Mid-Year Outlook: Seven Questions That Could Shape Markets in the Second Half of 2024

by Kevin McCreadie, John Christofilos, Bill DeRoche, Rune Sollihaug, David Stonehouse, Stephen Way, AGF Investments

Members of AGF Investments’ Office of the CIO (OCIO) recently held their annual mid-year outlook roundtable to discuss the key issues facing investors heading into the back half of the year.

Questions and answers that follow have been edited for clarity and length.

This round table discussion took place before U.S. President Biden suspended his campaign for the 2024 Democratic Party nomination.

Can equity markets continue rallying at the torrid pace of the past eight months?

Kevin McCreadie (KM): Broad market-capitalization equity indexes like the S&P 500 Index and S&P/TSX Composite Index had a great first half to 2024, even though interest rate cuts haven’t materialized to the extent many investors thought they would at the start of the year. Remember, expectations were for six or seven cuts in the United States by the end of the year, but now we might be looking at one or two cuts, tops.

That said, I wouldn’t expect similar returns in the second half, especially if the handful of large-cap tech stocks that have fueled the rally grow more expensive and begin to wane from here. That doesn’t mean we won’t see some of these market cap-weighted equity indexes continue to move higher, but it’s hard to believe they’ll continue to climb at the same pace given some of the potential headwinds that are ahead, including the potential for a slowing economy which could put a damper on earnings. A more likely scenario is a range-bound market of much smaller gains from current levels or even some potential losses.

John Christofilos (JC): I believe the equity markets will continue to grind higher. Historically, when markets perform positively in the first half of a year – as they did this year – the second half is positive to varying degrees as well.

Bill DeRoche (BD): It’s hard to see markets continue to go up to the same extent as the past eight months or so. I’m not predicting something horrible like a massive correction is about to happen, but the macro backdrop seems to be getting more challenging and I believe more caution is likely warranted right now because of that.

Steve Way (SW): The key to the second half is whether earnings growth can persist. If you look at the S&P 500 Index, for instance, the earnings profile was solid in the first half, but that’s largely because of the small number of tech names that Kevin alluded to already. In fact, earnings for the average stock listed on the index were not nearly as robust.

KM: And the earnings growth of some of these tech names are going to be very hard to maintain. Sure, they may still grow, but maybe not at the same torrid pace.

Rune Sollihaug (RS): I believe equity markets are going to trade a bit sideways this summer with retail investors, who seem to be coming back into the market, maybe giving them a boost. But I believe you’re going to see a bit more volatility in the market come late summer and into the fall.

David Stonehouse (DS): When the U.S. market rally started back in the fall of last year, there were several catalysts working in the market’s favour, including a shift in monetary policy towards more accommodative interest rates in the near future. Sentiment was also poor and ready for a reversal, and earnings trajectories were on the cusp of turning more favourable.

However, now, after such a strong move higher, these tailwinds have largely manifested and aren’t nearly as strong as they once were. At the same time, valuations are starting to look expensive in some cases and we’re coming into a period of seasonal weakness.

I wouldn’t be surprised if some equity markets corrected, but still believe the fundamental backdrop for stocks is sound and wouldn’t be surprised if the S&P 500 Index finished higher than where it is now even if it shows some weakness in the interim.

SW: If you look outside the United States, the major index gains have been far less significant to date in Europe, Japan and Emerging Markets, which could result in relative opportunities – across these regions versus the U.S. – in the coming few months.

Do you expect U.S. equity market performance to remain concentrated in a very small percentage of names in the second half of the year?

JC: I hope we see some broadening out across other sectors. Saying that, I don’t expect large-cap technology stock returns to wane significantly. A more reasonable expectation is for them to gain less than they have as capital gets spread across other sectors, especially those who will benefit from a lower rate environment that I believe we will be entering globally.

KM: Investors tend to crowd into names they know when there is uncertainty. And in a way, the large U.S. tech giants that have fueled the rally have become the new “staples” for people. And I don’t see that changing dramatically until central banks start to cut rates more aggressively, which would alleviate the higher cost of funding that is plaguing many of the smaller companies that haven’t participated in the market rally to date, but also provide relief to the consumer so they drive demand for a more diversified basket of goods and services higher.

DS: When you look at the history of secular bull markets, the last one also clearly favoured blue chip, large capitalization stocks that people know. And I agree that more monetary stimulus is likely needed for medium and small capitalization (SMID) stocks to perform better this time around. But if central banks do embark on an aggressive rate cutting cycle, it’s likely because the economy is in recession. And that’s not generally a good backdrop for SMID names. So, it’s a bit of a quandary.

