A major market rotation is underway with the recent strength in small-cap and value stocks.
Earlier this month, leadership shifted out of large cap companies and into small-cap stocks in Canada and especially in the U.S. The Russell 2000, a U.S. small-cap index, has posted a double-digit gain in the past week alone. Rate cuts expectations by central banks have provided underlying support for small-cap stocks to rally. Add to that, the elevated valuations of some large-cap stocks and healthy gains in the sector, which have some investors cashing in their profits and buying value stocks. But is this new leadership sustainable?
Analysts’ forecast returns, recommendations and yields for all stocks in the S&P/TSX SmallCap Index
This week, the Globe and Mail spoke with Invesco’s chief global market strategist Kristina Hooper to get the answer to that question. With this recent broadening in outperformance, she discussed where she sees investment opportunities in the stock market.
A key message in your 2024 mid-year report is the divergence in economic growth and inflation expectations between global economies. What is your assessment of the Canadian economy, the Canadian stock market, and the Canadian dollar?
I’m rather positive on the Canadian stock market and the Canadian economy, although I think markets will move in advance of the economy as they often do. Along with that, I would anticipate some strengthening of the Canadian dollar and it’s all because of monetary policy.
The Bank of Canada was quicker to act than other major developed economies’ central banks and has already begun cutting. I believe we will see the Fed start cutting soon. So that creates an environment where the U.S. dollar weakens at least somewhat relative to other major currencies like the Canadian dollar.
We have this more or less global environment of easing for major developed economies. That is going to be supportive of an economic reacceleration that could start as early as the end of this year.
Now, of course, there’s pressure on consumers right now, and the Canadian consumer feels it more than the U.S. consumer. But we’ve already seen a little easing of that with one rate cut and I think it will continue.
I think markets are already starting to anticipate that will happen then that means that the more cyclical areas of the stock market are likely to perform better in anticipation of that reacceleration. That’s the base case.
Of course, there’s always the potential that central banks were too late, that they kept rates too aggressively high for too long, but that’s not my base case.
Do you have a target for the S&P/TSX Composite Index?
We do not, but when I look at Canadian stocks, the MSCI Canada Index, for example, what I’m seeing are stocks that are, for the most part, more attractively valued than U.S. stocks and have far greater cyclical exposure than U.S. stocks. So, I’m optimistic that we’ll see better performance going forward. For the first half of this year, the TSX has been up about 5 per cent, in price terms. I wouldn’t be surprised to see a doubling of that in the back half of this year if my base case is right.
Are you saying that the Canadian stock market will outperform the U.S. stock market because of its attractive valuation and its greater cyclical exposure?
Yes, that’s what I think will happen. Now, it could be that Canadian stocks just modestly outpaced U.S. stocks. But I think directionally, we’re likely headed for a period where Canadian equities outperform U.S. equities.
Earnings growth has been solid, inflation has been normalizing, and central banks, like you mentioned, they’re expected to lower interest rates, if they haven’t already. These forces provide support for the stock market. So, where are we in this bull market?
I think the bull market has legs. And the reason I think it has legs is because [leadership] has been rather narrow.
So, one of two things can happen, either the bull market ends and stocks fall or there’s some kind of rotation, a change in participation, a broadening, something happens that makes this sustainable and I think that’s what we’re seeing.
We’ve seen it a few times before but we haven’t had the monetary policy coming from the Fed to back it up. I think it’s more sustainable this time because I think we’re close to the Fed starting to cut.
So, my expectation is that there are undervalued areas of the U.S. stock market and there are certainly very undervalued areas of the global stock market and that should give this rally legs.
Just to expand on your response, can you identify those undervalued areas in the U.S. and global stock markets?
In particular, small caps and some of the more industrial cyclical names, I think are more attractively valued. I can’t say that they’re screaming buys, but there are definitely opportunities and there are a lot of value names that have been overlooked and are attractively valued.
If you go outside the U.S., there are lots of attractive spots as well. Chinese equities, a number of emerging market equities look attractive, Canadian equities. If we look at the TSX, the forward P/E ratio is rather attractive.
Yes, we have a lot of bank stocks and energy stocks in our Index.
And financials have led recently and could certainly do more of the same going forward.
In your mid-year outlook report, you suggested going forward leadership may shift to non-U.S. economies. Can you elaborate on what countries you see favourable economic conditions where equity investors may realize solid returns and the reasons behind your recommendations. Can you distill that down to specific countries? You briefly mentioned China and emerging markets.
