Fourth Quarter Wrap-up
2017 was a good year for equity markets, especially for the U.S. and most international markets. Unfortunately, the Canadian stock market has lagged behind our southern counterpart for the sixth time in the last seven years, with the S&P/TSX Price Composite up 6% versus the S&P500's 11.7% (Cdn$). This doesn't paint the true picture, however, as the S&P/TSX Small Cap index was only up 0.3%, so the overall breadth of our market was actually fairly weak. One of the primary reasons over the last few years has been a struggling energy sector in Canada, which after a nice rebound year in 2016, fell back again last year with the S&P/TSX Capped Energy Price Index declining 12.6%. Over the last four years, this sector composite is down almost 30%. Making up one fifth of the S&P/TSX Composite (it used to be higher), it is easy to see why our market overall has lagged behind the U.S. That being said, there is more at play here, where the general overall health of the economy in the U.S. has been stronger, and seemingly stronger heading into 2018 with more pro-growth fiscal policies out of Washington compared to Ottawa. In international markets, the strongest player was Emerging Markets, which rose almost 26% (Cdn$). Overall, the MSCI EAFE Index (developed international markets) increased a solid 13.9%.
It was a more difficult year for fixed income markets, but the FTSE TMX Canada Universe Bond Index still managed to pull off a 2.5% total return. The high yield bond market fared better, returning north of 5%. We are no doubt in a rising rate environment, at least domestically and in the U.S., and this will put the most price pressure on longer-dated bonds and those with the lowest interest rates (i.e. government bonds). Although likely too early to determine, the secular bull market in bonds here has seemingly come to an end. These longer dated government bonds will now likely be used more as portfolio insurance against equity market corrections, as opposed to big contributors to portfolio returns. We have some exposure there for portfolio protection, but we are focusing our portfolios to the corporate space, with the use of investment grade and high yield corporate bonds with relatively shorter maturities, as well as other pockets of the fixed income markets that will likely fare better in a rising rate environment (floating rate or rate-reset preferred shares as an example) and for further diversification. Emerging market debt is also an area that we think can provide excess returns where valuations and yields could be seen to be at attractive relative levels when one considers the supportive behavior of the balance of payments.
Currency played a fairly large role in stymying U.S. equity returns for Canadian investors last year with the Loonie rising about 7% against the Greenback. Although we could see some further pressure on the U.S. Dollar in the near-term, we don't expect a repeat of 2017 to happen this year, but favor a bit more of a range bound outcome. In other words, our view is more neutral to slightly negative on the Loonie this year. Overall economic health appears to be stronger in the U.S., and we expect three rate hikes by the U.S. Federal Reserve versus perhaps only two here in Canada. If we see more pro-growth fiscal stimulus from the U.S. it could further aid their economy, but on the other hand, if the resource sector here rebounds it could further help the Loonie.
Milestone strategy and outlook
We continue to reiterate our constructive stance on equity markets, based on our positive fundamental thesis that we have had in place since the second quarter of 2016. Many of our previous posts discuss the basis of this thesis. At present, our Milestone Recession Risk™ Composite continues to forecast extremely low recession risk for the U.S. and even globally. Indeed, we are witnessing a synchronized global growth pattern that we hope will continue to gain momentum, and we are seeing more evidence of this. We feel this is the more likely scenario; however, we need to stay grounded by the fact that developed market central banks, primarily the Federal Reserve, the European Central Bank and the Bank of Japan, could make a policy misstep. In the past, we often have seen recessions caused or exacerbated by such a mistake.
For these year-end comments, we would like to highlight a couple myths or perhaps misconceptions that many people perceive as big risks to the current market. These two are the current flattening yield curve and the very high level of U.S. small business optimism. Let's first discuss the flattening yield U.S. federal yield curve. If you are unfamiliar with the term yield curve, essentially it is a curve on a graph in which the yield of government fixed-interest securities is plotted against the length of time they have to run to maturity. When short-term rates rise faster than long-term rates, the yield is said to be flattening. At some point the yield curve can become flat across time, or even invert where short-term rates are higher than longer-term rates. In the past, recessions have always been preceded by a flat to inverted yield curve, so it is understandable where the concern lies.
As of the end of 2017, the U.S. yield curve has narrowed to just 57 basis points as measured by the difference between the 2 and 10-year yields which is where the bulk of the debt lies. Although many believe a flattening of the yield curve to this current degree is a sign of market and economic trouble ahead, history tells a different story. In the past three long-term economic and market cycles, when the spread has declined to 60 basis points or less, the median gain to the cycle equity market peak was over 60% and a recession was more than two years away. Although we expect more volatile markets this year versus last year's record low level of volatility, and likely a correction at some point, history suggests that at this point in the cycle any correction should be temporary and should be bought.
If we look at the two prior major cycles, we believe the current one is more similar to that of the mid-90's as opposed to the mid-2000's. When the slope of the curve hit this point in 1994, it took more than three years for the curve to invert and the five years after that point were some of the best years ever for equity markets. Even in the last cycle, which we view as less comparable, when the slope first hit this point in 2005, it took almost another year for the curve to invert with subsequent stock markets for two more years.
There is also another important consideration to make, which is the recent U.S. corporate tax cut. We believe this could push the yield curve inversion out in time by potentially causing the yield curve to steepen later this year.
When taking the evidence as a whole, it is unlikely that the yield curve will invert within the next year and possibly two or more years. And past instances show that even when the curve inverts, an equity bull market is likely to persist for two or more years beyond the inversion.
The other point we wanted to discuss this quarter is the recent extreme level of U.S. small business confidence, as evidenced by the Small Business Optimism Index that is reported by the National Federation of Independent Business (NFIB). In November, The NFIB reported that its index hit a level of 107.5 in November, the highest level since September 1983. There are market participants who view this as a contrarian signal where the business outlook has become too optimistic, and that it forecasts equity markets are hitting a cycle peak and that a recession is on the horizon. However, again, the evidence does not support this view. In the past three major economic cycles over the past thirty years, a U.S. recession did not begin until a median 37 months after the peak in the NFIB Small Business Optimism Index. In addition, the median stock market gain to peak was over 33.5% over the following three years. In similar fashion to the yield curve evidence we discussed, history has demonstrated that we likely remain years away from a recession-driven bear market.
To conclude, although we expected greater volatility and that we are currently susceptible to a near-term correction at some point this year, we remain focused on our overall positive fundamental thesis, and that U.S. and most global markets should continue to reflect the evidence that many past headwinds have become tailwinds for economic and earnings growth. This includes a global synchronized recovery, strong U.S. economic fundamentals as shown through the ramping up of capital spending and accelerating domestic activity, a demographic-driven increase in home ownership, real household income jumping with strong employment, and lastly the U.S. corporate tax cuts just recently approved in late December.
Here is our Milestone Market Report on economic data, capital markets, commodities and currencies through December 31st, 2017: (click for PDF version)