The first half of 2019 was terrific for financial markets regardless of whether you were a stock or bond investor. Over the second quarter global stocks rose modestly after an outstanding first quarter despite signs of slowing growth in Europe and Japan, deteriorating trade relations and the prospect of rising U.S. interest rates. It was a volatile quarter as markets came under pressure largely due to trade and political turmoil, but strong earnings growth helped to boost investor sentiment.
By all indication Canada’s economy is growing at a much faster pace with a bigger trade surplus than it had in the final three months of last year and the first quarter of this year. Canada has been able to generate strong job gains over the past two years adding almost 700,000 jobs. The unemployment rate has fallen to its lowest level since 1976. This has led the Canadian dollar to its highest point in eight months as trade data adds to the evidence that the economy is firming even more. This has given the Bank of Canada more ammunition to resist pressure to lower interest rates and potentially overheat the economy.
Growth in the U.S. is slowing, as the dramatic tax cutting boost has largely played out. The U.S. Federal Reserve was on a trajectory to normalising monetary policy but circumstances have changed so the Fed pressed the pause button on tightening. Still, global investors poured money into U.S. assets, contributing to the currency being overvalued and stock markets hitting record highs. However, it is the future path of trade policy that will likely be a key catalyst that is very difficult to predict. In the best case scenario, a trade deal with China rejuvenates the economy, the Fed cuts rates to “un-invert” the yield curve creating a mini cycle that drives markets higher for the next few years.
The European Central Bank is unlikely to begin hiking interest rates until 2020 due to fears of a drought in liquidity. Italy is in recession, while Germany is hovering just above one. The U.K. economy is showing signs of a sharp decline, potentially even a recession over Brexit concerns. It is also being battered by the worldwide slowdown due to mounting trade tensions between the U.S. and China. With so much uncertainty, businesses remain reluctant to invest and sentiment remains subdued over the potential disruption of Brexit and weakening sales growth.
The data out of Asia-Pacific had a disappointing tone in the second quarter as exports from the region and manufacturing activity have slowed. Japan’s economy continues to look lackluster, with the planned raising of the value-added tax remaining a risk. The outlook for Australia remains weak, although there have been a number of positive developments that should help the housing market to stabilize. The central bank has also cut rates and appears likely to cut again this year.
Emerging markets as a whole have made remarkable strides with economic and financial reform. While they are not immune to U.S. sentiment or the dollar, they are far more resilient than before. Emerging market equities saw a strong rally in the first part of this year after spending 2018 in a defensive crouch. China remains in focus. Its main objectives are to ensure there is an affluent middle class, rising incomes and positive demographics. While economic data has been mixed to soft recently as a result of the escalating U.S. trade war it is not all bad news. The government has also turned on the stimulus taps pumping credit into the financial system, focusing on infrastructure spending.
Stocks around the world are mostly rallying. Canadian stocks increased by 2.6% in the quarter (all returns in Canadian dollar terms), while the U.S. market climbed 2.2%. International large cap stocks gained 2.0% propelled by European stocks markets, but were held back by weak-to-mediocre Asian and Emerging Market results. Canadian bonds continued to deliver strong returns gaining 2.5% in the quarter and 6.5% year-to-date. So, while the noise of impending doom is constantly being bandied about; the reality is quite investor-friendly indeed.
The second half of the year saw a fragile world economy amid the exacerbating trade war between the U.S. and China. The International Monetary Fund acknowledged that in its April report and cut global growth for 2019 from 3.5% to 3.3%. The agency also downgraded the growth outlook of the Canadian economy in 2019 to 1.5%; down four-tenths of a percentage point from its previous level. That appears consistent with Statistics Canada’s findings of an anemic 0.4% annualized Canadian GDP growth mainly due to falling exports. In spite of that prognosis, the second quarter started with strong GDP numbers against a backdrop of surging oil output and seemed to signal a rebound after sluggish growth in the previous two quarters. The job market continues to defy economists as April added more than 106,000 jobs; the biggest one month job gain in more than 40 years.
