Knowledge Centre

Q3 2018

MARKET COMMENT

In 2017 the global economy enjoyed its strongest expansion since 2011 but it is slowing slightly this year. While global growth is coming off its recent peak, there are very few signs that any slowdown will be sharp. Growth is set to remain steady in Canada, the U.S. and Japan, while slowing in Europe; although prospects for Asian giants China and India have brightened enough to offset a mild deceleration in rich countries. Still, with the economic expansion in the U.S. now entering its 10th year, investors must remain alert to signs of an eventual decline and any foreshadowing of a downturn.

The Canadian economy shot ahead in the second quarter after a surge in exports of energy, aircraft and pharmaceutical products. However this came with little momentum and is unlikely to be sustained over the remainder of the year. Consumer spending growth has moderated since 2017 and is not expected to add much of a helping hand despite monetary policy remaining accommodative. Many businesses are reporting capacity constraints across a range of industries and headline inflation is running above target. Given this, the probability of further increases in interest rates is high now that the uncertainty of NAFTA is behind us, which will allow the Canadian dollar to find support.

The U.S. is experiencing its longest post war economic cycle as the stimulus from corporate tax cuts and increased fiscal spending have lengthened the expansion. However those actions are now leading to higher interest rates. Inflationary pressures are building up both on wages (albeit gradually) and on the cost of goods and commodities. Job growth is good with unemployment near 18 year lows. Inflation combined with the ongoing global trade brawl will likely reinforce the need for gradually raising interest rates.

Europe has once again started to decelerate after growth peaked in 2017, but it can continue expand at an above-trend pace driven by domestic demand. There are initial signs of upward pressure on inflation which will likely to reinforce the cautious approach of gently removing stimulus in the belief that a range of risks from protectionism to emerging market turbulence and Brexit will not be enough to derail growth. The U.K. is experiencing its weakest expansion since 2012 as the inflationary effect of currencies following the Brexit decision is hurting consumers and trade worries are denting business demand.

Emerging markets are experiencing their worst losing streak since 2002. Since the trade friction between China and the U.S. began, developing countries have been in a precarious situation as much of the investment community have taken a “hands off” approach; waiting for the selloff to run its course and then return to cheaper and oversold financial markets.

The rest of the world outside of the U.S. was for the most part swimming in a sea of red ink after losing ground during the quarter. On the last day of the quarter due to NAFTA induced trade worries the Canadian stock market slipped into a loss of 0.6% for the quarter after being in positive territory the day before. The U.S. stock market is within 1% of its all time high, gaining 6.0% (all returns in Canadian dollar terms), its biggest quarterly gain since the end of 2013. International stocks fell, down 0.4%, on the back of weaker European and emerging market stocks. Canadian bonds once again lost value, down 1.0% with longer dated bonds taking the brunt of the impact and shorter dated bond holding steady.

Global economic growth has started to decelerate and is expected to slow further in the coming years. However, at this stage domestic demand is continuing to be the main driving force behind the expansion, particularly in light of the uncertainty about tariffs. Global inflation will likely continue picking up, while currencies in the developing world have been hit by a toxic mix of a strong U.S. dollar and rising U.S. interest rates, contributing to investor uncertainty.


CANADIAN EQUITIES

The Canadian economy has been very resilient even in the face of tariffs and trade war tensions with the U.S. thanks to surging exports and strong domestic demand. In the markets, the apathy towards Canadian equities, particularly in the resources and financial sectors, has been evident. As a result, the S&P/TSX struggled to remain in positive territory with -0.6% total return over the quarter while in the U.S., the S&P 500 posted a strong 6.0% return in Canadian dollar terms.

The share price performance year to date has been mixed at times but overall in favour of momentum stocks in the Health Care and Technology sectors. In the Health Care sector investors seemed to be chasing easier returns with pot stocks. These can see large gains in matter of days thanks to the upcoming legalization of cannabis in October. Conversely, sentiment towards traditional economic sectors such as Energy appears to be creeping lower and lower despite the strong rally of the energy benchmark price. Western Canadian Select (WCS) is the Canadian energy benchmark and it has been experiencing another round of challenges despite higher energy prices elsewhere. Some of its contracts have traded at a US$40-per barrel discount to its American counterpart the WTI (West Texas Intermediate) and that explains the energy sector’s underperformance.

