Across the financial landscape all anyone is talking about is Trump, tantrums and tariffs. Tensions are not going to disappear, but they are going to ebb and flow. However, looking below the surface, things are a little more placid. Certainly, investors’ nerves have been rattled. While there have been several days of large declines in the financial markets, for the most part investors are better off than they were at the start of the year. Investors just need to push aside the political distractions and recognize the world’s economies are only now normalizing and previously growth has been quite slow, disjointed and restrained.
Despite this period of turmoil and uncertainty, the Canadian stock market has hit a record high. Obviously, this is impressive considering the recent economic news, ongoing trade woes, soft housing market conditions and weaker Canadian dollar. Clearly, investors are looking past the escalating tensions and are repositioning themselves in part due to the very attractive Canadian equity valuations relative to U.S. equities. This is something that normally happens during the late stages of an economic cycle, which could be very rewarding for investors over the coming years.
The U.S. market navigated, virtually unscathed, through a gauntlet of central bank meetings, a historic summit between the U.S. and North Korea, and flaring trade tensions. This is even more impressive considering that the Federal Reserve lifted interest rates for a second time in 2018, amid rising inflation and the lowest jobless rate in nearly two decades. Volatility has been trending decisively lower since it surged in February. Still, the road ahead looks fraught with potential landmines especially if the tariffs result in lasting damage and escalating tensions.
The European economy has been a puzzle lately as some indicators are pointing up, some down and some sideways. It is hard to know whether it is the beginning of a decline or simply a normalization following a period of strong growth. Amid so much uncertainty the European Central Bank is closing one chapter by shutting down its bond buying program; but it has also promised to continue other stimulus efforts for now. This can be justified by robust underlying growth, unemployment falling to its lowest level in a decade, and a rebound in inflation and wages.
For the rest of the world, last year’s financial market boom seems to have been completely forgotten as we’ve seen the worst start to a year for emerging market stocks since 2010. They began the year as a market darling only to be toppled by a surge in the dollar, a 16% leap in oil prices and rising political risks. While only a few small markets are at any material risk of crisis, it has truly been a test of investors’ patience. China, in particular, long seen as the world’s growth engine, slipped into a bear market falling more than 20% below its high earlier in the year.
Investors have had a difficult time staying upright in 2018 as the financial markets have generated plenty of volatility. So far this year the U.S. stock market has posted 36 one-day swing days of 1% or more versus only four times in all of 2017. While the ride has been choppy, at the end of the day, the results have been positive. Canadian stocks were up 6.8% in the quarter (1.9% for the year-to-date) and U.S. stocks climbed 5.5% over the last 3 months (7.2% YTD, all figures in Canadian dollar terms). International stocks as a whole gained 1.1% in the quarter (2.2% YTD); while emerging market stocks lost 6.6% (-3.1% YTD). Bonds continued to lag only climbing 0.5% in the quarter and 0.6% for the year-to-date.
Investors breezed into 2018 expecting to pick up easy returns. Instead, euphoria was replaced with volatility and uncertainty. This sea of change stemmed from the snap stock selloff in early February. Since then, markets have become more vulnerable to growing political uncertainty and investors are becoming risk averse. The extreme swing in market psychology from a time when all risks were being ignored to one that is hyper-sensitive is cloaking the bright spots which are still plentiful.
The second quarter saw a sudden change of narrative on global economies. At the start of the year there were fears over trade tensions and some optimism on a possible deal, but in the second quarter that optimism quickly faded as talk of a trade war erupted between the U.S. and the rest of the major economies. Also, heightened political risk with populist governments in Europe, and nuclear programs in North Korea and Iran added to global concerns. Yet for most of the quarter these tensions turned out to be noise. The overall macro backdrop remained supportive amid rate normalization in North America and prospects of decent global growth for 2018.
The Canadian economy particularly has shown much resilience with expectations of moderate expansion in the second quarter despite recently imposed tariffs, especially with steel and aluminum. The job market has been tight with about 23,000 new jobs per month over the last twelve months. Although trade concerns weighed more on many global markets, the S&P/TSX index went into rally mode to reach record highs and posted its best quarterly performance since 2013 with 6.8% gain on a total return basis.
