Q1 2016 | Market update
Sadiq S. Adatia
Chief Investment Officer
Opinions as of April 4, 2016
Canadian equities finally turned higher in Q1
The first quarter highlighted why investing in the equity markets can sometimes feel like being on a roller coaster ride as they dropped sharply in the first half of the quarter before a strong bounce back in the second half. And after it was all said and done, the S&P 500 and S&P/TSX Composite Index were actually higher. The volatility was probably caused by a combination of factors including slower growth in China and the Eurozone, weaker oil prices and mediocre economic news in the U.S. However, oil started to rebound, U.S. job numbers surprised on the upside and with little further noise coming out of China, it helped push markets back up.
Despite a bounce back, many markets still finished down
On March 16, the Fed signaled that there could be four rate hikes in 2016. But when it decided not to raise rates at its first meeting of the year, it caused most investors to lower their expectations to one or two rates hikes this year – a view we have held all along.
The Bank of Canada held rates steady as well (though the bias was toward a rate cut). But the BoC believes the new federal budget should add stimulus to the economy, and as such, a rate cut was not warranted at this time. We think this was a prudent move, given high consumer debt levels and an already elevated housing market.
After lagging behind most equity markets for the past few years, the S&P/TSX was one of the best performers in Q1 up 4.5% led by a rebound in the materials sector.
Resource sectors bounce back
Though U.S. economic data still remains somewhat mixed, U.S. equity markets gained some traction in the second half of the quarter ending up 1.3%.
The European Central Bank lowered rates again and extended its quantitative easing program. Though this was good news, the European market did not react positively, as most were expecting. The MSCI EAFE Index ended the period with a large loss of -2.9% in U.S. dollar terms. The Euro STOXX 50 Index declined -7.7% in local currency.
The MSCI Emerging Markets Index ended up 5.7% in U.S. dollar terms. In local currency terms, Chinese mainland stocks declined by -6.8%, while India also had a negative return of - 2.6%.
Canadian bond yields go lower
North American bond yields were also quite volatile and actually declined further in Q1. As a matter of fact, after starting the quarter at 1.39%, the yield on Canadian 10-year government bonds actually broke below 1.00% intraday during the quarter, before ending the quarter at 1.23%. Weak oil prices and slow economic growth should keep yields relatively low for most of the year.
With the Fed pausing on raising rates, we saw U.S. 10-year government bond yields head lower as well. The U.S. 10-year Treasury yields declined from 2.27% to 1.77% during the quarter. We expect yields to slowly move higher as the Fed raises rates later this year. The spread between U.S. and Canadian bond yields should continue to diverge as their economies continue to move in different directions.
Finally a relief for Canadian equities
This has not been a statement you’ve heard often over the last few years, but Canadian equities were one of the brighter spots in the equity markets.
However, not much has changed in our view from an economic perspective. Though oil prices did rebound a bit, they remain significantly lower than a year ago. Furthermore, energy companies are hardly feeling optimistic. At the time of writing, West Texas Intermediate crude was sitting at about US$36 a barrel, and though we do expect to see prices continue to rise this year, the path will not be a straight line.
Though most sectors were positive during the quarter, the shining star was actually the materials sector, up 20%. The energy sector was also up, returning 8.9%.
It is worth mentioning that the Canadian dollar rebounded during the quarter as well, which does not come as surprise given the bounce back in oil prices. However, this will put even more pressure on an already hurting manufacturing sector. Though we were bullish on the Canadian dollar when it fell below 70 U.S. cents earlier this year, we are now in the fairly-valued camp.
The new government came out with their budget and though they stayed somewhat true to their campaign promises, many were hoping for something more powerful. We were not overly impressed as there was very little to help spur the economy in the short term. The infrastructure spend was good, but will have a more positive impact over the longer term. Overall, we feel it lacked the stimulus to help push the economy out of a difficult position and create much-needed jobs.
