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A weak global economy is being offset largely by declining inflation and easing financial conditions which has had the effect of propelling many financial markets to record highs around the world. Despite vibrant stocks markets there are many potential strains that could put pressure on the euphoria. These include geopolitical threats, the prospect of resurgent inflation, ongoing conflicts in Ukraine and the Middle East, growing tensions between the U.S. and China, and the threat of rising trade protectionism. However, as all investors know, you need to peek through the clouds to see the sunshine.

The Canadian economy appears to be on track for a soft landing despite the unexpected acceleration in inflation in May, (up for the first time in five months) and without a major spike in unemployment which is just above pre-pandemic levels. The only area that has remained elevated is wage inflation. All of which allowed the Bank of Canada to become the first G7 nation to begin loosening monetary policy as it cut its key interest rate by 0.25% to 4.75%, the first interest rate cut since early 2022. However, Canada’s lagging productivity (output per worker) is our Achilles’ heel. Sagging productivity is depressing corporate profits but thanks to a low valued currency and strong population growth relief could be just around the corner.

The U.S. economy has defied prophecies of doom since 2022 (when the Federal Reserve began an aggressive rate hiking campaign to stamp out inflation) as it continues to outperform most other advanced economies. U.S. economic growth is now slowing but so is inflation. The job market lost a bit of momentum but remains both healthy and tight without showing any signs of cracking. This has revived hopes that the U.S. Federal Reserve will cut its own key lending rate this year. U.S. stocks have posted an impressive election year rally so far in 2024 and is on pace for its best first half performance during an election year since 1976.

Europe’s underlying inflation has eased and the economy is staging a small rebound. As such, the European Central Bank has joined the central banks of Canada, Sweden, and Switzerland in undoing some of the steepest interest rate hikes in recent history with its first cut. It is expected that there will be three more rate cuts by the end of 2024. Wage growth is elevated but if inflation (which has fallen largely thanks to lower fuel costs and a normalization in supply after some post-pandemic snags) continues to moderate, then a sustainable recovery is likely. The U.K. economy has started growing again and now that inflation has fallen sharply to its lowest level in nearly three years, pressure is mounting to cut interest rates from the current 16 year high. Consumers are still living with far higher prices and are struggling to make ends meet which raises the question of why the current government has triggered a general election on a few marginally improved “feelgood” factors; and potentially throwing the recovery into disarray again.

For the first half of 2024 global stocks have been on an absolute tear; Canada not so much. Canadian stocks are up what normally would be a respectable 6.1% for the year to date (YTD) although they lost 0.5% in Q2 (all returns in Canadian dollar terms). However, U.S. stocks have set the pace, surging 5.4% for the quarter and 19.5% in the first six months. International stocks have gained 0.9% for Q2 and 9.6% for the year, slightly trailing Emerging Markets, which returned 6.3% quarterly and 11.6% YTD. Bonds had a strong rally in June, but the gains were not sufficient to offset earlier losses and as such were only up 0.9% for Q2 and are down 0.4% year to date.

The global economy is at a turning point as nations strive to contain inflation, rising debt levels, and geopolitical uncertainty. Given the potential uncertainty and economic adversity still on the horizon, investors would be justified for going into hiding. Instead, they have turned these challenges into opportunities and are reaping the rewards as they remain invested and continue to redeploy available funds into the markets.

The Canadian economy has been holding up better than anticipated in 2024 although it is still behind its long term average, especially given the staggering population growth of the last few years. Second quarter GDP is expected to be 1.8% on an annualized basis, a slight improvement from the 1.7% recorded in the first quarter. The positive growth numbers have not resulted in a decent job market as unemployment reached 6.2% in May, its highest level in two years on the backdrop of population growth. Although the Canadian equity index, the S&P / TSX, started the year strongly the second quarter saw a slight performance detraction with a 0.5% loss. Overall, the index managed to close with a comfortable 6.1% gain in the first half although that performance has lagged the S&P 500 by a wide margin.