In other words, if the U.S. Federal Reserve (Fed) and its counterparts can stick a soft landing (i.e. not cause a recession) and still cut rates by two or three percentage points over the next 12 or 18 months, then SMID stocks seem well positioned to benefit and we’ll get the breadth in performance that has been missing of late. But if the economy lands hard, that might not be the case and there’s also the potential that today’s “highflyers” come down to earth as well.

KM: I don’t like to compare the current dynamic to the late 1990s because it was a very different time, but there was a similar crowding effect into large cap names back then as well. And if you recall, some of the smaller-sized stocks did quite well in the three-to-four-year period following that recession, largely because their valuations never got excessive like some of their larger counterparts. I believe that’s something to consider this time around, too.

SW: One of the reasons for the disparity between these big technology stocks and the rest of the market has been the large spread in earnings growth. In the first quarter, for instance, S&P 500 tech earnings were about 40% versus just 1.3% for the rest of the index. But that spread is expected to narrow to something like 8% by the time we get to the end of the year. If that proves true, it could lead to greater balance of returns across sectors. Still, I agree that we really need to see interest rates cuts to have a true broadening of performance, but the question is, why are central banks cutting?

How well do you expect fixed income markets to perform in the second half of this year?

DS: Similar to equity markets, we’ve had a really nice run in U.S. 10-year Treasuries since October, but most of that occurred near the end of last year when the Fed was still expected to cut rates six or seven times this year. As a result, yields ended up being too low heading into 2024, only to climb higher over the next few months as rate cut expectations plummeted, leading to marginally negative total returns in the U.S. so far this year, and just slightly positive ones in Canada.

Going forward, then, it’s not unreasonable to expect mid-single digit returns from government bonds, but this is likely to be attributed to the coupon (i.e. annual income paid on a bond) as opposed to any great drop in yields even though we’ve seen them fall in recent weeks. For bonds to return double digits, the economy would have to deteriorate significantly from here and force central bankers to cut rates more than is currently expected. But that doesn’t seem like the world we are currently in.

KM: I agree, but what worries me somewhat about the fixed income market is the potential response of central banks to a weakening economy. In the past, when inflation was a non-issue, it was almost a guarantee that they would cut rates aggressively. But this time around, what if they prioritize inflation and don’t ease as much as they would have in the past?

BD: I tend to look at this in terms of the interaction between real rates and the breakeven on inflation. If central banks hold rates higher for longer, you probably get some movement downward on the breakeven on the inflation side, and if rates go down the breakeven probably goes up, but either way that movement is likely to be in a tight range, which lends itself to the coupon-clipping environment that has already been mentioned.

DS: Let me just add that I’m also positive on credit heading into the second half of the year, largely given the healthy backdrop for corporate cash flows. But the scope for tighter spreads (and therefore capital gains) may be limited from here and any advantage that credit has over government bonds may be incremental.

What actions do you expect central banks around the world to take in the second half of the year?

DS: It’s a quandary what to do for some central banks right now. The Fed is probably itching to cut rates to alleviate some of the pressures that are developing in the lower end of the consumer market, and this may be even more pronounced in Canada, but the disinflationary trend that we’ve seen over the past year still isn’t strong enough for them to act aggressively. In fact, it may take a recession for them to start cutting rates in a forceful way.

SW: I believe it's going to be very difficult for the Fed to hit its 2% inflation target without doing damage to the economy, especially given some of the inflationary pressures that remain persistent. But how long does it hold off on cutting rates in trying to achieve its inflation target, even if the economy starts to flounder? Granted, that’s not really the case right now. Economic growth is still relatively solid in the U.S., but it’s nonetheless one of the big questions for me going forward.

BD: I agree, there's a lot less certainty around rate cuts than normal. The Fed normally likes to be predictable, but in this instance, I believe it remains extremely data dependent and won’t tip its hat until it’s absolutely certain what it wants to do next. So, trying to predict when and how many cuts are in front of us is kind of like spitting in the wind.

DS: It’s way too nuanced to make a precise prediction on the number of rate cuts the Fed is going to make over the next few months, especially given how variable the data they depend on has been lately. There are just too many moving parts. That said, I do believe we’re on the cusp of a modest rate adjustment cycle in the U.S. and would not be surprised if the Fed lowers its key lending rate at least once before the end of the year, if not twice, as some estimates currently predict.

RS: In my opinion, there’s no data to support any serious cuts to interest rates, at least in the U.S.

KM: The U.S. election may play a role in the Fed’s decision as well. For instance, it may decide to remain sitting on its hands until the New Year, for no other reason than not wanting to be accused of political bias leading up to the vote. And what if the election result ends up being contested and markets tumble from the potential chaos that creates? In that scenario, the Fed may feel like it has no other choice but to cut rates in an attempt to stem the bleeding.