We still feel that there will be some pain in Canadian equities next quarter, however, some good opportunities may present themselves. But, as we have always said, patience is the key.
Political risks start to emerge for the U.S. economy
Like most other markets, the U.S. equity market headed significantly lower but rebounded back by the end of the quarter. Economic news remains mixed – good job numbers and decent corporate profits, but weaker manufacturing numbers. The Fed’s decision to pause on their proposed interest rate increases was probably a good thing and should help the U.S. economy continue to grow.
The big question however, remains on the political front. Who will be the next president of the United States - Donald Trump, Hillary Clinton or someone else? It is too early to tell who may be the frontrunner, but is either candidate good for the U.S., or more importantly, for Canada? And as the election nears, we expect a more volatile U.S. market with very little upside.
Since Q3 2015, we have predicted that the U.S. market would hold its own but not hit another new high, and that is what transpired in Q1. We still expect the U.S. equity market to have a positive year, but risks are becoming more pronounced.
Slower progress in the eurozone
The eurozone has had slower progress than we expected. The ECB decision to lower interest rates and increase the amound of QE, did not trigger as much positive momentum as we were hoping. We still feel the eurozone economy is doing the right things, but perhaps the progress will be slower than we first envisoned. Unemployment continues to decline but at a very slow place. Furthermore, the risk of Britain leaving the European Union could have severe consequences for the confidence of investors.
Still too early to be bullish on emerging markets
In U.S. dollar terms, emerging markets bounced back but we don’t think they are out of the woods quite yet. Despite attractive valuations we still have concerns over China in the short term, as well as other markets like Brazil and Russia.
As such, we believe emerging markets will remain quite volatile and the strong U.S. dollar will continue to be a headwind. And despite being bearish in the short term we are more optimistic longer term on emerging markets, particularly in countries like India.
Outlook: Worried about what’s next
Volatility showed it ugly self again in Q1 with markets getting hammered early on before surging in the second half of the period. We believe this type of volatility will persist for most of the year. We remain consistent in our view about the U.S. economy, but when it comes to the U.S. equity market we think risks don’t justify the rewards. The eurozone slowed a bit during the quarter and the catalyst we were expecting (ECB increasing QE) did not really push markets higher.
At home, things continue to look bleak. Oil prices remain low and energy-dependent provinces are feeling tremendous pain. Unemployment has moved higher and will likely continue to trend that way. Consumers continue to tap into credit as they increase their debt. The Canadian dollar dropped below 70 U.S. cents for a short period before bouncing back strongly to end the quarter at nearly 77 U.S. cents. We think this is roughly fair value, but where it goes from here really depends on what happens to oil prices and whether the Fed raises rates in June. We expect Canadian bond yields not to change much during the quarter but to trend higher in the U.S. as the Fed raises rates. This means that Canadian bonds may have a neutral to slightly positive return next quarter while foreign bonds may not be as lucky.
Overall, we feel less optimistic and continue to feel that further upside in most equity and bond markets may be limited. Asset allocation continues to be the key this year given the strong divergence in policies and economies. We are taking a conservative approach and happily wait for opportunities.
This commentary contains information in summary form, for your convenience, published by Sun Life Global Investments (Canada) Inc. Although this commentary has been prepared from sources believed to be reliable, Sun Life Global Investments (Canada) Inc. cannot guarantee its accuracy or completeness and is intended to provide you with general information and should not be construed as providing specific individual financial, investment, tax, or legal advice. The views expressed are those of the author and not necessarily the opinions of Sun Life Global Investments (Canada) Inc. Please note, any future or forward looking statements contained in this commentary are speculative in nature and cannot be relied upon. There is no guarantee that these events will occur or in the manner speculated. Please speak with your professional advisors before acting on any information contained in this commentary.
© Sun Life Global Investments (Canada) Inc., 2016. Sun Life Global Investments (Canada) Inc. is a member of the Sun Life Financial group of companies.