Commentary - 1st quarter 2024

Are US equities too expensive?

The performance of U.S. stocks, up over 50% since their October 2022 low, is remarkable, not least because they have left other markets, including the Canadian stock market, far behind. It's not that the Canadian stock market is doing badly - up  almost 28% over the same period - but rather that it can't keep pace with the U.S. stock market. And this outperformance has now lasted for a decade.

You don't have to look far and wide to understand that it's the earnings growth of American companies that explains their performance on the stock market. Earnings of companies in the S&P500 index have grown at a rate of 7.3%/year since 2014, compared to 5.0% for those in the S&P/TSX Composite. And because investors like growth, they're willing to pay more for American companies: their price/earnings ratio indicates that they're trading at 22 times next year's anticipated earnings, compared with 15 times in Canada and 14 times on European markets.

This increase in profits is mainly driven  by  the technology sector  and is largely generated outside the U.S., benefiting from global economic growth.

So, should we reduce our allocation to Canadian and international equities in the portfolio and put all our eggs in the U.S. basket?

It's not just technology

When you take a closer look, it's not just high-growth sectors like technology that price-to-earnings ratios are high in the U.S. As The Economist recently¹ this is also the case in sectors of the old economy such as financials, consumer staples and utilities.

Seen in this light, U.S. equities may look expensive. Indeed, for equal growth, why would an investor agree to pay more for $1 in profits² from a U.S. oil or financial company than for the same dollar of profits generated by a Canadian or international company? That's why we said in our last quarterly letter that U.S. investors should buy Canadian stocks.

Cisco 2.0?

Even technology and communications sectors, some companies seem to have very high price/earnings ratios. This is particularly true of companies working in the field of artificial intelligence, such as Nvidia. This company has a virtual monopoly on the microprocessors needed to develop and deploy artificial intelligence. Its sales and profits have literally exploded since last summer, which explains why its share price has risen by over 500% since January 2023, its market value is now $2.3 trillion and its price/earnings ratio is 76x. To justify such a high market value, Nvidia will need to continue to grow sales and profits, knowing that other companies will come to challenge its lucrative monopoly. A tall order!

One can't help but draw paralleld with another well-known company - Cisco Systems - which was also at the forefront of a technological revolution and briefly held the title of the world's largest company by market capitalization in early 2000. Today, Cisco is still a profitable company, but its market capitalization now ranks it 58th in the world. Expectations were clearly too high, and its shares far too expensive, in 2000.

Good old dividends

Which brings us back to Canadian equities, which are 1/3 cheaper than US equities (a price/earnings ratio of 15x in Canada vs. 22x in the US), or US equities are 50% more expensive than Canadian ones. To justify such a spread, U.S. corporate earnings would have to continue to grow 50% faster than those of Canadian companies over a long period, say a decade.

That's not impossible - especially since productivity is growing faster in the U.S. than in Canada - but it's still an optimistic scenario. Otherwise, the gap between price/earnings ratios will close, and Canadian equities will have performed better over the next decade.

There are other reasons to allocate a good portion of the portfolio to Canadian equities. As we have repeatedly pointed out, they provide excellent diversification (they are dominated by the financial and resource sectors) against techno-centric US equities.

Canadian equities also pay significantly higher dividends than U.S. equities: 3.1% in Canada vs. 1.4% in the U.S. (S&P500). In a prolonged stock market downturn, these dividends could make all the difference, especially for a retired investor looking for income.

Market Review

Canadian equities: gold shines again

Despite a less remarkable performance than the US stock market, the Canadian stock market still had a good quarter, up 6.6%.

The main reason for the divergence in performance is that the largest sector on the Canadian stock market, finance (mainly banks), was unable to keep pace with the US stock market, despite a very good return of 4.4% for the quarter. Despite generally positive results, the six major Canadian banks significantly increased their loan loss provisions - an indication that they remain cautious about their customers' economic health. Canadian banks don't offer the same growth potential as the Nvidia, Apple and Google of the world, but their solidity and a dividend yield of around 4.6% are valuable assets in a portfolio built for retirement.

Oil rebounded this year - up 16.1% - due to Ukrainian drone attacks on Russian oil installations, as well as production cuts by OPEC and its allies. The higher barrel price benefited the energy sector, which closed the quarter up 11.7%.

The commodity that attracted the most interest was gold, which reached a new high of $2,217 per ounce, up 7.5% over the quarter. In response to the freezing of Russian assets by the G7 countries, some central banks, notably China's, are replacing part of their foreign currency holdings with gold. However, this rise in the price of gold was only partially reflected by mining companies. The gold sector as a whole closed up 3.6%.

It was another difficult quarter for the communications and utilities sectors, down 10.0% and 2.3% respectively. This is undoubtedly due to rising interest rates on bonds, making them more attractive than dividend-paying stocks.

