Quarterly Macroeconomic Overview and Outlook: Fall 2017

October 24, 2017

Key takeaways:

  • Synchronized economic expansion should support equity performance.
  • Interest rates are on the rise, but a recovery in bond yields will take time.
  • Expect the U.S. dollar to rebound and currency volatility to continue.

This quarter, we’ve identified three global trends that we think will have the greatest impact on our clients’ portfolios. In this update, we’ll tell you what we see happening in today’s markets, where we expect markets to go from here, and how we’re positioning our portfolios to adapt to these key market trends.

Global economic expansion becomes more synchronized

For years, global economic growth was driven by a strong and thriving U.S. economy. Over the past several months, however, we’ve seen a significant reversal of this trend. Although the U.S. economy continues to expand, global growth has become much more synchronized across regions and sectors.

This synchronized growth is driving strong global equity market performance, which we expect to continue. As such, we’ve increased our exposure to equities by another notch, to a neutral-overweight position. Further supporting our positive view on equities is the recovery we’ve seen in earnings trends over the past nine months, after almost two years of flat earnings results. If this trend continues to strengthen, we would see it as an opportunity to further increase our allocation to equities.

Turning our attention to individual markets, all economies in the Eurozone finally appear to be on solid ground after a long period of volatility. We believe this growth path is sustainable, which will benefit equities. Election uncertainty in the Germany and France has largely been resolved, and we’ve increased our positions in those countries accordingly. We’ve also slightly increased our exposure to Switzerland, but we remain underweight in that market. Compared to Switzerland, we continue to find better investment opportunities in Germany and France and prefer to maintain our overweight positions in those markets.

Elsewhere, we’ve increased our exposure to Canada and Australia. However, we again remain underweight in these two markets, largely because of our negative view on commodities and commodity-linked economies.

Oil prices continue to be a headwind for Canada

The Canadian economy has strengthened, providing support for equities. On the downside, we don’t believe oil is profitable at current levels, and with prices being range-bound, we see limited upside potential for this commodity. In addition, Chinese growth, while still impressive, has slowed–as expected–moderating demand for materials. We expect these factors to weigh on both the Australian and Canadian markets, which are heavily weighted toward commodities and materials. In terms of the Canadian market, the financials sector has also weakened, putting additional pressure on Canadian equities.

The U.S. remains relatively strong

Although growth has become more synchronized across regions, this has not dampened our positive outlook on the United States. The U.S. economy remains strong on a relative basis and continues to expand, and we believe there is a very low probability of a recession over the next 12 months. We are therefore maintaining our overweight exposure to the U.S. That said, should global economic strength continue along the same path, we would consider reducing our exposure to the United States and increasing our allocations to other markets.

Keeping an eye on the U.K. and North Korea

Of course, every quarter brings its share of negative news as well. We continue to monitor global geopolitical risks, with Brexit continuing to drive uncertainty in the U.K. and North Korea contributing to global tensions. We expect the Brexit process to be drawn out and to have a negative impact only on the U.K. economy. As a result, we don’t believe U.K. equities are well positioned at this time, and we will remain underweight in that country.

Overall, though, we believe geopolitical risk is subsiding and has had minimal impact on capital market performance. We will continue to follow the situation with North Korea, but we believe the probability of an extreme event is low.

Emerging markets rebound

Turning away from developed markets, we have also witnessed strong performance since the beginning of the year from emerging markets in local currency terms, after a period of underperformance. For more information about emerging markets, please review the Fund Spotlight, which highlights the MDPIM Emerging Markets Equity Pool.

Interest rates are on the rise, but yields will be slow to follow

Central banks and their policy rate decisions remain a driving force for fixed-income markets, which we expect to continue for some time.

The Bank of Canada pulls the trigger twice and the U.S. Federal Reserve provides clarity

The Bank of Canada increased its policy rate in July and again in September–for the first time since 2010–which came as a surprise to many market participants. We believe this may turn out to be a policy mistake, as Canada is experiencing very little inflationary pressure. This is a situation we’ll be monitoring over the coming period.

The European Central Bank (ECB) indicated that it could tighten its accommodative monetary policy by reducing its asset purchase program. However, the bank has provided no clarity on its path to normalize policy rates, and no changes are expected to be implemented before 2018.

In fact, the U.S. Federal Reserve (the Fed) has been the only central bank to establish a clear path for further policy rate hikes, and the magnitude and pace of any increases are expect to be moderate. The Fed has also said that it would begin reducing its balance sheet in October. All of this supports our positive outlook on the United States.

Despite the actions of the Bank of Canada, the Fed and the ECB, central banks globally remain very accommodative. The Bank of Japan, in particular, has held its policy rate near 0% for years, and we don’t believe its policy stance will change in the near term.

Furthermore, even though global interest rates are on the rise, they remain historically low, and we expect the subsequent recovery in bond yields to be very gradual and to take several years. Similarly, although inflation has increased globally, it generally remains below central bank targets and presents no cause for concern.

Taken as a whole, the current policy stances of global central banks support our increased focus on equities for the coming period. At the same time, our fixed-income position remains a good hedge against potential equity market volatility. With inflation expected to remain low, any increase in rates should be moderate, but fixed-income returns could be low over the coming years.

Currency volatility dampens returns for Canadian investors

Currency markets were particularly volatile over the quarter. Perhaps most significant for Canadian investors was the strengthening of the Canadian dollar against most major currencies. As we discussed earlier, global equity returns were strong, but this appreciation of the Canadian dollar reduced returns for Canadian investors.

While the Canadian dollar was on the rise, the U.S. dollar was weakening. The recent depreciation of the U.S. dollar was supportive of U.S. equities, but by the end of the quarter, the dollar had already started to strengthen. We expect the dollar to continue to rise over the coming period, partly in response to the Fed’s clear plan for policy rate increases.

Given this, we are maintaining our overweight position in the U.S. dollar and slightly underweight position in the Canadian dollar.

We are also maintaining our significantly underweight allocation to the yen. This is largely in response to the Bank of Japan’s monetary policy stance, which we believe will lead to widening interest rate differentials between Japan and the U.S.

With our spotlight on emerging markets, we remain cognizant that a rising U.S. dollar would have a negative impact on emerging market equity performance.

Conclusion

Over the coming period, we’ll be closely monitoring earnings trends. If they remain on an upward swing, we may look to increase our overweight allocation to equities even further. The U.S. equity market remains a particular focus, as its economy continues to expand with no sign of recession on the horizon. That said, the more synchronized this global expansion becomes, the more seriously we’ll consider increasing our positions in other global markets.

We’ll also be keeping an eye on central bank action and its impact on fixed-income markets. For now, though, we believe our fixed-income position continues to provide some protection against equity market volatility.

 

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