Q2 2018 | Market Update
Sadiq S. Adatia, Chief Investment Officer
Opinions as of July 5, 2018
This grey box was added on July 11 in response to the Bank of Canada’s rate decision. The Q2 Market Update starts at the “Highlights” section below (opinions as of July 5).
On July 11, the Bank of Canada raised its benchmark interest rate by 0.25% to 1.50%. Read Five takeaways from the BoC rate increase for additional insights.
Global Trade: The Number One Worry
Global trade took centre stage during the quarter as U.S. President Donald Trump brought forward additional tariffs, taking aim at both NAFTA and China, including an additional $50 billion in tariffs on Chinese exports. China retaliated, but Trump has a further $200 billion in potential tariffs on the table. Ultimately, this is a game China likely cannot win – given its $375 billion annual trade surplus with the U.S., it has more to lose.
Canada didn’t escape either, with Trump reacting angrily to comments on trade that Prime Minister Justin Trudeau made at the G7 Summit in June. The situation turned personal when one of Trump’s advisors crossed the line, saying there is a “special place in hell” for Prime Minister Trudeau. He later apologized, but it highlighted the increasing tensions over trade.
Even so, for the most part, North American markets continued to move higher but turned volatile near the end of the quarter. However, emerging markets, including China in particular, have had a much tougher time.
On the positive side, Trump’s meeting with North Korean leader Kim Jong-un ended up going better than expected, although there is uncertainty over what was actually agreed to.
On the interest rate front, a hawkish U.S. Federal Reserve has raised interest rates several times. But the BoC seems uncertain, given its decision to pause on interest rate increases in the quarter. While it’s possible that the BoC will raise rates in July, there is considerable speculation over whether they will follow through with further increases this year.
S&P/TSX Composite Index Moves Higher
In Canada, the S&P/TSX Composite Index bounced back and oil prices rebounded. Although there are still reasons to worry about Canada’s economy, some of those concerns seem to have softened, with the index hitting an all-time high in June (chart 1).
In Europe, political instability in Italy, as well as uncertainty surrounding Britain’s final exit from the EU, caused the markets to lose some faith. While economic data remains decent, there is concern that growth has peaked. And combined with worries over trade, it was not surprising to see European markets fall this quarter.
Led by declines in India and China, emerging markets were down sharply in the quarter. Political issues hurt Indian equities, and economic growth has slowed. In China, markets reacted negatively to the country’s trade dispute with the U.S.
Overall, we still see good global economic growth, but definitely with heightened risk. With that being said, we still expect equity markets to be higher by year-end.
CHART 1: S&P/TSX COMPOSITE INDEX MOVES HIGHER
Canadian Economy: Are Things Getting Better?
Yes, for the first time in seven years, I will actually say the Canadian economy is improving! However, let’s be clear: I’m not bullish – just less bearish. That said, not much has changed on the potential risks to Canada’s economy, including cracks in the housing market, record-breaking consumer debt loads and ongoing trade disputes.
However, while the BoC is sending out mixed signals on the direction of interest rates, we feel more confident that the slowdown in consumer spending will not be as hard in 2018 as previously feared. Similarly, while there is evidence of a slowdown in sales, which should lead to lower real estate prices (more so in Toronto and Vancouver) there likely won’t be a hard landing at this time. Moreover, equity valuations in Canada seem more reasonable compared to other parts of the world.
Oil prices continued to climb, which should give a boost to Canada’s economy. Crude has consistently traded above US$65 a barrel, and jumped to just over US$73 a barrel late in the quarter. The recent OPEC news about marginally increasing oil supplies was well received by the market and may ultimately be good news for energy stocks. But so far the performance of energy equities has been a bit disappointing, given where oil prices are (chart 2).
We see the S&P/TSX Composite Index moving up slightly from here, but it will likely continue to be volatile given the uncertainty around NAFTA and the BoC’s interest rate policy.
