Market Volatility and a Mid-Year Equity Market Update (Ep 100)

Head of Investment Strategy Neil Linsdell joins host Chris Cooksey for his regular update visit to discuss the recent market volatility and give an overview of what has gone on so far in 2024, including

• Review of 2024 so far
• Recent volatility
• The Sahm rule
• Interest rates
• Magnificent 7 and AI
• Tech stock trends

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Transcript

Chris Cooksey: Hello and welcome to the Advantaged Investor, a Raymond James Limited podcast that provides perspective for Canadian investors who want to remain knowledgeable, informed, and focused on long term success. We are recording this on August 6, 2024, I'm Chris Cooksey from the Raymond James Corporate Communications and Marketing Department and today, Head of Investment Strategy, Neil Linsdell, returns to the podcast for his regular update visit. Recently, we have seen the return of market volatility, so the timing of this episode works out very, very well. Welcome back to the Advantaged Investor, Neil, I really appreciate you taking the time today., and I hope you're doing well.

Neil Linsdell: Thanks. Pleasure to be here. Exciting week.

Chris Cooksey: Yes, yes, that is for sure. Now, the last time you were here, I think it was early May, we talked about Canada's economy weakening and you expected the Bank of Canada to start cutting rates in June, which obviously was a good call. We've seen two Canadian rate cuts since then. As I always say, my variable rate mortgage appreciates every single one of those. So please continue despite what the wider economic benefits might be. I'm just being selfish here. And we discussed how the U. S. economy was faring better than Canada but had a little bit stickier inflation. We've seen the Fed pushing off starting its own rate cycle or interest rate cutting cycle. After last week, they may regret waiting until September, but I will let the expert in you talk to us about that. And when we originally scheduled this recording, of course, we were just going to do the normal update, and so maybe we do that first - what's gone on in the first part of the year, and then after that, let's hear your thoughts on what happened last week.

Neil Linsdell: Sure. I guess that's the elephant in the room. Let's start with the economy. As we discussed last time, we've seen weakening of the Canadian economy and with inflation firmly under that three percent bound. You've got a two percent target, but a one to three percent bound the Bank of Canada has indeed proceeded with two rate cuts so far this year and we'd expect to see another two before the end of the year. Maybe even one at each of the three meetings the Bank of Canada is going to have. So that would be September 4, October 23, and December 11. We're also looking at cuts continuing into the first half of 2025, so you'll be happy about your mortgage. And as you mentioned the U. S. has continued to demonstrate a stronger economy than what we have in Canada. And with better unemployment rate statistics, which we'll talk about. So we'll talk about the jobs report from Friday, work in a interest rate discussion and expectations. But overall, the U.S. Is still looking better right now than Canada. And so what have we seen in the equity market? The 1st half of 2024 we have the Canadian equity market, which we look at a TSX composite that was up around 6%, compare that to 12 percent for all of 2023. We did subsequently have a bit of a run up through July, but that was all given back with the sell off that we that we just had recently. Now we're pretty much just flat with where we were at the end of Q2. The U.S. market, when we talk about the U S market, we're talking about the S&P 500, and that was up around 15 percent in the first half of 2024, so better performance and that compared to 26 percent for the full year in 2023. But that performance was driven by the Magnificent 7 and AI tech stocks that we've talked a lot about. So right after the end of the quarter, the S&P peaked around July 16. With the recent sell off that you mentioned, we're that's came down around 7 percent from that high, but we're still up 11 percent year to date.

Chris Cooksey: All right. Now as I mentioned when we were talking before we started recording, I saw a bear in the woods last week. I hope we're not transitioning to a bear in the markets. Hopefully, regarding this big sell off, you can just give us a little idea why that happened and reassure me if you will. No pressure.

Neil Linsdell: What happened last week? Well, leading up to Friday, we had seen some weakening in tech stocks over the last few weeks. We saw a little bit of weak manufacturing data with the PMI, but everything really all came to a head on Friday, you might recall, that was as the U.S. put out a jobs report that was weaker than expected. What the report said was in July, the U.S. created 114, 000 jobs. So that doesn't sound awful, and it's not. But it was lower than the average expectation of 175, 000 jobs being created. And basically the 114 was lower than 73 out of the 74 economists that had been forecasting that number.

Chris Cooksey: Wow. A sweep of the podium, as they said, we'll throw in an Olympic reference since it's that time of year, but I guess it's still positive because job creation was still going in the right direction, albeit at a lower number than expected.

Neil Linsdell: Right. So, it's still positive, but it was the second weakest month since the pandemic, but what really struck a chord was the increase in the unemployment rate and the fact that triggered the Sahm rule. So, the July unemployment rate was 4.3%, that doesn't sound alarming, especially we've got 6.4 percent unemployment in Canada, but at 4.3% that was higher than the expectation, which was to hold at the 4.1 percent level that we'd seen in June.

