Forecasts of improving global economic growth, moderating inflation, lower interest rates, and positive year-over-year earnings growth all provide a positive backdrop for the stock market. But are these positive expectations already priced into equities?
To break down where the economy may be headed, what type of returns investors may see, earnings expectations, and how investors may want to position their portfolios, The Globe and Mail recently spoke with Stu Morrow, chief investment strategist at Morgan Stanley Wealth Management Canada.
Before we discuss your portfolio recommendations, I want to set the stage for our readers with your base case view on the Canadian economy.
Our base case for Canada is a soft landing, so averting a recession, but we have noted the risks are skewed to the downside for the Canadian economy in terms of inflation staying higher than expected, therefore, not giving the Bank of Canada the ability to lower interest rates, which has an impact on the consumer and possibly on the housing side and business investment as well.
Base case on the inflation front remains targeting toward the 2-per-cent level over the next year and change but not a straight line, so a non-linear inflation outlook that eventually gets back to target in 2025. Policy rate cuts begin in midyear with the first cut of 25 basis points in July.
In terms of consumer spending, we expect that to be slowing due to higher rates. Canadian households are very interest-rate sensitive. We’d expect a slight rebound in consumer spending in 2025 if we get the expected rate cuts and policy rates are lower into next year.
We also think business investment is weighed down by higher interest rates and maybe uncertainty around the path of inflation and the availability of labour. We see the labour market slowing, with job gains below the Bank of Canada’s monthly replacement rate of about 50,000 jobs.
And less supportive fiscal policy is something to watch.
You’re expecting 100 basis points of cuts by the Bank of Canada in 2024 and a further 150 basis points of cuts in 2025. Why do you see the policy rate declining to 2.5 per cent in 2025?
We think that the economy is slowing into the second half of this year. Inflation is coming down. Getting back to a neutral rate of around 2.5 per cent makes sense to us.
Turning to your portfolio recommendations, you have a market-weight recommendation on Canadian equities. Can you briefly explain your call based on fundamentals, valuation and technical indicators?
From a fundamental perspective, looking at the expected earnings for companies in the S&P/TSX Composite Index, we see some slight potential downside for the bottom-up consensus estimates for this year, less so in 2025. Taking 5 per cent off the growth rate, I think, is a reasonable downside scenario for earnings.
Valuations for the TSX are not demanding but I think are going to be held back by higher real interest rates. Using the argument that real interest rates and multiples have a positive correlation, we don’t see multiples going up on lower real interest rates. So, there’s a bit of a near-term cap on the price-to-earnings multiple on the S&P/TSX Composite Index.
Technicals are mixed. Right now, we see sentiment as neutral.
For 2024, what is your expected return for the S&P/TSX Composite Index?
I think mid-single-digit returns.
With the reporting season under way, what’s your outlook for earnings growth?
The market’s currently expecting the TSX Composite to deliver 9.4-per-cent year-over-year earnings growth in 2024, that’s bottom up. To us, 5-, 6-per-cent year-over-year growth seems reasonable if we assume some potential downside risk on the Canadian banking side and the consumer side.
While you’re neutral on the Canadian stock market, you have an underweight recommendation on U.S. equities. Why are you so bearish on U.S. equities? Mike Wilson, Morgan Stanley’s chief U.S. equity strategist, has a year-end target of 4,500 for the S&P 500 in his base case scenario, well below the current level.
Valuation for sure. The valuation on the S&P 500, specifically, has been driven by a handful of stocks. A lot of what we saw last year was driven by multiple expansion from seven stocks and we certainly don’t think that that’s something to chase or something that’s sustainable. The other 493 stocks have underperformed on multiple expansion and earnings growth as well. For us, valuation is holding us back and sitting at 20 times forward earnings certainly seems expensive, relative to where we were in the past.
I would also say that where we’re sitting today is quite different from this time last year; US$2-trillion in fiscal policy supported the U.S. economy.
The other thing we look at is the equity risk premium, which is the premium or the yield you get for being in the U.S. market versus Treasuries. It sits at around 100 basis points today. Historically, it’s ranged anywhere from 100 basis points up to 600 basis points. For us to get comfortable with the U.S. market, we think investors should be more compensated to assume that earnings risk and 100 basis points over treasuries isn’t really, to us, warranting an exciting view of U.S. equities. We like to see the equity risk premium at around 300, 350 basis points.
