Calm in Equity Markets May Be Short-Lived

Text transcript

Leslie Alba, director, portfolio solutions, CIBC Asset Management.

Up to mid-July, equity markets have held up reasonably well relative to expectations. However, we believe that’s unlikely to persist through 2023 and into next year.

There are a couple of reasons equity markets have continued to rise recently. Firstly, inflation continues to decline from peak levels seen last year, and the economy has shown some resilience, and so this has left equity market participants relatively optimistic.

Secondly, enthusiasm around artificial intelligence has provided a boost to stock returns, especially for chip makers and companies associated with these new technologies. However, strong equity performance, looking at the S&P 500 as a major market, has been driven by a very narrow set of stocks. Through to mid-July, the seven largest companies in the S&P 500 by market cap, so Nvidia, Apple, Microsoft, Meta, Tesla, Amazon, and Alphabet, delivered almost 95% of the indexes’ returns. Again, that’s up to mid-July 2023.

The remaining 493 names in the index have delivered flat returns in aggregate, on a market cap weighted basis. We seldom see this degree of outperformance and it’s led to valuation stretching across those big seven names who might soon start to feel some valuation pressure if they continue to outpace the rest of the index by the same magnitude.

And then when we look at the VIX index, which measures the implied volatility of the S&P 500, it’s at its lowest point since the start of COVID. So, the market appears to be relatively calm despite continued economic vulnerability. And then the investors’ intelligence bull/bear ratio, which is a well-respected gauge for market sentiment, has reached a level that tends to 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.

On the bond side, bond yield curves remain inverted and have actually recently become more inverted through to the end of June as a short end of the curve continue to move upwards, while expectations around longer term rates remained relatively more stable. With an inverted yield curve, investors aren’t paid to take on additional duration or interest rate risk.

Although the economy has so far been resilient relative to expectations, our view is that the recession is delayed, not avoided. Central banks are still fighting inflation, and they need to be careful not to provoke major lag defects of higher interest rates on the economy. So far, the strength of the consumer has been a key driver of economic support in Canada. Continued tightness in labour markets and robust demand is causing persistent inflation pressures and services.

However, when we look at excess savings as a percentage of GDP, we find evidence of depletion in both Canada and the United States. Also, banks haven’t been increasing their lending rates in lockstep with policy rates, so there’s a risk of further tightening of financial conditions being driven by the banking sector. While labour markets have remained relatively tight, our expectation is that earnings will fall across most sectors and this 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. Perhaps a sort of calm before the storm.

At current interest rate levels, high cash returns result in low expected risk premiums. In other words, investors are arguably paid less in this environment to take on additional risk. So, incremental value can be created by positioning relatively defensively, especially in this environment.

Equities appear to be headed for their December 2021 highs, and valuations remain rich. That said, long-term strategic asset allocation tends to be the largest contributor to a client’s broader investment objectives. And in that regard, although short-term headwinds are top of mind, we continue to recommend sticking to a diversified strategic asset allocation to meet long-term investment goals.

We expect continued volatility through to the end of the year and into the next. And while our base expectation is for potential challenges in markets, we acknowledge the possibility that equity market momentum can persist despite these economic pressures. The recent technical recession in Europe hadn’t deterred European markets from exhibiting positive returns in 2023 to mid-July. And so in this environment, staying invested in a long-term strategic asset allocation is the best course of action.

There are a few ways investors can diversify their portfolios. The first is through traditional assets. Bond and cash yields now offer a powerful source of return potential, and higher yields are generating better income than the past, which will at least partially shield the portfolios from equity drawdowns. Also, government bonds should benefit from a scenario where the Bank of Canada cuts rates to provide stimulus during an economic recession. The second way to diversify is through sector allocation. With technology names driving the majority of recent positive stock performance, investors can diversify away from concentration risk by looking for value in other parts of the market, whether that be industries that have sold off and have the potential to recover quickly, or smaller market cap names that are exposed to favourable themes but don’t carry lofty valuations.

Another way to diversify is through alternative assets. We’re particularly positive on private assets. These are liquid and so aren’t appropriate for all investors, but a core tenet of the investment case for private market alternatives is the opportunity to enhance expected returns relative to traditional public assets. This opportunity arises from a willingness to forego liquidity and to participate in niche, emerging, or segmented markets and sectors. In private markets, information asymmetries and heterogeneities are relatively persistent. Complexity, transactions, search costs are high, and competition is scarcer. All of these facets enable investors with skill and often scale to do well.

Finally, an interesting way to diversify can be through incorporating financial engineering into portfolios to deliver specific outcomes such as drawdown protection, volatility reduction, or yield enhancement. Of course, not all of these tools will be suitable for all investors, and one needs to think very carefully about how to combine various assets to achieve desired results. So, with all portfolio construction, the client’s objectives, circumstances, time horizon, risk tolerance and constraints need to be taken into consideration.

A key risk for investors in the current environment is driven by the disconnect we’re seeing between economic data, fixed income market signals, and equity market performance. Economic data, although reasonably resilient so far, is showing signs of weakness when we pull back layers of various economic indicators.

Meanwhile, the inverted yield curve demonstrates the market’s pessimistic outlook, while equity markets have been more optimistic. And when not all signals point to the same potential outcome, it’s easier to get it wrong. Also, momentum can persist, and asset prices can deviate from underlying fundamentals for a very long time. This makes market timing very hard to get right.

Through research looking at decades of data, we find that patience has historically been rewarded and so has a willingness to take appropriate risk. For this reason, remaining invested and sticking to a long-term strategic asset allocation is the best way to deliver on desired long-term outcomes.