Thoughts on the Market: May Edition
Is the economic slowdown finally here?
We wrote about the surging U.S. GDP readings back in our January monthly, noting how a resurgence in technology investment, housing strength and real wage growth were helping to drive strong economic growth despite higher interest rates. Four months later, it appears the rate hikes are finally creating their intended effects. Let’s dig into the data.
We have highlighted the Atlanta Fed GDPNow measure, which provides a GDP estimate based on real time data releases, before in our monthly letters. The month-end reading usually tracks real GDP closely, and thus, the intra-quarter measures can be clairvoyant. While early May readouts suggested that Q2 2024 U.S. GDP was tracking towards the 3.5-4.0% level, economic data released in late May and early June is painting a less robust picture. The current estimate sits below 3%.
Figure 1: Real GDP Estimate for Q2 2024
Source: Atlanta Federal Reserve Board
If this estimate holds, it’s a small victory for the U.S. Federal Reserve in its attempts to bring down inflation and a step towards justifying its first rate cut. The risk is that the measure continues to deteriorate, and multiple rate cuts are needed to stabilze the economy.
The housing market in the U.S. may appear strong on the surface, with prices up 7% year-over-year, but inventory data is finally broaching a point that may unlock the sluggish existing home sales market. As a refresher, low housing affordability in addition to the availability of 30-year term mortgages has led many U.S. homeowners to remain in their current premises as they have been unwilling to trade up and lose the favourable rates (sub 4% interest rates) attached to their existing mortgages. This was a boon for homebuilders as they faced less competition from the existing home market. However, housing inventory has risen quickly in the past year (up 35%) and is now approaching levels last seen in mid-2020 (Figure 2). There is still more room for inventory to increase back to 2017-19 levels before the market has truly normalized post-Covid. Altos Research provides a comprehensive overview of the market for more information.
Figure 2: Weekly Housing Inventory in the U.S.
Source: Altos Research
Slowing home prices has a couple of main effects on inflation. The direct and most obvious effect is lower housing related inflation readings in the monthly Consumer Price Index releases. The secondary effect is a decrease in household wealth accumulation. People feel richer when their homes are appreciating in value and some even tap their home equity through fund structures like reverse mortgages and home equity lines of credit. We believe this “using of homes as an ATM” is a key tenet to Canada’s housing policy, but one that has long-term consequences such as higher debt levels and out-migration.
This is a key reason why Canada’s economy is likely underperforming that of the U.S. in productivity and growth. High debt levels are constraining spending. Bank of Nova Scotia revealed on its second quarter conference call that holders of variable rate mortgages have cut back their spending 10% despite very high credit scores and only 50% loan-to-home values (e.g., a $1 million mortgage on a $2 million dollar house). And like the U.S., the major market of Toronto is starting to see some inventory pressure as April 2024 active listings were 74% higher than last year’s depressed levels. This could put downward pressure on house prices and spending, and is a key reason why the Bank of Canada was forced to cut interest rates last week.
While a slowing economy can put pressure on corporate revenue and earnings in the short term, we believe it will provide some reprieve from higher inflation and lead to lower interest rates. This will benefit valuations in less economically sensitive sectors like utilities and some commercial real estate in areas like healthcare and multi-family. Additionally, interest expense will fall as high-cost debt is re-priced. It sets up for the next cycle, when consumer confidence returns, and personal consumption increases further. We have long argued that disinflationary forces will prevail, and this month’s data further supports this theory.
GLOBAL EQUITY GROWTH FUND
The MWG Global Equity Growth Fund rose 2.0% in May, less than the 3.6% increase in its benchmark. Year-to-date, the Fund has returned 15.8% versus the benchmark return of 12.2%. The Fund’s top three performers in the month were Qualcomm (+23%), Manulife (+11%) and Linamar (+10%), while Docebo (-24%), Converge (-12%) and Air Canada (-10%) were the biggest detractors.
Portfolio Managers Summary
The portfolio rebounded back to all-time highs, with Nvidia powering the market higher and the key source of our underperformance versus the benchmark. The portfolio is well positioned for continued growth in artificial intelligence investing, with over a quarter of the portfolio exposed to growth in AI through cloud services providers and semi-conductor companies. We find many consumer-focused names are trading below historical levels and remain well positioned for consumer spending rebounds in the future.
During the month, we added a small position in Hudbay Minerals Inc, a gold and copper producer with operations in Canada and Chile. We believe the company is poised to generate strong cash flow given the current commodity price backdrop and the potential to improve mining operations at the recently acquired Copper Mountain Mine in B.C.
INCOME GROWTH FUND
The MWG Income Growth Fund rose 2.5% in May, less than the 3.1% increase in its benchmark. Year-to-date, the Fund has returned 5.4% versus the benchmark return of 9.1%. The Fund’s top three performers in the month were Pfizer (+13%), Manulife (+11%) and Kingfisher (+11%), while Cogent (-7%), TD Bank (-7%) and Doman Building (-6%) were the biggest detractors.
Portfolio Managers Summary
The portfolio performed well in May as dividend stocks finally began responding to the prospect of lower rates. Utility stocks like Capital Power and Enbridge as well as financials like Manulife and Power Financial have rallied approximately 10% in recent weeks as the market has adjusted to the lower interest rate paradigm and is now looking through to earnings and dividend growth. These companies generate sustainable dividends in the 5-7% range, which should increase as earnings rise. With the recent rate cut in Canada likely to be the first of several in the next year, we expect investors hunting for yield to turn to companies in this portfolio.
This Month’s Portfolio Update is written by our Head of Research, Jamie Murray, CFA.
The purpose is to provide insight into our portfolio construction and how our research shapes our investment decisions. As always, we welcome any feedback or questions you may have on these monthly commentaries.