Halftime

Commodities are up.

On the economic front, inflation is down pretty much everywhere. A basket of 10 major economies shows 8 have seen inflation improvements of 2023 continue in 2024. Japan and Denmark were the outliers. The weakening yen is certainly keeping inflation higher in Japan, and if you have been to Copenhagen, nobody notices inflation because everything already costs ridiculously too much (all worth it, though). Canada has added +200k jobs this year, and based on a nonfarm payroll survey, the U.S. has added about 1.2m jobs. By most general measures, reasonable economic growth was the norm, certainly strong enough to have economist recession probabilities drop nicely.

Suppose the only real challenge was the narrowness of the market and the divergence among some markets. Canada’s TSX is up about 5%, which isn’t bad but certainly not as good as many others. Europe is up about 10%, Asia is too, and the U.S. S&P 500 is ahead by just under 20% [all total return in CAD]. The U.S. has become a bit more challenging due to its narrow leadership, as five companies contributed half of the market’s gains.

Let’s summarize the 1^st half: just about everybody made money. And generally, the surprises were to the upside.

2^nd half – continuation or reversal?

The trend is your friend, or so the saying goes. If this holds, the 2^nd half (2H) should have some pretty smooth sailing, given the 1H. And there is good news out there with, of course, some challenges. Here are our big highlights for the 2^nd half:

1. Economy: Improving global economy continues for a while even as U.S. growth slows. Then, likely beyond 2H, everything slows
2. Inflation: Generally falls further, even with some counter-trend scares. Yields likely remain stuck in a range
3. Volatility: Political risk causes periods of higher volatility and uncertainty
4. Divergence: Diverging economic activity will continue to drive diverging market performance. 2H gains will be more variable, likely even with some markets giving back some of the earlier gains.

1. Economy – Goldilocks for now

The manufacturing recession or slowdown of 2022/2023, which fooled most of us into thinking a real recession was imminent, appears to be over. Take your pick from industrial activity, PMI surveys or global trade – there is a rising trend of activity globally. Better global economic activity has certainly pushed folk’s recession probabilities lower and yet has not been too strong to reverse gains on inflation. That is Goldilocks, just the way she likes her porridge.

We do not question the improvement in manufacturing activity; however, we are not convinced of its longevity. The chart below shows global trade over the past few years with a number of rather large rises and drops. The pandemic drop was followed by an unprecedented spike as we all sat at home and ordered stuff. Then, there was a big drop as mobility returned. We all went out on revenge travel and stopped ordering as much stuff as possible. So is the latest rebound just a bounce back as people’s spending on services/goods gets closer to normal, or is it a sign of rising global aggregate demand?

We just don’t see where a sustainable increase in demand would come from. The consumer, helped by wage gains and decent employment growth, appears to have blown through accumulated savings from the pandemic years and inflation/higher rates have eroded things further. Now, the job market is starting to falter a bit. How about credit growth? Well, that has slowed due to higher borrowing costs. Then there is government. Fiscal spending, looking at deficits, remains robust given a global economy that is reasonably healthy. But it is the rate of change that matters, and this is also starting to slow down.

Add it all up, this rise in global economic growth will likely falter down the road a bit. In the near term, though, it will likely continue. Trade continues to rise, with Korea and Taiwan exports growing decently. These are two canary economies for global economic activity, given their higher leverage to exports. And PMI survey data in major economies continues to firm.

We are encouraged that 12 of 16 major manufacturing economies have a PMI survey over 50 – expansion territory. Yet the number of 52 ½, let’s say more robust activity, is still pretty low. Call it a healthy manufacturing environment, but not gangbusters. Equally interesting are some of the divergences in economic activity. In the following chart, we have a weighted (based on the size of the economy) leading economic indicator score for developed economies and developing/emerging economies. The sample size is smaller, given that not every country creates a leading economic indicator measure. Still, it is worth noting the trend for developed economies is rather flattish while emerging economies appear to be doing better.

The global economy is doing better, and we believe this could last for a bit. However, given increasing cracks in the U.S. consumer, rolling over of stimulus momentum, and ongoing drag from higher yields/inflation, we don’t believe this recent uptick in growth is the start of an extended economic expansion.

Portfolio thoughts – We remain a mild underweight in equities and holding more cash. Still at the party but standing closer to the door and not cutting a rug on the dancefloor. It also has us looking more outside North America, including an existing international developed market that is overweight and a recent increase in emerging markets' exposure. Tilted to where the growth is improving and not slowing.

