This week we will eschew our usual “punny” title and instead settle in for a quick mid-year update as well as an outlook for the second half of the year.

The “Megas” Mask the Reality

The headline if one focuses on the S&P 500 is that the first half of 2023 was great for stocks. Let’s start with a chart and then comment:

Through the end of May, the S&P 500 was up ~11%, which might give the impression that most stocks are enjoying a renaissance of sorts in 2023. However, we would note that the S&P 500 is market cap weighted, which means the largest stocks in the index enjoy undue influence over the movements of the S&P 500. To put this in some perspective, Apple and Microsoft – the two largest weights in the index – count the same as the bottom 293 stocks in the index. Let’s add a line to the above chart and then comment:

Here, we have added the equal-weighted S&P 500, which unlike the regular S&P 500, gives each stock in the index an equal say in how the index performs. Through the end of May, the equal-weighted S&P 500 was up ~1%, which was similar to the performance of the TSX:

Old McDonald had a ChatGPT - AI-AI-O

In the near future, we will take the time to do a deeper dive into the artificial intelligence (AI) mania that has taken hold over the past 6-months, but for now, we will acknowledge that the bold move in the S&P 500 has largely been driven by the handful of stocks that offer exposure to AI. Whether or not these stocks are able to monetize AI in any meaningful way remains a very open question in our view, but stock investors are famous for betting the farm on new technologies only to find out that monetizing said technology proves challenging.

Inflation – On the Way Down, but a Rough Patch May be Ahead

If one wanted to boil down the last 18-months (let alone the first 6-months of 2023) to one word, it would almost certainly be “inflation”. The good news is, inflation is clearly on the decline, the bad news is, the pathway to sustainable 2% inflation, which is the goal that central bankers such as the U.S. Federal Reserve and the Bank of Canada seek, is likely to prove elusive for some time to come. Let’s start with our favorite chart and then comment:

As you can see, annual inflation (the red line) has been in steady decline over the past 11-months. Last June, inflation was at 8.9%, while last month it hit 4.1%. This has largely occurred because we had some very big monthly readings in the first part of 2022 (the gold bars to the right) that we have replaced with significantly lower monthly numbers in 2023 (the blue bars to the right). June of last year (the towering gold bar to the right) is up next for replacement, so there is a very good chance that year-over-year inflation is going to drop into the 3’s by the end of this month.

However, to get to the 2% long-term target, inflation needs to average ~0.17% per month, which is significantly lower than the ~0.26% we have been averaging since the June 2022 peak in inflation. In other words, inflation has moved in the right direction as we replaced 2022’s really ugly numbers with better numbers, but what we have seen is still not enough.

Rate Relief is Some Way Off

Piggybacking on the above, both the Bank of Canada and the U.S. Federal Reserve seem determined to continue with their respective tightening campaigns, despite recent “pauses”. The BoC overnight rate now sits at 4.75% with another 0.25% hike likely in July, while the U.S. Fed Funds rate sits at 5.125% with another 0.25% to 0.50% likely in the coming months. Probably more important than a bit more tightening is the question as to when both central banks will begin to lower rates. At the start of 2023, the consensus view was that rate cuts were likely late in the year, but this view has now sighted to the middle of 2024. For our part, we would not be surprised to see rate cuts pushed out to the back end of 2024, as both central banks will not only want to see inflation at 2%, but also several months of data that suggests inflation is likely to stay there.

The Economy – You Have to Fall First to be Lazarus

Against the backdrop of ~500 basis points of interest rate hikes over the past 18-months, one would be forgiven for assuming that the economy would be somewhere between troubled and in deep trouble. However, despite this central banker “heavy lifting”, both the U.S. and Canadian economies have thus far avoided recession with job creation continuing to be the key propellant.

The U.S. economy is continuing to create jobs at an alarmingly high clip. To put the 4.07 million jobs the U.S. economy has created over the past 12-months in some perspective, if we put up a chart of annual payrolls from circa 1985 through 2020 and overlaid 4 million on the chart, this is what it would look like:

 

In case you missed it, the U.S. economy failed to achieve 4-million jobs in any 12-month period over this 35-year stretch and yet it achieved it over the past 12-months amidst an unprecedented tightening cycle. There are lots of reasons for this primarily centering around the aftereffects of COVID, but the resiliency is still incredible in our view.

The Outlook – The Good, the Bad and the Ugly-ish

As mentioned above, the jobs market continues to provide more than hope that the proverbial “soft landing” of the economy is a possibility. However, as we have also written in the past, the yield curve, which has been a great predictor of recessions, has been inverted for roughly the past year:

We would note in the chart above that inversions (when the yield on long-term bonds is lower than the yield on short-term bonds) tend to lead recessions (the grey bars) and the yield curve is the most-inverted it has been since the early 1980’s. Add to this tightening credit conditions, which have been exacerbated by the problems in the U.S. banking system, and the overall outlook for the economy is muted at best over the next 6-months.

As for the stock market, we take a mixed view. On the one hand, a muted economic outlook is generally bad for corporate earnings, which tend to be highly correlated to the performance of stocks. But, on the other hand, as we mentioned at the start of this excessively long missive – most stocks in the index (especially in Canada) are down sharply from their late 2021 levels, and, in our view, are better reflecting the economic reality than some large cap AI-fueled stories. Thus, while we have concerns over the economy in the second half of 2023, we are starting to see significant value in several areas of the market, especially if we start to think about the eventual economic recovery in 2024 and beyond.

Lastly, we would be remiss if we did not touch on interest rates. As mentioned, there is likely little relief coming from the Bank of Canada in 2023. However, the Bank is also well aware of the amount of Canada’s very high debt levels and their sensitivity to interest rates:

 

Canadian debt levels are 60-70% above those of the U.S. with ~70% of Canadian debt in mortgages. With ~20% of these mortgages maturing annually and many of them likely to reset at significantly higher rates, we would suspect that the BoC is likely to look to provide interest rate relief on a more aggressive schedule than the U.S. Fed. Thus, we tend to have a positive view of the bond market, especially in Canada, as interest rates move inversely to bond prices (all else equal) and while we think rate cuts in 2023 are unlikely, we do think the BoC has the potential to be a quarter or two ahead of the U.S. when it comes to rate relief.