So, when I was talking about Chinese equities in particular, I was talking about attractive valuations. But, I’ll be the first one to admit that valuations on their own are not enough. Typically, we need to see catalysts.
Valuations look very attractive among European equities and U.K. equities. I’m particularly excited about U.K. equities because the new U.K. government appears to be focused on supporting economic growth, already starting to utilize forms of industrial policy to support that with the announcement of a National Wealth Fund. That’s just one example where, from my perspective, it can’t just be valuations, there has to be another catalyst.
Now, the catalyst can be as simple as rate cuts and for that reason, European equities arguably look good. Although, I think we’re going to see some volatility as we wait for the formation of a new French government. Also with Europe, we’re seeing a decline in consumer sentiment. We need to be more cautious with European equities or at least anticipate there will be more volatility.
Asia emerging markets looks attractive. Indian equities have historically been expensive. And if people were to look at valuations relative to history, they’re at the high end of their range, but there are reasons why Indian equities can perform well despite high valuations so I would not exclude Indian equities.
What I would say is it’s important to be well diversified and that includes diversification along valuation lines. So pairing exposure to Indian equities with exposure to Indonesia, Singapore, and Vietnam, they do not have as compelling a demographic story as India, but they do have compelling demographic stories and they have relatively modest valuations compared to India.
You favour small caps over large caps yet we are seeing some weakness emerging in the U.S. economy. With a potential slowdown in the economy and perhaps a higher for longer interest rate environment that would lend itself to large cap stocks outperforming. Also, the U.S. ISM Manufacturing Index remains in contractionary territory, which tends to be positive for U.S. growth stocks over U.S. small cap and value stocks. So, why do you favour small caps over large caps?
No, you’re absolutely right. If the U.S. economy continues to slow down, we’re not going to see small caps perform well, we’re not going to see cyclicals perform well.
But my thesis is that central banks will have acted in time to avoid a further slowdown, especially the Fed, and that their cutting, combined with some easing of inflation, which will result in improved real wages, will be enough drivers for the economy to start to reaccelerate, developed economies to start to reaccelerate, including Canada, including the U.S.
Certainly cracks are forming in economies but my base case is that central banks will have acted in time and it seems that markets, at least today, are anticipating that and that’s why we’ve seen this small but meaningful rally in the small caps, in the cyclicals.
You see a rotation from growth stocks to value stocks, which is counter to the dominant trend that’s been in place over many years. Why do you see a rotation into value stocks?
I think it’s largely a monetary policy story and an expectation of improvement, but it’s certainly supported by valuation.
Growth can coexist and perform well with value. There’s enough cash sitting on sidelines that can come in and push up value stocks without significant amounts coming out of growth stocks.
So, you’re advocating more of a barbell strategy where both growth stocks and value stocks can rally?
Well, I think growth could take a back seat to value, but I don’t expect growth to have any kind of significant drop. I would say that it’s more about the outperformance of value but not to the exclusion of growth.
China’s second quarter GDP came in below expectations rising 4.7 per cent year-over-year, down from 5.3 per cent year-over-year report in the first quarter. China’s economic growth is particularly important for commodity demand. What are your expectations for commodities such as gold, copper, oil?
I don’t make calls on specific commodities, but I will say I’m most positive on the industrial commodities because of my thesis around a reacceleration in the economy and that includes being positive on energy. Of course, there are other factors at work, for oil in particular, it’s not just a demand story, it is very much a supply story. But all else being equal, I think we will see increased demand from China. I don’t worry too much about one quarter GDP. I think that directionally China is headed in a positive direction so I would anticipate that we will see increased demand. It may be modest in the near-term, but I do think we will see it.
On July 10, results from the AAII investor sentiment survey showed a 49.2 per cent bullish reading, which is well above the historical average of 37.5 per cent. Does this high bullish reading concern you?
No, I mean, it certainly could mean we see a pullback soon, but I’m very comfortable with the idea that we could see a small pullback in the near-term. I think sometimes having that clearing of the deck can be very healthy.
What should investors pay close attention to? There’s certain a lot of things, but what would you isolate and identify as an important item?
I think investors should pay close attention to their long-term goals. To get caught up in noise, in one data point, and of course, politics, that’s when investors tend to make mistakes. From my perspective, it’s about having an asset allocation, having the discipline to stick to it and focusing on long-term goals.