Quarterly Investment Review and Outlook: Q1 2018

April 26, 2018

Key takeaways:

  • Market volatility makes a comeback after 15 months of calm
  • Global economic growth slows but remains solid
  • Central banks’ inflation targets appear within reach

From nuclear rhetoric coming out of North Korea to the ongoing uncertainty surrounding Brexit, 2017 was a volatile year in terms of headline news. However, it was an uncharacteristically calm year for equity markets. This extended period of calm came to an end in the first quarter of 2018, as volatility returned.

Despite increased volatility, conditions for both equity and fixed income markets remain supportive. The global economy continues to strengthen, albeit at a slower pace. Earnings momentum remains positive across markets and sectors. And although central banks continue to tighten their monetary policies, global interest rates are still historically low.

Here are the three most significant themes affecting today’s markets and our current portfolio positioning.

Volatility makes a comeback

After 15 months of positive returns for many global equity markets, including one of the best Januarys on record for the S&P 500 Index, market volatility returned in February and March. Although this shouldn’t be cause for concern, it may require an adjustment in investors’ expectations.

Investors can no longer reasonably expect double-digit equity returns quarter after quarter. Instead, we’re anticipating more muted returns in the 7% to 10% range over the longer term, while fixed income returns could trend in the 1% to 2% range.

Still, these are solid returns, supporting our view that we’re at least a year away from an impending bear market. But what brought on this sudden return of volatility?

Trade tariffs and protectionism

Many of the recent dips have stemmed from protectionist trade talk coming out of the U.S., and subsequently China. North American Free Trade Agreement (NAFTA) renegotiations were front and centre in Canadian investors’ minds for much of the quarter, but concerns have eased somewhat as talks between the U.S. and Canada have taken on a more positive tone.

Beyond NAFTA, the U.S. announced plans to implement 25% tariffs on US$60 billion of Chinese imports. In response, China imposed tariffs on 128 American products. Both of these announcements contributed to significant, albeit short-lived, bouts of volatility. In our view, the ultimate impact on investors will be minimal, as we believe the global economy can absorb these tariffs without disrupting growth.

Other factors at play

Significant data breaches from large tech firms, most recently Facebook, the U.S. Federal Reserve’s (the Fed) continued interest rate hikes and news that global growth is decelerating have all played their part in increasing volatility. And for commodity-dependent economies, such as Canada and Australia, there’s the added uncertainty of oil and material prices.

Oil prices strengthen but remain range-bound, while materials lag

Although oil prices rose above US$60 per barrel (bbl) over the quarter, we expect them to remain constrained within a range of about US$55 to US$75/bbl over the coming months. Prices will likely remain capped by U.S. shale producers and moderate demand, while OPEC supply cuts should create a floor. In Canada, oil is trading at a significant discount, so while we don’t expect a return to prices around US$45/bbl, Canada’s oil producers will continue to struggle.

Meanwhile, slowing Chinese demand continues to weigh on materials prices, giving them limited room to rise.

Because of this, we’re maintaining slight underweight exposure to Canada, but we will monitor oil prices for any sustained upward movement. We’re also maintaining underweight exposure to Australia until there’s some positive news for materials prices, which we believe to be unlikely over next 12 months.

Bullish on equities

Despite the return of market volatility, the global economy continues to grow and many central banks are getting closer to reaching their inflation targets. We therefore remain bullish on equities and will maintain our overweight allocation relative to fixed income.

Global growth continues, but at a slower pace

The global economy remains on solid footing, with all major countries in expansion mode and a low probability of recession over the next 12 months. Global growth has been largely supported by U.S. fiscal spending and tax cuts. That said, the quarter brought an end to growth acceleration.

There were early signs of slowing growth in Europe and Japan, while Chinese growth slowed as expected. On the other hand, indicators in Canada and the U.S. pointed to continued expansion.

Global earnings also remained positive and broad-based, particularly in international markets.

Overweight U.S. for now

Given a strong domestic economy and earnings, and the impact of tax reform and a lower dollar, we are maintaining our overweight exposure to the U.S., but this remains a defensive overweight. Should global economic strength continue, we would consider reducing this overweight and increasing our allocations to select international markets.

Neutral on emerging markets, mixed view on Europe

Earnings growth in emerging markets is strong on an absolute basis and relative to developed markets, which we expect to continue over the coming months. We also expect the recent weakness in the U.S. dollar will benefit emerging market equities. Still, trade tensions between the U.S. and China support a neutral position at this time, as does slowing Chinese growth.

In Europe, we remain underweight in the U.K., as growth expectations are less attractive than other regions. Instead, we’ll maintain overweight exposure to France and Germany, based on the relative strength of their economies and banking sectors, and overall positive earnings results.

With inflation targets within reach, rates continue to rise

Global interest rates continued to rise, and at an accelerated pace, as inflation expectations continued to recover. The inflation target of most central banks remains around 2.00%, which is beginning to appear within reach.

Higher interest rates have created a more challenging environment for fixed income investors compared with 2017, but we don’t expect returns to dip into negative territory. In fact, the trade tensions and other issues that have contributed to equity market volatility have had little impact on bond markets. Combined with a low risk of inflation surprises, we believe this continues to make bonds a good hedge against potential equity market declines.

Fed stays on track, while Bank of Canada lags

The Bank of Canada (BoC) raised its overnight interest rate target in January to 1.25%. It maintained this rate at its March meeting, and bond yields declined. In response, we positioned our Canadian fixed income portfolios with lower-than-benchmark interest rate risk and an overweight allocation to credit.

Meanwhile, the Fed waited until March to implement its first interest rate hike of the year, increasing the target federal funds rate to 1.50%–1.75%. The Fed anticipates two more increases of 0.25% in 2018, three more in 2019 and another two in 2020. That would put the target rate at 3.25%–3.50% in 2020, which is still low by historical standards.

Based on current economic conditions in Canada, we expect the BoC to continue to lag the Fed in terms of future rate increases.

Japan remains accommodative

We expect the Bank of Japan (BoJ) to remain accommodative for some time, likely leading to a weaker yen, which would be favourable for exports. Japanese equities are also well positioned to benefit from the BoJ’s easy monetary policy and continued global growth. As a result, we’re maintaining our slight overweight exposure to Japan.

What investors can expect

Expect equity market volatility to remain a key theme throughout 2018. Although it may have come as a surprise to some investors following such an extended period of calm, increased volatility is to be expected in the later stages of an economic cycle. While that can mean higher risk, it also presents opportunities for long-term investors. Our portfolios are designed for long-term success, which is why we build downside protection into our funds. That typically means our funds should fare better than their respective benchmarks when a downturn comes.

Other trends we’ll be monitoring include trade tensions between the U.S. and China. The tariffs announced so far should have minimal impact on market performance, but a more significant disruption in global trade could put global growth at risk.

We’ll also be keeping an eye on rising interest rates as central banks continue tightening. Higher rates will eventually dampen economic activity, but for now, rates remain very low and support our overweight allocation to equities.

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