Knowledge Centre

After nearly a decade of flooding the world with easy money to jump-start sluggish post-recession economies, central bankers are changing their tune. Investors have ramped up expectations that tight monetary policy and stimulus are coming to an end as Canada, the U.K. and Europe will soon be following the U.S. down a hawkish path. The net effect has been a rise in bond yields and fatigue in the world’s stock markets as the markets in general have become somewhat lackluster.

Canadian economic growth accelerated at a 3.8% annual rate over the past six months, as the impact of housing and autos have surged at a 12% pace. Machinery manufacturing was up almost 15% and the high-tech sector expanded at an 8% clip. Even the financial sector managed to churn out nearly 6% annual growth. Commodities sectors continued to constrain the economic expansion so much so that not even the weak Canadian dollar (despite its recent 6% rebound) was able to boost it. All in all, the recovery now seems very well entrenched.

The current U.S. recovery is long in the tooth and a recent batch of weak economic data and doubts that Donald Trump could enact his pro-growth agenda has tempered its outlook. Still, industrial production was shown to have ample slack and potential for further growth. The Federal Reserve is staying the course and continuing to tighten monetary policy despite the U.S. dollar posting its biggest quarterly decline in seven years which may have consequences to the economy’s continued expansion.

Recovery in Europe is strengthening and broad based unlike the last uneven and fragile upturn in 2013. In fresh signals of healthy growth, employment rose to reach a record high surpassing its previous peak in 2008. The European central bank is expected to maintain sub-zero interest rates and massive bond purchases but there is a chance this may not happen as a change in direction could come quickly if inflation appears persistent. The volatile U.K. elections have led to a number of questions over the Brexit timing and a slumping currency as politicians scramble to deal with the fallout.

Confidence among Japan’s manufacturers hit its highest level in more than three years adding to signs its recovery is sustainable. This expansion is being propelled by robust exports and a boost from private consumption. The job market is the tightest it has been in 25 years and inflation remains subdued. China has cut its economic growth target to 6.5% to give policymakers more room to push through painful reforms and contain financial risks after years of debt fuelled stimulus. Meanwhile, company profits have accelerated as investment income and sales have jumped noticeably.

Equity valuations are starting to become somewhat rich and are above their 10 year averages, while bond yields across the world remain near historic lows. Canada, the world’s fastest growing developed economy, had the worst performing stock market, dropping 1.6%; its first quarterly drop since 2015. Weakness in commodity prices and fears of an overheated property market were the main reasons for the underperformance. U.S. stocks touched record highs, gaining 0.7% in the quarter (all figures are in Canadian dollar terms). International stocks climbed 3.7%, principally based upon Europe’s strongest quarter in six years. Bonds did manage to eke out a 1.1% gain.

In a world where central banks are looking to hike interest rates, investors might think about rushing for the exit. Efforts by hawkish central bankers to move away from low rate policies is just a baby step to normalizing financial markets and tiptoeing towards reversing stimulative policies. Yet with inflation nowhere to be found and economic growth increasing it is much too early to flee the markets. There is no need to get ahead of ourselves.

The second quarter of 2017 saw an improving world economy with solid advances in Europe and the Emerging Markets. Canada also posted strong growth for six months in a row signalLing a significant turnaround for the economy versus earlier declines. As the global economy showed traction, major central banks reverted to a hawkish tone, even in regions like Europe where some countries experienced negative rates months ago. In Canada the central bank has maintained a dovish rhetoric as recently as in the first quarter, but quickly reverted to a possible rate hike on the backdrop of solid growth. Unfortunately, just like at the start of the year, the Canadian markets have moved in the opposite direction vis-a-vis the economy. While the first half of 2017 was decent for global equity markets, some even with double digit returns, the TSX lagged considerably and struggled to keep its performance in positive territory. It managed unsuccessfully to find support and broke down to six month lows with a loss of 1.6% on a total return basis for the quarter; one of the worst performing benchmarks. Year-to-date it is recording a meagre 0.7% return.

The strong rebound of the Canadian economy has naturally been very beneficial to the labour market with jobs numbers not seen in four years. This has led to a 6.5% unemployment rate, the lowest since the last recession. The Loonie has declined due to the volatility of oil prices but as the Bank of Canada has explicitly reverted to a hawkish stance, there is a clear path upward. For some analysts the Bank of Canada policy shift appears aggressive as inflation is well below its 2% target and indebtedness, though elevated, has recently stabilized. Thus an aggressive tightening move is raising concerns over the potential for an adverse impact on an economy that a few months ago was at the brink of a recession. The Canadian economy seems on pace for decent growth this year despite mixed contributions from the energy sector. All things considered, the future state of the energy sector, household indebtedness, and Trump economics will continue to be the determining factors for the course of the economy.

