It was an eventful three months across financial markets, with a plethora of economic data, global trade developments and monetary policy matters to keep investors occupied. While the global economy’s overall growth trends remained encouraging, several market risks managed to suppress investor appetite.
Domestically, there were plenty of reasons to celebrate Canada’s 151st last quarter, as the nation has enjoyed a year of successes underpinned by a strong macroeconomic backdrop. Wages are growing, jobs are abundant, exports are rising, and the economy is running at full capacity. Nevertheless, a cloud of uncertainty is darkening the economic outlook amid an eroding trade relationship with the U.S., concerns over an aging business cycle, and housing market risks. The stricter mortgage rules that took effect in January have cooled the country’s hottest markets, but have not precipitated the kind of crash many analysts had feared.
Globally, economic growth trends remained upbeat throughout the quarter. We have noted, however, that while the U.S. economy continues on its path of gain, growth rates have tapered in Europe, Asia and select emerging markets. The change of pace has certainly not swayed central bankers’ intentions to raise interest rates in North America. Yet across the pond, the ECB will only begin weaning the European economy off stimulus next year. Meanwhile, Japan will lag its peers in dialing back crisis-mode policies, motivated to maintain ultra-low interest rates due to sluggish inflation and large levels of public debt. Global quantitative easing is thus on course to end later this year (See Chart). And while it is still premature to be concerned over U.S. inflation levels, the closely-monitored core personal consumption price index reading reached the 2% target level for the first time in six years last quarter.
The more disconcerting theme remains the growing litany of trade risks and government policies that threaten to stifle global trade. We believe that if these tensions are not ultimately settled, trade wars could cause undue harm to economic growth. Higher input costs via imposed tariffs and rising energy prices could further incite inflation.
In a replay of what we saw during the first quarter of the year, the Canadian bond market began Q2 on weak footing, with yields increasing across the entire curve in early April as inflationary and supply concerns, as well as strong economic data in the U.S., led investors to demand higher compensation for the increased risks. However the sharp increase in long-term rates began to reverse in the second half of April on news of weaker global economic data and easing geopolitical tensions. Despite continued Canadian economic strength, the Bank of Canada chose to leave interest rates unchanged at their April meeting citing various risks to their outlook, namely housing market risks, record debt levels, and NAFTA uncertainties.
May felt like a repeat of April, with the Canadian bond market experiencing a significant sell-off during the first half of the month, in tandem with U.S. rates (despite the Fed leaving interest rates unchanged at its May meeting). All of this was reversed during the second half of May, with long-term rates ending the month lower and short-term rates ending only slightly higher. The Bank of Canada once again chose to leave the overnight rate unchanged at 1.25% at its meeting on May 30. The remainder of the quarter continued to exhibit volatility, particularly at the long end of the yield curve, but ended in positive territory with long-term bonds outperforming short-term counterparts and the yield curve flattening slightly. Despite continued strength in Canadian economic fundamentals, corporate credits spreads widened slightly during the quarter, particularly across short- and medium-term bonds. For the quarter, the Canadian bond market (FTSE TMX Canada Universe Bond Index) returned 0.5%, with the long-term bond market up 0.9% and the short-term bond market up 0.3%.
We have begun to see mixed economic data in Canada with a shift in the drivers of economic growth and a deteriorating trade relationship with the U.S. Nevertheless, the Bank of Canada remains reasonably upbeat about the Canadian economy and increased the overnight rate at its July meeting. We expect that continued global trade uncertainty, including the impact of tariffs on economic growth and consumer prices, will result in ongoing volatility within the Canadian bond market. Consequently, we continue to focus on shorter-duration, high-quality bonds within our client portfolios, in order to preserve capital while being mindful of the need to provide protection should equity markets consolidate.
In stark contrast to 2017, where equity markets and economic growth across the globe were synchronized, the first half of 2018 has been one of divergences. At the start of the year, markets dealt with turbulence as investors began fretting over rising inflation and the prospect of global trade wars. The resulting impact on interest rates and currencies had different implications for individual countries.
While the ongoing trade spats remain front-page news and the tariffs imposed will have real consequences, investor concerns have subsided in cases where earnings growth continues to move higher and where the economic impact appears manageable.
After being the worst performer in both CAD and local currency terms in Q1, the Canadian equity market posted a strong performance in the second quarter, driven by the sharp rebound in both the energy and health care sectors (primarily cannabis-related stocks), as well as ongoing strength in the technology sector. In fact, the Canadian equity market was one of the best performing markets in Q2, even ahead of the U.S. market, which continued to move higher on strong economic data and corporate earnings. In the U.S., robust activity levels and tax reform have analysts forecasting a 21% increase in S&P 500 earnings for 2018. The underlying earnings growth appears to support stock prices despite equity valuations remaining above historical levels. For the rest of the world, however, the narrative has not been quite as rosy. GDP growth forecasts have edged downwards for larger developed economies, leading economic indicators have been weak, earnings growth has been softer than in the U.S. and currencies have been under pressure relative to the USD. All of this resulted in weaker equity market returns compared to the U.S. and Canada, with emerging markets posting a decline after being the top performer in Q1.
Although a negative for Canadian travellers and importers, the continued CAD depreciation was a positive for client portfolios as it bolstered loonie-denominated returns. For the quarter, the S&P/TSX, S&P 500, MSCI EAFE and MSCI EM Indices returned 6.8%, 5.5%, 1.0% and -6.0% (CAD), respectively.
As the numbers illustrate, in any one quarter (or year), equity returns can vary significantly from one region to the next. This highlights the importance of geographic diversification in reducing portfolio volatility and generating higher returns over the long-term.
Despite the resurgence of market volatility this quarter, we continue to maintain a cautiously optimistic outlook on financial markets. A broad range of economic indicators highlight that the global economy remains in expansion mode. In addition, corporate earnings growth is gaining momentum in both developed and emerging markets. We are however mindful of risks related to the withdrawal of monetary stimulus, rising inflation, and historically elevated asset valuations. Our sub-advisors have proactively shifted their strategies over the last year in order to manage these risks, with emphasis on capital preservation.
Our portfolios continue to favour high-quality equities over cash and bonds. Our fixed income mandates hold shorter duration bonds to minimize interest rate risk, as well as higher credit quality so as to reduce credit risk. Within our equity portfolios, the objective is to remain globally diversified in order to benefit from the growth resurgence in developed and emerging markets. We continue favouring well-established dividend-paying companies with a track record of thriving through market cycles.