Ironically, despite elevated risks on the economic front and in financial markets, stock markets around the world posted arguably the best first half ever with most in double-digit return territory. Canadian markets in particular had a strong first half with a 16.2% total return, out of sync with a sluggish economy but in line with improving corporate earnings and higher energy prices. Strong domestic demand driven by government and business spending has counterbalanced the trade drag in terms of affecting Canadian growth. Additionally, the housing market no longer appears to be highly vulnerable after months of decline.
Halfway through the year most of the TSX sectors continue to impress by posting double-digit returns; a rare occurrence after last year’s beating. Technology was the clear leader gaining 43.8% followed by Health Care at 35.5% and Industrials at 20.3%. In particular, Technology and Health Care have been posting strong gains for some time. The latter due to the legalization of cannabis last year, which significantly boosted cannabis related stocks. Investors’ interest in rotating into Information Technology seems to indicate that that bull run is far from over. On the downside Energy has lagged over the first half of 2019. Though prices improved considerably since the first quarter due to mandatory production cuts by Alberta’s government, the trajectory has been very noisy. Investors wary of trade tensions between the U.S. and China embarked on a technical selloff of the commodity. The sector fell into bear territory in the second quarter after peaking in April and as result it returned an anemic 1.1% for the first six months. One notable development in recent years is that the sector has been out of favour with International players who have been selling their Canadian energy assets. Canadian players jumped on the opportunity and it is estimated that they spent about $37.4 billion consolidating assets in the oil sands in an effort to become more efficient.
The first half of the year saw Canada’s yield curve invert the most in a decade and that fueled speculation of an imminent recession. Also the GDP slowdown during the period has added to investors’ anxiety. On a positive note, consumer spending is strong and fears of a housing market collapse appear increasingly unlikely. The first GDP reading of the second quarter signaled some turnaround in the economy although overall 2019 growth has been revised down. The Bank of Canada, in its latest update on the economy, made it clear that it will move to a more dovish tone should economic growth continue to fall behind its outlook. Thus there still appears to be opportunity for the economy to maintain its resilience and propel the Canadian market even higher.
During the second quarter of 2019 the Canadian FTSE TMX Universe Bond Index gained 2.5% and has risen 6.5% so far this year. Bonds have rallied as expectations for future central bank interest rate hikes have fallen dramatically. A few months ago there were expectations for a series of hikes but we have not seen any changes to base rates so far this year in the U.S. or Canada. Over the course of 2018 the Bank of Canada raised rates in July and again in October bringing the Canadian interest rate benchmark to 1.75%. In the U.S., the Federal Reserve increased its benchmark interest rate in December 2018 to the target range of 2.25% to 2.5%. Major central banks have remained accommodative as global inflation has remained low and global growth is moderate. In Europe, the European Central Bank is not expected to hike rates in the near term. In China, policy is expected to remain easy but authorities there are cautious as financial conditions could become too stimulative.
Canadian interest rates are almost certainly on hold until at least 2020. The Bank of Canada published a revised outlook that showed that the economy stalled at the end of 2018 but the bank’s 2019 Financial System Review also found that progress has been made on two key factors, household debt and housing affordability. The challenges associated with high household debt and imbalances in the housing market have declined modestly. The share of Canadians falling behind on their debt payments remained relatively low while housing resales and price growth have slowed significantly in Toronto and Vancouver over the past two years. These factors are alleviating some of the policymakers’ concerns over inflation. Their policy announcements do not suggest that interest rates would rise in the foreseeable future.
Gross domestic product was growing at an annual rate of 2% in the third quarter of 2018 but then decelerated to rates of 0.4% in the fourth quarter and 0.3% in the first quarter of this year, according to the central bank’s quarterly Monetary Policy Report. Governor Stephen Poloz noted that the central bank had allowed for a slowdown due to lower oil prices but their expectations for strength in non-energy exports have disappointed. Both have struggled and are robbing the economy of an offset to the falling investment in real estate and weaker household consumption. The Bank of Canada predicts a rebound will be ignited by growth in the second quarter but the recovery likely won’t be big enough to offset the damage already done. The central bank now predicts GDP will expand by a tepid 1.2% in 2019. That means there is little danger of the economy generating rapid inflation and explains why policy makers stopped talking about the need for higher interest rates.
