Third Quarter Wrap-up
The third quarter was, overall, a very positive one for equity markets, especially with the U.S. hitting new highs (in local currency), and a rather difficult period for fixed income markets. The S&P/TSX Composite rose 2.98% and on a total return basis it is now up 4.45% year-to-date. South of the border, the S&P500 Price Index advanced 3.96% and is now sitting with a healthy 14.24% return this year on a total return basis. However, in Canadian Dollar terms, it is only up 6.04% year-to-date. From a Canadian perspective, global equity returns have been much more muted, with the Loonie marching 7.8% higher against the Greenback this year. The large appreciation of our dollar has primarily been against the U.S., although the Loonie also rose 3.5% versus the Yen. On the other hand, our currency has actually fallen versus the Euro, down 4.1% this year.
In international markets, the MSCI Europe/Asia/Far East price index (local) is up 8.6% year-to-date and 9.3% in Canadian dollar terms, not including dividends. The biggest strength in equity markets this year has come from emerging markets as reflected by the MSCI Emerging Markets price index up 17% in Canadian dollar terms and almost 19% on a total return basis. Emerging markets have no doubt benefited greatly this year by a weak U.S. dollar, but in addition to this, strong economic growth and easing monetary policy from their central banks (as opposed to tightening bias in North America) is giving their markets an extra boost. It usually surprises our clients when we note that emerging markets account for the vast majority of global economic growth (estimates are 65% over next few years) even though their collective size is much smaller than developed markets in terms of equity market capitalization. We continue to believe a reasonable allocation to these growth markets is an important part of our portfolio construction.
As opposed to equity markets, Canadian fixed income markets have had a more difficult year as bond yields have risen, and dramatically so, since mid-year when the Bank of Canada increased the overnight rate from 0.5% to 0.75%, the first such increase in over 7 years. They have since boosted the rate by another 0.25% to stand currently at 1%. This was not expected at all coming into 2017 and it's one of the primary reasons for a rebounding Loonie, in addition to much better than expected GDP growth in the first two quarters of this year. As we noted in our last commentary, it is this change of expectation that drove the Loonie higher. In fact, the second quarter GDP number reflected an annualized rate of 4.5%, significantly higher than the 3.1% annualized growth posted by the U.S. As a result of higher yields here, the FTSE TMX Canada Bond Universe is now up only 0.48% (total return) this year, after a steep fall of 1.84% in the third quarter. Higher yielding (lower quality) corporate bonds have fared better this year as they correlate more closely with equity markets. The FTSE Canada HYBrid Bond Index is up 2.8% this year.
Lastly, in the commodity world, we have definitely seen a stabilization of oil prices since early 2016 when WTI Crude prices bottomed out under US$40. That being said, prices are down 3.8% this year (much more in Canadian dollars) after a strong rebound in 2016. We have seen this weakness extended to Canadian energy companies with the S&P/TSX Capped Energy Index down 14% year-to-date. On the precious and base metals front, gold and copper prices are up over 11% and 17% respectively (U.S. dollar terms).
Milestone strategy and outlook
We continue to reiterate our constructive stance, based on our positive fundamental thesis we have had in place since the second quarter of 2016. We have discussed this at length in previous quarterly market commentaries and in our bi-weekly Market Insights blog posts, so instead of repeating much of this, we thought we would sum up this thesis with a diagram we created depicting what we believe to be the process for what drives equity markets higher or lower. In this case, we currently think the upward trend will continue for quite some time.
Ultimately, it is our believe that equity markets are most closely correlated to corporate earnings growth, and we are seeing very strong numbers the last few quarters and continue to expect high single to double digit earnings growth for the S&P 500, at least through the first half of 2018. As we have noted in previous commentaries, we tend to focus on the U.S. when it comes to the markets and recession risk due to the fact they are the primary driver as opposed to Canada which only represents a very small portion of global market capitalization.
Now, earnings growth in turn is driven by economic activity which remains in an uptrend and even currently accelerating. Some of the headwinds that have been in place in the recent past now appear to be tailwinds, with the economic growth pattern now represented on a global scale, and not just in the States. There is clear evidence of a synchronized global recovery (Canada, Europe, Japan, China, India, etc.).
Economic activity is driven primarily by the availability of credit and the steepness of the yield curve. For those not familiar with that term, a yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates. We are referring specifically to the yield curve of government bonds in North America. Both the availability of money and the yield curve, remain in a pro-growth status. From all accounts, credit remains very robust.
The availability of credit and the steepness of the yield curve are primarily driven by U.S. Federal Reserve/Bank of Canada monetary policy. Although short term rates have risen (the Fed has risen four times, and Canada two, so far this cycle), policy still remains accommodative, and likely so through 2017 and most of 2018. There could be some headwinds coming in later next year and into 2019 in this area.
Lastly, U.S. Federal Reserve/Bank of Canada monetary policy is driven by core inflation. Inflation remains in the low end of the range for the last twenty years, and still well below the Fed's target rate. The Fed's preferred data when assessing inflation is the core Personal Consumption Expenditures Price Index (PCE). The core PCE measures the prices paid by consumers for goods and services without the volatility caused by movements in food and energy prices to reveal underlying inflation trends. Currently, this stands at only a 1.3% year-over-year rate. The more recognizable inflation gauge, the core Consumer Price Index (CPI) also currently stands well under 2% at 1.7%. In Canada, the year-over-year core CPI has risen just 0.9% in each of the last four months. This gives the Fed and the Bank of Canada leeway in raising rates slowly despite strong economic growth.
To sum up, equity markets are most closely correlated to earnings growth, which are driven by economic activity, which in turn is driven by the availability of money and the yield curve, which is driven primarily by central banks whose monetary policies are driven by core inflation. We currently view all steps of this process in a pro-growth stage.
In addition, some of the headwinds that we have seen recently have turned more into tailwinds for U.S., such as a currency that has stabilized at lower levels, real median income for households has moved into record territory, capital spending is ramping up, and fiscal stimulus of lower regulation and possible corporate tax cuts. This is in context to what we see as a synchronized global growth pattern.
We will finish up with an update to our Milestone Recession Risk (MRR) Composite™ which continues to reflect extremely low U.S. recession risk over the coming months with only one of our ten indicators flashing red. As we noted above, the one tailwind of the process we described above that could be become a headwind later next year is the yield curve and availability of credit. The U.S. treasury yield curve is one of the ten indicators in our composite and one we will be watching closely. We will also note that although our intermediate to longer term view remains positive, we are more cautious in the very near-term as markets are currently in an overbought and extreme positive sentiment position. Although we could see some near-term volatility in October via flat or slight corrective action (historically the most volatile month for markets), we believe this will likely subside over the coming weeks.
Here is our Milestone Market Report on economic data, capital markets, commodities and currencies through September 29th, 2017: (click for PDF version)