Mid-Year Review

"It was developed by a Turkish couple leading a German company partnered with a U.S. multinational led by a Greek immigrant with a Scandinavian chief scientific officer". That comes from our friends at the Capital Group and refers to the development of the Pfizer/BioNtech vaccine shortly after Chinese scientists published the virus's genome. In an age marked by global competition and, at times, the building of fences between countries, it's nice to see that we are all still in it together.?

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Second feel-good thought for midyear; CRISPR (clustered regularly interspaced short palindromic repeats) technology has been used to successfully treat disease?in vivo?(inside the human body). Biotech start-up company Intellia Therapeutics and its partner Regeneron let the world know last week that their gene-editing techniques reduced the amount of harmful liver protein associated with a genetic nerve disorder. While the complete understanding of this technology is above my paygrade, we are moving into a world where we are not just treating a disease; we are dealing at the DNA level to stop the problem from even occurring.

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Despite the exciting advances that we have seen, are seeing and will continue to see, a lot of the media continue to paint an ominous picture/negative bias to what is happening around us, even as markets press forward, economies grow, and the world continues to move forward and innovate. That's unfortunate as they may be doing a disservice to investors. By focusing on process, I find myself in a very constructive camp overall. I don't just buy the market; I buy great companies. For companies to be considered candidates in our portfolio, they need to embrace technology at all levels, transparent, constantly be innovating, and part of a cleaner energy solution for our planet. I now find myself looking at companies and asking the question; do you view yourself as a technology company with a specific focus, like banking, logistics, commerce, etc. The term technology is now ubiquitous with being pragmatic, adaptive and innovative. If companies do not demonstrate that, they are not worthy of your investor dollars as they will be left behind.?

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Applying that filter has allowed for above-average results over the course of this year, which is encouraging. I find myself having the push and pull on my brain as we are about to enter earnings season again in the next couple of weeks. I am a firm believer the central banks have a well-articulated strategy to deal with inflation going forward, and because of that and the reopening of the economy, I see better results for companies in the future and, by extension, a strong stock market. I am seeing oil look to start to bump up against resistance in the short-term, small-cap stocks becoming rangebound and breadth retreating in the marketplace, which has prompted my process to add some more defence into portfolios as of late. While I don't see anything remotely dire on the radar, the current "bulletproof-ness" of these markets and my constant thinking about our asset allocation are causing me to tap the brake here. Again, nothing will have a material effect on the next 12+ months; I just like to be ready to take advantage of any pause in markets.

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Why am I so optimistic about the coming 12+ months…??

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1. It's early in the business cycle

Equity markets tend to lead the business cycle, and this cycle appears to have room to run. The last five elongated U.S. business cycles lasted an average of seven years and produced, on average, a cumulative 25% growth in U.S. real gross domestic product (GDP). The current cycle is only one year old, and as one example, the U.S. real GDP is only just returning to where it was at the start of 2020.

2. The economy is hot

Consumer spending, business investment, and housing are all improving. Leading indicators for the global economy are approaching multi-year highs, suggesting that the economy may grow above trend for the foreseeable future.

3. A strong economy suggests companies could grow into their valuations

There's been a lot of hand wringing about valuations, but valuations are almost always elevated one year after a recession. However, history informs us that stocks grew into their multiples after every recession since the early 1990s. Leading indicators signal that a V-shaped recovery in earnings growth could be imminent, and research shows that stocks produced consistent double-digit returns during periods of positive earnings growth over the past 31 years, regardless of what multiples did.

4. Financial conditions very supportive

Interest rates are low, the U.S. dollar is relatively weak, corporate bond spreads are tight, and the stock market is strong. Admittedly that can be painted by the media to sound ominous to investors, but historically the time to become concerned has been when financial conditions have tightened meaningfully, not when they are historically easy.

5. The U.S. Federal Reserve isn't expected to raise rates until late 2022

In short, don't fight the U.S. Federal Reserve (Fed). The process of policy normalization may be in the offing, but the Fed is unlikely to tighten policy meaningfully with the "real" unemployment rate, which includes part-time workers and those who are marginally attached to the labour force, still above 10%.

6. Historically, it's not the first interest rate hike that tends to matter anyway

A review of past initial rate hikes in business cycles ('94, '04,' 15) indicates that returns remain robust in the 12 months prior to and 36 months post the first interest rate hike, weakening only when the U.S. Treasury yield curve flattens.

7. The bond market believes the rate of inflation may moderate.

Short-term inflation expectations are above 3%, but 3-year and 5-year inflation expectations are around 2.5%, closer to the Fed's perceived "comfort zone." If accurate, then near-term inflation that's supportive of corporate earnings, followed by moderating inflation pressure that allows the Fed to maintain policy support, feels like a very favourable backdrop for risk assets.

8. There is capacity in the economy to increase production.

Businesses are looking to rehire to match the growing demand and investing to rebuild inventories and improve production capabilities, both of which should suppress inflation concerns. Capital expenditures are back to pre-pandemic levels. The "real" unemployment rate, which includes part-time employees and those who are only marginally attached to the labour force, stands at 10.2%, suggesting that the economy isn't close to full employment.

9. There's a lot of money on the sidelines.

There is $20 trillion USD total in cash, checking deposits, savings deposits, and other "near money." While investors focus on goods inflation, it is reasonable to expect that "too much money, chasing too few assets" could result in asset price inflation.

10. Investors are not euphoric about equities.

It is said that market cycles tend to end in investor euphoria. Since the global financial crisis, investors have allocated over $3 trillion USD into bond mutual fund and ETF strategies and over $1 trillion USD into money market strategies. On the other hand, investors have only allocated a cumulative $550 billion USD to equity strategies, according to research. It appears there's space to go before investors appear "euphoric".?

Interestingly we have seen mini pullbacks (rotational correction) in the market this year as investors continue to shift between cyclical, secular growth and, at times, defensive names. It is hard to see those pullbacks as market averages (TSX, DOW) continue to push higher as the winners are outpacing the losers. With bonds fairly anchored at this point, diversification is happening at the stock market level, and I continue to look at adjustments within our equity space to ensure that volatility is reduced and we achieve a consistent result. It may be quiet this summer, but based on the above GDP expectations, dividend increases, share buybacks and further merger and acquisition activity, I expect a healthy end to the second half of this year.