At the start of the year investors were wary that geopolitics would have a more pronounced impact on the global economy and markets rather than business fundamentals and that has proven true. Over the last six months with the U.S. trade war against the rest of the world, renewed populism in parts of Europe and the North Korea nuclear issue, volatility has returned with a vengeance. However, Canada seems to be dodging these global threats so far with a resilient economy and an unemployment rate at a record 5.8%. The strong job market is causing inflationary pressures as the latest Consumer Price Index measures showed inflation levels above the Bank of Canada’s benchmark rate of 2%. On the other hand, the threats are not preventing the S&P/ TSX from making new highs as it did on June 22 when it closed at 16,450 points.
After years of negative news regarding household debt, there seems to be a turning point as the debt load got a bit lighter according to June data from Statistics Canada. Also Canadian banks, though not stellar in the second quarter, have improved a lot thanks to their strong balance sheets and profitability. Thus their exposure to housing is not a major concern to some investors. Years of underperformance have made the S&P/TSX a bargain compared to other global markets and with improving energy prices the index can rise to within striking distance of its long term average return.
During the second quarter of 2018 the Canadian FTSE TMX Universe Bond Index gained 0.5% and has risen 0.6% so far this year. The Bank of Canada raised its key lending rate in July and September of 2017 and again in January by a quarter point to 1.25%. Interest rates are recovering from the once record lows of last summer in response to signs of an improving economy. The central bank has taken a cautious stance on rate adjustments but investors are pricing in at least two more hikes by the end of this year. The recent increases overwhelm the two rate cuts introduced in 2015 which were to help cushion and stimulate the economy from the collapse in oil prices. In the U.S. the Federal Reserve has raised interest rates eight times since the financial crisis with the two most recent rate hikes coming in March and June 2018. The U.S. central bank has increased its benchmark interest rate target range each time by 0.25% to a new band of 1.75% to 2.0%.
The most recent version of the Bank of Canada’s biannual Financial System Review (FSR) was released in early June. The FSR is the central bank’s main vehicle for communicating developments related to stability of the financial system. At the FSR release press conference Governor Stephen S. Poloz confirmed that the main vulnerabilities they see today are the same as those in the last FSR in November. They are elevated household debt, imbalances in some housing markets and cyberattacks.
Governor Poloz noted that, “there are several factors helping to lessen the vulnerability related to household indebtedness. There have been a series of changes to mortgage lending guidelines, a slowdown in credit growth along with higher interest rates. As well, a solid expansion in the Canadian economy is leading to strong growth in employment and income and, over time, this will support Canadians’ ability to manage their debt, even at a time of rising interest rates”.
In the U.S., long term bond yields briefly broke above 3% earlier this year for the first time since 2014. It didn’t take very long for the yield to fall back below that level but many investors say a bear market is near as rates inevitably rise and deficits grow but they are missing one key point: The 30 year bull run pretty much ended years ago as U.S. government bond returns have failed to keep up with even the recent weak inflation.
In their June 13 press release, the U.S. Federal Reserve observed that the labour market continued to strengthen and that economic activity has been rising at a solid rate. Job gains have been strong, on average, in recent months and the unemployment rate has declined. Recent data suggests that growth of household spending has picked up, while business fixed investment has continued to grow strongly. The stance of monetary policy remains accommodative, thereby supporting strong labour market conditions and a sustained return to 2% inflation.
The Standard & Poor’s 500 index climbed 3.4% in U.S. dollar terms over the second quarter of 2018 and year to date the index is up 2.6%. In Canadian dollar terms the respective change was 5.6% for the quarter and 7.6% year to date as the loonie lost 2.1% during the second quarter and has weakened by 5.0% so far this year. The long bull market in the U.S. has now passed its ninth birthday and, while it has been a long run, the longest post war bull market lasted for nearly 10 years until March 2000.
The books are now closed on a tumultuous first half of 2018 that saw volatility surge amid trade war fears and a faster moving central bank. While the going got rough, including twin routs in February and March, U.S. stocks avoided disaster as earnings showed no sign of unraveling. By at least one measure, corporate earnings are the best in nearly a quarter century. According to Thomson Reuters I/B/E/S, 499 companies out of the S&P 500 index have reported Q1 earnings as of June 29 and 78.2% have reported earnings per share that were above analysts’ expectations, putting the season on track for the highest earnings beat rate on record, going back to 1994. The first quarter growth rate for earnings is 26.5% above the same period last year. The recent quarterly results have seen outperformance of about 3 to 4% better than analysts’ consensus estimates on average. What’s really impressive is that expectations were already lofty and the quarter represented the first in which expectations were raised to factor in fiscal stimulus measures such as the corporate tax cuts which took effect in late 2017.