Either way, it does seem as if the Fed’s path has now diverged from other central banks, including the European Central Bank (ECB) and Bank of Canada (BoC), both of which have already begun cutting rates and seem poised to make additional cuts as the year progresses. Of course, that’s not a guarantee. While the economic backdrop these central banks face is weaker than in the U.S., inflation is still very much a concern for both and it remains to seen how aggressive they will be.

JC: Generally speaking, I expect a rate cut cycle to unfold in many countries globally, albeit in slightly different ways.

DS: To that end, I'm worried about the BoC, in particular, not being in a position to ease policy as smoothly or as regularly as some investors might hope. It may have to reign in future cuts or do a stutter step with them to ensure that inflation falls further and stays firmly under control.

SW: The Bank of Japan, meanwhile, is in a different headspace entirely. It raised rates earlier this year for the first time in 17 years and some forecasters believe it will continue to normalize rates later this month it becomes more confident that their 2% inflation target has been reached and inflation will persist above this level.

DS: Central banks in Australia and New Zealand may also be contemplating rate increases. So, to Kevin’s point, central bank policy is no longer a monolithic phenomenon. And because of that, investors may not get the type of massive tailwind they would from a more globally coordinated easing cycle.

Will the global economy be in better or worse shape by the end of the year?

KM: In aggregate, the U.S. economy is still in good shape and the country’s GDP growth is probably going to continue outpacing that of Europe and Canada over the next couple of quarters. But there are some cracks in the façade, especially as it relates to the lower end of the country’s wealth scale. Higher prices for gas, food and housing are clearly taking their toll on consumers from this segment of the population, and it remains to be seen whether those on the higher end of the scale (i.e. those who are better positioned to handle the higher cost of living) will continue to take up the slack or whether they too will hit a breaking point and be forced to curtail their spending as well.

DS: If the consumer side of the economy does start to soften in the United States, maybe the saving grace is an upsurge in global manufacturing. While the latest Purchasing Manager stats haven’t been as hot over the past couple of months, there has been a trajectory of improvement stretching back several months that seems sustainable because of the growing need for new and improved infrastructure and the trend toward reshoring.

SW: One of the other big concerns for the economy globally is China. Historically, it’s been a main driver of global growth but that’s not necessarily true right now and it seems unlikely that China’s government will provide the kind of aggressive stimulus that may be needed to change that. There’s also the question as to whether the country’s real estate market has bottomed. If it has, then perhaps that could be one of the catalysts that helps create a more positive trajectory for China going forward.

DS: Canada’s economy, meanwhile, may have hit its weak point this past winter, and looks to be on a little bit of an upswing. That said, growth is still relatively anaemic and it’s hard to see that improving much given how stretched the Canadian consumer is compared to its counterpart south of the border. Indeed, one of the unique problems in Canada is our method of mortgage renewal, which forces homeowners to typically reset their rate every five years, versus the U.S., where mortgages can be fixed for up to 30 years, rendering the increase in interest rates over the past few years a moot point for those who locked in a lower rate prior to that.

SW: Europe’s economy may also strengthen a bit in the second half now that the ECB has begun cutting rates, but I believe any acceleration will be modest at best. I’m also a bit more optimistic about Japan despite its economy being weaker than expected in the first half. The key here is the country’s wage growth, which is driving inflation higher. Hopefully, it spurs greater consumption which has been sorely lacking in Japan for years, and not just more savings.

JC: The caveat for me is that inflation continues to moderate and employment holds in. As long as people are working and prices continue to grind lower, global economies are likely to do just fine. My biggest fear is that a geopolitical event spooks markets and causes investors to get ultra defensive again.

What impact will the U.S. election in November have on capital markets?

KM: U.S. elections have historically been good catalysts for markets, but this time could end up being very different, especially in light of the recent assassination attempt targeting former president Donald Trump. While markets have climbed higher on the premise that Trump may win the election in a landslide, it’s reasonable to believe that more volatility associated with the presidential race is in store.

Clearly the country is in a crisis. And given how close the race between Trump and President Biden was before the shooting, a contested outcome in November, while less likely at the moment, should not be completely ruled out. Nor should the prospect of even more civil unrest breaking out in the days, weeks and months ahead.

DS: An unruly outcome would likely be a problem for markets, but at least the policies of the two main parties are reasonably well known, which may alleviate some of the concern. In fact, I believe there’s a case for both to be viewed favourably by markets, albeit for different reasons. A Democrat win, for instance, might fuel expectations of increased government stimulus, while a Republican win could drive anticipation of tax cuts and deregulation.

RS: Another concern for some investors might be the enactment of more tariffs if Trump gets into power. Tariffs are inflationary and could have an impact on markets.

