Q2 2023 Market Commentary: Positive signs include some strength in equities – and AI is all the rage
by Vittorio Ciccone | M.Sc | Louisbourg Investments
As we enter the second half of 2023, the economy has proven more resilient than expected. Canada and the US saw an uptick in GDP, with consumers still spending despite the higher interest rates. Low unemployment rates persist, and inflation continues to run higher than central banks’ targets.
Meanwhile, concerns over the US regional and global banking failures eased as central banks and governments stepped in to help. President Biden and Congress reached an agreement to suspend the debt limit until January 2025.
According to RBC Economics, Canadians’ excess savings from the pandemic began to diminish as the higher rates took their toll. Until recently, the savings had helped offset some of the increases’ effects. As well, interest rates, along with higher prices, are eating away at Canadians’ after-tax wages. RBC is predicting a recession for Canada.
Raising interest rates is the Bank of Canada’s response to inflation, as it is with the US Federal Reserve. However, many believe the worse of the rate hikes is over. J.P. Morgan Research expects that, as the Fed’s policies continue to add restrictions and slow overall growth, the US will enter a recession near the end of 2023 – but a mild one. The rest of the world will be watching what the Fed does over the next year to see where US rates move. There’s a widespread feeling that by mid-2024 the FED will begin to cut rates.
Globally, despite the continuing war in Ukraine, energy prices have lowered close to normal levels. Moreover, the supply chain disruptions caused by the pandemic and the war have eased. Economists are watching China’s higher-skewing demographic trends, as the aging population may prove a drag on that country’s growth. In the UK, inflation is starting to moderate, but still remains high due to increased wages and energy prices. European inflation overall was impacted by energy prices over the winter months; however, inflation is expected to come down in Q2 as the European Central Bank (ECB) maintains its focus on raising rates.
Equity markets summary
Thanks to Mathieu Roy, Head of Equities at Louisbourg Investments, for the following information.
Technology Sector Drives US Equities
Equities continue to hold quite strongly into the second quarter. That said, performance was mixed across regions. US equities demonstrated clear leadership, buoyed by resilient economic indicators and ongoing advancements that are creating enthusiasm in the impactful technology sector. International and Canadian equities generated small gains, just enough to maintain their first-quarter advance.
Canadian Equities Lag Behind US Counterparts
Canadian equities haven’t inspired the same enthusiasm as equities south of the border. For example, large US technology firms’ optimism about new, generative artificial intelligence (AI) did little to create similar excitement for most Canadian companies. The S&P/TSX Composite Index still managed to yield a small positive return (+1.1%), but breadth was weak across sectors, with positive returns from only six out of 11. Technology (+17%) stood out, a result of improving sentiment toward one significant company, Shopify. Consumer Discretionary (+6%) was the only other sector that offered a significant contribution. Materials (-6%), Real Estate (-3%) and Consumer Staples (-3%) were the worst-performing areas of the market.
Technology Continues to Propel US Equities
In Q2, US equities (+6.3%) continued to defy expectations, with global equities marching higher despite obstacles. The US economy has remained more resilient than expected, with jobs growth and household spending only gradually moderating. Still, core inflation continues at levels far above the Fed’s target.
Amid these developments, as noted, growing enthusiasm around generative AI has largely driven market performance. The rapid adoption of ChatGPT by consumers attracted a lot of attention, but it’s also worth noting NVIDIA’s remarkable first quarter. That international software company’s management highlighted the enormous demand for its GPUs, convincing investors of the technology’s transformative potential. As a result, investors eagerly sought the next potential AI winners, leading to a few standout companies driving outsized returns. To provide some context on the low-market breadth, we estimate that two-thirds of the S&P 500's return can be attributed to just seven companies.
Overall, international equities ended Q1 up 0.9% in CAD, significantly lagging behind their US peers. We attribute this mainly to the underlying index composition. International equities have a much lower concentration in technology, thus not benefitting as much from the generative AI narrative. Nevertheless, we should point out that currencies also played an important role, with the Japanese yen depreciating significantly against the Canadian dollar.
Investors' Risk Appetite: Sectorial Analysis and Performance
Viewed on a sectorial basis, investors generally had a higher appetite for risk, with Industrials (+4%), Technologies (+4%) and Consumer Discretionary (+3%) leading the index. By contrast, Communication Services (-5%), Real Estate (-4%) and Consumer Staples (-3%) all underperformed. Materials (-4%) also stood out as a laggard, which we attribute to a weaker Chinese economy than expected.
Investors continue to be more excited by the Fed pausing than worried about the added burden that monetary tightening will have on the economy. Intent on fighting inflation, central banks have made some progress, but wage inflation continues to be sticky. We doubt the Fed will turn to drastically easing monetary conditions in the near term. For that reason, we expect to see a decelerating economy that may turn into a recession.
In the short term, business conditions are likely to continue to get more difficult for companies –something that equity markets are not discounting aggressively. In the mid-term, easier money is likely to come back as the economy weakens and inflation softens, making conditions attractive for equities.
All things considered; we believe the risk-reward proposition is only fair at this point. Also, investors should hold a neutral-to-slightly-underweight equity allocation based on their respective investment policies. We currently prefer Canadian and US equities, given that international equities need to deal with both long-term challenges, such as climate change, and short-term challenges related to Russia’s attack on Ukraine.