Sector performance has been showing more breath with positive contributions across various sectors, contrary to the U.S. which has been dominated by an AI (Artificial Intelligence) theme. For the past six months, Energy, Materials and Consumer Staples have led the pack with 17%, 12.6% and 11% gains respectively. Energy prices have been lower than a few months ago albeit still trading in profitable territory. The Canadian energy sector has also been supported by the Trans Mountain pipeline expansion project. Bullish investors estimate that the project, which is underway, would lead to better crude pricing differentials and less volatility. Gold prices have surged to all time highs in 2024 but has retreated slightly in the second quarter to trade in a range bound territory due to investors’ indecision on the future trajectory of US interest rates. Telecommunications and Utilities have detracted the most from the index during the first half with returns of -13.7% and -3.3% respectively. Although decreasing rates are favourable for these sectors, some individual players have been dealing with costly major acquisitions and infrastructure renewal. As for Financials, the story has been different with a tamed 2.1% return year to date primarily over investor wariness of potential mortgage defaults. There is some degree of dissonance in the data related to capital flows in the Canadian markets; on one hand, investors have pulled about $37 billions out of Canadian markets over the past twelve months mainly from equity investments over mixed government policies and corporate taxation. On the other hand, there seems to be growing enthusiasm from other investors about the S&P / TSX, which set a new all time high during the quarter and some analysts forecast more gains in the quarters ahead.

There is undeniable evidence that the cumulative interest rate hikes of the past two years have created cracks in the economy. The labour market has considerably softened with higher unemployment rates relative to the long term average. The greater Toronto area for example, known for its significant contribution to Canadian GDP, has seen an unemployment rate in the 8% range; the highest in ten years. The Bank of Canada’s decision on June 5th to ease the key rate 25 basis points is clearly a step in the right direction. Although the bank might be walking on a thin rope amid the excruciating trade off between high inflation and financial stability, its latest guidance infers the willingness for more rate cuts ahead as inflation continues to recede. The S&P / TSX’s remarkable resilience in the first half should not eclipse its lacklustre performance relative to the S&P 500 as it is trading at a historic 6.2 discount on a forward price to earning ratio (PE) basis. However, unlike the S&P 500 where the AI frenzy has seen few players disproportionally doing the heavy lifting, the S&P / TSX gains have rotated across different sectors, a trend that should hold as rates normalize.

The Canadian bond market rebounded in the second quarter, returning 0.9%, but is still in negative territory for the year at -0.4% as of June 30th. Bond investors would have been encouraged by falling yields only to be hit with a reality check in the latest CPI report, resulting in a jump in short to mid term rates. A significant amount of the average Canadian’s wealth is tied up in real estate and Canadians purchased homes in record numbers through the pandemic when rates were under one percent. As it has been nearly 5 years since the pandemic started, many borrowers will have to renew their mortgages in the near future, and many will have to renew into higher rates. This would come as a blow to the Canadian consumers ability to spend and invest into the economy.

The annual inflation rate in Canada rose to 2.9% in May after coming down to a three year low of 2.7% in April. Coming into 2024, investors were betting on the Bank of Canada (BOC) to loosen their highly restrictive policy enacted in 2022. However, given the acceleration in prices for groceries and energy, Canadians will have to remain patient as the economy works its way through the remaining inflationary pressures led by wage growth. It’s important to remember that Canada was the first of the G7 nations to loosen its monetary policy with a 25bp rate cut in June 2024, a feat not possible if the BOC hadn’t acted in the face of hyper inflation.

The key overnight rate sits at 4.75% and the BOC has announced it will remain that way as inflation remains “too high” to consider cutting the rate for the fourth time in a row. Although some investors will be disappointed by the decision, numbers show that the restrictive policy implemented by the BOC has seemingly done its job over the past two years.

As of May 2024, food inflation slowed down to 2.3% compared to 8.3% one year prior. The transportation index is down from its record highs of June 2022 and despite the overall CPI index increasing, core inflation has fallen below 2%, down from its record high of 2.3% in June 2022. Since reaching an all time high of 7.2% in Q4 2022, inflation expectations have fallen to 4.9%. Clearly, a huge improvement with some ways to go.

Headlines would have had some Canadians convinced that the country was in a recession but the success of the BOC’s monetary tightening has put the topic on hold as Canada looks to be on track for a soft landing. Some concerns about underlying inflation persist amidst global risks, namely attacks on Red Sea shipping routes and the ongoing wars across the Atlantic. Fundamentally, the Canadian economy looks to be in good shape. Canada’s population is growing rapidly, boosting the workforce along with increasing economic activity in smaller, underserved communities across the country.

