returns may revert to the historical norm of mid-single digits.
Ultimately, the next few weeks and months may deliver renewed volatility. This is typical for the time of year and the uncertainty that comes with elections. Through the remainder of the year, we should gain greater clarity towards the direction of economic growth, which itself should eliminate some of the uncertainty and improve investor sentiment.
