{"id":7451,"date":"2023-08-02T20:00:00","date_gmt":"2023-08-03T00:00:00","guid":{"rendered":"https:\/\/www.rbcwealthmanagement.com\/en-asia\/insights\/a-durable-equity-rally-faces-strengthening-headwinds"},"modified":"2023-11-01T11:14:27","modified_gmt":"2023-11-01T15:14:27","slug":"a-durable-equity-rally-faces-strengthening-headwinds","status":"publish","type":"post","link":"https:\/\/www.rbcwealthmanagement.com\/en-asia\/insights\/a-durable-equity-rally-faces-strengthening-headwinds","title":{"rendered":"A durable equity rally faces strengthening headwinds"},"content":{"rendered":" \t<div class=\"wp-block-rbcwm-well well is-style-is-style-b-blue-tint-4 b-blue-tint-4 mb-3 migrated\"> \t\t <ul class=\"list-spaced wp-block-list\"> <li> The stock market rally off the washed-out lows of early last fall has run further and for longer than most had expected. U.S. large-cap outperformance has been largely powered by a handful of surging Tech and tech-related stocks, whose outsized weight in the benchmark index has left many fund managers running to avoid being left behind. <\/li> <li> The strong stock market and some better-than-forecast economic data have once again raised hopes that the U.S. economy could experience a \u201csoft landing\u201d without a recession. While such a benign outcome can\u2019t be ruled out, several headwinds already suggest the going is about to get tougher as the full impact of the Fed\u2019s historic series of rate increases is yet to be felt in the economy. Notwithstanding all the above, and though the compelling valuations of last autumn are long gone, we think this rally has some time left to run. But with recession still the most probable outcome, investors should adopt a focused approach to individual stock selections. <\/li> <li> The equity rally from the lows of early autumn 2022 continued through July 2023 \u2013 that is to say, for much longer than most had thought likely until recently. Japan\u2019s TOPIX and the U.S. S&amp;P 500 have led the way. It has been a much more anaemic affair for U.S. small caps, as well as for Canada\u2019s TSX and the UK FTSE All-Share. And the going has been downright soggy for the Korean KOSPI, which we mention here because it is viewed in some quarters as a leading indicator of the future direction of the U.S. economy and stock market due to South Korea\u2019s role as a major exporter of computer chips, smart phones, industrial goods, and consumer durables into the U.S. <\/li> <\/ul>  \t<\/div>           <p>       The comparatively energetic advance of the S&amp;P 500 is largely       attributable to the much-reported-upon performance leadership of a handful       of mega-cap Technology and tech-related stocks, which together account for       more than 25 percent of the index by weight; the unweighted index presents a less       dynamic picture. None of those high-flying mega-cap stocks are included in       the more sedately performing indexes outside the U.S.     <\/p>     <p>       Our position since this rally unfolded has been to leave equity portfolios       invested up to the recommended levels for their long-term strategic asset       allocation. Our view has been that the washed-out market momentum,       significant P\/E retrenchment (from 22x trailing-12-month earnings at the       peak of the market in January 2022, to just 16x at the early autumn low),       and intensely negative investor sentiment that prevailed back in September       and October would give way to a stretch in which all those markers       reversed direction. Whether any rally would be robust enough to set new       market highs has been far from clear, but staying invested long enough to       find out has seemed the right approach.     <\/p>     <p>       Many are now attributing the longevity and strength of the stock market       advance to the growing belief that the U.S. economy will enjoy a soft       landing and avoid recession. This view is supported by the fact that \u2013 so       far \u2013 the economy is still growing, while the employment picture is almost       unanimously characterised as \u201cresilient\u201d in light of a high (but       declining) number of unfilled jobs and a very low unemployment rate. The       view that \u201cthe stock market is moving higher because the U.S. economy is       stronger than expected\u201d often gets turned around by the same speaker to       \u201cthe market\u2019s rise is telling us the U.S. economy is about to improve       further\u201d \u2013 which sounds like circular reasoning to us.     <\/p>     <h3>Monthly hiring pace set to reach multiyear low<\/h3>     <div class=\"row mb-4 migrated\">       <div class=\"col-lg-10 col-md-8 col-sm-8 col-xs-10 col-xxs-12\">         <img decoding=\"async\" src=\"https:\/\/www.rbcwealthmanagement.com\/en-asia\/wp-content\/uploads\/sites\/8\/2023\/08\/durable-rally-headwinds-en-chart-1.png\" alt=\"U.S. nonfarm payrolls and small business hiring plans\" class=\"img-fluid mb-1-half\" \/>         <p           class=\"sr-only\"           id=\"chart1desc\"         >           The chart shows the month-over-month change in total U.S. nonfarm           payrolls and the percentage of small businesses reporting plans to           hire workers monthly from January 2021 through June 2023, and the           projected change in nonfarm payrolls in July 2023. Nonfarm payrolls           increased by roughly 200,000 in June 2023, a multiyear low, and the           projected increase in July 2023 is roughly the same. The percentage of           small businesses with hiring plans decreased to roughly 15 percent in June           after increasing in the two previous months. The high point for small           business hiring intentions in this period was 32 percent in July 2021, and           the number has been at or below 20 percent