Chris Cooksey: Now I follow Claudia Sahm on Twitter and she always talks about the Sahm rule. I'm very interested in this next response because you know, when someone names a rule after themselves, you're always wondering what it is. So maybe you can just talk a bit what triggered the Sahm rule.

Neil Linsdell: Right. Let me explain that. The Sahm rule created, as you said, by Claudia Sahm, she's a former Fed economist. It's a recession indicator. What it says is that, try to follow me on this, it says that if the three month average of the unemployment rate is 0.5 percent higher than the 12 month low of that average, then the U.S. is entering recession. Basically gauges the speed and severity of an increase in the unemployment rate. Now, keep in mind that even Claudia, as you, you're probably well aware if you're following her, cautions that we need to consider that the current environment might be throwing off the predictive capabilities of the sample, so you have to think about that. Consider that there's three types of unemployed people. There's the people that were laid off. There's people that quit and a third group would be people entering the labour force that are looking for jobs And that can be boosted if you have a high level of immigration. We haven't really seen substantial layoffs and that's what we would be concerned about, getting into that spiral of companies laying off workers because of declining demand, which feeds into further reductions in demand, further layoffs, and we don't want to get into that cycle, and we're not seeing that. Overall, what we're still seeing and expecting is economic growth in the U.S. through the latter half of 2024, just at a lower rate. For now we're seeing more of an impact from increasing supply of workers, that third category. So slower employment growth and cooler labour markets, sure, but we're not seeing lots of layoffs or other data points that would, you know, stoke more heightened concerns right now about a recession.

Chris Cooksey: I'm going to go out on a limb here and say this has impacted the outlook for interest rate cuts in the U.S. and maybe get into Canada after that.

Neil Linsdell: Yeah. The last Fed meeting was July 31. That was right before all this drama started to unfold, and at that point the Federal Reserve had held rates steady at 5%, but certainly they were messaging at that point that inflation seemed to be slowly heading in the right direction, basically setting the table for a cut at the next meeting, which would be September 18. The market had been expecting another rate cut, probably November 7 or December 18, which are the two following meetings. That would bring the rate for the entire year down from 5.5% currently to about five percent by the end of the year. After that jobs report, however, markets got really spooked about the potential for a U.S. recession, and expectations jumped to half a percentage point cut in September. Maybe even the Fed would cut rates between meetings. Now, to me, that would require really dramatic deterioration in the U.S. economy. We're just not there. But the overall expectation has increased. Now the market is expecting more than one percent of cuts spread out over the three remaining meetings this year. Instead of expectations of the Fed cutting rates gradually as inflation gets under control, which is what we were looking at the beginning of the year, concerns now shifting to the Fed cutting rates because it has to in order to keep the U.S. from falling into a recession. Now we're back to people speculating that the Fed is behind the curve and should have had better foresight to cut rates earlier, as I think you might be alluding to there. I mean, being the Fed chairman really is a thankless job. And you asked what the impact is on Canada. As far as the impact on Canada, remember the difference in the policy rate between countries can influence the foreign exchange rate. As Canada started to cut rates in June, while the U.S. was holding rates steady, that put pressure on the value of the Canadian dollar versus the U.S. dollar, as Canada has continued to cut. Since then, we've seen the value of the Canadian dollar go from about 73 cents U.S. to 72 cents U.S. And we watched the potential for the Fed to keep pushing out rate cuts and that would further pressure. We'd expect to see a little bit further weakening. With the expectations rising dramatically for Fed rate cuts to start, that would alleviate some of that downward pressure on the loonie.

Chris Cooksey: All right. Now, when it comes to foreign exchange, people have been getting pretty cheap money out of Japan and the yen carry trade for a while now, I think and I'm guessing that, as I think Japan just raised rates, that has sort of messed that trade up a bit. And we're probably seeing selling pressures in equity markets. So explain to us what's going on there.

Neil Linsdell: Yeah. So that's basically what you set up. For about last 17 years or so, Japan has had zero or negative policy rates. Global investors have essentially been able to borrow in Japan at ultra low rates or they do that by borrowing government bonds and then selling them, going short and they've used that cash to invest in other assets that could be equities in Japan or more likely in equities in the U.S. Think about the magnificent seven. Now, if you borrow in yen, but you invest in US dollars, you have to be concerned about the foreign exchange impact, similar to what we just talked about with between the US dollar and the loonie. But as the Bank of Japan started to signal and then follow through on rate hikes, while the expectation for rate cuts in the in the U.S., that causes the yen to appreciate against the U.S. dollar. Making that carry trade less profitable. When investors need to unwind that trade, they have to sell those assets that they've invested in putting more pressure on the assets. That increases the market sell off that we've been seeing.

