Q1 2018 | Market update
Sadiq S. Adatia, Chief Investment Officer
Opinions as of April 5, 2018
VOLATILITY SOARED DURING THE QUARTER
After experiencing exceptionally low volatility in 2017, equity markets have turned volatile and investors should brace for a rockier ride this year. In fact, the CBOE Volatility Index, which was under 10 for most of 2017 spiked to over 40 at times in Q1, and has averaged almost 25. And with investors whipsawed by volatility, markets sold off worldwide. (Chart 1).
On the interest-rate front, both the Bank of Canada and the U.S. Federal Reserve raised rates – but they went about it quite differently. The BoC increased rates in January and then paused at their next meeting. The U.S. Federal Reserve did just the opposite by raising them in March. This has led to uncertainty over how many rate hikes we can expect in both countries by year-end.
In the U.S., President Donald Trump appeared to fire the opening shots in an international trade war by proposing to place a 25% tariff on steel and a 10% tariff on aluminum entering the U.S. He followed that by proposing to place tariffs on $60 billion in Chinese exports. And China countered by threatening to impose tariffs on $50 billion in U.S. products.
With the threat of a trade war looming, the market sold off to close near the February lows. It then recouped nearly all those losses before plummeting again, with waves of volatility likely to continue until trade issues are resolved.
Earlier in the quarter, President Trump agreed to meet with North Korean leader Kim Jong Un with the objective of denuclearizing the Korean Peninsula. It’s not clear how this could actually happen, but at least they are talking calmly – something investors have embraced.
Compared to 2017, the Canadian economy started the year with employment softening, while home sales continue to disappoint, particularly in Ontario. With new mortgage rules in place, and three rate hikes by the BoC over the last 6 months, the pressure on consumers is steadily increasing. Not surprisingly, the S&P/TSX Composite Index was down 4.5% on the quarter (Chart 1).
In Europe, economic data still looks promising, and consumer confidence remains high. However, potential trade disruptions triggered by Trump’s proposed tariffs could quickly stall things.
Emerging markets continued to be among the top performers, despite rising trade tensions between the U.S. and China. Indeed, growth remains solid across most emerging market economies and this has helped valuations, which continue to look cheaper than developed markets. Overall, continuing robust economic growth suggests emerging markets can still go higher, but volatility will likely increase as well.
MARKETS SELL OFF ACROSS THE WORLD
CANADIAN ECONOMY: 2018 LOOKS VERY DIFFERENT THAN 2017
As mentioned in our commentary at the end of the last quarter, we expected 2018 to look quite different in Canada than 2017, and early indications seem to support this. For one, job numbers have been a bit disappointing and a slowdown in housing sales seems to be continuing.
While home prices still have not dropped, slowing sales seem to be implying that price declines may not be far off. NAFTA has also become more of a focus with Trump continuing to mention Canada in the list of countries that he wants to hammer out a better trade deal with. If so, this will pressure the Canadian economy even more. As well, Trump’s decision to link proposed tariffs on steel and aluminum to the NAFTA negotiations may be a sign that he is actually trying to squeeze concessions out of Canada before signing off on a revamped NAFTA.
Although the BoC raised interest rates in recent months, we believe that it was a positive that the bank paused and appeared to push the possibility of further rate hikes out to later in the year. Our hope is that the BoC will remain on pause to year-end, or at least until we have greater clarity on the future of NAFTA.
Oil has been the one bright spot in the Canadian economy, trading consistently above US$60 a barrel, and at the time of writing, over US$62 a barrel. This is definitely very good news for oil companies, and more importantly, the economy. However, it is worth pointing out that energy stocks have not participated as oil prices climbed and are down this year (Chart 2).
As a result, we don’t see much upside in the S&P/TSX Composite Index, which lagged foreign equity markets in the first quarter. (Chart 1). And the index could potentially head lower with the economy slowing as consumers become ever more stretched.
