First Quarter wrap-up
The first quarter of 2017 was generally a favorable one for the majority of global markets. Most of the rise in equity markets occurred in the first six to eight weeks of the year (a continuation of the ‘Trump rally’ from last year) with equities chattering sideways for the most part since then. After an outperforming year for the S&P/TSX Composite in 2016, the Canadian market has since levelled off (up 1.7% year-to-date), underperforming most developed markets around the world. The S&P 500 and the MSCI EAFE (Europe, Asia & Far East) have advanced 3.6% and 5.9% in Canadian dollars (CAD), respectively. The MSCI Emerging Markets index has been a standout, up 10.5% (CAD) this year due to strong Chinese and Indian equity markets.
Of note, we mentioned in our last commentary that the S&P/TSX Composite had yet to hit a new all-time high surpassing its September 2014 high, whereas the S&P 500 for the U.S. continued to hit all-time highs in the latter half of 2016. This finally changed in mid-February when our market finally hit a new high.
In the fixed income markets, after a sharp rise in long-term interest rates following the Trump victory last year, rates have levelled off and are actually down as we move into the second quarter of 2017. The result is a 1.2% year-to-date return for the FTSE TMX Canadian Universe Bond Index, and approximately 2.5% for the high yield market in Canada and the U.S. The Canadian bond market continues to maintain a significant spread over U.S. bonds of approximately 0.70-0.75% on 10 and 30-year rates. On March 15th, the U.S. Federal Reserve hiked the benchmark rate for the third time this cycle (last two times were December of 2015 and 2016) to a range of 0.75%-1%. The expectation from their forecast and from market participants is to raise this at least two more times this year. The result is a flattening yield curve which is not a favorable scenario for equity markets. That being said, it is still fairly steep and central banks around the world still remain very accommodative. At this point in time, we do not expect a rate hike from the Bank of Canada this year.
Energy markets have also levelled off after hitting an intermediate-term high back in December. Crude prices have moved back to the low USD$50 range while Natural Gas prices have dropped back to around USD$3.20, after recovering from a USD$2.55 low in mid-February. The S&P/TSX Capped Energy Index is down 9.6% this year after rising over 36% last year. Although the trend is much improved from a year ago, the fact remains that this energy index continues to be in a long-term bear market, still down well over 50% from its 2008 all-time high.
In our year-end commentary we wrote that one of the biggest themes coming out of 2016 was the rapidly evolving political landscape and the global rise of populism. This is still true this year, but it would seem this has tapered off a bit with some lessening risks out of Europe. Geopolitical risks still remain of course, and are running high at this time with the developing situations in Syria and North Korea. Although this is weighing negatively on markets, we believe that some of the positive discussions recently between Trump and China’s President Xi may be an even larger positive. One of the largest risks, in our view, from a Trump victory was his original stance of imposing trading barriers and starting a trade war, even deeming China a currency manipulator. He has since backed off this rhetoric quite significantly, expressing a much more collaborative sentiment of late. Although it remains to be seen how much confidence Xi will have in Trump’s new, more cooperative position, it is certainly a positive to see they are making an effort to work things out. We believe that this move toward a more amiable relationship, if it continues, will be a considerable positive for equities.
Moving more to the economic front, the U.S. remains the strongest game in town for the developed world. They are also the closest to a normalization in interest rate policy. We are seeing very strong consumer confidence numbers which should result in stronger spending, making up the bulk of their GDP. We have also seen much improvement on the manufacturing side. Employment remains strong. Inflation has risen substantially from a year ago, but the Consumer Price Index is still within the target window for the U.S. Federal reserve, and we don’t view it as a risk yet at this point. Still, despite strong measures of consumer and business confidence since the election, it hasn’t translated in a pick-up in GDP, which remains at a mid-1% figure. It is quite possible that we won’t see any real acceleration in economic growth unless we see some major economic reforms out of Washington, rather than just the talk and tweets we’ve seen of late.
Globally, we are now starting to see stronger economic growth numbers out of Europe and Japan than recent past, essentially putting global recession fears to the side for the time being (risk for the U.S. has been low for some time, but has been elevated internationally). Our Milestone Recession Risk (MRR) composite remains in the very low risk area. We continue to monitor this closely as it is a primary guide for our longer-term strategic asset allocation.
It remains our position that although there are some near-term concerns keeping any enthusiasm at bay, our positive fundamental core thesis remains alive and well. Since the 1950s, U.S. recessions have always been led by an inversion of the yield curve (i.e. 6-month interest rates higher than 10-year rates) and those inversions have lasted on average 15 months. If we assume long-term rates don’t change much, based on current U.S. Federal Reserve projections, the yield curve wouldn’t invert until at least late 2018. Combining this with the length of inversion, one could estimate recession risk rising in late 2019 to early 2020. Tony Dwyer, Canacord’s Chief U.S. Market Strategist, summarizes very well what drives the equity market (we have slightly altered the wording to make it more understandable):
- Equity Markets correlate most directly to the direction of corporate earnings, which are positive and showing double-digit growth.
- Corporate earnings move with the direction of the economy, and both the domestic and global economy continue to recover.
- Economy moves with the availability of money driven by the slope of the yield curve, which should remain positive through most of 2018.
- The positive slope of the yield curve is driven by historically accommodative U.S. Federal Reserve policy as measured by the Real Fed Funds Rate.
- Fed policy is driven by core inflation, which remains low and in the middle of the 20-year range.
For U.S. corporate earnings, we are seeing strong growth numbers, although the comparison is an easy one from a year ago when the U.S. was coming out of an earnings recession. This earnings growth, in our view, will be an important driver for equity returns going forward, as we are transitioning from an interest rate-driven bull market to a fundamental earnings-driven market in the latter part of this cycle. This will likely become more evident in the coming quarters, especially if inflation and long-term interest rates stay in check, which is our base case scenario at this point. In the short-term, similar to earlier in the year, we remain a bit more neutral on developed equity markets, but remain positive in the intermediate to longer-term. From a bottom-up perspective on security selection, as we discussed in our 2016 Third Quarter wrap-up towards the end of a cycle, a more active and tactical approach to asset allocation and sector weightings becomes more important. We continue to recommend diversification globally with a healthy allocation to Emerging Markets, along with allocations to alternative strategies and real assets.