2024 Q2 Coleford Quarterly Commentary

Despite a many months’ long effort to quell inflation through tight monetary supply (i.e. the highest interest rates in two decades), the U.S. economy has demonstrated remarkable resilience.

Strong consumer spending and healthy corporate fundamentals have collectively powered this performance, which in turn has kept U.S. labour well occupied and signalled to the world that America remains a critical engine of global growth.

U.S. Interest Rate Expectations

America’s sustained strength has surprised many investors and called into question expectations of interest rate relief in the short run.

For his part, Jerome Powell, Chair of the U.S. Federal Reserve, has indicated two potential paths to interest rate cuts: significant weakness in the labour market; or, a sustainable drop in inflation to  2%, the agreed upon target for that key measure. While inflation did decelerate in 2023, it remained above 3% in early 2024, making rate cut predictions more difficult. As noted above, there has been no significant weakness in U.S. labour markets either, meaning both paths to monetary policy relief have been blocked so far.

However, general sentiment remains optimistic with investors betting that the Consumer Price Index will align more closely with the Federal Reserve’s 2% inflation target by year-end. This optimism is partly due to modest improvements in the price of U.S. rental accommodation, a major component of the Core Consumer Price Index, and what is viewed as potential seasonal distortions in inflation data for certain goods and services.

Global Impact

The U.S. economy’s performance stands in stark contrast to weaker growth and inflation expectations elsewhere in the world, including Europe and China.

To put an exclamation point on this bifurcated outlook, the International Monetary Fund (IMF) projects the U.S. economy will grow at more than triple the rate of other major developed countries: +2.7% growth compared to just +0.8% for Europe.

U.S. Growth Offsetting China and EU Weakness

In the graphic above from May 2024, The Capital Group took quantitative and qualitative factors along with structural and cyclical influences (like debt levels and demographics) to compile an illustration of which countries should experience fragile growth/headwinds and which ones would benefit from resilient growth/tailwinds. The big winners are India, the U.S. and Japan shown upward and to the right in this graphic with the laggards (China in particular) shown downward and to the left of the chart. These circles help to illustrate the relative strength of the U.S. which offsets weaker or “fragile” growth in China and the European Union.

The strong performance of the U.S. economy has a global ripple effect. Just as the rest of the world can be hurt by a downturn south of our border, a robust U.S. economy can positively impact other export-oriented economies. This dynamic is currently unfolding, with many capital market participants forecasting U.S growth closer to 3% (higher than the IMF) driven by sustained consumer spending, a tight labour market, and investments in diversified supply chains.

The Ripple Effects

Among the beneficiaries of U.S. economic strength is India, which is emerging as a significant manufacturing hub in a post-pandemic world. As China’s economy matures, and China is faced with the prospect of punishing tariffs from the United States and other western economies, many companies are turning to India for additional manufacturing capacity. This shift is a testament to India’s growing importance in global supply chains and its potential to drive regional economic growth.

At home in Canada, there is also an opportunity to take advantage of shifting supply chain preferences and protectionist sentiments. For instance, the Parliamentary Budget Office estimates the total cost of government support for EV battery manufacturing to be $43.6 billion, highlighting Canada’s strategic move to become a key player in the evolving global manufacturing landscape.

Outlook for Asset Prices

Investors are closely watching the Federal Reserve’s next policy moves scheduled for July 31, September 18, November 7 and December 18, with many anticipating that a decrease in interest rates could further boost asset prices. As central banks in other parts of the world are expected to cut rates more rapidly, the U.S. economy’s robust performance could also lead to a favourable environment for global asset markets generally. While the possibility of rate cuts in the U.S. remains contingent on labour market performance and inflation trends, it is worth keeping in mind that America’s current resilience is a testament to that economy’s enduring strength even in the face of tight monetary policy. This dynamic underscores the pivotal role of the United States in the global macro environment.

EQUITIES

Last quarter, we reported that corporate earnings were on a recovery path. Recent company results and forecasts continue to point in the same positive direction. This trend spans various sectors, indicating robust economic health and improving business conditions.

As for dividends, the landscape is evolving significantly. Traditionally, dividends were associated with mature industries characterized by slower growth prospects. However, dividends are now gaining favour among information technology giants. In 2023, tech companies accounted for 14.1% of the total cash dividends paid by S&P 500 companies, making them the second largest contributor by sector in dollar terms.

Signalling a continued shift in the market narrative, companies including Meta (Facebook), Alphabet (Google), and Salesforce all introduced dividends in the first half of 2024.   Dividend policies are seen as  demonstrations of capital discipline among tech innovators and represent newfound commitments to delivering returns beyond capital appreciation for shareholders.

While the dividend yields of many tech firms are modest, the absolute dollar amounts are substantial, and continued strong earnings growth is expected both this year and in 2025 to support these payouts. This broadening market creates opportunities for dividend-oriented investors to generate income while they wait for capital appreciation.

For the Coleford Equity Portfolio, Alphabet’s introduction of a regular dividend is a positive development. In our view, it enhances the attractiveness of owning this structurally advantaged company.  Additionally, the strength of the U.S. market benefits the Coleford Equity Portfolio as it is increasingly exposed to U.S. businesses.

Largest S&P 500 Dividend Payers (2023)

FIXED INCOME

On June 5^th, Canada became the first G7 nation to reduce interest rates when the Bank of Canada cut its key overnight rate by 25 basis points to 4.75%. This was the first reduction in four years and was widely anticipated by the capital markets, which had priced in a 75% chance of a cut prior to the announcement.

This reduction signifies the beginning of a shift towards more ‘normal’ interest rate levels. It follows a prolonged period of battling rising inflation pressures which led the BoC to increase (and hold) its policy rate at 5.0% since July 2023. Despite this cut, Canadian monetary policy remains in ‘restrictive’ territory, implying a cautious easing rather than aggressive stimulation of the economy.

The rate cut was made possible due to persistently lower inflation readings over the past year. Key measures of CPI that the Bank of Canada prefers to use, have eased significantly in 2024, dipping below 3% this quarter for the first time in almost three years. Coupled with a weaker economic backdrop, these measures suggested that highly restrictive monetary policy was no longer necessary. The Bank of Canada also pointed to softening labour market conditions – with employment growth lagging behind the working-age population – and gradually moderating wage pressures. Looking ahead, the BoC expects price pressures to continue to unwind, with headline CPI inching back to the Bank’s 2% target by 2025, despite an improving economic outlook.

With the initial rate cut now implemented, attention will shift to the pace and extent of further reductions. The BoC has provided limited guidance, emphasizing that decisions will be made “one meeting at a time,” while acknowledging that inflationary risks remain.

CLOSING THOUGHTS

As always, it’s impossible to predict how factors including inflation, policy interest rates and the upcoming U.S. presidential election will influence the capital markets, but one thing is certain: investing in structurally advantaged, dividend-paying companies will stand the test of time. We will continue to watch for signs of sustainable economic and corporate earnings growth this summer with particular emphasis on the U.S.

I am in favor of helping the prosperity of all countries because, when we are all prosperous, the trade with each becomes more valuable to the other.
– U.S. President Howard Taft 1905 –