SW: To that point, the Peterson Institute for International Economics said recently that Trump’s proposal to levy a 60% tariff on all imports from China and a 10% tariff on imports from the rest of the world could increase the average cost for a middle-income U.S. family by $1,700 a year. And Moody's, the credit rating agency, is forecasting a U.S. recession next year if these policies get enacted in their current fashion.

Granted, both political parties seem to be in favour of deglobalization, especially if China’s manufacturing prowess is weakened in the process. And this is despite the inflationary implications of taking such a stance.

KM: And regardless of what happens on that front, the USMCA Trade Agreement between the U.S., Mexico and Canada will need to be extended in 2026, which could lead to yet another round of trade negotiations that are disruptive to markets.

SW: Trump has also talked about replacing U.S. Federal Reserve Chairman Jerome Powell and his former trade chief Robert Lighthizer is said to be considering new policies that would weaken the U.S. dollar relative to other currencies, which could bolster U.S. exports, yet fuel even more inflation.

DS: Higher inflation wouldn’t be good for bonds. And if you got a Republican sweep (i.e. the GOP wins both houses of Congress and the presidency), which is possible, that might not be great for U.S. Treasuries, either. That’s because, even though the Democrats may be more associated with government spending, it’s very unlikely that the Republicans will do much to curb the country’s US$2-trillion deficit, especially if they lower taxes. And the more it looks like one party has unanimity over these kinds of decisions in Washington, the worse it probably gets for the U.S. Treasury market.

KM: On the other hand, if Biden is elected, it’s probably going to be a split government, which may be a comfort to some investors. Nothing too dramatic can likely get done in that kind of scenario.

BD: At some point, running a US$2-trillion deficit is going to be frowned upon by markets. I don't know when that happens, but we could really have a problem when it does.

DS: I agree. There has to be a day of reckoning eventually, but it's incredibly difficult to predict when because it's probably gone on a lot longer and to a much larger degree than people would have thought 10 or 20 years ago.

KM: It’s interesting, if we go back to the 2016 election, markets dipped in the immediate aftermath of Trump’s victory but then rallied on the realization that he was likely to enact a pro-business agenda highlighted by lower taxes and greater deregulation. But I don’t know if that happens again this time around. The fiscal condition of the country has gotten far more precarious in the intervening years and policies that do not address the ballooning deficit head on may not be well received.

What other geopolitical events have the potential to disrupt markets in a positive or negative way?

KM: The biggest risks in my opinion are the ongoing wars in Ukraine and the Middle East. I’m not sure markets fully appreciate the potential risks associated with these two conflicts, especially as it relates to energy markets, which are particularly susceptible to escalating tensions. It could be a real problem, for instance, if Russia and NATO begin to spar more aggressively or the Israel/Hamas situation spills into Lebanon.

RS: I don't see any improvement in the Middle East. Investors should be prepared for the situation to deteriorate further before it gets better.

DS: It’s very surprising to me that the Middle East conflict hasn’t had more serious ramifications for the markets and whether it’s rising oil prices or some other market event, I’m worried that we’re going to be facing a major problem if current tensions boil over into other parts of the region.

KM: To that point, there’s been almost no attention being paid to the fact that Houthi attacks on commercial ships in the Red Sea has gone unabated in recent months despite the growing presence of the U.S. Navy.

BD: What’s going on there equates to the biggest naval battle since World War II, at least in terms of the number of U.S. ships that have been deployed. So, yes, it’s a very big potential risk for markets to consider.

KM: Investors also need to keep an eye on elections that are taking place outside the United States this year, some of which could have a profound impact on the political and therefore economic direction of certain countries. For instance, French markets have been unsettled ever since President Emmanuel Macron called a snap election following his party’s loss in a vote for European Union lawmakers earlier in June. And they could remain shaken after the surprise results of the election, which saw left wing parties outperform the far right, leaving the country’s parliament potentially gridlocked.

SW: The growing tensions in the South China Sea between the Philippines and China are also potentially troubling as is the ongoing friction between the U.S. and China regarding Taiwan’s independence.

BD: My biggest worry is that, globally, we lack the kind of serious statesmanship that is likely required to mediate many of the geopolitical risks we’ve discussed. Instead, we have a lot of grandstanding, which is very disconcerting to me, not just because of the human tragedy that continues to unfold, but also because peace is such an important component of a successful economy.

DS: Perhaps the irony there is that Donald Trump may have the best chance of securing a resolution with Russia in regard to the Ukraine War if he’s elected in November. And even though the conditions of such a resolution are likely to be controversial, if not contested, we may see some form of de-escalation in that particular conflict.

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