The relatively strong performance of the Canadian economy has moved it into almost full capacity, which is creating inflationary pressures. July’s inflation reached its higher level in seven years which prompted the Bank of Canada to raise the interest rate to 1.5%, the highest since 2009. Following months of negotiations, a tentative deal on NAFTA was reached at the end of Q3 and this new development should boost sentiment positively after a protracted period of anxiety with adverse consequences to some sectors of the economy.

During the last nine years, global markets have been mostly bullish and we continue in one of the longest bull runs in history. However the Canadian markets have not been on par with other global markets over that period in terms of realized returns despite strong corporate earnings (especially in the larger sectors like Financials). Canadian market underperformance appears ironic as its economy has been one the best performing in the world, reaching a four decades low in unemployment numbers a few months ago. The tentative agreement on NAFTA as well as efforts to improve the WCS Canadian energy price should relieve the pressure on the Canadian market and pave the way for more positive results.


FIXED INCOME

The Canadian FTSE TMX Universe Bond Index fell 1.0% in the third quarter of 2018. Year to date the index is slightly in negative territory reflecting a 0.3% loss.

The Bank of Canada raised its key lending rate by another quarter point in July to 1.5%. The bank noted that there were a number of encouraging signs for the economy as the housing market is stabilizing, energy prices are climbing and businesses are spending. The bank expects the global economy to grow by about 3.75% in 2018 and 3.5% in 2019, and remarked that the U.S. economy is proving to be stronger than they expected which is reinforcing market expectations of higher U.S. interest rates and supporting a strong U.S. dollar. Meanwhile, the Canadian dollar is lower, reflecting both U.S. dollar strength and concerns about trade wars. The central bank is concerned that trade protectionism is the most important threat to global prospects.

The U.S. Federal Reserve raised its benchmark interest rate in September for the third time in a year, pushing the upper bound of the widely monitored rate range to 2.25%. The U.S. has now raised interest rates nine times since the financial crisis. U.S. Federal Reserve Chairman Jerome Powell, discounting the risk that a trade war may throw a global recovery off track, said the economy is on the cusp of several years where the job market remains strong and inflation stays around the Fed’s 2% target.

Fed officials warned last year that there was no need for a tax cut in the midst of a steady economic expansion. President Trump and Congress ignored that advice, cutting taxes and increasing spending. The result has been a short term increase in economic growth, which has reinforced the Fed’s conviction that it needs to continue raising interest rates to maintain control of inflation at roughly the 2% annual pace. Low interest rates, a stable financial system, ongoing global growth and the boost from recent tax cuts and increased federal spending continue to support the U.S. economic expansion. The Fed chairman explained that after a solid start to the year, growth appears to have accelerated as “robust job gains, rising after-tax incomes and optimism among households have lifted consumer spending in recent months. Investment by businesses has continued to grow at a healthy rate,”


U.S. EQUITIES

The Standard & Poor’s 500 index, which tracks the stock prices of the 500 largest public companies in America, rose 7.7% in U.S. dollar terms over the third quarter of 2018 and in Canadian dollar terms the index was up 6.0%. Year to date the benchmark is up 10.6% and in Canadian dollars it was ahead 13.8%. U.S. stocks flourished in the third quarter and broke several records in the process. The S&P 500 share index hit a new milestone on August 22nd when the benchmark index marked 3,453 days without a fall of 20% or more. By many metrics that makes it the longest bull-run in index history, starting from the low set on 9 March 2009 when the world was reeling from the financial crisis. Since that date the index has more than quadrupled.

Like July and August, Wall Street maintained its bullish run in September even though September is traditionally notorious for seeing strong downturns. Despite lingering trade related concerns especially between the United States and China, Wall Street’s robust performance in the third quarter was fueled by strong earnings results and solid macro-economic data. U.S. Gross Domestic Product expanded at a 4.2% annual rate in the second quarter of 2018, its fastest pace in three years, according to the Commerce Department.

The unemployment rate remained at an 18 year low of 3.9% and average wages increased at a rate of 0.5% in August, the best pace since January. Personal income rose 0.3% in August while the personal savings rate remained unchanged at 6.6% from July. The Conference Board reported that the U.S. consumer confidence index for the month of August jumped to 133.4, marking its highest reading since October 2000.

