Summer 2018: Quarterly market update

July 24, 2018

 

Key Takeaways

  • The global economy continues to grow
  • Strong economic data continues to push rates higher
  • Prospect of all-out China-U.S. trade war looms

Global economic growth has continued apace, albeit with less synchronization around the globe. Earnings have been strong and broad based across countries and sectors, while financial market conditions remain stable, showing little signs of stress despite the correction earlier in the year.

All this happened while tensions with Canada’s largest trading partner increased as the Trump administration amped up its threat to end the North American Free Trade Agreement (NAFTA) and imposed high-profile tariffs on many of its largest trading partners. 

During the past quarter, we saw three main themes drive the market as we continue to position our current portfolio for success:

The global economy shows real strength

The global growth story remains in place, with improving corporate profitability, increasing export orders, low levels of unemployment and solid wage growth. Despite coming off 2017 highs, purchasing managers’ index (PMI) readings—a key indicator of economic health and current business conditions— remain positive across countries. It’s important to note that global PMI readings remain elevated relative to past years.

Despite market volatility increasing back to more normal levels, the global economy continues to grow. Central banks are slowly but surely moving away from emergency rates, but they remain structurally low. Inflation is in check, more-or-less at central bank targets they so covet.  For these reasons, we maintained our overweight allocation to equities relative to fixed income.

Staying overweight American equities as the U.S. economy continues to drive global growth

A strong U.S. economy continues to lead global growth with impressive corporate earnings and positive jobs growth. A hawkish Federal Reserve raised rates twice in 2018 so far, with 2 additional 0.25% increases expected for the rest of the year. In their June statement, the Fed  confirmed our thesis of further economic expansion within the U.S., which supports equity prices domestically and abroad. For these reasons, we remain overweight U.S. equities and the U.S. dollar.

Selective positioning in Europe

Despite decelerating from 2017 levels, Europe’s economies experienced sturdy growth and the region remains on solid footing. France and Germany in particular have demonstrated good economic growth and earnings with PMIs being attractive.

On the other hand, the U.K. continues to lick its self-imposed Brexit wounds, creating an environment of low growth and high inflation. For these reasons (and others) we continue to favour France and Germany over the U.K. and Switzerland at this time.

Commodities weighing on Canadian and Australian positioning

While commodity prices have come up, they remain low and range bound. In the case of Canada, oil prices remain discounted due to pipeline availability, or the lack thereof. Similarly, Australia is contending with metals prices. We are underweight both countries, however, strong global growth has increased demand for Canadian exports, boosted Canadian business investment and unemployment remains at 40-year lows—as a result, we’ve reduced our underweight to Canadian equites.

Strong economic data continues to push rates higher

Interest rates around the world are on the rise as central banks respond to global growth and the necessity to shift away from the emergency policy needed post 2008. Policy makers including the U.S. Federal Reserve, the Bank of Canada and the Bank of England all have been raising rates slowly but surely. The European Central Bank also announced the end date for asset purchasing under its quantitative easing program (end of 2018).

Central banks still see continuous economic expansion and a low probability of recession, an outlook we agree with at this time. As Inflation expectations and real yields continue to recover, our fixed income positioning favours longer term bonds over shorter term bonds as the yield curve flattens—a phenomenon that occurs when short-term bond yields rise faster (and prices fall more) than long-term bond yields.

Trade rhetoric turns into action

With NAFTA renegotiations staling, the U.S. enacting tariffs on steel and aluminum and on $34 billion worth of Chinese goods, trade related headlines have been abundant. While we will continue to monitor these developing stories, we believe that current enacted and proposed tariffs will have a minor impact on global growth. U.S. trade penalties thus far have had little impact on the positioning and the performance of our portfolios.  

Canada, the U.S. and Mexico will work something out… eventually  

A deal remains likely as Canada, Mexico, and the U.S. are natural trading partners with bonds that go beyond geography. Synergies, complementary resources and skills means a solution is mutually beneficial. Over time, U.S. consumers and manufacturers might end up taking the biggest hit in the form of higher prices and higher materials costs. For example, U.S. economic consultants estimated that each steel/aluminum industry job gained from the tariffs, will cost 16 jobs in other areas.1 

Testing the largest trade relationship in the world

While the U.S. is at odds with most of the developed world with regards to trade, by far the most important trade story line is playing out between China and the U.S. The risk of escalation is something we are watching very closely as China retaliates to the first round of U.S. imposed tariffs.

What can investors expect?

For the time being, investors should continue to see the benefits of global economic improvement. Measures of current risk have moved up slightly, but from a very low level and overall risk remains low. Although we saw a correction earlier this year, we do not believe it signals an impending bear market. In fact, we believe that equities remain favourable over fixed income for the next 12 months.

With that being said, as the economic cycle shifts into later stage growth, we will be keeping a close watch on interest rates, inflation, economic data and geopolical events as they play out. Additional headlines are sure to come, particularly about global trade dynamics as the U.S. moves towards mid-term elections.

As always, we will continue to monitor global conditions and make suitable adjustments to our strategy when appropriate.

 

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