We think the enthusiastic run-up in the market so far this year reflects a sort of calm before the big political storm to come. Through the end of the year, democratic countries totalling nearly half of the world’s population will have held their votes, including in a high-stakes U.S. election.
More than one billion people around the world have already voted in 2024, changing the political landscape in India, where the Modi government was reduced to a minority coalition; in the U.K., where a new Labour government was elected; and in France, where the country’s parliament became even more fractured. A common theme in these votes was voters’ dissatisfaction with current leadership and a desire for change.
We see considerable risk that the current status quo for global economic policy, interest rates and trade could be upended. A change in risk perception tends to move slowly at first, transmitting initially through sovereign and corporate bond markets, and then accelerating into equity markets.
With these political risks in mind, this month’s note looks at potential outcomes for the U.S. election in November and how we are positioning our portfolios for long-term returns.
Strong First-half performance
North American markets marched ahead in the first six months of 2024, with the S&P/TSX posting a 6.1% return and the S&P 500 returning 15.3%. Our Veritas Canadian Equity Fund returned 10.0% in the first half, while our Veritas Absolute Return Fund was up 7.4%. Our covered option strategy, the Veritas Next Edge Premium Yield Fund, returned 5.3%.
Our decision to underweight banks and overweight Energy and Materials helped the performance of our funds, with outsized contributions from Agnico Eagle Mines (TSX, NYSE: AEM), Wheaton Precious Metals (TSX, NYSE: WPM) and oil sands producers Suncor Energy (TSX, NYSE: SU), Cenovus Energy (TSX, NYSE: CVE) and Canadian Natural Resources (TSX, NYSE: CNQ).
Outside of Energy and Materials, whose capped S&P/TSX indices advanced 19.5% and 13.7%, respectively, only half of the stocks in the S&P/TSX Composite posted positive returns over the first six months. It remains a stock-pickers market. Our Canadian Equity and Absolute Return funds saw outsized contributions from Bombardier (TSX: BBD.b), Dorian LPG (NYSE: LPG), Canadian Western Bank (TSX: CWB), Aritzia (TSX: ATZ) and goeasy (TSX, NYSE: GSY).
Looking ahead, we see reasons to be optimistic over the remainder of the year, even as we keep an eye on potential political and economic risks.
A Good Start Often Precedes a Good Second Half
The S&P 500 has generated a positive first-half return in 24 of 34 years since 1990. In 20 of those 24 years, the positive first half was followed by a positive second-half return for the U.S. index. Not to be outdone, the S&P/TSX posted a positive second half in 18 of those same 24 years. Even though there are still risks on the horizon, the odds appear to be stacked in equity investors’ favour.
Looking Ahead: Keep an Eye on U.S. Elections and the Direction of Bond Yields
A recent outlook report by the U.S. Congressional Budget Office (CBO) projects U.S. fiscal deficits exceeding 5% of GDP every year from now until 2034, owing to rising interest costs and spending on social security, Medicare and other entitlements. By running a string of outsized fiscal deficits, the U.S. appears to be walking a difficult tightrope between stimulating its economy and staving off inflation.
Funding these fiscal deficits could sustain uncomfortable levels of inflation and force a re-rating of long-term bond yields. Relative to central bank rates for this stage of the cycle, with 10-year U.S. Treasury yields are trading at a 100 basis point discount to the Fed Funds rate, versus their historical 100 bps average premium. A spike in 10-year yields would have ripple effects across equity and credit markets, not to mention risk a significant economic slowdown in the U.S. and elsewhere.
In setting their long-term expectations, markets are no doubt tracking how U.S. elections will play out in November. Objectively, Joe Biden and Donald Trump present a very different set of fiscal and economic scenarios if they return as president. Below, we consider some of these scenarios and their implications for investors.
Markets Always Gaze Ahead
Trump’s policies are likely to include a renewal of the 2017 tax cuts he introduced in his first term, which sunset in 2025. The tax cuts skew toward higher-income households and would arguably leave more income directed to investments. The U.S. estimates renewing the tax cuts would cost about $4 trillion over 10 years – about 15% of GDP at 2023 rates. The move would almost certainly cement current U.S. fiscal problems through at least 2035. For its part the CBO assumes these tax cuts sunset, and even then, it projects deficits exceeding 5% of GDP in every year through 2034.
Candidate Trump has also mused about slapping 10% tariffs on all imports entering the United States. Congress generally governs tariff policies, but the U.S. President is given exceptional powers to enact new tariffs on national security grounds, which Trump used in his first term to levy tariffs on steel, aluminium, solar panels, washing machines and a range of goods from China. The moves resulted in retaliatory tariffs and heated negotiations to remove or reduce the charges.
It should go without saying that tariffs don’t make countries richer. Tariffs merely tax and redirect trade flows and resources, often in less efficient ways that increase transaction costs, drive up input prices and generate inflation for end consumers. Past experience has shown that gains in government revenue are generally far lower than the costs to consumers and industries. Trade partners are also likely to retaliate with their own tariffs, hurting U.S. exports.
