Calm in equity markets may be short-lived

Equity markets have shown resilience and held up well in the first half of 2023, but Leslie Alba, director of portfolio solutions at CIBC Asset Management, warns the calm may not last.

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One reason for the recent market optimism, according to Alba, is the decline in inflation from peak levels seen last year.

“The economy has shown some resilience, and this has left equity market participants relatively optimistic,” she said.

In addition, she said the enthusiasm around artificial intelligence has boosted stock returns, especially for chip makers and tech companies associated with the emerging technology.

However, Alba said the equity market’s strong performance is being driven by a narrow set of stocks, with seven companies—Nvidia, Apple, Microsoft, Meta, Tesla, Amazon and Alphabet—delivering almost 95% of the returns in the S&P 500 up to mid-July.

This level of outperformance has led to “valuation stretching” across these large-cap companies, raising concerns if they continue to outpace the rest of the index by the same magnitude.

Despite the relative calmness in the market to date, Alba warns that there are indications of excess optimism.

The VIX index, which measures the implied volatility of the S&P 500, is at its lowest point since the start of the Covid-19 pandemic, she said. Additionally, the Investors Intelligence bull/bear ratio, a respected gauge of market sentiment, has reached levels that typically precede equity selloffs.

“In our view, these are indications of excess optimism across equity market participants, and that can contrast with signals from the bond yield curve,” said Alba.

In this environment, Alba said a recession may be delayed but not avoided, as central banks continue to battle inflation while being cautious not to trigger major economic downturns through higher interest rates.

Last week, the Federal Reserve raised its key interest rate for the 11th time in 17 months, while the Bank of Canada hiked its key interest rate by a quarter point in mid-July, bringing it to 5%.

To date, Alba said consumer strength has been a key driver of economic support in Canada, but the potential depletion of excess savings and further tightening of financial conditions pose risks. In addition, if earnings fall, she said the pressure on corporate profits could lead to job layoffs.

“All of these considerations support our view that we seem to be headed for some choppy waters, even if markets have been more calm recently,” said Alba. “Perhaps a sort of calm before the storm.”

Given these potential challenges, Alba said investors should be prepared for volatility. Although equity valuations remain rich, she emphasizes the importance of sticking to a diversified strategic asset allocation to meet long-term investment goals.

So while short-term headwinds are top of mind, she said “long-term strategic asset allocation tends to be the largest contributor to a client’s broader investment objectives.”

Against this backdrop, Alba said investors have a number of avenues for diversification.

One option, she said, is through traditional assets, as bond and cash yields are now offering attractive returns that can offset potential equity drawdowns. Additionally, government bonds could benefit from possible rate cuts by the Bank of Canada to stimulate the economy during a recession.

The second way investors can diversify is through sector allocation, Alba said. With technology names driving the majority of recent positive stock performance, investors can avoid concentration risk by looking for value in other parts of the market.

Alba also recommends exploring private assets, which can enhance expected returns compared to traditional public assets. She said these private market alternatives may involve investing in niche, emerging, or segmented markets and sectors where information asymmetries and heterogeneities exist.

“All of these facets enable investors with skill and often scale to do well,” she said.

Lastly, she said financial engineering can play a role in achieving specific outcomes, such as drawdown protection, volatility reduction or yield enhancement. However, it is crucial for investors to carefully assess their objectives, risk tolerance and constraints when incorporating these tools into their portfolios.

Despite the challenges posed by conflicting signals from economic data, fixed income markets and equity performance, Alba encourages investors to remain patient and willing to take appropriate risks.

“When not all signals point to the same potential outcome, it’s easier to get it wrong,” she said.

Alba said investors should consider a well-diversified and disciplined approach to achieve their long-term financial objectives.

“Remaining invested and sticking to a long-term strategic asset allocation is the best way to deliver on desired long-term outcomes,” she said.