In the U.S. the Federal Reserve got some attention in late June for putting out a statement which seemed to change its previous promise that it would be “patient’’ before cutting interest rates. The market took that to be a call for an imminent rate cut, however the Fed Chair, Jerome Powell, followed up with a press conference where he pointed out that the most recent data, such as the June retail sales report, were quite a bit better than expected. He noted that consumer spending is more than two-thirds of the economy and that the service sector is strong. To be sure, there are problems as there were signs of weakness in business investment in the second quarter, especially in manufacturing. There are also concerns about weakness overseas, which may be partly due to China trying to reduce its debt load and growing more slowly. Another is cheaper oil but cheap gasoline means consumers have more money to spend on other things. There is also a risk to global supply chains and these events do bear monitoring but if the economy keeps chugging along it will be hard for central bankers to cut rates without signs of declining inflation.
The market has long feared the end of the ten year old expansion but the odds of a recession this year are still quite small. Economic expansions are not limited by time as demonstrated by Australia which has now gone 27 years without a recession. In North America consumer balance sheets are fine, the job market is in decent shape and there’s little inflation to be found. At this time there don’t seem to be any compelling reasons to break out of the current steady interest rate scenario.
The books are now closed on a tumultuous first half of 2019 that saw volatility surge thanks to trade war fears. U.S. equities advanced strongly in the quarter, despite heightened geopolitical tensions, as the Standard & Poor’s 500 index climbed 4.3% in U.S. dollar terms over the second quarter. Year to date the index is up a stellar 18.5%. In Canadian dollar terms the respective change was 2.2% for the quarter and 14.5% year to date. The loonie gained 2.1% during the second quarter and it has increased by 4.1% so far this year.
The long bull market in the U.S. has now passed its tenth birthday and the recent run-up in U.S. stock prices may seem surprising for those who have been waiting quite a long time for a market reversal. Certainly there is no shortage of things that can go wrong with the long running global expansion which has been led by the U.S. For example, the world’s two largest economies are locked in a trade dispute that tests competing visions of national economic management; the UK is lumbering toward a decision on exiting the Eurozone as the politicians relentlessly push the hard decisions further and further into the future; reforms in France have sparked protests; and leadership contests in Italy, Brazil and Mexico have lent support to various populist extremes.
In the U.S., the political system appears to be dysfunctional and the government will face challenges as a new fiscal year begins in the fall with the pressing need to fund ongoing operations. Paying for all these services will require that the government debt ceiling be raised once Treasury Secretary Mnuchin has run out of tricks to keep the government funded. Despite all the negative tidings, there is the potential for deals to get done and in particular the global economy may arrive at a net improvement in trading relationships, with better protection of intellectual property rights and increased openness of Chinese markets. That being said, global trade growth is likely to be slower than in its heyday before the Great Recession.
Investors seem to believe the Federal Reserve is correct to keep interest rates unchanged for now, with expectations that rates may move lower later this year to sustain economic expansion. Fed Chair Jerome Powell deserves credit for preaching patience to an administration that seems to expect immediate results. This honeymoon could linger for a while yet but the trade war means there will be an inevitable uptick in prices for manufactured goods coming from overseas. So far though, inflation has been kept at bay as firms are reluctant to raise prices. They are afraid of losing business but have been able to keep a lid on labour costs by finding a surprisingly large number of new workers. More people are getting jobs than policymakers once thought possible and wages and prices aren’t spinning out of control the way some had predicted.