Given the strong earnings numbers, the advance of the S&P 500 index was surprisingly paltry. It isn’t easy to pinpoint exactly what’s troubling investors. There are signs that harmonized global growth is starting to unwind and that has hurt investor confidence. Concerns about global trade tensions between China and the U.S. and the fear that the stellar earnings could be as good as it gets for stocks are all combining to undermine the sort of confidence that was in abundance during last year’s run of repeated records for equity benchmarks. Investors may also be concerned that the U.S. economy is in its ninth year of expansion and the Federal Reserve is moving to normalize monetary policy from crisis era levels. Another headwind is the strengthening dollar and rising interest rates. Recently the dollar put in its best monthly rise since President Donald Trump’s election and the yield on the 10 year Treasury note touched its highest level in more than four years, briefly rising above 3% in the quarter.
The U.S. equity market continues to show signs of late cycle angst. While political uncertainty, threats of a trade war, hostile rhetoric and bullying of U.S. manufacturers are not helpful, the strength in the economy and a healthy earnings outlook should be supportive of U.S. equities.
The uncertainty surrounding the global outlook has increased as stock markets around the world slumped in recent weeks amid mounting trade tensions between the U.S. and everyone else. It is undeniable that investors had recently been quite enamored with the return prospects for international stocks, but these days they are dumping riskier stocks and seeking safe harbours for their money. They are reacting to signals of more rapid policy tightening, although full policy normalization will take years.
Economic growth across the European Union (EU) looks like it will remain robust this year and next, particularly when compared with Britain. The debt crisis that had ravaged the Eurozone and many of its members, notably Greece, is now past. Europe has finally turned the page of the crisis. Unemployment in the 19 countries that use the euro fell to its lowest level in a decade as the region’s economy kept benefitting from waning worries over debt. The EU statistics office, Eurostat, said the rate dropped to 8.5% in February from 8.6% in the previous month marking the lowest level since December 2008. While unemployment was down, annual inflation in the Eurozone jumped to 1.4% in March, ending several months of decline but failing to come near the European Central Bank’s (ECB) own target of close to 2%. Britain will continue to lag the Eurozone over the coming years, with the economy hobbled by Brexit uncertainty. As the country prepares to leave the EU on March 29, 2019, its future relationship with the Eurozone remains unclear.
The euro sold off after the ECB announced that it would look to finish its bond buying program by yearend but also pledged to leave interest rates unchanged until mid-2019. The ECB announced it would taper its asset purchases further in October to €15 billion a month from €30 billion before the quantitative easing program likely concludes in December.
Japan’s tightest labour market in decades just got tighter driving companies to hire more workers in full-time, permanent positions. That’s positive news for the Bank of Japan as it struggles to generate 2% inflation. Consumer prices in Tokyo, a leading indicator for the nation, rose more than expected. The unemployment rate in May fell to 2.2%, the lowest since 1992. As companies struggle to find workers they’re hiring more staff on permanent, full-time contracts, which generally means higher pay and benefits. Still, challenges to the economy abound. The export dependent nation faces fallout from global trade tensions and the slowing of growth in China. Japan’s factory output fell slightly in May after rising for three consecutive months.
The world’s second biggest economy cooled slightly in March as China faces an escalating U.S. trade spat which could have damaging economic consequences hitting exporters of both nations and shattering global growth. Economists are penciling China’s growth to slow to 6.5% this year, from a solid 6.9% in 2017, also due to a cooling property market and rising borrowing costs.
For the most part the second quarter was weak for international stocks as the overall market fell 1.0% (all figures are in U.S. dollar terms). Overall, European stocks were down 2.7% last quarter, which was better than Asian stock markets which lost 5.0%. Emerging markets tumbled in the second quarter after a stronger dollar and higher U.S. interest rates led many investors to flee from riskier developing markets. The MSCI Emerging Markets stock index fell 8.7% over the past three months, the index’s worst quarterly performance since the third quarter of 2015.
Some investors’ patience with stocks is waning, particularly in Europe where this was supposed to be the moment when European equities would finally catch up with the U.S., lifted by a revival in economic growth and corporate earnings. Instead, investors are once again preparing to start de-emphasising international stocks in light of the simmering trade war and the dithering on the interest rate outlook.