EQUITIES COMMENT – WILL STOCKS CONTINUE TO RALLY?

After a strong finish to 2023, both Canadian and U.S. stocks continued to gain during the first quarter of 2024.  Increased optimism about the economy was a key driver.  Add in some decent news on inflation, continued excitement about Artificial Intelligence as well as increased oil prices and you have a recipe for higher stock prices.   During the quarter, the TSX Composite gained 7% and the S&P 500 was up 13% in Canadian dollar terms.  Both indexes made new all-time high’s during the quarter.  As you can see from the graphs, stocks experienced a lengthy period of consolidation from early 2022 to November of 2023. 

This was the time during which both the Bank of Canada and the Federal Reserve were raising interest rates.  Once the central banks indicated rate increases were behind us and that cuts were coming in 2024, stocks started to rally.   However, so far in 2024, the number of expected rate cuts has been reduced and the timing of the first rate cut has been delayed due to surprising economic strength, particularly in the U.S.

When we look at sector performance for the first quarter, you can see that most sectors had positive returns.  Industrials and Energy had 11% or more gains in both Canada and the U.S.  Industrials benefitted from stronger economic activity and higher oil prices boosted Energy stocks.  The tiny Health Care sector was the best performer of the TSX due to strength in Bausch Health.  In the U.S., Financials, Technology and Communications had double digit returns.   The worst performing sector of the TSX was Communications.  BCE, Telus and Rogers are included in this group.  Pressure from the federal government to lower the price for internet and wireless services has dampened the near term outlook for profits in the sector.  Increased competitive activity from Quebecor (purchased Freedom Mobile from Shaw) and Rogers (trying to gain share in Western Canada) has also pressured pricing.  On the plus side, the high level of immigration is providing growth in customers industry wide.

Real Estate and Utilities were laggards on both sides of the border.  Communications, Real Estate and Utilities are considered “defensive” and/or “interest sensitive” sectors.  These characteristics worked against them during the quarter.  Defensive stocks are not as sensitive to the economic cycle so when growth is strong, investors have less interest in them.  When growth is weak, the stocks are in favour.  The surprising improvement in economic growth in recent months has been negative for many defensive stocks.  These sectors are also sensitive to interest rates.  All borrow heavily to finance large capital spending projects.  When interest rates are high, it costs them more to finance their debt.  As well, the dividends these stocks pay become less attractive to investors when rates are high like they are now.  We find a lot of the stocks in these groups are offering very good value for patient investors.

The TSX Composite and the S&P 500 surpassed our year end targets of 22,000 and 5,100 during the first quarter!   We expected p/e multiples (the ratio of a stock or stock index price to the underlying earnings) to remain stable this year however, they have increased in anticipation of faster earnings growth.   Stronger than expected economic data combined with better than projected earnings results have boosted earnings forecasts.   Given the improved outlook, we are increasing our targets to 23,000 for the TSX and 5,350 for the S&P.   This does not provide a lot of upside from current levels.   After the gains over the last six months, to have a correction in stocks would not be a surprise.

Risks (upside and downside) to our forecast include:

Economy - It is holding up much better than expected to higher interest rates.  Normally, rising interest rates have a lagged negative impact on economic activity.  Given the distortions caused by the pandemic, it could be the lag is longer than normal this time.  If a recession were to occur, it would be negative for stock prices.  This is especially true now as the probability of a recession in 2024 is considered low by many investors and stock valuations  (p/e multiples) have increased.  Should a recession arise, stock prices would likely decline due to lower earnings and falling p/e multiples.  On the other hand, continued strength in the economy will support earnings and stocks.

Inflation – This is a key factor influencing rate cuts.  Inflation has been declining however, it remains above the central banks’ 2% inflation target.  Higher wages and increased costs for services like restaurants, housing, utilities and recreation are boosting inflation while lower goods prices are causing disinflation in some categories.   Lack of progress in getting inflation down could cause bond yields to rise and delay rate cuts even more.  Eventually, this could put downward pressure on stocks.  The faster inflation reaches 2%, the better for stocks.

U.S. election – The outcome is too close to call.  Should Trump win, his election agenda could provide a short term boost to the economy and stock market if he cuts taxes.  On the other hand, raising tariffs would hurt economic growth and damage confidence worldwide.

Supply Chain Disruptions - The wars in Ukraine and Gaza have impacted trade and supply chains.  This has put upward pressure on inflation.  Continued attacks in the Red Sea have caused an increase in shipping costs due to higher insurance rates and longer shipping times.  In recent days, the collapse of the Baltimore bridge and earthquake in Taiwan are also impacting the flow of goods.  The risk of a wider Middle East war that could affect oil production and transportation would also be inflationary.

Artificial Intelligence - Disappointing results from influential stocks such as NVIDIA or META could cause p/e multiples in the Technology sector to deflate.  Because Technology makes up 30% of the S&P 500, a reduction in valuation would have a negative impact on the overall index. 

Will stocks continue to rally?  We have increased our year end targets but expect a correction could occur between now and the end of the year, prompted by one or more of the risks we have mentioned.