June 2024 Wealth Notes

Introduction

Welcome to the latest edition of Verus Wealth Notes, where we provide a focused analysis of current economic trends and their implications for investors. In this quarter’s newsletter, we delve into critical developments across major markets and asset classes, offering insights to inform strategic investment decisions.

We begin by scrutinizing the evolving landscape of the US consumer. Despite previous resilience driven by low debt costs and surplus savings, emerging indicators suggest a potential slowdown ahead. Our analysis challenges prevailing optimistic forecasts, highlighting factors such as depleted excess savings, declining full-time employment, and rising debt costs as early signs of economic headwinds.

In the first half of 2024, the S&P 500 boasted a 14.6% return, largely driven by concentrated gains from its top 10 stocks, which contributed 10.90% to the total. Nvidia alone accounted for 4.77% of this return. This stark contrast underscores the index’s heavy reliance on a handful of tech giants, prompting concerns about market concentration and the potential for FOMO-driven bubbles, particularly in the artificial intelligence sector. Opportunities may lie in overlooked sectors like small and mid-cap stocks, currently trading at attractive valuations.

Shifting our attention to Canada, we explore the repercussions of recent fiscal policies on investor sentiment. With significant capital outflows and a challenging economic outlook exacerbated by restrictive monetary policies, we assess the implications for the Canadian dollar and equity markets.

Throughout this newsletter, our strategy remains rooted in fundamental analysis, risk management, and a disciplined approach to portfolio allocation. By focusing on enduring principles and prudent investment strategies, we aim to guide you through market complexities.

Economics

US Consumer Resilience: Slowdown Ahead?

Many of our regular readers are familiar with our discussions on the remarkable strength of the US consumer, as highlighted in our previous wealth notes. In our Q3 2022 and Q2 2023 podcasts, we extensively analyzed how most market economists and analysts underestimated the resilience of the US consumer, which constitutes 70% of the US GDP and thus anchors the economy. We explained that the US consumer remained exceptionally strong due to low debt service costs and elevated levels of excess savings. Contrary to the prevailing opinion that higher interest rates would weaken the US consumer, the past 12-18 months unfolded differently than most analysts anticipated, aligning exactly with our predictions. This is why we maintained a bullish outlook throughout 2023.

Fast forward to today, and the roles have reversed. After their incorrect forecasts in 2022 and 2023, many market experts now predict a strong economy, a soft landing for the US, and continued consumer resilience, with any slowdown being mild. At Verus Financial, we believe these optimistic forecasts are misguided.

We anticipate a significant slowdown in the US consumer over the next 3-12 months, shifting the narrative from resilience to struggle and survival. Our conviction is supported by several strong indicators:

Excess Savings

The excess savings that Americans accumulated during COVID, a critical factor in consumer resilience, have now been depleted. The substantial buffer that once existed is gone.

Employment Picture: Headline VS. Reality

Contrary to news headlines suggesting a robust labor market, the reality is different. In May, the US reported an increase of 272,000 jobs, seemingly robust growth. However, full-time employment has fallen for the fifth time in six months, resulting in an annual decline of just under 1%—the largest ever recorded outside a recession.

Additionally, wage growth has declined rapidly, leaving consumers without the high wages needed to support spending.

Increased Debt Cost

As companies shift to part-time employment to preserve profit margins, household purchasing power is eroding. This is leading to increased delinquencies at commercial banks for car loans and credit card loans. The serious default rate on credit card loans is now at 7%, the highest in a generation, even with an unemployment rate of just under 4%.

First Sign of Weakness: Start of Something New?

The combined effects of the above factors suggest we are at an inflection point for the US consumer. First-quarter GDP growth was revised from 1.6% to 1.3% annualized, a small change but one primarily due to weaker household consumption than initially reported. This indicates potential underlying weaknesses in the economy.

At Verus Financial, we believe these indicators signal a challenging period ahead for the US consumer. The story is shifting from resilience to one of struggle and survival.

Everyone wants out of Canada

Our Wealth Notes often highlight the challenges facing Canada, and unfortunately, the situation continues to deteriorate. The recent Canadian budget released in April made international headlines, generating significant backlash. For a comprehensive summary of the budget, visit our blog post here.

In short, the new budget reinforces the perception that the current liberal government is unsupportive of business in Canada. This has prompted businesses to reevaluate their operations in the country and professionals to consider relocating to higher-paying, more tax-efficient regions. The repercussions of these ongoing changes are still uncertain, but the outlook is bleak. We may be witnessing the beginning of another “brain drain” similar to what occurred in the 1980s under Pierre Trudeau. Only time will tell.