Beyond the slack in the labour market, forces like technology and globalization may also be keeping prices down as consumers with Amazon in their pockets can easily avoid overpaying. In fact the Fed’s chairman has called weak inflation “one of the major challenges of our time.” Some policy makers think there is room for a rate cut while inflation remains stuck below the central bank’s 2% target. That could further stimulate the economy, helping to create more jobs and boost wages without pushing prices too high. But lowering rates is posing a challenge for the Federal Reserve as keeping rates low could also hinder the central bank’s ability to manage the economy when the next downturn occurs.
The U.S. equity market continues to show signs of late cycle angst but, while trade disputes may generate negative headlines, there may be light at the end of the tunnel. China and the U.S. will be driven to reach an agreement as the threat of not doing so becomes increasingly evident. In the meantime the underlying strength in the economy and a healthy earnings outlook should be supportive of U.S. equities.
Global growth has stabilized in the U.S. and China while Europe is likely to move in an upward trajectory by the end of the year. While economic data has largely normalized it does not mean that there should be an expectation for significant growth over the remainder of the year. With global inflation remaining benign, there should be opportunities for central banks to stimulate their economies as needed. However, there are still meaningful downside risks thanks to political uncertainty and weakness in the global industrial sector.
Europe’s long anticipated growth rebound remains just that; anticipated. European stocks did manage to rise despite signs of slower economic growth, escalating trade tensions and dampened investor sentiment. Political turmoil also weighed on markets with a new populist ruling coalition in Italy, political protests in France and increased uncertainty about Brexit. Meanwhile, Spain ousted its Prime Minister amid a political fundraising scandal, which has further heightened uncertainty. The European Central Bank announced it will begin winding down its massive bond-buying stimulus program and has made it clear that it would not consider raising interest rates until at least late 2019.
The Bank of England cut its forecast for the U.K. economy to zero as global trade tensions and growing fears of a no-deal Brexit are becoming omnipresent. Britain’s economy is now on track to stagnate in the second quarter, due to the likely hangover from rapid stockpiling by companies earlier this year as they scrambled to prepare for the Brexit deadline. There is a mixed picture for inflation as wage pressures have leveled off despite the labour market remaining tight. If there isn’t a smooth Brexit process in place the central bank fears a chaotic exit from the EU would hurt Britain’s already weakened economy dramatically and probably mean interest rate cuts.
Japanese stocks finished in positive territory after a very turbulent quarter affected by the U.S. / China trade war and news of a decline in the country’s growth rate. However, the falling Yen gave a boost to Japan’s export-driven corporations. After an impressive run of nine consecutive positive quarters, this quarter’s negative growth should allow the Bank of Japan to maintain an ultra-loose monetary policy, particularly since labour markets are tightening without prices rising.
Despite a host of supportive steps since last year, China’s economy is still fighting to get back on firmer ground as investors fear a longer and costlier trade war with the U.S. China’s industrial output growth unexpectedly slowed to its weakest level since early 2002 and investment cooled, which should trigger additional monetary easing in the coming months. China has weathered the latest downturn so far by injecting further stimulus including hundreds of billions of dollars in infrastructure spending on road, rail and port projects, as well as tax cuts for companies.
Globally, stocks advanced by 4.0% (in U.S. dollar terms), apparently unperturbed by the worldwide turmoil over trade. European stocks led the charge gaining 4.9%, propelled by Germany’s 7.8% surge; while the U.K. essentially brought up the rear by eking out a 0.9% gain. Asian stock as a whole were up 1.3%; which was led by Australia’s scintillating 7.4% climb but constrained by Japan’s weak 1.1% uptick and Hong Kong’s small 1.0% increase.
The further maturity of the global business cycle is likely to increase uncertainty. As the cycle matures, tighter labour conditions tend to put upward pressure on wages and generate headwinds for corporate profit margins. On the other hand, consumers seem healthy as strong job markets and rising wages have led to decent spending rates. Global growth will remain in expansion mode, but the outlook is deteriorating and may have passed its peak. Looking forward, the world will continue to muddle through especially if all major economies once again prioritize supportive monetary policies.