A second, often less understood, effect of tariffs is their effect on exchange rates. By raising import prices, tariffs reduce demand and the outflows of a country’s currency to purchase the imports. Lowering the supply of a country’s currency among its trading partners tends to drive up the country’s exchange rate. The higher exchange rate makes exports less competitive, reducing outbound trade and slowing the economy. A new round of tariff wars could, therefore, produce stagflation – higher prices coupled with an economic slowdown starting in the export market.
A second risk is Mr. Trump’s approach to trade agreements overall. The July 1, 2026 renewal deadline for the U.S., Mexico and Canada (USMCA) trade agreement could trigger a new round of bargaining. If one or more parties decline to renew, the agreement remains in force through 2036, but with annual reviews scheduled in each of the remaining ten years. Any party can withdraw from the agreement with six months’ notice (a feature carried over from NAFTA). Should Trump’s trade relations turn combative, the USMCA review process could provide the battlefield.
Lastly, Mr. Trump has also floated the idea of an additional 1% cut to the U.S. corporate tax rate and a further lowering of income taxes, which could boost market sentiment. As a result, despite the complications a Trump win raises, the initial reaction to his victory may well be positive for equity markets. Bond markets, on the other hand, could react negatively if a Trump win reignites trade and fiscal concerns.
What about Joe?
Mr. Biden’s economic platform includes sunsetting a portion of the 2017 tax cuts – those that benefit individuals making more than $400,000. He has also proposed increasing corporate tax rates, a 25% minimum tax on billionaires, and expanding the Child Tax Credit.
During his term, President Biden introduced a broad range of spending programs for infrastructure, clean energy, electric vehicles, public transit, and semiconductors. While Mr. Biden has enjoyed low unemployment rates and a strengthening economy since the pandemic, the jury is still out on his administration’s industrial spending as much of its effects are only now reaching the economy.
Given Mr. Biden’s spending ambitions, we do not expect the U.S. fiscal gap to improve much under his watch. Recall that the CBO estimates assumed that all the 2017 tax cuts sunset; Mr. Biden plans to keep some of their provisions in place.
Mr. Biden’s advantage, perhaps, is his greater predictability. More of the same on spending, with tax adjustments around the edges, is unlikely to spook equity or bond markets, particularly if the U.S. Congress remains divided. Neither the Democrats nor the Republicans want the 2017 tax cuts to fully sunset, pressuring both sides to come to the table. As a result, we suspect the market reaction to a Biden win may be no reaction at all.
Perceptions of Risk Matter
Rising perceptions of risk in either the bond or equity markets have the potential to damage even safe, dividend-paying stocks.
To illustrate, consider a relatively safe stock paying a $5 dividend on its $100 share price and growing its earnings at 3%. Investors can reasonably expect a steady 8% return, consisting of a 5% yield and 3% price appreciation tied to growth.
To attract investors away from safe bonds, the stock currently offers a yield premium of 80 bps over 10-year U.S. Treasuries (i.e. $5/$100 = 5% less 4.2% = 80 bps). If U.S. Treasuries were to rise to 4.8% and the required premium was to increase to 100 bps, that same stock would fall 14% to $86, all else equal, calculated based on the $5 dividend divided by the newly required 5.8% yield (4.8%+100 bps). Therein lies the risk.
The antidote for these valuation risks is to buy shares in companies with 1) free cash flow yields well in excess of Treasury yields; and 2) strong prospects for growing shareholder value over time. Reasonably priced companies with good management teams, consistent free cash flows, investment discipline and earnings growth tend to see their equity premiums narrow over time, increasing their share values.
How We Are Positioning Our Funds
In the current environment, we are avoiding Canada’s Big Six banks, which continue to face headwinds from slowing loan growth and deteriorating credit conditions. In their place, we own a selection of lower-risk insurers, such as Sun Life Financial (TSX, NYSE: SLF) and Great West Life (TSX: GWO); undervalued REITs, such as Granite REIT (TSX: GRT.u) and RioCan REIT (TSX: REI.u); and Utility names that have growth catalysts, such as ATCO (TSX: ACO.x) and Altagas (TSX: ALA).
We are not tied to specific sector weights; rather, we build our portfolios from the bottom up based on the opportunities we find in our investment research and due diligence. We continue to look for compelling investments in undervalued and underappreciated names.
As an example, we originally bought Bombardier (TSX: BBD.b) at $22 per share just after it spun off its train division and relaunched as a pure-play business jet manufacturer. Most investors avoided the name because of its long history of corporate missteps, but we saw value in the company’s streamlined plans and beaten-up share price.
Similarly, we profited this year from picking up shares in Canadian Western Bank (TSX: CWB) after examining its loan book and business prospects. Our entry price of $25 per share represented a deep discount to book value. That value surfaced when National Bank (TSX: NA) made its takeout offer.
As always, we benefit from the excellent investment analysis produced by our affiliate, Veritas Investment Research, which remains a key source of ideas and support for our funds.
We thank you for your continued support.
Your fellow investors,
Anthony Scilipoti
Sam LaBell