Anticipated volatility in September didn’t come as expected. Though markets wobbled at the beginning of the month, risk appetite and optimism came back in a hurry following the Fed jump-starting its easing cycle with a 50bp cut mid-month. With more rate cuts on the horizon, markets pushed to all-time highs this month in both Canada and the United States. Focus has now shifted towards the data, Q3 earnings, and, of course, the US election in November. The path ahead remains uncertain with the fog of the election all around. Regardless of the limited visibility, markets appear cautiously confident.
The economy will be a key focus in the coming months. Growth is starting to slow after a relatively strong first half of 2024 globally. The bond market has recognized this, with yields initially falling. However, after bottoming in September, yields have begun to rise again, signalling some hope that the recent cuts may begin to enhance growth prospects. Commodities have broadly moved higher following the massive stimulus announcement out of China, reflecting higher demand expectations.
September was a strong month for global markets. Gold hit a new high of $2,685/oz, and bonds rose nearly 2%. The S&P 500 finished the quarter up 6% and posted a 2.1% gain for September, bringing its year-to-date performance to 22.1%. Equal weight outperformed in the quarter, rising 9.6%/ Thi still lags the cap-weighted index, but the gap is closing. The S&P/TSX Composite outperformed the US, rising 3.2% in the month and 10.5% in Q3. It’s still lagging the US year-to-date but the gap has shrunk. International stocks have done well, led by emerging markets, which rose by 6.7% in September, buoyed by the news from China. With yields falling, bonds had a great quarter, and after a difficult first half of the year, both Canadian and US bonds are back on track.
With the stock market, housing, and gold prices at record highs, bond yields sitting at 3-4%, and unemployment and inflation rates at favourable levels, these are optimal economic conditions that may not last; make sure you enjoy it while you can.
Markets are well known to ‘climb a wall of worry’ and have done that very well this year. We entered the year on the lookout for a recession and slowdown in earnings growth, yet those fears have diminished, and markets have now embraced the thoughts of an economic ‘soft landing’ in the US, which the data appears to corroborate.
The final good news that dropped at the end of September was China launching its long-awaited stimulus programs. The post-COVID experience in China has been much more muted than in other parts of the world, in large part due to the ongoing property market woes. Lower rates and plenty of stimulus have investors rushing to the front of the line, driving Chinese markets up 25% in just five trading days following the announcement. Commodities and emerging markets have all reacted positively.
There is lots of good news being priced in, which has led to moderately extended valuations, at least in the US. Returns have historically been lacklustre from these levels forward, as seen in the chart below. The forward earnings multiple for the S&P 500 is ~24x, which is rare. Looking back to 1990 it’s only been here around 2.8% of the time. Average 12-month returns from this level are negative, which is concerning. So, have we priced all the good news? It’s a valid question. When things seem too easy, they seldom last long. We continue to expect some volatility to pop up in financial markets. US corporate earnings season will kick off shortly and shine some light on consumer health. We have already seen examples of disappointments being punished, which adds to the risk around the reporting date.
With the US election now just one month away, a definite fog is on the horizon. It is not quite a dark cloud, but there is enough haze to prevent allocators from making any big bets. As we write, it remains a toss-up and too close to call. The best bet is to continue on the course, watch the incoming data, and, once we get through the fog, set a new course. Until then, trepidation caused by elevated event risk may cause markets to tread water until it passes. As investors treading water, just keeping your head above the waves can help you survive, but we must remember that actually, to grow, investors must remember how much they love to swim, risks be damned.
One positive development over the quarter has been the broadening out of the rally. Everyone knows large technology companies and AI hype dominated the first part of this year. That mania faded over the last few months. We have seen strong returns come back to forgotten parts of the market, such as financials, REITs, and dividend payers. A broad-based rally is undoubtedly a positive.
Heading into the final quarter of what has been a very positive year, investors have the right to be content with themselves. But complacency can be dangerous, too. With the backdrop so positive, it is curious to see traditional safe-haven assets such as gold at record highs. Maybe it’s telling us something we should be paying attention to. Or has gold just joined the ‘everything rally?’ Regardless, it has been a good year, and once we get past the uncertainty of the US election, markets should continue to march higher. Just don’t forget October tends to keep things interesting.
Ripples in the Current
Too many cuts priced in
The market may be pricing in too many interest rate cuts from the Federal Reserve, given that the US economy continues to grow. Jerome Powell did his best recently to emphasize his intentions the Fed is “not on any preset course” and that the most recent cut should not be interpreted as a sign that future rate cuts will be aggressive. Despite this, money markets saw, even last week, a one-in-three chance that the Fed would cut another 50bps in November. This will depend heavily on the data, of course, but given that government policies remain more inflationary than deflationary, it’s likely the market has overshot rate expectations to the downside. It’s already begun to walk back some of these expectations. The chart below shows the anticipated FOMC rate over the course of next year. It’s already begun to move higher. The right balance between bringing inflation down and supporting labour markets is key. We’ll see further readjustments – but we have our doubts that we’ll see another 175bps decline in short rates by the end of 2025. As always, the data will dictate the path, not market expectations.