Chris Cooksey: All right. Now, with the recent market sell off, you've talked a lot about the magnificent 7, and artificial intelligence is always out there. Are these still big drivers of the U. S. market?

Neil Linsdell: Yes. the magnificent 7 stocks, so that's NVIDIA, Microsoft, Apple, Alphabet (Google) Amazon, Meta, and Tesla. Those stocks are all still up this year, except for Tesla, which is actually now down around 21 percent year to date. If we focus on the AI specifically, Nvidia is the poster child for artificial intelligence and that's still more than doubled since the start of this year. So to your question, AI enthusiasm has continued to be a big reason for the performance. Over the last year, interestingly, we've gotten into Q2 results and conference calls, there's been some impatience coming into the market lately around all the money that companies have been investing and investors are now looking for a return on those investments.

Chris Cooksey: So about this impatient with the returns first of all, couldn't they just put it into the AI engine and find out how long it'll take? I kid but I guess that’s, not where we're at. Maybe just talk a little bit about this impatience and that sort of thing.

Neil Linsdell: Yeah, so if we think about AI, again, it's still an important aspect of what we think about is going to impact the markets, the company performance, productivity, and such, and that's going to be over the next 10 years plus. We always want to be mindful to the fact that new technologies are great but after the initial enthusiasm wears off, we still need to ensure that they can be monetized, which means all those billions of dollars being spent on NVIDIA chips. Those eventually have to yield some productivity, profitability improvements for companies buying the chips and not just for the company selling chips. In between, there's a lot of software applications, process improvements that need to be implemented, and those can take time. And by that we're talking quarters and years. Some companies are going to enable those improvements. And some of those companies are in the magnificent seven. They are sometimes referred to as hyper-scalers. Alphabet Meta, Microsoft, Amazon. The magnificent seven is probably going to continue to be important, but there may be a little bit of a shift, but AI enthusiasm isn't dead. But there's impatience among investors right now. Everybody wants to see the returns immediately. Interestingly, there's one comparison that's pretty popular. If you think back to the dot com bubble, I think we're both of the vintage, we both remember that time, but for anybody that's a little bit younger in the audience, so in the late nineties, you couldn't lay fiber optic cables fast enough. Then we suddenly had too much capacity and the fiber was left dark. Until we had enough applications to make use of it. And I worked at Nortel in the late nineties, I had a great front row seat to some of that. But the point is you need the hardware and the software applications and if you get the timing right, you get great value. That fiber was really important over the longer term, but not necessarily as quickly as the folks laying it anticipated. Right now, as we're looking at AI, I've heard commentary that the risk of under investment is greater than the risk of over investment. Nobody wants to be left behind.

Chris Cooksey: Yeah, yeah, yeah. For instance probably regretting when you look at NVIDIA, getting back to the nineties, Intel was the boss. And now I guess Intel is struggling to keep up a bit in my non expertise mind anyway. In your monthly Insights and Strategies report that just came out, which you can find on our website or various social medias we have, you write about the rotation from mega cap tech stocks to mid and small caps. Is this the direction of the market right now?

Neil Linsdell: Well, so you might hear more about the great rotation, which is mostly about investors taking profits from mega caps and technology stocks to a certain extent moving into smaller, midsize companies and shifting away from growth names to more value and defensive names, especially if we are talking about a slower economy, and that actually played out in July, which seems ages ago, although it was just a few weeks and this is a sort of rebalancing that some stocks, that have very high valuation multiples based on perfect conditions going forward. When the possibility of disappointing against those numbers. because you've got overly optimistic expectations or weight against the prospect of further outperformance, it's not surprising that some investors might prefer to rotate into stocks with lower valuation multiples. Although, you still need good or perhaps defensive earnings generation. Plus, interest rates are on the way down and that can provide a better environment to some of those mid and a small cap stock. It wouldn't be unexpected to see this this rotation.

Chris Cooksey: This rotation is a good reminder to make sure you are, you know, well diversified in your investment approach.

Neil Linsdell: Yeah, absolutely.

Chris Cooksey: Well, Neil, thank you for your time today. We'll talk again in the fall.

Neil Linsdell: Thanks a lot. Great to be here.

Chris Cooksey: Reach out to us at advantagedinvestorpod@raymondjames.ca. Subscribe through Apple, Spotify, or wherever you get your podcasts. Please contact your advisor with any questions you have. Thank you for taking the time to listen today. Until next time, stay well.

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