On your bullish call on fixed income, why the overweight recommendation and what returns are you expecting from fixed income?
So, a couple of things on fixed income. One, I’d say that we think we’re toward the end of the rate-hiking cycle. We certainly think that that’s a period where investors are going to be rewarded by being invested in fixed income. Second, coupons for investment grade government bonds are at 4 to 5 per cent. If we think about the risk of being we’re wrong, with interest rates increasing another 50 to 100 basis points from here, or if we’re correct and rates go down 50 or 100 basis points, then that upside potential versus downside risk for bonds is attractive – it’s an asymmetric payoff.
From a volatility-adjusted return, if we’re expecting total returns of investment grade government bonds of 5 to 7 per cent over the next year but we’re doing it at a quarter of the volatility compared to the equity side, when we’re expecting similar mid-single-digit total returns for equities, that volatility-adjusted return is much more attractive on the fixed-income side, at least tactically.
Which fixed-income investments look the most attractive to you?
Our call is to be overweight fixed income on the investment grade and government side as well. For now, we’re not making a duration call.
Based on your sector analysis, looking at future earnings growth and price-to-earnings multiples, are there certain sectors in the S&P/TSX Composite Index that stood out to you as potential outperformers in 2024?
On the financials side, there is a stressed price-to-earnings multiple that is only slightly higher than what the current price-to-earnings multiple is and that tells me that there is there is some downside priced into financials, specifically the banks. There is potential there this year, I think, for investors to add to financials at some point, if we get rate cuts as expected.
On the consumer discretionary side, I think is a little bit too early and it’s a very mixed sector in Canada. But, I think if the year progresses as expected and we avert a recession, I think there is some opportunity on the consumer discretionary side.
Outside of that, I think, market-weight exposures in other sectors, like industrials and staples, makes a lot of sense.
What do you mean by a stressed P/E multiple?
Stressed P/E represents the current index value divided by a downside scenario to consensus earnings-per-share growth estimates. So, a lower EPS growth estimate versus the consensus, in effect, making the financials sector appear to be more expensive on a P/E basis.
What about the technology sector? Earnings in the technology sector in the S&P/TSX Composite Index are forecast to grow over 40 per cent in 2024 and nearly 20 per cent in 2025.
It is a small weight right now in Canada but you’re absolutely right. There are probably a very small handful of companies in that sector that are currently doing really well but it’s hard for us to make that aggregate call at the index level if it’s a 4-per-cent contributor to earnings in the TSX.
Given the strong earnings growth in the technology sector but the lack of investment opportunities here in Canada, if an investor wants to get exposure to technology, even though you’re underweight the U.S. equity market overall, would you say that the technology sector is perhaps somewhere where you would have an overweight recommendation?
No, I wouldn’t say that. For a longer-term investor looking for exposure to technology, obviously the U.S. market has the breadth of names and subsectors in technology that we don’t have in Canada. But no, I wouldn’t say to be overweight.
I have a follow-up question on valuation. When I look at the forward price-to-earnings multiple for the S&P/TSX Composite Index, it’s not expensive and is below its 10-year average. Why you have such a strong conviction that we’re not going to see multiple expansion?
We just don’t think real rates are going to go much lower than they are today. The other part of it is, I think, that what’s going to be needed to drive foreign flows back into Canadian equities would be global growth picking up, probably from China, that would boost sentiment on materials and energy. So, the multiple I think is held back a little bit by where we are in the cycle, which isn’t expecting much global economic growth.
Lastly, I have a question on a technical indicator. In your 2024 outlook report, you mentioned that approximately 60 per cent of stocks in the S&P/TSX Composite Index are trading above their 200-day moving averages. This wide breadth seems positive, reflecting broad strength in the market. How do you view it?
Technically, when you get close to 20 per cent of constituents that are trading at or above their 200-day moving averages, that’s typically the good contrarian buy signal. Likewise, historically, at above 80 per cent, we say that’s perhaps a point in time where you may want to realize some profits or reduce some exposure just based on technical. So, it’s sitting at 60 per cent right now and our risk dashboard that is neutral.
Jennifer Dowty