A Tale of Two Halves?

There is the belief that investment markets are now at an important inflection point, creating the potential for market participants to look back on 2024 as being a year of two halves.

The first half of this year unfolded with stronger-than-expected economic data, particularly in the U.S., fueling optimism that a recession could be avoided, and corporate profitability would remain resilient. Nowhere was this more apparent than in the enthusiasm investors showed towards AI-related technology companies – and more specifically to just six companies – Apple, Alphabet, Amazon, Meta, Microsoft and Nvidia. In the first half of this year, these six companies alone accounted for almost half of the entire gain of the MSCI world index. They also dominate equity markets given their massive increase as a percentage of the overall index – which stood at 19.3% (as of June 30, 2024)!

This is a level of market concentration that many investors have never experienced before and has created a circumstance of increased instability in the equity market. Why has this increased instability you may ask? Looking to nature may provide an apt analogy. Climate scientists have long focused on the importance of biodiversity in an ecosystem, and have developed the concept of “ecosystem instability”.

• Ecosystem Instability: Biodiversity is crucial for maintaining the stability and resilience of ecosystems. When biodiversity decreases, ecosystems become less stable and more vulnerable to disruptions, such as natural disasters and climate change.¹

There are parallels to be drawn from this example for equity markets. As the diversity of return drivers in the equity market decreases (i.e. only a few stocks drive the majority of returns), it becomes more vulnerable to potentially larger drawdowns based on small changes in investor sentiment towards these stocks.

While the first half of 2024 was dominated by market concentration,  as we are witnessing in the third quarter, changes are clearly occurring.

Most notably, the economic data has started to soften, including in the labour markets, and inflation is moving much closer to central bank targets. This has led most central banks to take a U-turn and shift their views from ‘higher for longer’ to ‘been high for long enough’. The Bank of Canada has now cut interest rates three times (from 5% to 4.25%) this year, with the expectation they will cut rates two more times. While the Federal Reserve delivered a significant 0.5% cut in September, they are widely expected to = continue reducing interest rates through the end of 2024.

Here’s a more technical version:

The shift in economic outlook has significantly impacted the equity markets, increasing volatility and altering market leadership. Stocks that excelled in the first half of the year are now underperforming, while previously overlooked sectors are gaining strength. For instance, in the third quarter:

• Stable, established companies are outperforming high-growth stocks,
• Smaller-cap stocks are outpacing large-cap ones,
• Defensive sectors like consumer staples and utilities are leading over tech and communications.

At Northwood, we see this as a more favorable environment for our equity managers, who focus on selecting fundamentally sound companies.

While market changes can bring uncertainty, we remain confident that the best approach is to follow a disciplined, long-term investment strategy, guided by strategic asset allocation, and avoiding short-term reactions.

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