Message From the President and CEO

August 1, 2017

We started the year with cautious optimism, and most of the risks we saw at the time abated during the second quarter. This led to equities outperforming fixed income. The second quarter of 2017 also saw continued growth in the global economy. Earnings improved broadly across countries and across sectors, and political risks receded in Europe.

However, as financial markets move through the second half of 2017, it is still worth debating whether there is an economic slowdown in the United States. As the world’s most important economic driver, the U.S. economy remains key to global economic growth prospects.

Real U.S. gross domestic product (GDP) increased at an annual rate of 1.4% in the first quarter of 2017, which was revised up from 0.7%. By comparison, in the fourth quarter of 2016, real GDP increased 2.1%. According to the U.S. Federal Reserve, the first quarter was not indicative of the rest of the year. But if GDP growth is below 2% again for the second quarter, that would certainly indicate a slowdown.

Besides watching U.S. GDP, we closely monitor data from the Markit Purchasing Managers’ Index (PMI), a broad business survey that provides an early indication of the economy’s health. Although the U.S. PMI has come down in recent months, the survey indicates that business conditions remain supportive and that corporations are doing their part to grow the economy.

We see the strength of U.S. equities and the actions of the U.S. Federal Reserve playing out in one of three scenarios for the rest of 2017. In our first scenario, the Fed would stay the course with another interest-rate increase, which would be the third this year. At the same time, the Fed would start reducing its balance sheet—the aim being to further remove stimulus from the economy as it continues to grow and inflation gradually comes in line with Fed expectations of around 2%. This scenario would be positive for equity markets.

Our second scenario sees the Fed keeping rates at current levels based on the view that there is not enough upward pressure on inflation to warrant an increase. This is assuming that the economy keeps growing at a reasonable pace. This scenario is also positive for equity markets.

Our third scenario is the least likely but the most troublesome for markets. It sees the Fed continuing to raise rates even if there is no clear inflation pick-up. This could inadvertently slow down the economy. We estimate that this last scenario has only a 10% probability of being realized. We believe that the Fed will follow scenario one or two, and that stocks will outperform bonds over the next 12 months.

Turning to Canada, the economic data looks relatively good. But we have to remind ourselves that this rebound is from a technical recession in 2015, after oil prices crashed and the Bank of Canada slashed interest rates. Although oil has recovered from those extreme lows, it has been range-bound between US$40 and US$50 per barrel, which remains unprofitable for Canadian producers. We do not expect the price of oil to move much higher for the rest of the year.

Meanwhile, Canadian banks and financial services companies have performed extremely well since the early 2000s and were not materially affected by the financial crisis. Going forward, however, higher real estate prices in a rising interest rate environment; and weakness in the energy sector could dampen profitability in the financial services sector.

The Canadian equity market is the only major developed market to produce a negative return year to date. Clearly, the Bank of Canada’s guidance ahead of its July 12 decision to raise the overnight lending rate by 25 basis points to 0.75% was not well received. The benchmark S&P/TSX Composite Index was down 0.69% over the six months ending June 30, 2017.

We do have some concerns that the Bank of Canada might be raising interest rates prematurely, given that its mandate is to manage inflation. Currently at 1.3%, inflation is significantly below the 2% target, and we are not seeing significant inflationary pressures.

Having our major trading partner, the U.S., on a growth path since the financial crisis has been good for Canada. However, the recent rise in the Canadian dollar in the wake of interest rate expectations could erode the competitiveness of our exports and lead to an economic slowdown. Overall, with global growth on track and interest rate hikes here likely to happen in a measured way, we remain cautiously optimistic and expect to see continued strength in Canada’s economy in the second half of the year.  

We continue to recommend that investors maintain an investment strategy that features diversification and active management aligned with their investment time horizon. To learn more about the impact of global economic trends on your investments and how we construct MD portfolios, I encourage you to talk to your MD Advisor.

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