Q4 2018 | Market Update
Sadiq S. Adatia, Chief Investment Officer
Opinions as of January 1, 2019
Volatility surges, markets suffer worst quarter since 2008
Investors often find a year-end rally in their Christmas stocking. As we anticipated, this year there wasn’t one, with key indexes plummeting worldwide as Q4 came to a close. In the end, the S&P 500 and the Dow Jones Industrial Average were down 4.4% and 3.9% respectively for the year – their biggest annual losses since 2008. Most of the losses came during an extremely volatile December, with the two key indexes posting their worst monthly performance since 1931.
Is the worst of the market rout now behind us? Given concerns over rising interest rates and the ongoing fallout from the U.S./China tariff war, we expect volatility to continue. However, with the recent sell-off, we remain roughly neutral on equities in general. We do not expect another major downturn from here and will look for opportunities to add to our equity weightings when appropriate.
Major markets tumble worldwide
As the markets fell, we expected increased volatility and further pullbacks. To potentially mitigate risk in the portfolios, we initiated hedges on volatility, the U.S. stock market, including technology stocks, and emerging market equities. We also reduced equity exposure in other specific areas.
The losses in U.S. markets were in sharp contrast to the country’s prevailing economic fundamentals. In fact, despite Wall Street’s woes, the Main Street economy continued to perform well. Consumer confidence is high, job growth remains strong, and wages are rising. Despite this positive backdrop, investors abandoned the market as worries mounted over rising interest rates, an escalating tariff war with China, and ongoing political chaos in Washington with the government shutting down.
In Canada, the S&P/TSX Composite Index reached an all-time high in July. But prevailing market pessimism and falling oil prices added to investor concerns, with the index down 8.9% on the year (Chart 1).
In Europe, where the economy appears to have stalled, worries over the troubled Italian banking system and seemingly intractable negotiations surrounding Britain’s exit from the European Union weighed on the market in 2018, with the MSCI EAFE Index correcting by 10.5%.
Stocks in emerging markets, battered by trade issues and a rising U.S. dollar also retreated in 2018, with the MSCI Emerging Markets Index tumbling 9.7%.
CHART 1: Markets tumble across the world
Source : Bloomberg.
Interest rates: The fed and BoC raise rates
On the interest rate front, the U.S. Federal Reserve Board raised rates 25 basis points in December, its fourth rate hike in 2018. The Fed’s so-called dot plot shows where each member of the Federal Open Market Committee believes interest rates are headed. In December, it suggested there will be two rate hikes in 2019, one less than previously forecasted in September. It also expects the benchmark rate to be near 2.9% at the end of 2019, compared to the previously projected rate of 3.1%
While the Fed continued to tighten at year-end, the Bank of Canada left interest rates unchanged in December after raising them in October. This left the BoC’s key overnight rate unchanged at 1.75%. Whether it raises at its next meeting in January is open to a number of questions, including the possible negative impact that the recent oil price collapse has had on the Canadian economy.
North American bond yields retreat
Canadian bond yields moved lower in Q4. The yield on Canadian 10-year bonds started the quarter at 2.27% and ended at 1.85%. The yields on U.S. 10-year Treasuries also moved lower, ending the quarter at 2.69%, down 40 bps. The move lower in the U.S. and Canada seemed to suggest that investors believe the economy is slowing. However, we expect that yields will move higher in both countries this year as interest rates continue to rise – albeit at a slower pace than previously predicted.
Oil price collapse clouds Canadian economy
Risks to the Canadian economy appeared to have been reduced with the signing of the new USMCA trade pact in September. But economic uncertainty returned with the collapse of oil prices in Q4, putting downward pressure on energy equities (Chart 2).
Western Canada Select, the Canadian heavy oil benchmark price, trades at a discount to West Texas Intermediate crude, which fell from a high of US$76-a-barrel in October to US$45-a-barrel on December 31. The discount, which reflects the higher cost of refining and shipping heavy oil, widened with the Canadian price trading below US$14-a-barrel at one point.
To help stem the fall in world oil prices, the Organization of Petroleum Exporting Countries (and its allies including Russia) agreed to reduce production. Alberta also ordered a mandatory cut amounting to 350,000 barrels a day. The decision by OPEC and Alberta sent oil prices higher, with WCS trading at US$45 a barrel December 31.
