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Posted by Craig Basinger on May 6th, 2024

Lots of Bulls and Bears

Take your pick. There is no shortage of both good and bad news floating about the financial markets. To be fair, this is always the case. The hard part is understanding which side is stronger today and which side will be stronger tomorrow. With markets up low to mid-single digits following a very strong Q4 finish to 2023, most would agree the optimists are carrying the day at the moment.

It is not just rose-coloured glasses; there is good news out there. Economic growth signs or momentum appear to be improving year-to-date. Dial back a few quarters, and the U.S. economy remained resilient while other economies softened or were rather lacklustre, including Canada, Europe, Japan, and China, to highlight some of the biggies. Today, while Canada is struggling, momentum in the U.S. has moved even higher, and there are signs of improvement in most jurisdictions.

The U.S. economy is better than resilient; global manufacturing is on the rise as well

Consensus estimates for U.S. economic growth in 2024 started rising a year ago and accelerated this year. Now when the largest economy in the world is accelerating, that certainly alleviates many of those recession fears (ourselves included; we’re still fearful but less so). Consumer confidence has been rising in the U.S. and elsewhere. Purchasing Manager surveys that track manufacturing activity have been firming up and becoming expansionary in many countries.

This good news has not been lost on the market. The S&P 500 has just posted back-to-back +10% quarters. The chart below is a bit selective on the time period, but a 5-month return of over 20% has rarely been seen outside of market recoveries from recessions. The market has clearly responded to the better news in fine fashion.

Market gains like these usually are only seen coming out of a recession

This move higher in the markets, which extends beyond the S&P to Japan, Europe and Canada, has pushed valuations higher. As we have harped on many times before, this market advance has not enjoyed any follow-through from earnings expectations. S&P 500 earnings estimates for 2024 have risen by a mere 1% so far this year and 2% for 2025 estimates. That’s not terrible, but given the market rally, it’s not great either. Global earnings outside the U.S. are worse, seeing 2024 and 2025 consensus estimates fall by 4%.

Higher markets with no follow-through on earnings does make for a weak foundation. Perhaps the uptick in economic data will make its way to corporate bottom lines… maybe. But it would really have to get going soon to start catching up.

A very different cycle

Every market or economic cycle is different, this one even more so for obvious reasons. Trying to ascertain what is really going on or what is most likely to happen next has become even more challenging due to the continued reverberations of the pandemic. Many long-standing relationships have been tested or even negated. Just look at the yield curve, which was all the talk a few years ago and now few pay it much mind. Has that relationship of an inverted 3-month/10-year yield stopped working as a precursor for a recession? We are seeing rising U.S. economic activity as the inversion is now a record at 19 months.

Broken, slow, distorted—take your pick. Only time will tell. Or how about fiscal spending, with the U.S. running its largest deficit outside war/pandemic/recession periods? Unemployment is near record lows. Is this really the time for aggressive fiscal spending/stimulus? Oh, and the monetary policy of raised rates is trying to fight inflation. If you want to lower inflation, fiscal spending levels are clearly counterproductive.

Perhaps one of the longer macro factors that can do much to explain everything for the economy and markets is money. Little eco101. Normally the money supply and the economy expand at roughly the same pace, with minor divergences. The money supply ballooned to combat the impact of the pandemic. There’s no question that that was the correct response. But when you create a bunch of new money much faster than the economy requires, well, weird stuff happens. More money than required results in an increase in savings. Add to this an economy that slows due to shutdowns and people unable to spend on things like travel and fancy restaurants, and well, that savings spike even faster.

As the economy and personal mobility return, all that money flows into an economy. Add lingering shortages, and presto, here comes inflation. Price inflation sucks; everyone complains about it, but have you noticed many people changing their behaviours? That trip to the South of France costs too much… still going, though. That is because there is too much money.

This didn’t just cause price inflation, more money leads to asset price inflation as well. That has helped stocks and real estate rise. But something is nearing inflection. Firstly, the saving rate has been falling fast, probably because price inflation is eating into disposable income and the first behaviour that suffers is savings.