A long string of corporate takeover activity in the U.S. and a better than expected second quarter earnings season on Wall Street have pushed equity markets to lofty levels. U.S. corporates earned record high profits in the first two quarters of 2018. In the first quarter, total earnings of S&P 500 companies were up 24.7% on 8.7% higher revenues and in the second quarter, total earnings of S&P 500 companies were up 25.2% on 8.7% higher revenues.

Steady economic growth over the last year hasn’t resulted in accelerating price pressures even though unemployment has dipped to levels officials believe should force employers to raise wages and prices. An example of this is Amazon which announced that it would begin paying all U.S. employees, including part-time, seasonal, and temporary workers, at least $15 an hour. In the coming months, the company will need to attract 100,000 seasonal employees in the U.S. Amazon has a high employee turnover rate which is very costly due to constantly recruiting and training workers, so paying a higher wage should help retain workers.

There are signs that we are in a classic late cycle expansion as we are seeing an economy with almost full employment and slowing momentum which tends to foretell a decline in corporate profit margins, but while the U.S. may well be in the mature stage of the economic cycle, there is still time and room for equity markets to run.


INTERNATIONAL EQUITIES

The trade war is now a reality. U.S. protectionism is materially affecting what is still a strong global economy. Global growth is becoming less balanced and less synchronized, as each marketplace is being impacted differently. Despite softening growth, inflation seems likely to move higher. If the slowdown remains modest then central banks can continue to gradually claw back monetary policy stimulus; but hopefully not all at once.

In Europe, growth is slowing again in what has become a recurring pattern over the past decade of shallow expansions followed by aimless meandering with a whole lot of worry and excessive arm waving. Of course, adding another developing crisis (think back to Greece and Brexit) as Italy is now a concern. Its woes are coming to the forefront because of worsening debt levels and fiscal foolishness which could ultimately spread and trigger a recession affecting all of Europe. Add to the picture less than cheery inflation levels, and the degree of investor worries have been ratcheted up a notch.

The U.K., which is world’s fifth largest economy, has steadily slowed since the referendum decision to leave the European Union. With less than eight months until Brexit is supposed to occur, the prospects are for even slower growth and home grown inflationary pressure. While the Bank of England has pushed interest rates above their financial crisis lows, no one should get too excited about this being a sign of things to come as the level of future uncertainty is creeping higher.

Australia’s economy remains one of the few exceptions as it continues to achieve solid growth levels, supported by government infrastructure programs, strong household consumption and an upbeat business environment. Interest rates remain at record lows with policy tightening still a ways off. Nonetheless, challenges are growing for the resource rich economy as the U.S. stokes trade tensions and turbulence roils some emerging markets threatening to slow worldwide growth.

China’s economic pace is slowing as efforts to crackdown on riskier lending (that has driven up corporate borrowing costs) is prompting the central bank to pump out more cash by cutting reserve requirements for lenders. Exports have weakened as a trade war with the U.S. intensifies. Softening real estate activity continues to weigh against strong consumer spending in China’s economy as it rebalances away from government driven investment and the export sector.

The Emerging Markets have been hit by a series of country specific shocks (Turkey’s credit-fueled growth running out of steam; Argentina’s policy missteps) and tightening financial conditions that have contributed to bouts of volatility and sharply depreciating currencies. As the fundamentals of most countries are generally robust and holding up, the overall impact of trouble spots should be limited over the long term.

Japan’s stock market reached its highest level since 1991, gaining 8.7% (all returns in U.S. dollar terms) in the quarter. This spearheaded the Asian stock markets to the largest gains of any region, up 2.6%. While international stock markets overall increased 1.4% in value, Europe climbed a meager 0.4%. The Emerging Market selloff had slightly reversed by the quarter end so they were only down 0.9%.

The global expansion remains steady supported by the above average level of U.S. growth. Yet the range of potential economic activity is widening. While stimulus fueled economies and productivity gains could further support growth, risks are escalating with the outbreak of trade disputes, rising price pressures and tighter financial conditions that will likely lead to a period of softer global growth.

 


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