since October 2022         <\/p>         <ul class=\"rbc-legend\">           <li class=\"rbc-legend-item\">             <div class=\"rbc-legend-bar c-tundra\"><\/div>             Nonfarm payrolls monthly change (thousands, LHS)           <\/li>           <li class=\"rbc-legend-item\">             <div class=\"rbc-legend-line c-dark-blue\"><div  class=\"rbc-legend-circle rbc-legend-outline b-dark-blue c-white\"><\/div><\/div>             Small businesses reporting plans to hire (RHS)           <\/li>         <\/ul>         <p class=\"disclaimer\">           Source &#8211; U.S. Bureau of Labor Statistics, National Federation of           Independent Business; data through 7\/31\/23         <\/p>       <\/div>     <\/div>     <p>       Growing optimism about the U.S. economic trajectory is probably part of       the story of why this rally has had legs. But we believe a less-welcome       phenomenon is in play, in which investor rationality is being overtaken by       FOMO (\u201cfear of missing out\u201d). Many individual investors aren\u2019t exposed to       the mega-cap stocks that have been driving the market higher, as they have       been unwilling to pay valuation multiples that always look too high. With       the seven biggest S&amp;P 500 stocks by market capitalization totaling 27 percent       of the index, even fund managers who do have exposure to this handful of       high-flying stocks usually don\u2019t have enough to let their portfolios keep       pace with the index benchmark. Hedge fund reporting suggests many of these       tactically driven funds were not positioned by late spring for a market       that was going to keep on moving higher, let alone accelerate as it has       done since mid-May.     <\/p>     <p>       We believe FOMO can feed on itself, driving markets to climb longer, and       reach higher levels, than anyone thinks is reasonable. Investors who have       been selling or planning to sell stocks they regarded as overvalued, only       to see them move appreciably higher, stop selling. Fund managers, most of       whom are losing ground against their benchmarks, are buying in       desperation.     <\/p>     <p>       In our view, this dynamic could keep the U.S. large-cap market advancing       further for some weeks or months yet. Beyond the small group of leaders,       the rest of the market, including other developed-economy stock markets,       are likely to be pulled higher too \u2013 for a while. In our view, though, it       will take more than FOMO to put this market advance on a sustainable       footing; at the very least, the U.S. will have to avoid recession and       experience some reacceleration in economic growth.     <\/p>     <h2>Is a soft landing possible?<\/h2>     <p>       Of course it is. And there\u2019s nothing wrong with hoping for the best.       However, planning for it is another matter \u2013 especially when most of the       reliable leading indicators of U.S. recession, which have been       consistently right over many decades, are giving progressively more       negative readings about where the U.S. economy is headed.     <\/p>     <h3>S&amp;P 500 Index vs. P\/E ratio<\/h3>     <h4>       Gains since September 2022 are due entirely to the rising P\/E ratio, with       earnings flat to down     <\/h4>     <div class=\"row mb-4 migrated\">       <div class=\"col-lg-10 col-md-8 col-sm-8 col-xs-10 col-xxs-12\">         <img decoding=\"async\" src=\"https:\/\/www.rbcwealthmanagement.com\/en-asia\/wp-content\/uploads\/sites\/8\/2023\/08\/durable-rally-headwinds-en-chart-2.png\" alt=\"S&#038;P 500 Index vs. P\/E ratio\" class=\"img-fluid mb-1-half\" \/>         <p           class=\"sr-only\"           id=\"chart2desc\"         >           The chart shows the value of the S&#038;P 500 Index and its           price-to-earnings (P\/E) ratio monthly from September 2022 through July           2023. Both the index and the P\/E ratio have increased roughly in           parallel over this period. In September 2022, the Index was at roughly           3600 and the P\/E ratio was 17.1x. In July 2023, the index was at           roughly 4600 and the P\/E ratio was 22.0x.         <\/p>         <ul class=\"rbc-legend rbc-legend-inline\">           <li class=\"rbc-legend-item\">             <div class=\"rbc-legend-line c-warm-yellow\"><\/div>             S&#038;P 500 Index (LHS)           <\/li>           <li class=\"rbc-legend-item\">             <div class=\"rbc-legend-line c-dark-blue\"><div  class=\"rbc-legend-circle rbc-legend-outline b-dark-blue c-white\"><\/div><\/div>             S&#038;P 500 P\/E ratio (RHS)           <\/li>         <\/ul>         <p class=\"disclaimer\">           Source &#8211; Thomson Reuters, Bloomberg; data through 7\/31\/23         <\/p>       <\/div>     <\/div>     <p>       In addition to the signals coming from macro indicators, there are       identifiable headwinds to growth facing the U.S. economy. Chief among them       is the increasing tightness of credit. Changes in monetary policy are       generally thought to take about a year to show up in the economy; from       that perspective, the first half of this year is only showing the effects       of the first 125 basis points of Fed rate hiking that took place over the       first six months of 2022, while the second half of this year will reflect       the further 275 basis points piled on from July to December 2022. Assuming       the Fed wraps up its tightening program with the policy interest rate at       5.50 percent, this means another 1.50 percent will be layered onto the accumulated       cost-of-borrowing burden through the first six months of next year.     <\/p>     <p>       This mounting cost of borrowing will likely be visited on an economy that       is decidedly less robust than it was last year. Here are a few of the       factors in play:     <\/p>     <ul class=\"list-spaced\">       <li>         <strong>Excess savings in the U.S. are gone, or soon will be.<\/strong>         (They remain at elevated levels in most other developed economies         including Canada, China, and Europe.) At the peak of the government\u2019s         pandemic assistance efforts in mid-2021, many recipients used assistance         payments to bulk up household savings by an estimated $2.2 trillion over         and above what would have been accumulated had the economy remained         open. Those balances have declined rapidly. One study undertaken by the         San Francisco Fed calculates that only $500 billion remained unspent by         April of this year, and that the remainder would likely be gone by         December. Another study, using a somewhat different methodology and         commissioned by the Federal Reserve itself, argues that these excess         savings had already been more than fully drawn down by the end of Q1.       <\/li>       <li>         <strong>Credit card balances are rising.<\/strong> Large banks\u2019 credit         card balances jumped by 32 percent in the two years ending in Q1. The payment         delinquency rate recently started moving higher after a multiyear         decline. Interest rates on credit card loans have risen from 14 percent to 21 percent         in a year and a half. And auto loans have been declining since last         fall, partly in response to sharply higher borrowing rates \u2013 up from 4.5 percent         to almost 8 percent over the 15 months ended in May. Lender refusals of auto         loan applications also jumped from 2 percent of all applications to 14 percent over         the same period, the highest refusal rate in years.       <\/li>       <li>         <strong           >Financial stress at the corporate level is unusually           elevated.<\/strong>         Our colleagues at RBC Brewin Dolphin in the UK recently highlighted a         June Fed staff note that calculated the proportion of non-financial         firms in financial distress, at 37 percent, had reached a level higher than         during most previous Fed tightening episodes since the 1970s. The         analysis reveals that, historically, there has been a bigger decline in         business investment among distressed firms than among healthy firms in         response to monetary tightening shocks. The same has been true with         regards to employment. Putting the two together, the note\u2019s authors         conclude that with a high proportion of firms in financial distress,         policy tightening is likely to have stronger negative effects on         economic growth this cycle than in most tightening cycles since the         early 1970s. And the financial sector is not immune from this stress, as         shown by the recent failures of three U.S. domestic banks, the travails         of the regional banking sector, and the forced sale of international         giant Credit Suisse.       <\/li>       <li>         <strong>Mortgage refinancing has become much more problematic.<\/strong>         A typical new U.S. 30-year mortgage now sports an interest rate of         6.78 percent \u2013 more than double the 3 percent that prevailed two years ago.         Understandably, the number of households applying to refinance has         plummeted over the same interval, from 27 percent of those with outstanding         mortgages to just 5 percent. But of the much smaller number now seeking to         refinance, fully 21 percent saw their applications rejected in June.       <\/li>       <li>         <strong>Profit margins are getting squeezed.<\/strong> Total revenues of         all U.S. manufacturing and distribution businesses have declined by         about 2.5 percent since last June, while Employment Cost Index data suggests         worker compensation has risen by more than 5 percent. Recent high-profile wage         settlements suggest that large corporate labour cost increases aren\u2019t         going away soon. With productivity declining, job cuts are likely to be         one response.       <\/li>     <\/ul>          <h2>Plan for it<\/h2>     <p>       The factors mentioned above do not, singly or collectively, preclude the       possibility of a soft landing for the U.S. economy. Neither do the       increasingly negative readings from our <a href=\"https:\/\/www.rbcwealthmanagement.com\/assets\/wp-content\/uploads\/documents\/insights\/global-insight-recession-scorecard-august-2023-en.pdf\" title=\"U.S. Recession Scorecard: Status quo\" target=\"_blank\" rel=\"noopener\">U.S.&nbsp;Recession Scorecard <\/a>. However,       historical probabilities inform our expectations that a U.S. recession       should arrive later this year or possibly early next year, that actual       S&amp;P 500 earnings will come in below current estimates, and that share       prices will go through a challenging period during which investors\u2019       unrealistic optimism eventually gives way to unrealistic pessimism.     <\/p>     <p>       In the meantime, we continue to recommend Market Weight equity exposure       for global balanced portfolios because we think the current advance from       early fall of 2022 has further to run. However, we believe investors       should limit individual stock selections to companies they would be       content to own through a recession. For us, that means high-quality       businesses with resilient balance sheets, sustainable dividends, and       business models that are not intensely sensitive to the economic cycle.     <\/p>","protected":false},"excerpt":{"rendered":"<p>Stock markets have kept climbing off their 2022 lows for longer than expected. 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