Stock market performance in May seemed to disappoint many investors as there were no big victories for either the bulls or the bears. The ‘sell in May and go away’ crowd was clearly let down as stocks did manage to pull out gains in most major markets. But Canadian investors were once again let down as the gold and metal stocks pulled the index to a loss for the month despite stellar earnings reports from all five of the major Canadian banks. Financial stocks were the largest positive contributors to the Canadian market in May, but it was only a gain of 1% as insurance stocks lost ground and offset the gains in the banking sector. However, on a year-to-date basis, the Canadian market remains the strongest among the major industrialized economies, with a 2014 gain of 7.2% for the S&P/TSX Index.

May14-1

The bigger surprise to most investors has been the strength in the bond market so far this year. After hitting multi-decade lows in mid-2012, interest rates had been on a slow upward climb which most investors expected would continue this year as the U.S. Federal Reserve started to remove their monetary stimulus (i.e. ‘easy money’ strategy) by tapering back on their monthly bond purchases. However, interest rates continue to fall all over the world, which made the relative security of the U.S. economy and its currency even more attractive to global investors looking for yield and safety. We still expect that the ongoing economic recovery and higher risk of inflation will lead to higher interest rates, but that has certainly not been the case so far in 2014!

One of the most important drivers of the performance of financial markets for the rest of the year will be the performance of the U.S. economy. After a dismal first quarter, expectations are for a pick-up in growth for the balance of the year. The risk, however, is that we have seen summer slowdowns in each of the prior four years. The chart below shows the move in one of our favourite economic indicators, the ISI Company Survey, which covers a wide variety of companies in many industries which sell both domestically and internationally. While this indicator has recently moved to an eight-year high, the chart below shows how it has peaked in May in each of the last four years (red line is the average for those same months in 2010-2013). While we don’t expect to see a repeat of the last four years in 2014, that is clearly a risk for the markets in the short term.

May14-2

Better overseas growth should also support economic and earnings growth from faltering over the balance of this year. For the past three years earnings growth for the S&P500 has been primarily driven by America’s domestic economic activity, while earnings growth from overseas markets, the euro zone in particular, has sagged. But S&P500 companies derive close to 40% of their profits from overseas markets and the Euro-zone accounts for the lion’s share of these foreign earnings. The “double dip” recession in the euro zone economy contributed to the contraction/stagnation in overseas earnings from 2012 to 2013. The good news is that the Euro-zone is on the mend. For the entire Euro-zone, the growth rate will still be low but the contraction is ending, with most of the improvement coming from the peripherals. Hence, overseas earnings growth could turn from a major drag to a positive contributor to overall earnings growth for the S&P500, a trend that is already underway.

1 2