Knowledge Centre

Q3 2019


The stock market’s summer doldrums are over and the start of the historically best quarter of the year is upon us. Of course, the market’s wall of worry is still quite high due to issues such as the lingering U.S./China trade war, general pessimism about the global economy, political turmoil and faltering credit conditions. And yet somehow the world’s financial markets are within close range of all-time highs.

Despite ongoing worries, Canada’s economic expansion in the 2nd quarter was impressive, especially following two straight quarters with hardly any growth. Canada’s second quarter growth was the best amongst G7 countries and the most it has been in any quarter over the past two years. The rebound was driven by the fastest quarterly increase in exports since 2014 and housing investment which recorded its first gain in 18 months. However, surprisingly weak consumption and business investment are raising doubts on the sustainability of this expansion due to concerns over the U.S./China trade war. One thing is clear however; the Bank of Canada will likely join the global trend toward easing monetary policy in the near future.

Weaker consumer spending and business cutbacks on investment sapped economic momentum in the United States. Slowing global growth, the fading effects of the 2017 tax cut and rising trade friction also weighed on the economy. There certainly remain some areas of strength: employment rates near record lows; increasing worker earnings; and tame inflation. Still, the outlook for consumers remains cloudy, as the Trump administration hit China with further tariffs. This is one of the reasons the U.S. Federal Reserve has been cutting rates by a quarter point and also has telegraphed its intentions to make additional cuts.

Meanwhile, Europe has an inflation problem in that there is not enough of it. The European Central Bank has long struggled with its inability to reach its inflation targets, which it has missed every year since 2013. Even though unemployment numbers fell to their lowest level since 2008, the risk of debilitating deflation is rising. So, they have pushed interest rates deep into negative territory, driving bonds further into negative-yielding levels. Germany’s economic performance was the worst of any eurozone country, hurtling it towards recession. Brexit has turned into an utter mess. This mind-boggling drama has pushed the British currency to 35-year lows and has dramatically increased the likelihood of a sharp economic slowdown.

China is hunkering down for a protracted trade war with the U.S. as its economic growth hit its slowest pace in at least 27 years. China’s factory output fell to its slowest pace in 17 years. China is the world’s largest exporter of goods and services, just ahead of the United States and Germany so troubles in China are a bad omen for the rest of the world.

The Canadian stock market is leading the way with its best start to the year since 2000, both for the quarter and year-to-date, climbing 2.5% and 19.1% respectively. Just behind is the U.S. stock market with 2.9% and 17.7%, respectively (all returns are in Canadian dollar terms). Internationally, the third quarter produced meager results at 0.2% for developed markets and -3.3% in the emerging market countries, although they have still achieved 10.5% and 3.3% respectively so far this year. The rate of performance for bonds has slowed down, eking out just 1.2% last quarter, but still earning a very respectable 7.8% so far this year.

For many investors there has been no summer break as they contemplate the future of one of the longest economic expansions in history. Concurrently, the profound demographic headwinds and directional shift away from globalization further muddy the waters. While these issues are important considerations, as the old saying goes, opportunities increase as things appear the murkiest.


The third quarter saw another wave of U.S. tariffs on China, catching investors off guard as they were expecting at least a truce or even an imminent resolution of the global trade dispute. The escalating trade war has already made history by dragging global economies to their slowest aggregate GDP growth rate in a decade. That situation also continues to undermine future growth and some global forecasters, notably Fitch Rating, have lowered their growth forecast for 2019, as well as for 2020. Nonetheless, GDP still hovers far from recessionary levels even though the Purchasing Manager Index (PMI) for 70% of the countries in the world are in contraction (a PMI below 50 for any country signals contraction). Had it not been for the resilience of consumer confidence and spending, the situation would have been much worse. In Canada, where that consumer confidence remains at historically high levels, the economy has been very resilient, creating a solid 304,000 jobs in the first eight months of 2019. That confidence translated into the financial markets and the S&P / TSX, after a blistering first half of the year, continued to be on a roll to reach an all-time high in September before retreating slightly by month end. It closed the third quarter with more than a 19% total return year-to-date, one of the best among major indices.

This outstanding performance should not overshadow the threat of persistent volatility like last August when Canadian stocks lost more than $90 billion dollars, a month which typically saw positive returns 70% of the time over the past ten years. A sector analysis reveals that Utilities, Staples and Financials led the pack during the quarter with respective gains of 9%, 7.2% and 4.2% on a total return basis. These sectors, typically described as value, are benefiting from recessionary fears. Investors seem to be rotating from growth sectors to value as corroborated by the value benchmark which outpaced growth by almost 2% during the quarter. Financials in particular rebounded decently year-to-date but continue to lag the main index by a wide margin. Eight of the largest lenders, which account for 20% of the index weight, contributed less than 10% of performance amid declining yields and continued uncertainties over household indebtedness. The laggards included Health Care with a 30% decline and Energy down 2.2%. Health Care stocks were under severe pressure as the embattled Cann Trust Holdings, once a Bay Street darling among cannabis investors, was accused of illegal production. This negative news spilled over to other high-flying cannabis producers as investors preferred to take their gains after months of outperformance.

