The saying goes, 'April showers bring May flowers.' While that's more of a weather reference, it also worked for the capital markets this year – especially if those flowers are in the form of semiconductors. After a weak equity performance in April, markets had a strong bounce back in May.
The weakness in April was primarily caused by investors realizing that all those expected rate cuts this year weren't going to occur due to persistent inflation in the US. While those fears continued into May and now seem to be the expectation, the strength of corporate earnings and significant buybacks was enough to allow markets to recover those losses and hit all-time highs by mid-month.
While in most cases, markets hitting record highs are celebrated, this time feels different. It could be the case that this rally isn't being celebrated because many investors have missed the bounce, but there is also an underlying concern that all may not be as good as the financial markets are indicating.
Yes, earnings are coming in stronger than what was forecasted at the beginning of the year, but we're also starting to see signs of stress amongst various sectors and parts of the economy. Looking just at the consumer sector, we see a divergence of performance between companies that focus on the higher-end consumer vs those that target the lower-end. Higher interest rates and money market returns disproportionately help those with cash and no debt vs. those in the opposite situation.
It's an important reminder that the stock market and the economy are not the same thing.
One theme that has remained for the year is who is winning. Everyone is very aware of the leadership of the semiconductor companies participating in the AI theme, particularly Nvidia. However, we have to ask, 'How long can this last?' The earnings for the group have been stellar, but who is left to add to positions? As May came to a close, markets saw an increase in volatility. While overall equity indices finished the month stronger, on several days, almost every sector was negative, with the exception of a certain technology group. Narrow markets are not healthy or sustainable.
Heading into June, attention will shift back towards the Central Banks. This should be the month we see the long-awaited interest rate cuts in several regions. The European Central Bank will likely be the first to embark on rate cuts unless the Bank of Canada decides to go the prior day. After a few years in which all Central Bankers had aligned policy, this will split the ranks as the US remains on the path of 'higher for longer' in a battle with inflation, most likely not cutting until the Fall.
With a divergence in Central bank policy, a narrowing of leadership in equity performance and an increasingly concerning geopolitical backdrop, the balance of the year is looking more uncertain. A mid-year pullback as we get a repricing of risk is a very real possibility. Markets had seen stronger performance in the first half of the year than many had expected. Earnings have been better, yet the bulk of these gains is coming from multiple expansion, adding to the risk that a lot of good news has been priced in at these levels.
While broad markets may be increasingly risky, there are several areas of opportunity. Valuations in the market's overlooked defensive parts look attractive, especially if bond yields begin to decline. With the added uncertainty around the upcoming US election, we may see the US dollar come under pressure, making an allocation towards real assets, such as commodities, which would perform in this situation. And with volatility near cycle lows, adding some protection or volatility strategies is prudent.
Markets saw a nice bounce back in May, but we aren't in the clear yet. With the risk of a volatile summer ahead of us, this is a time to remain cautious and ready to take advantage of opportunities. The concentration of a few names is making the broader markets more risky and susceptible to swings, but opportunities remain for those willing to look through the noise and into overlooked areas.
— Greg Taylor, CFA, is the Chief Investment Officer of Purpose Investments
All data sourced from Bloomberg unless otherwise noted.
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