Q2 PIMG Commentary: Mixed Messages

So far, in 2024, economic data and financial markets have provided many mixed messages. Inflation is generally lower, but not low enough to reduce interest rates in any meaningful way. Equities have exhibited continued strength and many indexes have reached new highs, but that strength is the result of only a handful of companies. Economic data continues to be resilient, yet unemployment amongst other data is now getting worse. Despite strong markets so far this year, these mixed messages have made it difficult for investors to gauge the near-term direction of the markets.

The Bank of Canada cut interest rates by a quarter of a percent to 4.75% on June 5th and signaled that more rate cuts could be delivered, should inflation continue to slow. Both of the Bank’s preferred measures of inflation moved to below the 3% threshold in April and are expected to continue decreasing throughout the year. Furthermore, Canada’s first-quarter GDP growth was softer than expected and labour data pointed to a tightening job market, suggesting more accommodative credit conditions could materialize. Still, the Bank noted that upside risks to inflation remained, magnified by uncertain geopolitical tensions and a relatively more hawkish U.S. Federal Reserve. This raised questions on how much room the Bank of Canada has to cut without sacrificing the value of our currency or reigniting inflation. The most recent inflationary data also saw Canada’s CPI move higher to 2.9% year over year, reducing the likelihood of a secondary interest rate cut in July.

Canadian bond markets have seen yields move marginally lower over the past month, despite the Bank of Canada’s cut in rates. Although we believe peak interest rates are behind us for this cycle, the resilience of inflation has bond yields telegraphing that more work needs to be done before longer-term bond prices can improve. Canada’s five and ten-year bond yields are currently around 3.5%, which are approximately 20 basis points higher than where they were entering 2024 and 40 basis points off April’s high of 3.9%. Attractive opportunities still exist across high-quality corporate bonds with three-to-seven-year maturities. GICs with maturities of one to two years are providing yields of around 5%, offering compelling cash flow for conservative assets.

Canadian equity indexes reached an all-time high in late May before seeing some weakness develop throughout June. While lower interest rates could be the catalyst to spark a new bout of positive performance for interest rate sensitive sectors such as utilities, REITs and telecoms, we have yet to see that materialize.

Several factors are likely contributing to this underperformance: 1) anchored bond yields as noted above, 2) Canada’s slowing economy and a resulting fall in consumer spending 3) Canadian productivity challenges and lack of foreign investment or worse, divestment and 4) fund flows that continue to support less capital-intensive assets. On the positive side, we do continue to see leadership amongst several of our core portfolio names with the likes of Royal Bank, Intact Financial, Gibson Energy, Cameco and CCL Industries trading at or near 2024 highs.

U.S. markets continue to be the clear, global leader. Sectors such as consumer discretionary, financials, and communication services and technology have been stand-out performers. Technology has been driven by companies such as Amazon, Microsoft, Apple and Google that have traded to new all-time highs. Nvidia has had an incredible run and recently took the crown as the world’s largest company. While its success in delivering GPUs for AI computation needs is driving remarkable revenue and earnings growth, we remain somewhat skeptical about how long this can last.

As noted in our last quarterly update we continue to monitor the concentration of the largest stocks that make up the S&P 500 index. While there was evidence of the market strength starting to broaden in Q1 we have seen this reverse in Q2. The S&P 500 grew by 3.92% in Q2. However, the S&P 493 (excluding the largest seven companies) experienced negative performance of 1.47%. Said differently, the largest seven companies continue to move higher while the rest of the market is showing relative underperformance. The largest companies are not only getting bigger but also more expensive, with Apple recently notching its highest valuation ever as measured by its price to earnings ratio. Fund flows are chasing a select few names, mostly to do with the artificial intelligence theme and leaving the rest of the market behind.

We have also seen continued signs of economic weakness both in Canada and the U.S. Unemployment numbers have ticked higher on both sides of the border while data such as manufacturing and service PMIs, typically used as real-time gauges of economic activity, has dipped significantly. While the market continues to shrug this data off there is likely a limit to how long this lasts. Our belief is that it’s time to sell or trim excessively valued positions and reallocate capital to less expensive areas of the market that have been out of favour. We are also continuing to monitor those companies that are more economically sensitive and have lightened up where we felt prudent to do so.

In the quarter we did more selling than buying for fully invested accounts. We reduced our position in Cameco, which has done exceptionally well but is now trading at a historically high valuation above our target. Walmart and Wells Fargo were also reduced in client portfolios for similar reasons. We parted ways with Air Canada as the booming travel numbers that we have seen over the last few years forced us to ask ourselves, what could possibly get better?

On the buy side we added Nutrien to client portfolios. This best-in-class Canadian fertilizer producer is a name we have owned in the past. The stock had traded down 50% over the last 18 months, in large part due to weaker commodity prices. As a global leader in a cyclical business, we are happy to pick up shares when commodity prices are low and the valuation “seems” excessive. We also added shares of Volkswagen to select client accounts. Volkswagen has had a difficult few years as the Chinese market, where they derive over 20% of sales, has been hampered by slowing sales and increased domestic competition. Buying shares of this global brand at less than 5X earnings, with the slowdown hopefully priced in, makes sense to us.

With risks as outlined continuing to mount we are taking a more guarded stance as we enter the summer months. We continue to allocate capital to areas of the market we believe are attractive in the context of a long-term time horizon, while reducing companies with excessive valuations. The result of this may be a higher cash position across accounts over the summer months. Fortunately, cash is offering a compelling yield and we have no doubt we will find attractive entry points into great long-term opportunities.

We look for a more balanced second half of the year, where we see more participation from the broader market.

Your Plena Wealth Advisory Team