2. Inflation & yields – Improving and rangebound

Inflation should continue to moderate in the 2^nd half of the year. The faster-moving components continue to elicit disinflationary pressure and the stickier components, which are still elevated, are starting to roll over. This is a good news story. This would have us believing bond yields should move lower; however, the improving economic activity and large issuances to fund deficit spending will limit this trend and likely keep yields rangebound.

The chart above is for U.S. 10-year yields, and our view is similar for Canada, albeit with lower yields. For now, we believe yields will remain rangebound. When/if elevated, an opportunity to add duration. When/if yields reach the lower bound, an opportunity to reduce bonds/durations.

If this current spat of improved economic growth slows, yields should come lower. And in the meantime, the current yields provide an adequate risk/return trade-off.

Portfolio thoughts – we do remain a very mild overweight bonds and are carrying a healthy duration. Some credit exposure is okay, but not too much, given that spreads are historically tight.

3. Volatility – Enter politics

Guessing the outcome of politics is not our strong suit. Even if you can guess right on, who wins which election, how the market reacts is another variable that often makes correct guesses end up being disappointing from an investment perspective. As a result, we do like to ignore politics. Besides, politics frustrates us.

That being said, it is not lost on us that the market reaction to elections so far this year has added a lot of volatility to markets. Surprise results in India led to a sudden drop, which recovered quickly. In Mexico, a less market-friendly elevation has caused equities to drop and not recover. Now, we have elevated political risk in France with a drop and partial recovery.

The takeaway is that politics is adding to market volatility this year. And that is likely going to increase as the more important U.S. election nears. Based on campaign talk, a republican sweep would likely be positive as corporate tax cuts could be extended. A democrat sweep could be troubling. But again, you never know how markets would react. If there was a split in control of the White House, Congress, and Senate, it would probably be the best result as that would limit the likelihood of policy changes. Most often, no interference is best as the economy remains more important.

Portfolio thoughts – We are in a world that has gradually reverted back to more protectionism, economic war/conflict between major nations, and even some regional hot wars. With elections this year, political risk is rising as well. We believe this supports tilting towards some more defensive strategies and holding gold. Maybe things will not devolve into a market that requires crisis alpha stabilizers, but we would err on the side of caution.

4. Divergence of returns – Some bad, some good

The divergence of stock market returns, particularly across geographical regions this year is much larger than investors have gotten used to. It presents a compelling dynamic for portfolio construction. While it can introduce challenges, particularly that of performance chasing, it also unlocks valuable opportunities for investors.

Performance and Uncertainty – The past few months have brought a significant bout of volatility across international markets. While most had kept up with the S&P 500 this year, that all changed earlier this month. June was election season and perhaps a reminder that elections can be a harbinger of volatility. Surprise results in India and Mexico rattled investors. Elections, especially when there is a surprise result, can quickly impact investor appetite and create a period of uncertainty. Sometimes, this is short-lived, such as in India, where the Nifty 50 fell nearly 9% in a day but quickly recovered and moved on to new highs and an impressive return of 12% off the lows. Other times, the results can be longer lasting. The Mexican market is still trading at the lows and is down by nearly 14% over the past month. The elections in June were a not-so-subtle reminder that markets don’t’ always move as one.

This return divergence has caught our attention. Looking across various major international market ETFs covering both individual countries and regions, the spread in returns has been quite large so far this year. There’s a 35% difference between the top-performing markets (US, India, and Taiwan) and the bottom-performing markets like Brazil and Latin America. Much of this occurred in the latter half of the second quarter.

In the chart below you can see how returns across international markets have diverged in Q2. It was an easy excuse to blame the poor Canadian markets for the outsized selling pressure due to the change in tax laws; however, Canada was not alone. Many markets began to weaken as the U.S. continued to make new highs. During the past three months [as of June 27], Canada declined by 2.7%, and the U.S. was up by around 5.0%, which is solid but far from the best. A trio of Asian countries Taiwan, India and China – take the podium.

Correlations – A key metric for understanding the synchronization of global markets is correlation, which quantifies the degree to which two markets move together. Historically, correlations between developed markets have been trending upwards, meaning their movements tend to be more synchronized. This peaked in 2020 when global markets moved nearly all as one. The average correlation between a basket of developed markets in 2020 was 0.81. This was well above the 10-year average correlation between developed markets of 0.62. That period was exceptionally high and well above the 10-year average, so essentially, all markets moved as one. This reduced the diversification benefit of international investing to some extent. However, recent market conditions have seen a decrease in correlations compared to historical averages. Year-to-date, the average correlation among the same group of markets is only 0.53. This could be a result of deglobalization, but most likely, a reduction in synchronized growth. This is a positive development for portfolio construction. Lower correlations between geographically diverse markets amplify the benefits of diversification. When one region experiences a downturn, another might perform well, offering a natural hedge and mitigating overall portfolio volatility.