South of the border, on March 20th, the Fed explained that rates would be maintained at the current range of 5.25% to 5.5% and projected that they may lower borrowing costs as we progress into the second half of the year. Given the interest rate disparity between the two nations, higher rates south of the border will likely attract more foreign capital, lowering the CAD / USD exchange rate. This is a positive for Canadian exports but of course makes importing foreign goods much more expensive.

Moving forward, it is clear that interest rates should trend downwards. Investors need to be careful not to get too ahead of themselves in setting their own expectations of when the cuts will take place. If rates continue to decline through the year, increased allocation to high quality short to intermediate duration bonds should generate total returns that eclipse the current yield offered in the market.

As with the global economy, the Canadian economy is at a turning point. Amongst the ongoing political and economic turmoil, as always, opportunities continue to present themselves to investors who are disciplined, patient and forward looking.

U.S. equities continued their rise in the second quarter of 2024, capping off three consecutive quarters of positive performance. The S&P 500 delivered a 4.3% for the quarter and 15.3% (in U.S. dollars) for the first half of 2024. Historically, the first half momentum in the index has continued through the end of the year.

The emergence of AI (artificial intelligence) companies is the most obvious driver behind the markets push to new highs. Leading the way, NVIDIA Corporation returned over 60% in the quarter, accounting for more than a third of the S&P 500 gains as of June 30th. Only two other sectors (Communication Services and Utilities) outperformed the broader index. Within the Information Technology sector, semiconductors lead the way as the only subsector to outperform through the quarter along with the sectors mega cap stocks. On the flipside, a majority of the index declined over the quarter. With the increase in demand for semiconductors, Utilities, and green energy stocks were also able to benefit.

The lack of market breadth comes as a concern for investors, Technology stocks make up nearly a third of the index, the largest share of the index since 2000 and the dot com boom. That being said, the market is in an overall healthier position than it was twenty-four years ago with lower valuations and encouraging company earnings and growth rates. Technological advances push the economy forward with increased efficiency and this time around, the largest, most reputable companies are the primary drivers behind the markets current run.

Turning to the overall economy, progress continues to be made by the Federal Reserve (Fed) in bringing prices back down to more normalized levels and an inflation target rate of 2%. Fed officials closely monitor monthly data to assess whether their battle against inflation is working and so far it has. The annual inflation rate slowed to 3.3% in May, the lowest in three months, and the core inflation rate slowed to 3.4%, the lowest rate in three years. The Fed will be extremely careful in both their decision of when to cut rates and their commentary on the economy. The last thing the Fed wants to do is spark another massive increase in prices by prematurely stimulating the economy. Although the numbers are encouraging, interest rates are still high which means mortgage rates are high and the U.S. economy still has expectations of increasing energy inflation and higher unemployment. The Fed rate currently sits at a range of 5.25%-5.5% and while progress has been made there is still some ways to go.

The broader economic conditions and market dynamics are what will influence the Fed’s decision on when and how much to cut rates. Coming into 2024, there was a growing sentiment that that the Fed may enact several rate cuts through the year but stubborn inflation has tempered expectations. There is an election in November and depending on which party comes out victorious there could be a trade war which would be a huge setback.

Moving forward, there will need to be a broadening of outperformers in the stock market. The S&P 500 is being led by only a handful of very large companies who make up a majority of the investible market, an unhealthy trait. Lower rates would spur Real Estate, lending activity, personal spending, construction, and more balance to the market. In such an environment, companies would see an increase in their margins, delivering outperformance. As mentioned in previous commentaries, this progression will need to take a gradual, healthy route to avoid slipping back into inflationary circumstances. The U.S. stock market has been very resilient as analysts have repeatedly called for a recession since 2022 only for the S&P 500 index to continue to beat expectations.

Global economic growth targets are inching up due to increased confidence for economic recovery in Europe, stronger momentum for domestic demand in emerging markets, and improvements in China’s exports. The expected pivot to global monetary policy easing is now taking shape with recent rate cuts setting the stage for a rapid onslaught of further cuts this year and into next. Inflation is surprisingly persistent due to high services costs and may cause central banks to remain cautious about loosening policy too rapidly.

