Despite worries over Brexit-induced uncertainties, an overdue Fed rate hike, a German bank on the ropes and a fleetingly possible Trump victory, markets were resilient in the face of it all. Oil price swings continued to be highly and positively correlated to equities – both enjoying healthy gains this quarter.  Equities received an additional boost when OPEC reached a quota agreement.  Oil prices in the range of $45-$60 would still be low enough to support consumer spending, while high enough to provide relief to the most vulnerable producers, including many in emerging markets. Deutsche Bank’s damage from a run-in with the U.S. regulators, while still ongoing, is now expected to be manageable and contained.  The most influential protagonist last quarter was the U.S. Fed.  In contrast to other central bankers, the Federal Reserve Board had investors curbing their enthusiasm – second-guessing the Fed’s ever-increasing hawkish tone.

Decisive action by the Bank of England attempted to skewer any talk of a Brexit-induced recession.  The BoE’s July quarter-point rate cut and stimulus package (the largest since 2009), supported both U.K. and European markets while reversing the downward trend in U.K business sentiment.  So far a recession in the U.K. and Europe has been averted.  Across the channel, markets should have been less enthusiastic about the ECB’s holding pattern on rates and stimulus; however such inaction was interpreted as Eurozone resilience to the Brexit shock.  In Japan, the BoJ creatively contributed to a supportive environment by keeping its deposit rate negative but announcing that it intends to ensure a steeper yield curve as a way to stimulate more bank-led lending.  Finally, the U.S. Fed, after initially setting an increasingly “hawkish” tone, opted to stay on the sidelines – holding firm on their current target rate.

Looking forward, one may reasonably expect an increase in volatility as the resurgence of oil prices feed into a rising inflation rate.  The Fed’s hand will be forced as U.S. inflation ticks up amidst a backdrop of full employment.  In the meantime, Central Bankers are starting to see the limits of monetary policy – especially negative interest rates and flat yield curves.  Easy money policies have fuelled equity multiples to overstretched territory; we are watching to see if corporate America can back these up with a resumption of profit growth.  Lastly, history tells us that markets are largely indifferent to presidential elections, but this time could be different.  A Trump victory, as unlikely as it seems, could also mean more of the same since the Founding Fathers wisely designed a system geared for political gridlock and compromise.

After a disappointing first half of the year, with GDP growth averaging 1.8%, economists worried that U.S. economic conditions had weakened.  However, recent evidence remains encouraging, with GDP hitting 2.5% in the third quarter and projected to be 2% in the fourth.  The American consumer is greatly contributing – having increased spending by 4.3% in the third quarter.  While inflation is poised to reach its 2% target due to the impact of rising energy prices, there is some concern about the undue impact of rising health care costs.  What’s more, declining business investment has been contributing negatively for several quarters now.  Perhaps the American economy isn’t so healthy. Should this important part of the economy continue to struggle, the Federal Reserve would be behoved to temper the pace of rate hikes.

Despite mixed data, many members of the Fed are chomping at the bit to normalize interest rates.  In contrast to Europe and Japan, where yields on cash are negative and negligible on longer term government bonds, U.S. rates are at least positive and have more pitch in their yield curve.  High-yield corporate bonds offer comparatively attractive returns but are susceptible to market shocks.

Fixed income markets experienced muted returns last quarter but are performing well for the year.  The Canadian and U.S. broad-based bond indices returned 1.1% and 0.5% in the past 90 days. The strongest performers were high-yield U.S. corporate bonds (+5.8%) and Emerging-Market debt (+3.8%), benefiting from narrowing spreads.

Given the gloomy tone of the IMF’s latest forecast – showing global growth at close to 3% this year, and 3.4% next, U.S. rates are expected to slowly move higher, while other sovereign yields remain stagnantly low.  Developed world government bonds now trade at negative yields and are at all-time lows due to increased fear caused by disappointing economic growth, and quantitative easing programs.  While the outlook for bond returns is quite modest, diversification along with the inclusion of investment-grade bonds is the key to downside protection in any portfolio. Historically, fixed-income strategies with designated allocations in high-quality bonds have outperformed other approaches during phases of market decline.

Fresh off the uncertainty created by the Eurosceptic win of the Brexit vote, investors sighed in relief as markets rallied from a short-lived sell off.  After weathering the Brexit storm, markets began the third quarter with strong momentum before settling into summer doldrums.  Apart from a positive trickle of U.S. economic data, investors were primarily motivated by continued accommodative Central Bank monetary policy.

The lion’s share of market gains last quarter occurred in the first month of trading, accompanied by incremental gains thereafter.  The developed world index more than recovered its Brexit losses.  The only significant hiccup took place in the days leading up to the Fed’s September rate announcement when U.S. equities experienced a 2% one-day drop over worries of rate tightening – the worst daily decline since the Brexit vote.  The world index was up 4.9%, led by Japan (+8.7%), Europe (+7.8%) and the U.S. (+3.8).

Canada’s TSX also had a strong showing (+5.5%) – most sectors contributing positively.  Negative contributors were Gold             (-5.9%), Health Care (-2.7%) and Materials (-1.1%) – suggesting that the commodities rebound rally has run its course.  Canada’s TSX has impressively kept pace with the U.S. index, returning 14% over the last twelve months.  While this return pattern is counterintuitive given Canada’s weak economy, the rebound in commodity prices has fueled a cyclical rally in the Materials (+56%) and Energy sectors (+23%). The currently positive outlook for these sectors hinges on stable commodity prices. Defensive sectors with higher dividend yields, such as Utilities (+17%) and Telecoms (+22%), now have lofty valuations and are susceptible to both a rise in interest rates and a correction.

U.S. equities continued full steam ahead, up 4.7% for the quarter and 13% for the year.  Reaching record valuation levels, investors in this asset class are prone to fits of negative sentiment resulting from every ebb and flow of economic data.  The U.S. election will also influence interim volatility until a clear winner starts to emerge in the polls.  Of ongoing concern is the impact of the Fed.  While it is reasonable to expect that a slower pace of tightening would support valuations, investors may grow inpatient with the current earnings recession.  Shares in companies with strong balance sheets and sustainable dividends should cope better in that environment.

Emerging Market equities are back in vogue lately, returning 7.4% last quarter – largely due to continued non-domestic fund flows into that asset class.  While historically prone to the risks of a rising US dollar and rising interest rates, the Fed’s dovishness combined with low developed-world growth rates have ameliorated this view.  Despite concerns of a credit bubble, China is also credited with this renewed confidence as its recent-past actions to depreciate its currency policy have helped its industrial sector reflate in addition to reviving its export-orientated sectors.  China’s GDP growth rate has appeared to stabilize – Q3 GDP growth rate was recorded at 6.7%.

Despite recent downgrades, global growth is still nominally positive. Global inflation is well below target, but is not deflationary.  Central banks are still accommodative, and as such, there is still a supportive climate for equities.  U.S. markets are looking relatively pricey, but selective upside remains, especially when corporate profitability resumes its upward trajectory.  Government bonds are overvalued and prone to capital losses when the FED changes its tone.  We favour investment-grade corporate bonds as a key buffer to equity market volatility.  Finally, we look to marginally increase cash positions over the next quarter for added defensiveness.

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