More broadly, though, it may call some of the pricing further down the line into question. The curve is already flattening, but if that data continues to be strong, we’ll see projected rate cuts continue to disappear. Which incidentally also goes against the weight of market positioning. Rates have already risen considerably from the September lows, which equities have happily absorbed. Should this continue, we’d expect that stocks would have an adverse reaction.
The labour question
When the fog is thick, visibility is reduced. Instruments such as a compass can help guide us through. Labour markets are the compass and they will guide the Fed and markets through the fog even when the course is unclear. This was reinforced by Jerome Powell this week. His remarks noted the puzzling disconnect between strong growth data and weaker unemployment data. Thankfully, the economy is still doing well, which must make the Fed a bit less worried that the weakening labour market will run out of control.
The latest employment report for September Nonfarm Payrolls rose 254,000, smashing expectations of a gain of 150,000. The unemployment rate dropped to 4.1%, going back to June levels. Only two out of 71 economists in the Bloomberg survey forecasted the unemployment rate to drop, which shows the futility of forecasting. The release has eased concerns that the jobs market was weakening faster than expected and the Fed was well behind the curve. Immediately, the market began walking back rate cut expectations and priced in under 100bps of Fed easing over the next four meetings. From the Fed's perspective, concerns over inflation were put to bed, with the attention instead focused on the labour market. Demand for workers is still healthy; if the labour market is the compass, it points straight ahead. No course change is required.
What type of landing?
Mentions of a ‘soft landing’ in the news have again surged. This might very well be the longest softest landing ever, as journalists have been mentioning it for three years now. The mentions peaked in August 2023, but the story count seen below is feverish. At some point, you have to think the runway is going to run out, and by that point, it won’t matter how soft the landing is. Perhaps the no-landing narrative will take flight once again. Following the latest jobs number, it’s a real possibility. For now, the soft landing is the most popular narrative supported by the data. The narrative plays an important role in influencing economic behaviour, markets, and even economic outcomes. Contagious ideas like this can shape expectations and even create their own momentum by serving as the lens through which investors interpret data.
Reading the ripples
Navigating the investment landscape through the fog of an uncertain election requires a delicate balance. While the growth path is promising, investors must remain vigilant about the potential impact of rising interest rates, unpredictable market reactions, and ongoing labour dynamics. Unemployment levels are not at a concerning level, and the concerning trend that was in place appears to have reversed. A soft landing, though a strong possibility, is not a given. Uncertainty is a constant variable when making portfolio allocation decisions. It’s hard to quantify, but looking at gold at an all-time high and cash levels on the sidelines approaching $6.5 trillion in the US, it’s clear that many investors are looking for ways to protect their gains by reducing risks.
S&P + Go to Sleep
While talking with a portfolio manager recently about US equity exposure, he asked, "Why not just buy the S&P and forget about it?" Honestly, it’s a fair question, and at first glance, the logical answer seems to be, "Why not?" US equities are quietly having one of their best years since the 90s. If you look at the S&P 500’s performance over the past 20 years, not only is this the best year so far through the end of September, but if you look at the top-ranked full calendar years, 2019, 2021, and 2023 all rank in the top four. Whether it's been a conscious decision to overweight US equities or simply the result of market growth and increasing model exposure, it’s no surprise that portfolios are so heavily tilted toward US stocks. Why wouldn’t they be when the market keeps rewarding that choice? It hasn’t been a mistake by any means. The S&P 500 total return index is up 64.5% in just two years. I mean, saying that out loud almost sounds ridiculous, but after 45 new highs in 2024, here we are!
Investors seem confident that the market will keep cruising along, but what if it doesn’t? Call me crazy, but it has happened a few times before. What if an unforeseen market event comes along, and the market takes a hit like it did in ’08? That kind of 50% pullback would cause devastation and wreck many retirement plans. While the current environment seems flooded with liquidity, there’s no guarantee that dip-buying will always be there to save the day. We may sound like a broken record, but our goal is to continue to bring awareness to underlying portfolio exposures that not all portfolio managers may be aware of.
Surprisingly, very few portfolio managers think they are overweight US exposure. We conducted a small survey, and out of 18 respondents, only two believed they were overweight. The rest of the respondents were split between underweight and neutral. Of course, the question was framed subjectively and is solely based on what you believe the US equity baseline should be for your portfolios. Still, for only two people to suggest they are overweight, leads me to believe that the average baseline for US equities is much higher than we would believe.
The baseline for US equity exposure has to have changed if 88% believe they are underweight or neutral. We reviewed 42 portfolios and compared them to our own baselines and models, and US equities, from our perspective, are overweight for most folks. But again, this is subjective. When compared to our baseline of 30%, the 46% average advisor model weight is significantly higher. Even if you bump up your baseline from 30% to 40%, there is still likely too much US exposure. If we consider anything up to 35% neutral, 79% of portfolios we review from our standards are overweight US equities, whereas 11% of survey respondents believe they are overweight US equities. The numbers aren’t adding up. Also, note the shocking range from just below 20% to almost 100% exposure within the US equity asset class.