What is certain is that foreign investors are losing confidence. Over the past 12 months, foreigners have sold off $37 billion worth of Canadian equities, a trend that started at the beginning of 2023 and is typically seen during a recession.

This lack of interest, while certainly reflecting a degree of confusion linked to government policies on energy transition and corporate taxation, is also due to a less favorable cyclical context, with restrictive monetary policy continuing to weigh on corporate profits.?

The dumping of equities by foreigners, combined with earning being hit hard in Canada vs. the US has led to one of the largest divergences between the valuations of our respective stock markets ever on record.

With many looking to exit, a pressing question is the impact on the Canadian Dollar (CAD). Considering the deteriorating economic landscape, the outlook for our currency is grim. If the economic divergence between Canada and the US continues, the interest rate differential will likely widen, leading to further depreciation of the CAD. This could benefit exporting companies, however.

We expect the USD/CAD to rise above 1.40 in the second half of 2024 before potentially appreciating in 2025 due to fiscal stimulus.

World: Fiscal Policy Keeping Us All Afloat?

When central banks began tightening monetary policy two years ago, many economists predicted that this would push the global economy into a recession. This assumption was based on the idea that higher interest rates would increase the cost of servicing elevated debt levels globally, thereby squeezing economic agents.

Twenty-four months later, the economy has proven more resilient to interest rate hikes than expected. Loose fiscal policy in advanced economies is a key reason for this outperformance. In 2023, there was a record deterioration in governments’ structural budget balances outside of recession periods. Widening deficits in wealthy countries like the United States, France, and Japan counteracted monetary policy, helping to maintain higher GDP growth (and inflation) than would otherwise have been the case.

Growth has been higher, yet still low by historical standards. While fiscal stimulus measures have been significant, they have not fully offset the impact of monetary tightening, leading to a slowdown in economic activity. Median annual growth in the G7 economies dropped to just 0.5% in the first quarter, its worst performance since 2013, excluding the early days of the COVID-19 pandemic.

The repercussions of rate hikes have been most pronouced in the Eurozone, particularly in countries like Germany, which have sound fiscal management. The region’s disappointing post-pandemic recovery in consumer spending means the economy continues to operate below potential, in stark contrast to the situation in the United States.

Markets

Performance Update

The second quarter was turbulent, resulting in uneven outcomes. US shares rose, driven by the information technology and communication services sectors. Enthusiasm around artificial intelligence (AI) significantly boosted related companies amid strong earnings and positive outlook statements, while materials and industrials lagged.

Initially, both stock and bond markets faced challenges due to persistently high inflation, which dimmed the outlook for Federal Reserve interest rate cuts. However, by the final days of the quarter, inflation news turned favourable, increasing investor confidence that the Federal Reserve would lower rates in September.

Q2 2024 witnessed a stark market divergence. Mega-cap stocks, fuelled by AI enthusiasm, drove S&P 500 gains, while small caps faltered. The bond market struggled as rising Treasury yields dampened overall performance. This divergence became more pronounced, with the top 10 companies by market capitalization now representing an unprecedented 38% of the total index, up from 34% at the end of Q1. This shift reflects investors’ growing optimism about the growth prospects of these industry giants, particularly as enthusiasm for AI technologies continues to fuel market sentiment and drive valuations higher.

The quarter began poorly for global bond markets, driven by renewed concerns about U.S. inflation that prompted investors to reassess the timing of interest rate cuts. However, the market environment improved later as softer labor market conditions emerged and encouraging news on inflation surfaced. Still, the FTSE Canada Universe Bond remains in negative territory for the year.

U.S Markets

Despite the impressive 14.6% return for the S&P 500 in the first half of 2024, this performance does not reflect the broader market’s health. In reality, the market is highly concentrated.

The top 10 stocks have contributed 10.90% of the 14.6% return, accounting for approximately 75% of the total. Notably, Nvidia alone has contributed 4.77%, which is 33% of the S&P 500’s total return for the year.

In contrast, the equally weighted S&P 500 index, which gives each company an equal weight and thus provides a more accurate representation of market breadth, is up by only 4.5%. This disparity highlights that the broader market is not performing as strongly as the headline index might suggest.

Some of you might wonder, why does it matter if the US market is so concentrated? The answer is straightforward: extreme market concentration poses significant risks for two interconnected reasons: 1) Fear of Missing Out (FOMO) and?2) Bubble Formation.

FOMO

Currently, FOMO is rampant, with Nvidia up over 155% year-to-date and tech stocks leading the charge. Everyone wants in on the action — just take a look at the graph below.