Europe is now in its sixth straight quarter of economic stagnation with the labour markets starting to soften, wage growth moderating, and inflation is likely easing back towards the European Central Bank (ECB) target before yearend. These factors allowed the bank to initiate its first rate cut, with two more expected this year. Future rate cuts could weaken the Euro and push up yields as funds flow into the U.S. The Fed has not yet begun cutting rates and the ECB will have to be careful not to get too far ahead of America. France’s fiscal woes have raised red flags as its debt-to-GDP ratio is now the third highest in Europe behind only Greece and Italy. It now accounts for a quarter of all eurozone debt, at a time when most other countries are on a steady downward trajectory. Austerity measures forced on Portugal, Italy, Greece, and Spain have since helped stabilize the euro zone, with Portugal and Greece emerging as models of fiscal restraint.

Inflation in the U.K. has returned to the target rate for the first time in nearly three years, a development that was seized on by the government as evidence that its economic plan is working; so, it called a surprise election to muddy the outlook. Despite the decline, the Bank of England has not yet reduced rates, but the pressure to cut interest rates will grow and should occur after the July elections. Although prices are rising at a slower rate, that does not help the million of working people whose standard of living has dropped precariously and are now worse off than they have been for years. Still, the U.K.’s economic outlook is improving which could help its stock markets play catch up.
Japan is back in the global spotlight. A strong stock market rally and a rise in the outlook from decades of either deflation or zero inflation has brought the attention of investors across the world back to Japan’s markets. Since its bubble burst in the 1990s, Japanese equities have stagnated; all that has changed in the past year with new historic highs as foreign investors have jumped into the market. Japan’s yen is at a three decade low, despite its first interest rate hike since 2007. The currency has been steadily falling for more than three years and has lost about a third of its value since the start of 2021. A weak yen has been a boon for exporters’ corporate profits and for tourists visiting Japan but it squeezes households by increasing import costs.

International equity markets so far this year have built upon last years strong returns with just as impressive results that have more than rebounded from the drubbing they took in 2022. For the first six months of this year they have gained 5.8% (all figures in U.S. dollar terms) although they lost 0.2% for the quarter. Europe as a whole was up 6.4% YTD, despite France’s 1.4% decline. The U.K. was one of the best places to invest as the market is up 6.9% in the first half of the year. Asian markets generated 5.2% YTD performance, with Japan gaining 6.5%.

Developed market equities have extended their gains from last year but it is still important to take a nimble approach to investing. The forces of persistent inflation and higher for longer interest rates need to be cleansed from the marketplace before unabridged growth can take hold. Still, the outlook has improved with mild inflation feeding mildly higher wages and improved corporate pricing power, reinforcing the upbeat outlook for equity returns for the next few years or longer.

Emerging market economic growth and optimism has moved higher as developed market growth has slowed down. The global investment landscape has been changing. For example, Mexico recently overtook China as America’s largest trade partner. As trade alliances shift and globalization reorganizes, downside risks are present, particularly with the upcoming U.S. elections, persistent headwinds in China, and rising Middle East tensions. Emerging market equities are one of the most mispriced asset classes in terms of improved earnings growth so they require constant vigilance.

Sentiment on China soured in recent years for reasons including increased regulatory oversight, weak economic recovery, and ongoing tensions with the U.S. The Chinese economy has been trapped in a real estate induced downturn and has robust debt levels. The currency has dropped to a seven month low on the back of softer than expected industrial production, retail sales, and consumer confidence. Investor patience has worn thin after months of waiting for more stimulus and as a result, China’s equity market has roughly halved since the start of 2021, with valuations close to record lows.

India’s growth is similar to China’s 20 years ago. However, there are key differences in terms of domestic political processes, investment as a share of GDP (much lower in India), labour force participation, including female labour force participation (lower in India) and services / manufacturing split (China is more manufacturing oriented than India). As a result, investors have been buying into India over the last year or two as an alternative to China. Unfortunately, recent political upheaval is raising questions about whether key infrastructure projects and reforms will continue. These jitters have caused Indian shares to fall 5% before continuing their impressive four year advance since the COVID-19 rout.

The importance of politically driven events has triggered turmoil around the developing world. South Africa’s currency and equities slid precariously on the prospect of a potential coalition government after a poor showing for the ruling party. Ongoing economic reforms after recent elections aimed at reducing fiscal imbalances and controlling inflation in Chile and Argentina could support structural growth and attractive investment opportunities. Taiwan, Pakistan, Indonesia, Russia, and Türkiye all hold important elections this year and could trigger the most dramatic market reactions so far.

