Quarterly Macroeconomic Overview and Outlook: Winter 2018

January 30, 2018

Key takeaways:

  • Synchronized global growth lifted equity markets around the world
  • Corporate earnings rose across regions and sectors, continuing the positive trend
  • Low inflation helped to keep interest rates contained

As 2017 came to an end, global equity markets continued to benefit from many of the same themes that drove market performance for much of the year. Synchronized global growth, positive earnings momentum and low interest rates were largely responsible for the strong returns experienced by most of the world’s equity markets.

While geopolitical risks remained in the headlines, particularly with respect to North Korea and the uncertainty surrounding Brexit, they failed to have a significant impact on capital market performance. Instead, we saw global equity markets post robust returns to end the year.

On the other hand, global bond yields remained low. Fixed income still provided decent investor returns, but this will become increasingly challenging going forward. Here, we take a look at the three biggest factors affecting markets today and how these factors are affecting the way we position our portfolios.

Synchronized global growth boosts equity markets

For the past few years, global economic growth has been dominated by the U.S. Around mid-2017, however, growth became much broader-based, with most regions contributing. This more synchronized growth continued throughout the fourth quarter, with all major countries in expansion mode and very low probability of recession at this time.

While U.S. growth remains solid, growth has improved in Europe and Japan. All economies in the Eurozone are finally improving, and we believe their growth path is sustainable. Meanwhile, Japan appears to be emerging from a 30-year period of very low growth.

Compared to the last decade, Chinese growth has slowed modestly,  but the country remains on solid footing as it shifts its economy away from being dependent on exports and heavy industries and towards a focus on services and local economy.

Despite a challenging energy sector, Canada led G-7 countries in GDP growth in 2017, with unemployment reaching 5.7% in the second half of the year—its  lowest level in almost 40 years.

This period of synchronized growth had been positive for equity markets across the globe, supporting our overweight allocation to equities, which we’re maintaining as we head into 2018.

Bullish on U.S., Continental Europe and Japan

Taking a closer look at our regional positions, we maintain a constructive view of the U.S., France, Germany and Japan, and are maintaining overweight allocations to those countries.

Although some analysts believe equity valuation in the U.S. are high, we think they’re still fair. With the economy still in expansion mode and the potential positive impact of tax reform, there are still many of opportunities to be found in many areas of the U.S. market.

Our Fund Spotlight this month is on the MDPIM U.S. Equity Pool, where we delve deeper into specific sectors and stocks to keep an eye on.

In continental Europe, we’re maintaining overweight exposure to France and Germany. France is benefiting from improvements in its economy, better corporate earnings and a recovering banking sector. Germany’s economy is strong on a relative basis, and earnings have been positive. Its banking sector is also in the midst of a recovery.

Our outlook on Japanese equities remains positive, and we have a modest overweight here. Recent strength in the global economy is a positive for Japanese equities, as exports are a key driver of the index’s performance.

Brexit, commodity weakness warrant caution

Conversely, we’re underweight the U.K. given the uncertainty that remains surrounding Brexit. We don’t believe U.K. equities are well positioned for the future, and we expect further currency volatility for the pound.

Finally, although we have increased our exposure to Canada, Australia and Switzerland somewhat, we’re still underweight in these countries. Switzerland’s equity market has a defensive tilt, making it unlikely to outperform if global growth continues to improve. The Swiss index also has a meaningful weight towards banks, which have struggled. Meanwhile, we remain wary of commodity-dependent economies, such as Canada and Australia, as commodity markets continue to face challenges.

Corporate earnings are on the rise

Global economic growth is also providing a boost to corporate earnings. After being relatively flat for two years, earnings growth has been positive and broad-based across regions and sectors. That said, some regions have fared better than others.

Commodity-linked markets continue to struggle…

Although the Canadian equity market posted gains, it underperformed its global peers largely because of the negative impact of the energy sector. Oil prices rose over the quarter, trending towards US$60/barrel, but they remain range-bound, capped by U.S. shale producers and moderate demand. On the positive side, OPEC supply cuts appear to have put a floor on prices, but we certainly won’t see the type of growth seen in the early 2000s. Furthermore, share prices in the energy sector have not yet caught up with higher energy prices, and may not for some time.

Meanwhile, Australia is exposed to slowing Chinese demand, which means limited upside for materials prices. The country may also face a housing bubble, as prices in its two largest cities have soared, and its employment trends are on the weaker side.

…while tax reform should be positive for the U.S.

Before the U.S. administration passed its tax reform bill in December, markets had already partly priced it into equity markets. The two sectors set to benefit most from the bill – financials and information technology – experienced strong gains. Small-cap stocks, which are more domestically-focused than their larger-cap peers, also received a boost from tax reform measures.

Our Fund Spotlight on the MDPIM U.S. Equity Pool offers more insight into the new tax bill and its impact on various areas of the market.

Inflation, interest rates remain low

Inflation increased somewhat over the quarter but remained below central bank targets, allowing central banks to remain largely accommodative. At the same time, deflation – which has been on the minds of central bankers for almost a decade – is no longer much of a risk.

The Fed did raise its federal funds rate again in December, but the move had been largely anticipated by the market, and the central bank’s policy outlook for 2018 remained unchanged. The U.S. short-term rate is still very low at 1.5% and is expected to increase very slowly, potentially reaching 3.0% by 2020.

The Bank of Canada held rates steady over the quarter, after surprising the market in September with its second rate increase of the year. Higher rates have had a slightly negative impact on Canada’s real estate sector and consumer spending, but again, the overnight rate remains very low at just 1.0%, giving little reason for concern.

The Bank of Japan has anchored its 10-year yield at 0% and is unlikely to change its policy stance over near term. This could lead to wider interest rate differentials versus the U.S. and a further weakening of the yen, which would be positive for exports.

On a global level, interest rates remain very low by historical standards and the pace of any interest rate increases has been moderate. We don’t expect this to change over the next few years, further supporting our positive view on equities.

Fixed income remains a good hedge

Turning to fixed income, we’ve adopted a somewhat shorter duration in our portfolios for less sensitivity to interest rates, although we’re not expecting rates to increase by much. And despite our current preference for equities, we believe bonds remain a good hedge against extreme market events, given the low risk of inflation shock.

A look towards 2018

Thanks to a combination of synchronized global growth, positive earnings momentum and low inflation, we expect equities to continue to outperform. With valuations on the rise, equity returns may be somewhat more muted in 2018, but we believe valuations remain fair in many markets and there are still plenty of opportunities to be found.

Fixed income returns may be lower heading into 2018, given current economic conditions, but the asset class remains a good hedge against equity market risk.

In terms of monetary policy, central banks will face a balancing act in the coming year. As economies continue to strengthen, central banks will look to tighten their monetary policies, but they’ll have to do so in a way that doesn’t stall economic growth.

We’ll continue to monitor geopolitical risks, particularly the situation in North Korea, uncertainty surrounding Brexit and upcoming elections in Italy, but currently, we don’t believe there’s significant cause for concern on a global scale.

Until this outlook changes, we’ll maintain our overweight allocation to equities and continue to favour the U.S., Continental Europe and Japan over the U.K. and commodity-linked economies, such as Canada and Australia.

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