On June 24th, 2024 the US set a record for the largest weekly inflow into tech fund ever on record. A staggering $8.7 billion worth of capital flowed in tech stocks in one week.?

Even fund managers are eager to join the party. The graph below displays the historical cash levels held by global fund managers dating back to 1999. Currently, these cash levels sit near record lows, indicating high optimism about equities moving forward. Interestingly, the points in time where fund managers had the highest levels of cash (marked with circles) all coincided with market bottoms, presenting significant buying opportunities. In our view, this serves as a strong contrarian indicator.

Bubble Formation

Narrow market leadership fosters FOMO, which in turn fuels bubble creation. One of the challenges in identifying and predicting bubbles is the uncertainty surrounding their duration and extent of price increases.

Bubbles can persist for months, even years, making it nearly impossible to time their bursting. During periods of market euphoria, it’s also difficult to gauge how disconnected prices are from underlying realities.

The current frenzy around artificial intelligence (AI) could potentially be a bubble. Despite speculation about AI adoption, improvements in productivity and corporate profitability, and societal benefits, it may be premature to justify some of the lofty valuations.

For instance, consider Nvidia, which trades at 23 times sales. This implies investors are paying $23 for every $1 of revenue. Another perspective: assuming no operating costs, growth, or sales expansion, it would take 23 years of distributing all earnings to shareholders for an investor to break even.

Putting aside Nvidia and the AI sector, historical parallels show that market concentration in terms of returns hasn’t been this pronounced since 1998/1999. While this isn’t a repeat of the tech bubble, history has shown that it can echo familiar patterns.

Where is the value:

As highlighted earlier, the top 10 contributors to the S&P 500 account for 10.5% of its 14.6% rate of return, leaving the remaining 490 stocks to contribute just 3.1%.

Currently, much of the US market outside of Tech has been overlooked, with attention focused heavily on the technology sector. We see significant value in these “left behind” businesses, particularly small and mid-cap companies. As depicted in the graph below, small-cap companies are trading at some of their cheapest valuations compared to large-cap counterparts since the tech bubble. Is this an opportunity knocking? We believe so!

Canadian Market

Compared to the US markets, the Canadian market (TSX) has delivered lackluster results this year, with a return of 4.55% thus far. Energy and materials companies have led the charge, returning 11.24% and 12.76% respectively in the first half of the year. Conversely, information technology and communication services have been the biggest detractors, declining by -2.88% and -9.84% respectively for the year.

As discussed in our March Wealth notes, all of Canada’s major banks have increased their loan loss provisions recently. This means they are setting aside funds in case some borrowers can’t repay their loans. This trend continues today. The longer the Bank of Canada keeps rates at these high levels, the more pressure it puts on individuals and corporations, leading banks to set aside even more for potential loan losses.

A major concern for many borrowers and lenders is that mortgages taken out at historically low rates in 2020 and 2021 are now up for renewal in the next two years. Many of these borrowers will face mortgage costs that could increase by 100 to 200%. For those whose incomes haven’t risen significantly in the past few years, this situation poses a serious challenge.

The full impact on banks remains uncertain but could add further challenges to an already struggling sector.

Despite potential headwinds, at Verus Financial, we believe the market is appropriately pricing in the consequences of Canada’s restrictive monetary policy, political challenges, and fragile economy. This is evident in the significant discount of the TSX compared to the S&P 500. While this reflects Canada’s cheaper valuation relative to the US, which isn’t necessarily negative at this point. Much of the negative news has likely already been factored into TSX prices, and if global valuations compress, Canada may experience less severe impacts than the US. Therefore, we remain confident in maintaining our exposure to high-quality dividend-paying Canadian companies during this critical period.

International Market

Similar to the Canadian market, international returns have been lackluster compared to the US. The MSCI EAFE has only returned 3.14% year-to-date. While the eurozone economy cannot be described as robust, recent indicators suggest it may not be weak enough to warrant a series of rapid rate cuts. In fact, there are signs that growth may have accelerated in the second quarter, as indicated by the latest S&P Global PMI index.

However, several factors suggest we may not see a wave of rate cuts in the Eurozone. Firstly, inflation remains above target, driven by persistent pressures in the services sector. Secondly, there is substantial wage growth and a remarkably strong labor market. These factors combined present a cautious outlook for monetary policy adjustments in the near term.

