Just over a year ago, there was much talk of declining global growth, deflation, and an elevated risk of a U.S. recession. Along with the damage caused by $30 oil, this negativity is now receding. Along with positive shifts in economic activity, higher inflation prospects are now evident concurrent with the end of the negative commodity shock and its deflationary effects.
Leading economic indicators, most notably equity markets, are showing gains lately. Most major global equity markets had strong returns last quarter, with a good portion of the optimism attributed to prospects of tax reform, less regulatory burden and fiscal stimulus promised by the newly elected President Trump. Credit for the rally should also be shared by firming fundamentals. Global growth has been surprising on the upside and corporate profits are now emerging from their “earnings recession”. A risk-on sentiment has now taken hold. Even the Fed’s quarter-point hike to interest rates in March has been a non-event for equity markets.
Ever mindful of elevated valuations in U.S. markets and the reality that economic growth is below historical averages, we are measured in our enthusiasm for U.S. equities as an ongoing contender for market leadership. The first quarter gain to U.S. equities since the Trump election has been supercharged by multiple expansion. Now in its ninth year, the post-crisis recovery has been supported by an ultra-low interest rate environment – support that is slowly fading with the Fed’s each move. What’s more the efficacy of the Trump administration has recently been called into question due to an inability to deliver on a key campaign pledge to reform the health care act (Obamacare). Trump has much more to accomplish. He needs cooperation from Congress to pass some positive legislation. He is back to working on revising Obamacare, with a need to saving big money to use to finance planned tax cuts. Meanwhile, the European economic union is facing challenges and there are growing geopolitical risks arising from North Korea, Iran, and Russia.
After a mere three months from the last rate hike, the U.S. Fed found another opportune moment in March to raise the funds rate by a quarter point to between 0.75% and 1%. Taking advantage of equity market strength, the Fed’s move signals that it has become less cautious, believing that the downside risks from the global economy and particularly China have diminished. While it is interesting to note that the Fed did not revise its previous forecasts for growth and inflation, the key message is that the economy is evolving as planned, and consequently, the Fed is following through on its intended hikes. Analysts expect that in response to rising inflation, the Fed will hike rates a total of four times both this year and next, taking the fed funds target range to between 1.50% and 1.75 by end-2017, and to between 2.50% and 2.75% by end-2018.
Despite March’s rate hike, fixed income markets rebounded somewhat last quarter with longer-dated maturities outperforming shorter maturities. The Canadian and U.S. broad-based bond indices advanced 1.2% and 0.8% respectively in the past 90 days, suggesting that the -3% rout in the final quarter of 2016 fully priced in the near-term threat of rising interest rates. The yield on U.S. 10-year Treasuries peaked at 2.65% in December and has been trading in a narrow range since then. Bond yields followed a similar pattern in other major regions, with corporate bonds performing slightly better. The fact that yields have risen so rapidly since last summer has greatly reduced the near-term valuation risk in this asset class. However, given the FED’s stated plans, the long-term direction for yields is higher from these historic lows necessitated by the global financial crisis.
Strengthening reflation would indicate that investors have seen the low point in bond yields after a multi-decade slide. As a result, we foresee most bond markets being challenged as yields rise. Despite the positive economic outlook, there are limits to how high yields can go in an environment where the GDP growth is below historic trend. In contrast to the U.S., central banks in Europe and Japan appear set to keep running ultra-easy money policies. Fund flows are exerting downward pressure on long-term yields as investors take advantage of relatively high yields in North America.