US equities: everything rises...except Tesla

Essentially the same factors as in 2023 - optimism surrounding a "soft landing" scenario and enthusiasm for artificial intelligence - helped US equities maintain their first-quarter momentum, with a 13.3% rise in Canadian dollar terms.

These two factors particularly benefited technology stocks and communications services, up 12.5% and 15.6% respectively over the quarter. In the absence of any real competition, all large-scale artificial intelligence projects are forced to adopt Nvidia's microprocessors. The company had another excellent quarter, up over 80%, enabling it to overtake Amazon in market capitalization. In a sign of the times, Super Micro Computer, a supplier of AI servers, saw its share price soar by 255% in 2024, joining the S&P 500 index and leading to the exit of household appliance company Whirpool. This growing concentration of technology stocks in the US market is a reminder of the importance of having a geographically well-diversified portfolio.

It wasn't just growth stocks that stood out. Rising oil prices also benefited US oil stocks, with the energy sector up 12.7%. The financial sector has returned 12.0% since the start of the year. US borrowers are showing less sensitivity to high interest rates, due to mortgage renewal periods of up to 30 years.

After seeing its stock double last year, Tesla delivered the worst performance of any S&P 500 stock, down nearly 30% over the quarter - at a time when global demand for electric vehicles is showing signs of slowing. Despite this, the consumer discretionary sector had a very good quarter, up 4.8%.

International equities: Japan again

As was the case last year, the strong performance of the Japanese stock market enabled international equities to do well, up 8.4% over the quarter (in Canadian dollars).

After decades of misery, the Nikkei 225 index finally returned to its 1989 level, as Japanese equities closed the quarter up 17.9%. Incidentally, Japan's encouraging economic outlook has led the central bank to end its negative interest rate regime, introduced in 2016 to combat deflation. However, interest rates in Japan remain well below those in other countries, resulting in a significant depreciation of the yen. As a result, the return on Japanese equities for the Canadian investor was 12.7% over the quarter.

European markets ended the first quarter up 7.0%, as recent data continues to show that inflationary pressures are easing. Proof that economic performance is not everything in stock markets, Germany ended the quarter up 8.6% despite its economic performance being one of the worst among developed countries. West of the German border, the Netherlands performed well, posting a 17.4% increase over the quarter. This performance was largely due to a 33% rise in the share price of ASML, a microprocessor manufacturer, which alone accounts for 20% of the index.

Emerging markets: Taiwan beats China (again)

The MSCI Emerging Markets Index returned 4.9% in Canadian dollars for the 1st quarter of 2024.

As we mentioned in the previous quarterly commentary, China's woes are nothing new, as Chinese equities have seen their value melt by more than 50% since 2021. The descent became more pronounced at the start of the year - down over 10% in January - prompting the Chinese authorities to take action in an attempt to reverse the trend. Chinese state-backed investment funds have purchased over $50 billion worth of shares in exchange-traded funds that track their country's benchmark indices. These efforts, combined with further expansionary central bank policies, helped recover much of January's decline, ending the quarter down 2.0%.

Elsewhere in the emerging markets, Taiwan was the standout performer, up 15.9% over the quarter. This performance was largely attributable to Taiwan Semiconductor Manufacturing, the sole manufacturer of chips designed by Nvidia. Up 35% over the quarter, it alone accounted for over a third of the Taiwanese index and the largest weighting in the emerging markets index.

South Korea and India also enjoyed a good quarter, up 6.1% and 5.1% respectively.

Bonds: keeping an eye on inflation

The rate on 10-year bonds fluctuates according to the news on inflation, and this news has been rather mixed recently. Indeed, although inflation has slowed considerably, at around 3% (in the US) it remains higher than the central banks' 2% target.

Against this backdrop, the bond market slightly raised its inflation³ and the rate on 10-year bonds in the United States rose from 3.87% to 4.21% over the quarter. In Canada, the 10-year rate was 3.45%, up by around 0.35%.

This rise in 10-year yields led to a fall in bond prices, so that the return on the bond portfolio was -1.2% over the quarter.

Notes

[1] As markets soar, should investors look beyond America? The Economist, March 24, 2024

[2] When you buy a share on the stock market, you acquire the entire stream of future earnings that will be generated by the company (at least conceptually). The sum of these future earnings is estimated by applying a ratio (the price/earnings ratio) to current earnings. If growth is equal, two companies operating in the same sector should therefore have similar price/earnings ratios.

[3] Inflation expectations are derived by subtracting the rate on inflation-protected bonds - TIPS, currently 1.95% - from that on regular bonds - US Treasuries, currently 4.21%. Current inflation expectations for the next 10 years are therefore 2.26%.