The strong year-to-date S&P / TSX performance put it among the strongest stock markets after years of subpar relative performance. This also represents the longest rally since 2017. But the third quarter saw some inflection points as the index posted gains at a decreasing pace and many analysts started making calls for a more defensive portfolio posture.

On the economic front, Canada defied recent downward projections to grow at an annualized rate of 3.7% in the second quarter. However July unexpectedly stalled which raised concerns for the vulnerability of the nation’s economy if there is a global slowdown. With slowing consumer spending still robust, and declining energy and commodity prices, it would be imprudent to predict that the Canadian economy could continue this pace in upcoming quarters. Better news is that concerns over a possible crash in the housing market have now begun to dissipate. The government’s new mortgage rules enacted months ago have created a more balanced environment for homebuyers. There still appears to be some capacity for the economy to deliver decent growth in the near future, especially after the upcoming federal elections if the current or new administration respects their expansionary fiscal agenda.


The Canadian FTSE TMX Universe Bond Index rose 1.2% in the third quarter of 2019 and the index has risen 7.8% so far this year. The Bank of Canada kept its benchmark interest rate steady at 1-3/4% at its September 4th meeting, as was widely expected, and the rate remains at its highest since December 2008. The central bank is almost ready to join the other major central banks in cutting interest rates, but not yet. The consensus agreed by Governor Stephen Poloz and his deputies was to leave the benchmark rate unchanged until at least the end of October.

In a speech to the Halifax Chamber of Commerce on the day after deciding to hold interest rates steady, Deputy Governor Lawrence Schembri discussed the key points the Governing Council considered in their decision. He explained that the Canadian economy continued to show strength despite the weakening global backdrop. The Canadian data since July has been stronger than the bank had anticipated as wages picked up and the housing market rebounded. Overall consumer spending though has been softening and business investment is weakening so the economy is expected to slow over the second half of the year. The U.S. / China trade war was the main risk to the central bank’s outlook in July and it has gotten worse since then, taking a toll on global economic growth.

The decision implies that policy makers think there is enough stimulus in the system to counter the effects of the trade wars for a little while longer. “Canada’s economy is operating close to potential,” the Bank of Canada said in its recent policy statement. “However, escalating trade conflicts and related uncertainty are taking a toll on the global and Canadian economies. In this context, the current degree of monetary stimulus remains appropriate.” That existing stimulus separates Canada from some of the countries where central banks have been cutting rates.

In the U.S., the Federal Reserve cut its benchmark interest rate in September. The rate reduction was the second since December 2008 when the Fed dropped its benchmark effectively to zero before initiating a series of nine raises that ended in December 2015. While the domestic economy has performed relatively well, the Fed cut rates amid concern that softness abroad threatens the decade-long U.S. expansion as President Trump’s trade war with China is hurting foreign demand.

The Fed’s moves are part of a trend around the world as 16 central banks lowered interest rates in the third quarter. Some analysts expect that another two dozen more central banks could slash rates in the fourth quarter and there are concerns that yields on U.S. bonds could turn negative. Negative interest rates represent a threat to the financial system because it operates under a fractional reserve banking mechanism where banks deposit a percentage, usually about 10%, into a central bank reserve account and the rest is either lent out or used to buy securities. This works when rates are positive and banks earn income on deposits but in a negative rate environment the bank must pay to hold loans and securities. In other words, banks would be punished for providing credit, which is the lifeblood of an economy.

Valuation models are another area of finance that will need to be reconsidered in a negative rate environment. Noble prizes have been awarded to economists who developed financial pricing models, but when a negative value is assumed for the risk-free rate the fair value calculation shoots off to infinity. To see the results of low or negative rate environments, look no further than the Eurozone and Japan as they account for 87% of the negative rates worldwide. Europe is essentially in recession with negative GDP in Italy and Germany; and in Asia, Japan is not doing much better. The U.S., UK, Canada, Australia and New Zealand are the only developed bond markets that do not currently have negative rates anywhere on their yield curves. If these countries also move into negative rate territory, the financial system will be under even more stress so these developments should be watched closely.


The U.S. Standard & Poor’s 500 index rose 1.7% in U.S. dollar terms over the third quarter of 2019 and 2.9% in Canadian dollar terms. Year-to-date the benchmark is up 20.6%, its best performance in the first three quarters of a year since 1997. In Canadian dollar terms the benchmark was ahead 17.6%.

The U.S. economy grew at an annual rate of 2.0% in the second quarter as consumer spending rose at a 4.3% clip. However business investment, which was supposed to be juiced by President Trump’s tax cut, fell by 5.5% and exports declined 5.2%. That means consumer spending accounted for all of the economy’s overall growth. Weak business investment cut 1 full percentage point from the rate the economy would have otherwise achieved. This was mostly due to declining inventories from reversing some anomalous inventory buildups in previous quarters. Net exports shaved another three quarters of a point but that was offset by higher government spending, mostly at the federal level.