Fixed income summary
Thanks to Heather Hurshman, Head of Fixed Income at Louisbourg Investments, for the following information.
Signs of Slowing Growth and Impact of Higher Interest Rates
The second quarter of 2023 was fraught with unexpected events. Widespread forest fires, surprise rate hikes by the Bank of Canada, a debt ceiling countdown and stronger-than-expected data were all potential market-moving factors. Despite this, market volatility diminished during Q2, as the maturing tightening cycle and relatively resilient economic data offered market participants some comfort over the bank failures of Q1.
The Canadian economy showed signs of slowing during the quarter, with no monthly gains in economic activity reported in March and April. After delivering higher-than-projected annualized growth in Q1 of 3.1%, GDP growth is expected to moderate to 1.6 % and 1.4% in 2024. By then, the impact of higher interest rates will have slowed household spending, a key contributor to overall growth. Consumer spending on goods and services has remained resilient in the face of higher interest rates, largely due to tight labour markets, elevated wage inflation and, perhaps more surprising, the stabilization/rebound in the interest-rate-sensitive housing market. Ultimately, the strength of these three factors, which help support consumer psychology and risk-taking, will need to weaken further for the Bank of Canada to reach its target inflation rate of 2%.
Labour market pressures are slowly easing, due to high levels of immigration and the continued return by workers to the post-pandemic job market. The unemployment rate rose to 5.2% during the quarter, although the level of hourly wage growth for full-time workers remains elevated at 5.1% year-over-year. It is estimated that wage inflation must decelerate to 3-4% for core inflation measures to meaningfully decline. Canada has experienced higher-than-average population growth in the last year, with a population increase of 2.7% in 2022, the highest rate of growth since 1957.
While the increase in Canada’s population has eased labour markets and contributed to GDP growth, it has also led to increased demand for housing and goods. The recent rebound in the housing sector should serve as an offset to the goals of tighter monetary policy by the Bank of Canada. Despite higher interest rates now being at restrictive levels, the continued strength in housing and labour markets, together with wage inflation, is expected to result in an elevated core inflation rate. This will require monetary policy rates to remain higher for longer and has the potential for necessitating further rate hikes.
Resilient Market Sentiment in Q2: Surprises from Central Banks
Market sentiment turned positive in Q2. Concerns surrounding tighter credit conditions and recessionary fears due to higher interest rates abated, as did turmoil in the banking sector; and risk assets continued to recover. The improving outlook was further supported by lower energy prices, improved supply chains and the easing of Chinese policies. Also, by the anticipated efficiency gains from developments in AI.
During the quarter, inflation pressures in Canada and the US remained well above target levels. In Canada, the pressures show signs of slowing, with the year-over-year Core Consumer Price Index (excluding food and energy) rates in May of 3.9% (median) and 5.3%, respectively.
Central banks this quarter surprised markets with policy actions and rhetoric indicative of further rate hikes. A particularly notable surprise was the Bank of Canada’s 25-basis-point increase in the overnight rate to 4.75%, despite the Bank having telegraphed a pause to further hikes in January. In addition, several other central banks have resumed or increased the pace of rate hikes, given the continued strength in core inflation pressures and resilience in the factors driving inflation.
Bond Yields and Returns: Impact of Central Bank Actions
During the second quarter of 2023, shorter-term bond yields rose significantly. The yield-curve inversion intensified due to: a more hawkish stance by central banks; the surprise rate hike by the Bank of Canada; and the timeline moving out for rate cuts getting priced into the market. Two-year Canada bond yields increased 85 basis points to 4.58%, while five-year yields increased 67 basis points to 3.68%. Ten-year Canada yields increased 37 basis points to 3.27%; 30-year yields increased by nine basis points to 3.09%.
The benchmark FTSE Canada Universe Bond Index produced a negative total return of -0.69% during the quarter. Short-term rates rose and the curve further inverted because of increased odds that short-term interest rates will remain higher for longer to combat elevated core inflation.
The short-term component of the overall Bond Index (one to five years) had a negative total return of -0.80%. The mid-term component (five to 10 years) was the largest negative contributor, losing -1.93% in total return. The long-term component (10 years +) of the Index managed to generate a positive return of 0.64%, reflecting the degree of inversion driving returns in Q2. The segmented returns across Index risk classes were comprised of -1.48% in Federals, -0.45% in Provincials and +0.18% in Corporates, reflecting to some degree the different term to maturity profiles of each of these classes.
Note from Ciccone McKay: The current macroeconomic situation is the perfect time to rethink your financial planning. Increased savings rates can go a long way to boost your future finances, as higher inflation eats away at your existing assets. If you do not have a financial plan, the current era could serve as a useful prompt for you to chat with a fiduciary. Our professional advisors can better equip you with the tools you need to be properly situated, not just for when years like 2022 occur — but for all the years ahead.
As always, for more information about Ciccone-McKay Financial Group, or if you want to chat with someone at the firm, we welcome your call: 604-688-5262.
Sources:
https://www.louisbourginvestments.com/Team/Mathieu-Roy%2C-CFA
https://www.louisbourginvestments.com/Team/Heather-Hurshman
RBC EconomicsJune 8, 2023. (2023, June 22). Canada’s economy is beating expectations, but for how long? RBC Thought Leadership. https://thoughtleadership.rbc.com/canadas-economy-is-beating-expectations-but-for-how-long/