Concentration Risk – Concentration risk is a hot topic in 2024. Typically, it's mentioned alongside the Mag 7 and how concentrated the U.S. market is. Concentration risk can also appear across a portfolio with an excessive tilt toward a particular country. More often than not, it’s the U.S., and why not? It’s had a stellar run the past decade-plus relative to international markets. The chart below shows the historical periods of U.S. dominance. The current run of relative outperformance began in 2008, and since then, the S&P 500 has outperformed the MSCI EAFE by over 350%. Significant by any standard, but at 16 years, the stretch of U.S. exceptionalism is stretched by historical standards. Ignoring the behavioural aspects of performance chasing and excessively tilting portfolios to the U.S., from growth alone, U.S. allocations are likely overly concentrated without rebalancing. Geographical concentration in a portfolio can exacerbate risk.

The solution is simple: rebalance and diversify.

Portfolio thoughts – From a portfolio construction standpoint, divergence is at the root of diversification. As we’ve seen in 2020, when all correlations approach one, portfolios don’t behave as designed. The divergence of stock market returns across international regions presents is actually a good thing for portfolio construction. Not every country gets to stand on the podium each quarter, but with proper diversification, the odds improve, and portfolios can gain some exposure to the winners while balancing risk and return.

At this point in time, we still like an overweight in international equities due to growth prospects and relative valuations. We’ve also warmed to Emerging Markets. While certainly higher risk, we believe that emerging markets offer the potential for higher growth. With the U.S. election in November, perhaps it too could bring about some volatility, as we’ve seen with other elections around the globe.

Market Cycle

Our market cycle indicators, which total a little over 40, help provide a picture of the health of the market and economy. No signal or indicator works every time, and taking a basket, the goal is to identify if the backdrop is eroding or improving. This helps differentiate between market weakness, which could be a buying opportunity to deploy cash or lean into it, and those that may have worse to come.

The indicators range from economic data, yields, spreads, commodities, markets and fundamentals. The good news is the number of bullish signals continued to rise in 2023, and this continued into 2024, with a bit of softening in the past few months. This lines up nicely with markets moving higher. The question is whether the recent tick-back lower is the start of deterioration or just a little bobble. For now, we are not concerned; the Market Cycle remains supportive of markets.

Digging into the specific indicators, we see that there have been a number of changes. While clearly more remain bullish than bearish, the bearish signals have ticked a bit higher. Even more impactful is the trend in the signal strengths for the U.S. economy (softening) and Fundamentals (improving). The ratio of signals improving last month for the U.S. economy was 7 better, 12 worsening. This past month, that eroded more to only 2 improving and 17 worsening.

Countering this trend was an uptick in fundamentals, as a lot of the earnings data has improved over the past month. 9 improving with only 3 deteriorating, compared to a month ago which was at 4 vs 8. Better economic data year-to-date appears to be making its way into earnings estimates for growth, which is positive.

Overall, the Market Cycle remains supportive, with a bit of a wobble of late.

No recent changes to our overall portfolio recommendations. We have a mild underweight on equities, which is very mild after our last few changes. Very mild overweight in bonds and holding a bit extra cash. Certainly a bit of a defensive lean. This carries into diversifiers as we are more focused on real assets (gold) and volatility reduction strategies.

The two changes in the past few months included:

• Splitting our gold bullion into a 50/50 split between bullion and gold miners in early March. We like gold for the 2nd half, and the miners have lagged the metal, creating a good opportunity. It has closed somewhat over the past few months.
• In early May, we trimmed Japan and Canadian equities to open a new position in emerging markets. As economic growth picks up internationally and potentially slows in North America, we believe emerging markets continue to offer a good opportunity.

Final Thoughts

The first half, by just about every measure, was a rather pleasant experience for investors. Inflation is better, the economy is better, earnings are better, and subsequently, markets are better. While we don’t like to be negative, the 2^nd half will certainly have greater challenges as this market has priced in a healthy dollop of good news. Election risk and divergence among economies may prove to be the biggest challenge for a smooth 2H.

— Craig Basinger is the Chief Market Strategist at Purpose Investments
— Derek Benedet is a Portfolio Manager at Purpose Investments
— Brett Gustafson is a Portfolio Analyst at Purpose Investments

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Sources: Charts are sourced to Bloomberg L. P.

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