ENERGY STOCKS FAIL TO FOLLOW OIL PRICES
CANADIAN BOND YIELDS ON A ROLLER COASTER RIDE
Canadian bond yields moved slightly higher in Q1 after the BoC raised interest rates. The yield on Canadian 10-year bonds started the quarter at 2.08% and ended at 2.09%. On the other hand, yields on U.S. 10-year Treasuries increased sharply throughout the quarter, ending at 2.74% up 28 basis points. The move higher in the U.S. was triggered by tax cuts and stronger economic data. We expect yields in both markets to continue to move higher in 2018.
U.S. ECONOMY: MOMENTUM MAY DRIVE MARKETS HIGHER
The U.S. economy continues to show good fundamentals, and with consumer confidence remaining high, we continue to be optimistic and see no reason at this point to change our opinion over the next few quarters. Indeed, recent tax cuts in the U.S. may benefit consumers and corporations (albeit not equally) and continue to help drive growth.
The wildcard in this equation surrounds Trump’s push on the international trade front. If he does implement a broad range of higher tariffs, it may initially be positive for the U.S. economy – possibly helping U.S. equities move higher. But longer term, it could be a negative if other countries counter the U.S. by adding tariffs of their own, causing the price of many products to rise.
INTERNATIONAL MARKETS STILL HAVE ROOM TO RUN
The eurozone economy continues to improve as unemployment declines and consumer confidence remains high. There is still lots of room for the economy to improve, but negotiations surrounding the UK’s exit from the European Union are ongoing and the Italian economy has shown some signs of weakness. Nevertheless, we remain overweight to European equities, but we have taken some money off the table given the uncertainty surrounding international trade discussions.
EMERGING MARKETS REMAINED STRONG
Emerging markets show no signs of slowing down after showing exceptional strength in 2017. However, volatility has increased and not all countries in the group had positive returns in the quarter. Of the major emerging market countries, China remained strong. This is a bit surprising given the trade tensions between the U.S. and China. While India was actually negative (Chart 1), growth in these markets cannot be denied. And with the Russian and Brazilian economies now appearing to move in the right direction, we have increased our weighting in emerging markets.
OUTLOOK: EXPECT EQUITY MARKETS TO HEAD HIGHER
With solid economic growth globally, we continue to remain slightly bullish on equities in general. But the months of record-low market volatility we experienced last year are now clearly behind us. In the U.S., tax cuts have boosted consumer confidence and that should help keep the economy growing. Job creation will continue, and although we may see two more rate hikes by the U.S. Federal Reserve this year, it should not slow down growth drastically. While corporate earnings are still strong, we expect earnings growth to start to slow. However, we remain slightly bullish on U.S. equities.
Europe’s economy is in good shape, and should continue to improve. However, we are a bit concerned as we come closer to Britain’s formal exit from the EU, slated for later this year. And while slightly bullish on European equities, we reduced our exposure during the quarter.
In Canada, we have started to see risks to growth emerge. For one, housing sales are slowing and consumers may follow suit by reducing their spending. Furthermore, NAFTA is a big question mark and until its future is resolved, business investment could deteriorate. As a result, even though we are positive on the Canadian energy sector, we increased our underweight exposure to Canada.
Emerging markets posted strong returns in the quarter, and we are still comfortable with equity valuations. Outside of a surge in the value of the U.S. dollar or the outbreak of a trade war between the U.S. and China, we do not see much downside risk in the near term and have increased our overweight exposure to emerging markets.
On the fixed income side, the Canadian dollar ended the quarter at just under US$0.78, but it could fall further. This is because with the U.S. Federal Reserve expected to raise rates at least twice by the end of the year, the uncertainty in the Canadian economy may reduce the ability of the BoC to raise rates. And that combination could put more downward pressure on the Canadian dollar versus its U.S. counterpart.
Canadian and U.S. bond yields should continue moving higher throughout 2018, which could be a negative for bonds. That said, with the increased volatility we’re experiencing, bonds still hold a valuable position inside portfolios.
Overall, we are positive on the global economy but are starting to see some early signs that the long bull market that began on March 9, 2009 may be ending. For now, we remain slightly bullish on equities, with a bias toward foreign markets. However, we are less positive on bonds.
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