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The more things change, the more they stay the same. Apparently, a little over two months ago, the calendar flipped in December to begin a new year; however, looking at financial markets, you could be forgiven for thinking that 2023 has just continued into its 15th month.
The themes that dominated last year continue to lead as we start this year. Artificial Intelligence remains the focus amongst investors who continue to shun factors such as value and dividends. The “Magnificent 7” group of leading technology companies is still a must-own, led by huge beats and stock reactions during the month of February from Facebook and Nvidia. But underneath the surface there are cracks emerging, and maybe the correct term is the “Magnificent 4,” as Telsa, Apple, and Google are now down in price on the year.
Interest rate policy continues to be a driving factor. We entered the year with expectations of five to six rate cuts in the U.S. But recent strong economic data, combined with sticky high inflation, is causing many to question those estimates. These data points have resulted in bond yields moving higher from the levels we closed the year at. Yet in an interesting switch, it isn’t impacting stocks the way many would have expected. The pattern had been that higher yields resulted in lower equity prices, but for now, that correlation between bond yields and equities has broken.
But how long can this last? For now, markets seem to have embraced the dream that the FOMC pulled off a miracle and executed the impossible “soft landing” they have long dreamed of. Earnings reports from the fourth quarter have reinforced this, as we are seeing numbers that have been coming in ahead of expectations. Earnings margins, on average, have not deteriorated to the levels feared, and demand for services remains. However, once again, there are cracks, and the rest of the world does not appear to be as lucky as the United States. China remains stuck in a no-growth environment, and Europe looks to be slipping into a recession.
Once again the situation in Canada is much different from that in the U.S., as our economy and consumer base remains weaker due to its sensitivity to mortgage rates. The Bank of Canada began hiking interest rates well before the FOMC, and as rate cuts are pushed back in the U.S., Canadians should expect to see cuts earlier. The recent bank earnings reinforced this as they continued to show caution around the consumer and a lack of growth. Once again, the S&P/TSX looks set to lag the U.S. markets.
What could cause a reversal of these trends that would allow other regions to join the party? It should come back to the belief the economy will survive a “higher for longer” rate environment. An understanding of this would help to trigger a flow of funds back toward the long-forgotten value and cyclical sectors. These groups have been in the penalty box for over a year. Add to that the underperformance of small-cap names that seem to have been ignored for years, and value markets like Canada will lag.
An area that re-emerged over the last year has been the crypto sector. The launch of the U.S. Spot Bitcoin ETFs has been the catalyst to open this asset class to the largest pool of capital in the world, the U.S. investor. Combined with a decrease in supply coming later this spring from the Halving, Bitcoin prices are once again challenging all-time highs. What this means for investors in other asset classes is a constant debate. Is this another example of excess you see near the top of the rally? Or is it a further example of the frustration of some at the loose money policies of central bankers? It could be a combo of both, but regardless of the reason for the rally, it has become an asset that is impossible to ignore.
As we enter March with equity markets at all-time highs, what should investors be doing? Markets have experienced an incredible rally since the end of October, when everyone was convinced that central bankers had kept rates too high for too long. But as the data are getting better and the “soft landing” seems more likely (at least in the U.S.), markets have celebrated with a record run. However, the rally has not been broadly based, and concentration risk is becoming very real in many markets.
The dream for investors would be a pause in the large-cap technology names and a catch-up rally for the lagging sectors. At present, the rally is held up by only a few names, and the risk of a correction increases. Let’s hope we see this broadening out in March – something that would be cause for celebration by almost everyone.
Greg Taylor, CFA, is the Chief Investment Officer of Purpose Investments Inc.
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Charts are sourced from Bloomberg unless otherwise noted.
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