Or on a more macro level, the gap between the amount of money out there and the economy is narrowing. It was that gap that fed inflation, both price and asset price inflation. When that gap closes, well, it sure isn’t good news for prices. And that gap is closing pretty fast.

Drunk on too much money? We are about to start sobering up

Then there is what we will call the echo in global trade. As we have pointed out, there is good news on the global trade front; it appears to be improving. Exports from Korea and Taiwan, historically early leaders in changes in the direction of global trade volumes, have been rising. Global manufacturing has been improving. So, the question is whether this is the start of a new healthy trend or is it an echo caused by some of the previous pandemic-induced gyrations?

When the pandemic hit, we all had way too much money and couldn’t spend it on fun travel/eating, so everyone bought stuff. Cars, home renovations for that walk-in wine cellar, then some wine, new TVs, etc. Add logistic and supply chain bottlenecks, and we kind of blew things up with this changed behaviour. As supply gradually caught up with demand, the global economy enjoyed the best of times, factories humming, ships full of stuff on their way to consumers. Evidence of this can be seen in global container volumes dropping in the 1st half of 2020, then increasing well above trend in 2021.

Global trade is up. Is it from rising demand or just an echo from the post-pandemic lull?

We all know how this story unfolded. Once mobility returned, revenge travel became the rage and people slowed down buying stuff. Cars, TVs, renovations had all finally been done or the latest version purchased so as we pivoted our behaviours and global trade fell back down. Planes and restaurants filled up, and inflation took off. During this period, our team debated whether this drop in trade and manufacturing activity could cause everyone to ring the recession warning bell while it was just another pandemic pivot of behaviour. In hindsight it does look like that was the case.

Now we see trade and activity turning back up, and everyone is convinced that global economic growth is on its way back up. Maybe. Or this move up is just another pandemic reverberation. As revenge travel fades and normal spending returns, it could easily look like growth given trade/manufacturing has fallen so low… the echo.

Dividend divergence

Higher yields in the bond market have weighed very heavily on dividend-paying equities; after all, bonds are a clear competing investment for investors looking for income, and those bonds pay more now than before. This weakness in the dividend space has created a potential opportunity given valuations and rather juicy dividend yields (before or after tax). However, higher yields, inflation, and growth gyrations have increased performance dispersion in the dividend space. We believe a more active or rotational approach to dividend investing has become more optimal. But first a bedtime story.

You hear the word Goldilocks a lot at present. It’s the phrase used to explain the perfect environment, when markets just go up with no solid reason, except for everything is “not too hot, not too cold, but just right.” We all remember the fairy tale. A girl wanders through the forest and into a bear house. She’s rather picky but tries all the food, the chairs and the beds looking for one that is ‘just right.’ The tale has been around for at least two centuries. The traditional story concludes with Goldilocks running away from the bears' house after they discover her sleeping in Baby Bear's bed. Goldilocks was a fussy home invader who would very likely meet her demise in the shadow of the bears' wrath. In the true-to-life version, her actions lead her into a very serious situation. In every perfect Goldilocks environment, the situation can change in an instant when the bears return home and discover that someone has eaten their dinner.

In 2024, inflation is the big bad bear coming back home. Its steady easing has halted, even reversed somewhat, and this has reduced the odds and timing of global central banks cutting rates. Bond yields have risen considerably, approaching their 2023 highs. The current level of Canadian and U.S. bond yields is not crippling high but high enough for investors to reevaluate their options and expectations. The buy-anything period is likely over, at least for now, and markets are entering a more volatile period; perhaps by circumstance, the timing also aligns with weaker seasonality. While the round trip of rate expectations has only recently impacted broader equity markets, the dividend space has been feeling the impact of higher bond yields for some time. Higher for longer, brings with it a unique set of risks to the dividend space. This has made the dividend space more challenging, and we believe increases the need for a more active management approach.