We expect oil prices to move higher from here. However, it remains to be seen what affect the oil price collapse will have on the broader economy, where there are already other concerns. These include the negative effect that higher interest rates are starting to have on consumer spending, with Canadians already carrying record high personal debt loads. Housing sales also appear to be slowing, and could be further affected if interest rates move higher.
That said, there are some positives for the economy, including construction of the massive $40-billion liquefied natural gas project in northern B.C. Given the extent of the losses on the S&P/TSX Composite Index, we are neutral. We do not see a growth story here, but given the low valuations, our positioning is more about risk management if global markets retreat again.
CHART 2: Energy sector follows oil prices lower
Source : Bloomberg.
U.S. Economy: Strength with growing risks
The U.S. economy is still performing well with strong job creation, and the greenback remaining quite strong. But that economic strength is playing out against a growing list of risks. Among the issues worrying investors: The Fed remains in a tightening mode (although softening), political turmoil in Washington continues with the shutdown of the government, and the tariff dispute with China continues.
We are also closely watching corporate earnings for indications that the U.S./China tariff battle is beginning to impact both economies. There have been some negative signs with the Purchasing Managers Index (a measure of manufacturing output in the U.S.) falling to its lowest level in more than two years in November.
And just after the quarter ended, Apple issued an earnings warning saying its iPhone sales in China fell sharply in November. The tech sector – particularly large U.S. technology equities, including the so-called FAANG stocks: Facebook, Amazon, Apple, Netflix and Google led the S&P 500’s record run. It was many of these same companies that led the market’s steep declines in December.
Apple CEO Tim Cook blamed the earnings shortfall on the tariff war and a slowing Chinese economy. If Apple’s sales problem in China spreads to other U.S. companies across the broader economy, it may be an indication that the trade war is beginning to hit home in both countries.
With those issues playing out in the background, we have reduced our U.S. equity exposure. But given the recent sell-off, we may find opportunities to increase our weighting again.
Brexit and Italy weigh on international markets
In Europe, economic growth appears to have stalled. Moreover, the uncertain political situation surrounding Britain’s exit from the EU is casting a further cloud on the market.
British MPs are expected to reject a separation agreement with the EU, hammered out by British Prime Minister Theresa May. If the U.K. ultimately opts for a “hard exit” and leaves the EU without a trade deal, we expect there will be negative economic consequences, not only for Britain, but in a number of EU countries as well.
In addition, concerns continue over the possible contagion effect Italy’s fragile banking system could have on the broader European banking system if it deteriorates.
As a result, we are underweight international equities. The one exception is Japan where both the investment climate and domestic economy appear to be improving.
Emerging markets: Is the worst over?
We believe the worst has been priced into emerging markets, which were under pressure for much of 2018. This may lead to a surprise to the upside. As well, by our measure, equity valuations are now attractive and longer-term prospects for emerging markets remain potentially better than developed ones.
That said, we are closely watching the Chinese economy for signs that the slowdown in its economy is gaining momentum. But for now, we are overweight emerging markets and may increase our exposure when the opportunity arises.
Outlook: Neutral on equities, underweight bonds
We are largely neutral on equities with a bias toward emerging markets. We have raised cash levels, and given the potential for further rate increases, we remain underweight bonds. We plan to deploy our cash when opportunities arise.
- U.S. economic growth appears to be still solid. However, given the concerns over trade and political uncertainty, we have reduced our exposure. But we plan to increase it when opportunities arise.
- Canadian economic growth could slow following the oil-price collapse. As well, rising interest rates may also erode consumer spending and add to the slowdown in the housing market. We remain neutral on Canada.
- A slowing economy, contentious Brexit negotiations, and Italy’s troubled banking system overhang European markets and we are underweight international equities.
- The worst of the correction may be over in emerging markets and we could increase our overweight position if opportunities arise.
- We expect the Canadian dollar to be valued between US70 and US75 cents in the coming weeks. However, the dollar remains heavily dependent on oil prices, trade and the strength of the U.S. economy. As a result, it could come under further downward pressure.
- Bond yields in Canada and the U.S. may rise in 2019, and consequently we are underweight. However, with uncertainty in the economy and increased market volatility, holding bonds in a portfolio is an important way to add stability in uncertain times.
Overall, we expect a bumpy road ahead. We will be looking for ways to reduce risk and take advantage of investment opportunities. However, for now, we are comfortable with how our portfolios are currently positioned.
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., 2019. Sun Life Global Investments (Canada) Inc. is a member of the Sun Life Financial group of companies.