The biggest potential disruption could be felt by the Mexican governing party’s unexpectedly lopsided victory which has investors concerned that it may use its mandate to sweep aside some of the checks on presidential power which have long been a source of comfort to the business community. The currency has fallen 8.9% since the election and Mexican stocks have declined 9.4%. What an investor wants least is for the rules of the game to suddenly change and none of the prospective measures being talked about by the new leaders are welcome by investors.

Emerging markets closed the second quarter with a 5.1% gain, but they earned a modest 7.7% (all figures in U.S. dollar terms) during the first half of 2024. This number masked the wide variance of results around the world. Asian stocks climbed 11.2% YTD, propelled by India’s 17.1% jump. Eastern European stocks gained 9.2% so far this year. Latin American stocks got trounced, falling 15.5% with Brazilian stocks dropping 18.6% and Mexico down 15.5% YTD.

The global economy is holding up relatively well with emerging market economic growth likely to hit more than 4.0% in 2024 compared to the developed markets where growth is expected to slow to 1.4%. Inflation is likely to remain on a downward path and easier monetary policies are on the horizon ,although the timing and size of rate cuts remain up in the air. Governments are increasingly opting for trade restrictions to protect their industries and workers against competition, and these could be met with a counter response, potentially raising geopolitical tensions.

The second quarter started in bear territory for REITs as they took a breather from the rebound of previous months. Globally, market sentiment continued to be mixed on the backdrop of volatile interest rates as the yield on ten year U.S. Treasuries jumped to its highest level since October 2023. The pace of disinflation was slower than initially expected and prompted the Federal Reserve to adopt a less dovish stance. In Canada particularly, the Consumer Price Index (CPI) has been on a downward trajectory for months and reached 2.7% in April; a three year low. For the first time in almost four years, the Bank of Canada (BOC) was able to build a case on slowing inflation and ease its key rate to 4.75%, a 25 basis point reduction. The move reignited interest rate sensitive assets and spurred hope of a turning point as the BOC hinted at subsequent cuts if inflation continues to trend lower. REITs have recovered some of their 2023 losses but continue to lag the broader equities index which is in positive territory. The S&P/TSX REITs is lagging, returning -6.0% for Q2 and -6.7% year to date, while the MSCI Global REITs has returned a modest -0.1% for the quarter and 1.5% year to date (all in Canadian dollars).

Drilling down into various segments of the REIT sector, weakness and repricing has further to go in some pockets of the market. The Canadian industrial segment, which experienced prominence months ago with a tight supply, has slowed down. Data available as of the first quarter of 2024 revealed negative net absorption of industrial space, especially in bigger cities. Vacancies in Toronto for instance have risen to 3.1%, the highest in seven years although the supply / demand dynamic remains solid and far from distress levels. In global markets such as the U.S., REIT refinancing in the months ahead poses some challenges. The Federal Reserve (Fed) estimates that 206 billion dollars of commercial REIT loans are due to be refinanced in 2024 with rates at a 20 year high. Although the banking system remains relatively solid, the Fed reported some increase in defaults since the end of 2023. The beleaguered office segment in Canada is far from seeing some light at the end of the tunnel although vacancies in some downtown offices across Canada improved in the last few months. New office supply has bottomed out to a 13 year low and the segment appears to be approaching a turning point.
The residential, apartment, and senior housing segments in Canada are exhibiting tremendous fundamentals despite trading at deep discounts to their NAV (Net Asset Value). A key tailwind for these segments is the growing Canadian population which leaped to another milestone in the first quarter of 2024, surpassing 41 million. Besides the changing demographics caused by immigration, there is also interprovincial migration that appears to favour smaller cities and regions with increased opportunities for their residential segments. Senior housing demand is one of the fastest growing segments despite the pandemic setback.

The BOC’s rate cut on June 5th and its guidance on potential future rate cuts is welcome news that might infuse a new dynamic for commercial REITs. However, major headwinds are still prevalent, notably lower activities within commercial REITs in Canada. As of Q1 2024, REITs saw about a $8.7 billion reduction in investment representing more than a 32% decline quarter over quarter. Most Canadian pension funds, world renown for their expertise and significant exposure to the real estate sector, acknowledged in their latest reports the bumpy road ahead. CPP (Canadian Pension Plan) alone lost 16% in its last fiscal year, the worst since the global financial crisis of 2008. The pension funds are reviewing and restructuring their massive real estate business that has been the envy of the world for more than three decades. The ultimate determinant for resurgence and stability in the REIT sector remains investors’ conviction that rates have finally turned the corner and will continue to fall.