The dividend factor has been under siege this year due to higher bond yields

The dividend factor (aka dividend stocks) has lagged other factors all year. While unfortunate, this has also created a bit of an opportunity. There are now many companies carrying dividend yields of 6% or 7%, that are pretty safe dividends. The challenge has become not just whether to add to dividend strategies, but how. Divergence in performance within the dividend space has increased, which means it's no longer best just to add anything with a yield to a portfolio. Not all yields are created equal, and the winning or losing factors keep changing.

We believe the more flexible approach, or a more active management approach, can better adapt to these changing market conditions. Especially compared to a more passive or index-hugging strategy.

Index misallocations – Let’s face it: The TSX is concentrated on Financials and Energy. Passive funds screening on yield amplifies the concentration risks. One of the more popular dividend ETFs has 56% of the fund allocated to Financials. These misallocations expose investors to higher sector-specific risks. Active management done right improves diversification and can reduce this concentration risk.

Dispersion – Active managers are particularly challenged in periods when dispersion is low and market leadership comes from extremely large stocks. When all the dividend stocks move together, who cares how you get exposure? But when the performance dispersion is high among dividend stocks, it matters how you are exposed. Dispersion across the dividend space is quite high and variability among dividend strategies in Canada is also on the rise. In the chart below, we look back at the Dow Jones Canada Select Dividend universe and plot the monthly return difference between the 25th and 75th percentile. Outside of the crisis period in 2020, the average dispersion this year is near the highs.

Dispersion in the dividend space is elevated

Volatile periods – Higher rates tend to increase volatility. Passive indexing tends to struggle when markets get choppy, whereas active managers can be nimble. Raise cash or actively increase company exposure to more defensive sectors. This proactive approach allows managers to manage risks, especially when it’s that most rate-sensitive sectors that are under pressure.

Unusual macro forces – Higher rates create market tension, especially for high-duration assets and highly leveraged companies. Active managers can identify and avoid companies that may have a high dividend yield but are vulnerable to rising borrowing costs. When rates are high, market inefficiencies tend to arise.

Canadians love dividends, but most active funds aren’t very active

There are dozens of dividend and income-focused funds and ETFs in Canada. Within the Morningstar Canadian Dividend and Income Equity category, there is no shortage of options. Among them are the bank-owned behemoths, with the top four funds managing over $50 billion dollars. When dissecting the universe an important metric to look at is the active share, which establishes the percentage of holdings that differ from the benchmark index. A portfolio with an active share between 20% and 60% is considered a closet indexer. Among these behemoths, the active share is as low as 35%, and the highest is just 53%. The category average active share for funds over $200 million is just 50%. In effect, the category is rife with closet indexers, as seen in the chart below. Most ‘active’ managers tend to look very much like the index. Liquidity also plays a part. The bigger the fund, the more difficult it is to look very different than the index, but that’s not the only reason. Career risk for portfolio managers is also a consideration. Our view is that it’s impossible to beat the market if you look like the market. Managers must strive to earn the fee they charge. For example, the Purpose Core Equity Income Fund has an active share of 72%, the third highest in the category, along with a strong performance record.

The Canadian dividend space is full of closet index funds and dividend funds

Digging deeper, in the chart below we have the sector allocations across the category. The vertical bars represent the range from maximum to minimum allocation for the sector, with the category average as well as the sector weight of the Purpose Core Equity Income Fund. By and large, most sectors have a somewhat limited exposure range, with the real major differences coming largely from the Energy and Financial sectors. These two sectors are where active managers can make a meaningful distinction from both the index as well as peers.

Allocation dispersion across Canadian dividend and income funds

Building a sustainable and high-performing dividend portfolio in Canada requires a keen eye and strategic selection. Active management empowers managers to go beyond the limitations of passive indexing, seeking out hidden gems, prioritizing quality over just high yields, and adapting to changing market conditions. Canadian dividend-paying companies make up the core of many advisor models and investor portfolios. Passive strategies play a key role in building robust portfolios to help reduce costs and provide broad market beta, but active management best suits the dividend-focused core, especially in present market conditions.