Ultimately, with interest rates in the Eurozone expected to remain restrictive for the foreseeable future, this could continue to pose challenges for European equities. In addition to economic factors, geopolitical tensions within the Eurozone, such as the Russia-Ukraine conflict or issues involving Israel, could further complicate matters. Given the Eurozone’s proximity to these conflicts, their impact should not be underestimated.

At Verus, we maintain a cautious stance on our international exposure. This cautious approach doesn’t imply exiting the international market entirely. The opportunities and diversification benefits remain compelling. However, we made adjustments earlier this year, reducing our international mandate by 35% in 2023 and by 6% year-to-date as of early February.

We are open to increasing our allocation in the future if valuations become more attractive and if we gain greater confidence in Europe’s ability to restore pricing and political stability.

Fixed Income

Not saying we told you so! But we told you so.?

The Bank of Canada (BoC) became the first G7 central bank to ease its policy target rate in June. The overnight target rate fell from 4.75% to 4.5%. As we have alluded to in our previous Wealth Notes and Podcast, we were quite vocal in saying that BoC would be the first to cut. What was also important about our historical comments was we also said that the BoC would cut the fastest and the deepest.?

We still remain steadfast in this conviction. Our analysis presented in the economic section, shows the substantial deterioration happening in our country. But what is more concerning is despite the cut in the policy rate in June, monetary policy in Canada remains the most restrictive in the G7.

The chart above highlights two critical points:

1. The current policy rate relative to inflation (CPI excluding food and energy) in Canada remains the highest among the G7 countries, indicating significant restraint.
2. The Canadian labor market is now the least tight compared to these nations.

Based on this analysis and our broader assessment of the Canadian economy, we maintain our expectation for faster and deeper interest rate cuts in Canada. We anticipate the policy rate to decrease to at least 4% by the end of Q4.

If our expectations materialize, we foresee potential capital appreciation in the fixed income space, particularly within our Verus Strategic Fixed Income (VFIX) mandate.

Alternatives

The window of opportunity is opening up for private real estate investors.

Globally, valuations are still adjusting downward from their peaks in 2022, driven by higher inflation, interest rates, and volatility. This dislocated environment presents investors with the chance to acquire high-quality assets at attractive prices, often below replacement cost. Bid-ask spreads are also beginning to narrow as investors demand higher risk premiums across various sectors.

Historically, the real estate asset class has shown strong performance following periods of dislocation. We view the current environment of repricing against a backdrop of solid market fundamentals as a promising opportunity. However, there are significant challenges ahead. Global transaction volumes have declined by 57% year-over-year, largely due to the increased cost of capital. In the short term, limited availability of financing is expected to create a markedly different environment compared to the low-rate era following the global financial crisis.

Since mid-2022, when rising interest rates began impacting private markets, dispersion has been a defining characteristic of the real estate asset class. We anticipate this trend to continue shaping investment strategies throughout 2024.

Private equity is currently navigating an adjustment phase in light of higher interest rates and market uncertainty. Despite these challenges, we maintain a positive outlook on the asset class, considering its track record of outperformance during periods of market volatility. There are indications that near-term opportunities could be compelling for buyers equipped with access to capital.

Commentary

As we reflect on our previous quarter’s commentary, our emphasis on maintaining strategic composure in the face of market exuberance remains pivotal. This disciplined approach has proven instrumental in securing positive results for the year, yet we remain cautious about future challenges.

Since our tactical adjustment in February, where we reduced positions in Verus US Focus Growth (VUFG) and Verus International Growth (VING), we have maintained a steady course. However, we are mindful of the significant concentration in AI sectors within the S&P 500. Should these sectors experience setbacks, the potential for market contagion across equities is a notable concern.

Our strategy remains focused on three key pillars. Firstly, we continue to prioritize businesses with robust and enduring fundamentals, which we believe can weather market volatility and irrational behaviour. Secondly, to mitigate potential equity downturns, we are slightly increasing our allocation to cash and fixed income. This adjustment aims to bolster stability and liquidity in our portfolio during uncertain market phases. Finally, we are monitoring opportunities to selectively increase exposure to small-cap stocks when favourable conditions arise. While short-term risks persist, we recognize the long-term growth potential in this segment.

In the context of market cycles, we adhere to the wisdom of Warren Buffett: “The stock market is a device for transferring money from the impatient to the patient.” This quote underscores our commitment to patience and disciplined investing. By maintaining a steadfast approach and focusing on enduring principles, we aim to navigate current market complexities while positioning ourselves advantageously for future opportunities.

Sources

NBF Strategy and Economic Report

NBI Asset Allocation Strategy

Morningstar Direct Inc.

Thompson One.

Bloomberg LP

Blackrock

Reuters