CHART 2: ENERGY SECTOR LAGS DESPITE HIGHER OIL PRICES
Canadian Bond Yields Continue To Be Volatile
Canadian bond yields moved slightly higher in Q2, but not without lots of ups and downs. The yield on Canadian 10-year bonds started the quarter at 1.76% and ended at 1.90%. The yield on U.S. 10-year Treasuries also moved higher and was up over 3% before ending the quarter at 2.85%, up 12 bps. The move higher in the U.S. resulted from stronger economic data, as well as higher interest rates. We expect yields in both markets to continue to move higher in 2018.
U.S. Economy: Will Trade Disputes Derail Growth?
Whether trade disputes will slow U.S. economic growth is the question many investors are asking. We believe the answer is no. U.S. consumers still seem very confident, jobs continue to be created and the positive impact from tax cuts continues to filter into the economy. Earnings also remain strong, and while equity valuations are a bit more expensive, they are not grossly mispriced.
This brings us to questions surrounding the current trade dispute and what impact it will have on the economy. We continue to believe that the U.S. will win a potential trade war over the short term given that it has the most ammunition and is dictating the terms. Nobody wants to give in on trade, but at the same time, nobody really wants to go toe-to-toe with the U.S., given how vital it is to most economies. As such, we still see more room for the U.S. equity market to move higher.
International Markets Will Likely Go Sideways
Much of the data from the Eurozone economy seems okay, but there is nothing to point to that could help growth improve. The thinking is that perhaps growth has actually peaked but it is still too early to tell. Furthermore, there is political instability in Italy and Brexit is still in flux causing companies to slow their capital investments in Europe. As a result, we recently moved from an overweight to a more neutral position on European equities.
Emerging Markets: Caught In A Trade War
The second quarter was not great for emerging markets with Chinese markets hit hard by the U.S./China trade war. Economic fundamentals are not bad in China but questions around trade leave lots of uncertainty. Other markets have also had some issues, including India, where growth has stalled and there is increasing political uncertainty. Given that the trade dispute could get worse before it gets better, we reduced our weighting in emerging markets but remain overweight.
Outlook: Still Expect Equity Markets To Move Higher
We have not changed our slightly bullish stance on equity markets, but we acknowledge that risk has grown.
We still have the most confidence in the U.S. market, and feel the economy has many things going right for it, and trade, though a big distraction, will be a win for the U.S. in the immediate future. Corporate earnings are still strong and consumer confidence remains high. As a result, we remain slightly bullish on U.S. equities.
We are less positive on Europe than previously, although economic data still looks decent. However, we can’t ignore that political risk has increased and Brexit is still unresolved. As such, we reduced our weighting again this quarter and are now roughly neutral on European equities.
In Canada, the rebound in oil prices was much needed and the economy has held up better than expected. How housing and consumer debt impact the economy will depend heavily on what the BoC does with respect to interest rates. The future of NAFTA is also a big question mark. We feel that these risks have not gone away, but perhaps have been reduced (with the exception of trade). As such, given current valuations, we have moved from underweight to neutral on Canada for the first time in about seven years.
Emerging markets face a big hurdle now with ongoing trade tensions, which makes it difficult to look out longer term. As such, we see more downside in the short term, and while still slightly overweight, we have reduced our weighting for now.
The Canadian dollar ended the quarter at just over US$0.75. With the U.S. expected to raise rates multiple times and some uncertainty on NAFTA, we don’t see much movement in the Canadian dollar versus the American dollar. However, a resolution in NAFTA could see a spike in the Canadian dollar.
Canadian and U.S. bond yields should continue moving higher throughout 2018, which would be negative for bonds. That being said, with increased market volatility, bonds still hold a valuable position inside portfolios.
Overall, we still like the fundamentals of the global economy but with higher market volatility and increased trade tensions, we are reducing risk in some areas. For now, we remain slightly bullish on equity markets with a bias toward U.S. equities. Though we are less positive on bonds, we still have a preference for Canadian bonds.
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