It’s probably one of two things: either investors don’t realize how much their exposure has increased, or they are aware and are just letting it run with a baseline higher than ours. Either of these scenarios makes sense and even if investors are not aware, it has been the right call for over a decade. After such a long stretch of success, it’s no surprise that investors have grown comfortable. Anchoring bias has led most of us here to focus on the recent strong runs of the S&P 500 so much that we have forgotten that similar returns have been found across the globe. Maybe it's time to rebrand anchoring bias as "comfortability bias."
But what about moving forward? We know the direction of rates in the US economy, and there’s a lot of hype around rate cuts being a boon for the market, but history shows it’s not that simple. Logical thinking might suggest that, with lower rates, stocks will do well. Borrowing becomes cheaper, and earnings start to improve, and over the long run, this is true. However, it is much more nuanced in the short term, and it is important to understand why the Fed cuts have a big impact. Look at what’s happened to the S&P 500 the last four times the Fed started cutting rates. The year before the cut, the market was up three out of four times. The 1 year forward returns show a 50/50 shot of a negative or positive return. This year, we’re seeing the best pre-cut performance in the last five cycles, but what happens next is anyone’s guess. We can expect the effects of these rate cuts will likely play across markets for quite some time. The “Fed playbook” is there, but just like any other playbook, sometimes that play gets blown up.
Without having a lot of data to evaluate for rate-cutting cycles, understanding the “Why?” for the Fed is important. The Fed's reasoning behind rate cuts can drive market reactions differently depending on whether it's a precaution against a recession or a routine policy adjustment. While some of the potential benefits of rate cuts may already be reflected in current stock prices, market volatility is expected due to ongoing uncertainty. Regardless, the market's response will not be very predictable in any environment as the Fed navigates these inflection points.
The bottom line is that portfolios are rightly or wrongly loaded up on US stocks, and while that’s been the right call for a while, it’s difficult to say if it will continue to be. As stated before, what you consider a “neutral” US allocation is subjective. It might differ from ours, but based on the data, most portfolios are far from what should be considered neutral. Keep an eye on your portfolio weightings, as there are many global opportunities to explore, and diversification remains a key strategy for long-term success. With increasing risks and high valuations, it might be time to rethink those weightings. We advocate for a more balanced approach. With valuations stretched as noted in the previous section, the potential for disappointments is elevated.
Market Cycle
Market cycle indicators eroded for a number of months and even dipped further intra-month in September, getting very close to crossing below 50, but they bounced back up to finish the month at 58% positive.
Compared to last month, the US economy has gained four bullish signals. GDP Now, from the Atlanta Fed, which is an econometric model built around more high-frequency data, increased from 2% at the end of August to 2.5%. This measure strengthened export estimates, which were the big driver. Other signals that flipped were the Citi Economic Surprise index and Consumer sentiment. Sentiment measures have increased to their highest level since April. Inflation easing would be a big contributor to this and lower interest rates. Manufacturing metrics are still moderately weak but are beginning to see some positive trends in the PMI data.
Outside the US, the Global Economy gained a bullish signal and lost one. Resulting in a 50/50 split. Our DRAM signals flipped to negative, but the Baltic Freight indicator moved into bullish territory. Shipping rates rose to their highest rates in nearly three months, largely thanks to China’s stimulus plans and surging commodity prices. The port shutdown in the US may begin to cause havoc with global shipping and supply chains, and this indicator is quite volatile. The KOSPI is still bearish, but it, along with a number of other indicators, is improving.
In September, we shifted our portfolio allocations slightly. Given the strong rebound in US equities, we partially unwound the tactical trade we made in August by trimming our US equity exposure by 2% and using those proceeds to further increase our international exposure. Valuations played a large part, as did the belief that international markets should benefit from improving growth prospects out of China.
Canadian equity and our bond exposure saw no change. Within fixed income, we remain underweight high yield, and overweight investment grade. Credit spreads are locked near three-year lows, which makes it difficult to seek additional risk in the high-yield space without being adequately rewarded. We prefer cash over bonds, as we are concerned that yields have fallen too quickly, pricing in many anticipated rate cuts that we believe may not fully materialize. Persistent inflation could prevent the smooth rate-cutting cycle from being factored into the market. If yields move much lower from these levels, we will evaluate the fixed income positioning, most notably our duration level. We believe there is enough defence in the portfolio given our factor tilts in equities, a decent duration, and lower bond credit exposure in case we run into further volatility ahead of the US election.
Final Thoughts
Our portfolio tilts comprise what we view as a delicately balanced portfolio. We don’t believe it’s the time to chase markets higher. Given the uncertainty over the next couple of months, we’re comfortable with a slight defensive tilt. Despite the fog, markets are at all-time highs. Rates might not go down as much as some expect, but if it's because the economy doesn’t falter, perhaps the most popular narrative is the right one.
Authors: Craig Basinger, Derek Benedet, Brett Gustafson
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Sources: Charts are sourced to Bloomberg L. P.
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