Final thoughts

There is lots of good and bad news these days. Challenges are this pesky inflation, stubborn earnings growth, valuations, and still lingering impacts of pandemic-induced behavioural changes. On the good side, there are some pockets of really attractive valuations, such as in the dividend space, an economy that appears to be gaining a bit of momentum that could help address the lack of earnings revisions. While our fear of a recession has diminished over the past few months, the risk of a price correction remains elevated. It has been a good start to the year, and very likely many twists and turns remain.

Authors: Craig Basinger, Derek Benedet, Brett Gustafson

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Sources: Charts are sourced to Bloomberg L. P.

The content of this document is for informational purposes only and is not being provided in the context of an offering of any securities described herein, nor is it a recommendation or solicitation to buy, hold or sell any security. The information is not investment advice, nor is it tailored to the needs or circumstances of any investor. Information contained in this document is not, and under no circumstances is it to be construed as, an offering memorandum, prospectus, advertisement or public offering of securities. No securities commission or similar regulatory authority has reviewed this document, and any representation to the contrary is an offence. Information contained in this document is believed to be accurate and reliable; however, we cannot guarantee that it is complete or current at all times. The information provided is subject to change without notice.

Commissions, trailing commissions, management fees and expenses all may be associated with investment funds. Please read the prospectus before investing. If the securities are purchased or sold on a stock exchange, you may pay more or receive less than the current net asset value. Investment funds are not guaranteed, their values change frequently, and past performance may not be repeated. Certain statements in this document are forward-looking. Forward-looking statements (“FLS”) are statements that are predictive in nature, depend on or refer to future events or conditions, or that include words such as “may,” “will,” “should,” “could,” “expect,” “anticipate,” intend,” “plan,” “believe,” “estimate” or other similar expressions. Statements that look forward in time or include anything other than historical information are subject to risks and uncertainties, and actual results, actions or events could differ materially from those set forth in the FLS. FLS are not guarantees of future performance and are, by their nature, based on numerous assumptions. Although the FLS contained in this document are based upon what Purpose Investments and the portfolio manager believe to be reasonable assumptions, Purpose Investments and the portfolio manager cannot assure that actual results will be consistent with these FLS. The reader is cautioned to consider the FLS carefully and not to place undue reliance on the FLS. Unless required by applicable law, it is not undertaken, and specifically disclaimed, that there is any intention or obligation to update or revise FLS, whether as a result of new information, future events or otherwise.

Craig Basinger, CFA

Craig Basinger is the Chief Market Strategist at Purpose Investments. With over 25 years of investment experience, Craig combines an educational foundation in economics & psychology with years of experience in both fundamental and quantitative research. A long-term student of the markets, Craig’s thoughts and insights can be seen in his Market Ethos publications and through his regular contributions on BNN.

Craig and his team bring a transparent and cost-efficient approach to investment management. The team provides asset allocation OCIO services and directly manages over $1 billion in assets. The team manages dividend mandates, quantitative risk reduction strategies and asset allocation services.

Derek Benedet

Derek is a Portfolio Manager at Purpose Investments. He has worked for the past sixteen years in the investment industry with experience at CIBC Wood Gundy, GMP Securities as well as Richardson Wealth. He is a Chartered Market Technician (CMT), a designation obtained through expertise in technical analyses and is granted by the Market Technicians Association. His unique investment approach combines technical analysis, quantitative finance and fundamental analysis.

Brett Gustafson

Brett is a Portfolio Analyst at Purpose. He is responsible for relationship management and advisor support and focuses heavily on portfolio analytics for advisors, our own proprietary models, as well as equity research. With over nine years of experience in the investment industry, Brett started his career out as an Investment Advisor at a Canadian independent asset management firm where he cared for several high-net-worth families. Brett graduated from the University of Calgary with a Bachelor of Commerce degree. He is currently pursuing his CFA designation with the goal of becoming a Portfolio Manager.