|Major Canadian Indices|
|S&P/TSX Capped Cdn. Sector ETF Indices|
|Cdn. Consumer Discretionary||7.0%||15.0%||13.1%||18.2%||7.5%|
|Cdn. Consumer Staples||3.1%||3.2%||20.1%||21.3%||12.5%|
|Cdn. Health Care||-2.8%||-23.8%||-7.9%||3.2%||6.2%|
|Cdn. Information Technology||7.7%||12.9%||18.0%||18.5%||6.6%|
|Cdn. Telecommunication Services||6.9%||14.1%||14.0%||13.6%||10.0%|
|Cdn. Real Estate||4.7%||9.2%||11.3%||11.1%||6.7%|
|S&P 500 (LargeCap)||5.2%||20.4%||17.5%||20.0%||9.1%|
|EAFE (Europe, Australasia, Far East)||6.6%||15.3%||7.4%||12.6%||3.0%|
|EM (Emerging Markets)||10.6%||20.8%||8.1%||7.2%||4.6%|
Surprisingly strong economic data, surging consumer and business confidence, and better-than-expected earnings propelled stocks higher in the past quarter – most major indexes delivering gains in the mid to high single digits and market leadership exhibited by Emerging Markets and Europe. U.S. equities had a healthy climb despite rising valuations while the gains for Japanese and Canadian stocks were more modest. U.S. equities, now priced at a premium, will require continued improvement in earnings to foster further gains. Fortunately, S&P 500 earnings exceeded analysts’ forecasts in the fourth quarter and now appear to be accelerating. Notwithstanding the inherent risks of Trump’s protectionist and trade policies on earnings, potential upside exists if and when impactful corporate-tax cuts and infrastructure spending materializes to further accelerate the economy.
In the U.S., equities have seemingly been made “great again” with the S&P 500 rising 9.9% since November’s presidential election. However, the causality of the Trump-Republican bicameral victory appears overplayed. After experiencing consistent gains for 109 trading days, American markets did suffer a 1% “down-day” at the first sign of policy risk – conspicuous from the Republican’s failure to overturn Obamacare. Fortunately, the American consumer is becoming stronger than ever. Rising payrolls, growing wages and a strengthening housing market are materialising into ever-growing consumer confidence – now at a 16-year high. On the corporate side, the earnings recession has reversed course with increasing forward guidance and last quarter’s earnings growing 8%.
Canada’s TSX, while lagging its developed market peers, experienced a good result (+2.4%) – with most sectors positive except for the drag of energy (-9.1%). After struggling in 2016 the outlook has started to improve – leading to revised targets of 2.3% GDP growth in 2017. Despite the optimism, economic risks include: ongoing over-reliance on the housing sector, the renewed NAFTA renegotiations and U.S. tax reform. With these risks in mind and along with low inflation, the Bank of Canada is expected to hold off on interest rate hikes.
Our portfolios also benefited from geographical diversification as market leadership changed to Europe and Emerging Markets last quarter. European equities recently experienced their largest fund inflows in over a year. Eurozone growth continues to surpass previous forecasts and, with rising U.S. rates and Europe’s QE continuing, the euro is expected to decline further, thus benefiting exporters. Inflation is starting to reappear and should eventually affect wages. With proven resilience in the wake of the ongoing Brexit debacle, sporadic terrorist attacks and recent voter rejection of nationalist populism, investors are starting to take advantage of the relative value offered by European stocks – a move that was rewarded with an 8% surge last quarter. Since the financial crisis of 2008, the Eurozone has been fending off deflationary forces. It appears that the ECB’s better-late-than-never QE program is reflating its economy and supporting both economic growth and financial markets. Eurozone growth has been larger and more reliable than the impact on equity markets. This gap can be expected to close over time.
Emerging Markets, long out of favour, are now benefiting from positive shifts in economic activity. Rising global demand for commodities along with improved commodity prices are helping to support the recovery in resource exporters such as Russia and Brazil. China is also seeing its declining growth rate stabilize, a reduction to capital outflows, and improvements to many indicators of economic activity. The risk for China is that interest rates are now rising following a long period of stability and consumers will have to better manage the high levels of debt in that environment. After a year and a half of strong fund outflows, investors are now being rewarded for investing in this significantly undervalued asset class – EM markets returned 10% last quarter.
The expectation of rising yields underpins our above-target weighting for equities over bonds. Stocks typically perform better in reflationary environments as they are more responsive to global growth and offer diversification benefits. With market volatility always a possibility, it is important to keep in mind that equities are best suited for long-term investing, and that the allocation in your portfolio should be geographically diversified and reflective of your investment horizon as well as risk tolerance. Fixed income investments, while considered less attractive in today’s low-interest-rate environment, are an effective diversifier and portfolio stabilizer.