American manufacturers posted their biggest contraction in September since the end of the 2007-2009 recession, reflecting a slowdown in the U.S. and global economies made worse by a tense trade war with China. The chief reason the economy slowed was a big drawdown in inventories. The Institute for Supply Management said its manufacturing index fell to 47.8% in September from 49.1%, marking its lowest level since June 2009. Manufacturers at home and abroad have faced waning demand and are struggling to cope with a global economic slowdown, exacerbated by the trade war between the U.S. and China, the world’s two largest economies. Manufacturing is a much smaller part of the U.S. economy than it used to be and so far the damage appears to be contained but there is a worry that it will get worse unless the U.S. and China ratchet down tensions.

The weak investment number was largely attributed to a draw down in inventories. Inventories are basically unsold goods such as new cars on dealer lots. When the value of inventories decline, it subtracts from gross domestic product (GDP). Falling inventories cut GDP in the second quarter by a full percentage point to 2.0% compared to the 3.1% pace of growth in the first quarter of the year. While that may seem like bad news, it really isn’t in this case. In the second quarter the value of inventories pretty much had to decline as companies had boosted inventories for three quarters in a row, pumping up GDP in the process, but they ran the risk of getting stuck with lots of unsold goods that they’d have to heavily discount to move, thereby harming profits. So firms did what they had to do. They trimmed production to prevent inventories from getting out of hand so this slowdown was overdue. Not that long ago an inventory overhang could trigger a recession as an excess buildup of goods was often the cause, or at least a big contributor to recessions throughout most of U.S. history. Rarely is that the case anymore. Advances in technology and business practices give companies real-time information on inventory levels, allowing them to adjust almost instantaneously if sales slow. Actual bad news would be if the value of inventories keeps falling and that could threaten the lifespan of a record U.S expansion, now in its 11th year.

The economic numbers aren’t that bad in the context that they may only be a reversion to the 2% to 2.5% mean that U.S. growth has shown since the 2008 financial crisis and not the opening act of a recession. To the extent things are weaker, it is because of softness in China’s economy, which has a number of causes and the one the U.S. can do the most to make better, or worse, is trade policy. This isn’t disastrous and many economists project a slight pickup in growth in the third quarter so GDP is likely to stay in the recent range.

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.


The darkening outlook for global trade is starting to become discouraging. The U.S./China trade war has led to new tariffs on hundreds of billions of dollars worth of traded goods. There is minimal expectation of a pending resolution which will likely continue to impair economic growth. In fact, further rounds of tariffs and retaliation, especially between the U.S. and Europe, could reinforce the destructive cycle of recrimination. Britain’s uncertain exit from the Eurozone is also adding to uncertainty for businesses. Still, investors for the most part have looked past these near-term troubles and as a result have earned meaningful returns this year.

The European Central Bank has begun to take aggressive steps to stimulate the economy and head off any potential downturn. Since 2014, they have imposed negative interest rates on deposits to encourage commercial banks to lend more. In a bid to increase lending, the bank increased this de facto penalty to -0.5% from -0.4% to free up the hoarded cash. As well they have re-started the quantitative easing program to buy government and corporate bonds, a move that pumps newly created money into the economy. This package of measures is also aimed at raising inflation which has been slipping further below targets. The threat of an escalating European/U.S. trade conflict is significantly impacting German consumer spending, which in turn is contributing to weakness in other European economies like Spain and Italy. The German economy is teetering on the edge of recession, as its traditionally export-reliant economy has become particularly vulnerable.

Ever since Britain set Brexit in motion through a referendum in 2016 confusion has reigned. The situation today is even more uncertain. With weeks to go before the deadline, the situation is bewildering. Britain could crash out of the European Union without a deal governing future trade. A no-deal Brexit would entangle trade in bureaucratic and logistical chaos, with a potential election or constitutional crisis on the horizon. This quagmire is not good for business and has burdened the British economy. Business investment has been weak as the economy contracted in the second quarter for the first time since 2012. It is extremely likely that the world’s sixth largest economy is heading into recession.

Japan has shown surprising strength but the country faces its most serious economic challenges in years. Trade wars and slowing exports are negatively impacting growth. Plus the pending increase in the national consumption tax could derail a promising growth streak and possibly throw the country into recession. Japan still has significant strengths; its consumers are spending and its businesses are investing, and they have so far managed to avoid the worst of President Trump’s tariff threats.

International stock markets did not produce positive performance in the third quarter as the weakening world economy, trade wars and fears of a potentially tumultuous Brexit have combined to depress markets. As a whole, stock markets declined 1.0% in the quarter (all figures in U.S. dollar terms); however, they were able to hold onto most of their year-to-date returns, climbing 13.3%. Europe lead the quarterly decline falling 1.8%; while Asia eked out a 0.8% return for the period.

The pronounced deterioration of global trade reflects the dangers that have been growing in recent months and are now beginning to weigh heavily on investors’ minds. Fortunately central banks around the world are cutting interest rates and trying to encourage borrowing in order to stage an economic resurgence. The only questions are will it be enough and is it in time to overcome the prevailing headwind?

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