Good morning,

The stock market has held up pretty well this year, all things considered.

Before this late summer sell-off, the S&P 500 was up almost 20 per cent from January, despite all the challenges thrown at it.

But CIBC Capital Markets says that may be about to change, and there’s a sound case for investors to increase their cash positions.

Until recently analysts had thought the strength of corporate earnings would be enough to support stock prices, but now they “are witnessing a sentiment change.”

One disturbing signal is that stocks are not responding as they should to earnings beats. In the second quarter of 2023, 79 per cent of 466 companies beat expectations, yet stocks did not react positively to these results, said the report.

“In our opinion, sentiment has shifted from “I’m really impressed by the better earnings” to “is that all you can do for me?”. This quarter’s price reaction to positive earnings surprises was one of the most negative in over a decade.”

The last time this happened at the end of 2019 and 2021 it was followed by poor performance by the S&P 500.

Another concern is that while corporate profitability has held up well amid higher interest rates, inflation and a host of macro challenges, these challenges are not going away, and in some cases are getting worse, says the report.

The shift away from globalization that began with U.S. president Donald Trump has continued under Joe Biden, with near-shoring and friend-shoring increasingly seen as the way to protect supply chains.

Shifting production takes time and investment and there is increased pressure on companies to manufacture in North America often at a higher cost, the analysts said.

Climate risks are also escalating, says the report. Before climate concerns mostly centred on shifting energy production from fossil fuels to higher cost renewables; now, businesses are being directly hit by changing weather.

“Business disruptions from weather events are becoming more commonplace — wildfires and droughts in North America have been the most vivid examples on this continent,” said the report.

While it’s hard to predict the impact of changing weather patterns, it is clearly negative, the report said, as supply chains are disrupted and insurance costs rise.

A few recent examples include drought in 2022 disrupting shipping on the Rhine river, an important channel for European manufacturing. Low water levels in the Panama Canal, which takes 40 per cent of U.S. container traffic, are now causing backlogs.

“In our opinion, the increased frequency of such “weather-related” issues will require businesses to build in redundancy, pay more for insurance, and to develop alternatives. The complications arising from climate change appear to be increasing,” said the report.

If all these challenges continue to boost expenses for companies, as CIBC suspects, it will result in further margin compression or higher price inflation as costs are passed on to customers.

“Either way, the outlook for equities is negative – lower profits or more valuation pressure from higher interest rates. The worst of all worlds would be both!”

Then there is the elephant in the room — the handful of mega-cap stocks that currently make up 30 per cent of the market capitalization of the S&P 500, which is close to a record level of concentration. What’s worse is these companies, which include tech giants Apple Inc, Alphabet inc, Amazon.com Inc and Microsoft Corp., are the most sensitive to higher interest rates.

A 10 to 20 per cent decline in these stocks could wipe 3 to 6 per cent off overall equity levels and would likely hit other stocks as well, the analysts said.

“We don’t believe a bear market is inevitable, but still think there is a sound case for increased cash positions given high short-term yields,” said the report.

Not keen on cash? CIBC says an alternative for those who want to remain fully invested is a defensive, highly diversified stock positioning. “An index that reflects this would be the S&P 500 Equal Weight Index, rather than the S&P 500 Cap Weight.”

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North America’s strategy to “de-risk” the supply chain by reducing dependency on China and Russia is making progress. BMO chief economist Douglas Porter, who brings us today’s chart, said inbound foreign investment to China has plunged to about $66 billion in the past four quarters from more than $300 billion in the year before that. Foreign direct investment has shrunk to less than $5 billion, the lowest in 25 years of data.

To put the decline in perspective, Porter stacked China’s investment inflows up against Canada’s, a much smaller country that has struggled to attract investment. Over the past four quarters, foreign direct investment inflows to Canada reached US$55 billion, nearly as much as China’s. The ratio of inflows to China vs Canada over the 15 years prior to that was five to one.

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China, known as the growth engine of the world, has posted some disappointing data over the past few months and concerns are rising about its property market and shadow banking. Should we be worried? David Rosenberg believes the China slowdown is more complex and has wider-ranging implications than what meets the eye. He and his team offer some key takeaways for investors on navigating this shift in China’s growth story. David Rosenberg: The Great China slowdown has wider implications than meets the eye

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Today’s Posthaste was written by Pamela Heaven, @pamheaven, with additional reporting from The Canadian Press, Thomson Reuters and Bloomberg.

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