During the second quarter of 2017 the Canadian FTSE TMX Universe Bond Index gained 1.1% and has risen 2.4% so far this year. The Bank of Canada is where it has been since July of 2015. In the U.S. the Federal Reserve increased its benchmark interest rate in December and twice so far in 2017, once in March and again in June. Each of the three increases was for a 1/4 point and marked rising confidence that the U.S. economy is poised for more growth. The minutes of the U.S. Federal Reserve’s May meeting confirmed that the central bank is now committed to shrinking its massive balance sheet. The Fed does not want to sell the assets on its $4.5 trillion balance sheet, but it will let them shrink as its bonds mature. That information put the long term debt market on a more comfortable footing as the U.S. has a plan to very gradually increase yields so as not to disrupt global bond markets. Higher rates seem to be a global trend; the Bank of England is starting to think about making its own move and the European Central Bank has been talking about moving away from quantitative easing.

Canada now has one of the fastest growing economies in the G7. The latest inflation figures could play a key role in any rate hike decision as the headline inflation rate has moved away from the bank’s 2% target. Weak growth in gasoline prices were a factor in lowering the annual inflation rate to 1.3% for the month of May. Canada’s inflation rate is now well below that of Britain, the U.S., China and the EU. Senior deputy governor Carolyn Wilkins indicated the weakness in core inflation is due to the lagged impact of past quarters but inflation is expected to rebound over the course of 2017 which should help justify an interest rate hike. Any increase in rates is expected to be gradual however.

It appears we have seen the end of the secular bond market bull run but that does not mean that we are heading into a bear market for bonds. In bond market terms, the yield curve has been flattening, which means that short and long term interest rates have been moving closer together. If the trend continues and short term rates rise above long term rates, the yield curve will become inverted. An inverted yield curve would express deep skepticism about the health of an economy but it’s important to note that just because the yield curve is flattening doesn’t mean that it will invert. One exception might be in Britain where the Bank of England is battling Brexit-induced inflation pressures and other concerns so it may be vulnerable to a downturn. The probability of a recession in Canada or the U.S. in the next 12 months though is low. More likely bond yields will remain low for some time as inflationary pressures are expected to be subdued.

The Standard & Poor’s 500 index climbed 3.1% in U.S. dollar terms over the second quarter of 2017 and year to date the index was up 9.3%. In Canadian dollar terms the respective change was 0.7% for the quarter and 6.0% year to date as the loonie gained 2.4% during the second quarter and has strengthened by 3.3% so far this year. The long bull market in the U.S. has now passed its eighth birthday and, while it has been a long run, the longest post war bull market lasted for nearly 10 years until March 2000.

U.S. gross domestic product (GDP) increased at a 1.4% annual rate in the first quarter of 2017, following a 2.1% rate of growth in the fourth quarter of 2016. The first quarter GDP number was not too far off the 1.6% expansion recorded in 2016 but it was the slowest growth rate since the second quarter of last year. However, the slowing pace of growth is not a true picture of the economy’s health. The unemployment rate fell to a 16 year low in May and the labour market is near full employment, generating stronger wage growth, and consumer confidence is near multi year highs. That suggests the mostly weather induced slowdown in consumer spending is likely to be temporary.

The Trump administration’s objective of swiftly boosting U.S. growth is facing numerous challenges. Since 2000, the economy grew at an average rate of 2% and a sustained average of 3% growth has not been seen since the 1990s. While the Atlanta Federal Reserve is forecasting annualized GDP growth of 2.9% in the second quarter that may be overly optimistic as the president’s economic program of tax cuts, regulatory rollbacks and infrastructure spending has yet to get off the ground.

U.S. banks passed the first round of the Fed’s stress tests to see how they would perform under adverse conditions like a 10% unemployment rate and turbulence in commercial real estate and corporate debt. The Fed’s chairwoman, Janet L. Yellen, made a bold prediction: that another financial crisis the likes of the one that exploded in 2008 was not likely “in our lifetime.” All major U.S. banks are now cleared to pay dividends after they all passed the qualitative portion of the Federal Reserve’s stress test for the first time in seven years.

A continuing source of concern for the U.S. equity market had been the political gridlock emanating from Washington. The U.S. Congress is trying to repeal the Affordable Care Act and to overhaul the tax code; two efforts that have stalled and consumed more time than was initially expected. Congress also needs to raise the national debt limit by early to mid-October to avoid defaulting on loan payments. There are many legitimate political concerns but the economy has continued to keep growing despite the politicians.

A year can certainly make all the difference. After an extended period of slow and slowing growth around the world, the outlook for investors had been one of trepidation and dismay. However, it appears now, to a large degree, that the world is entering a sustainable period of recovery. The nature of this recovery is very different from previous short-lived global recoveries because the global economy appears to be in much better shape this time around. We are finally overcoming the lasting residue of the financial crisis of 2008.

Europe is the last major regional bloc to essentially recover from an extended period of malaise and significant uncertainty. They appear to have finally gotten it right, certainly compared to past short-lived dalliances with recovery. It may be in its best shape since 2008 and is following in the footsteps of the U.S. economic recovery. There are several key reasons for this new optimism: monetary policy remains supportive; labour productivity has been improving; capital investment has rebounded very well; populism appears contained; and investor sentiment has hit a ten-year high.

The U.K. economy slowed more sharply than first thought in early 2017 as household consumption was hit by rising inflation that followed the Brexit vote and exporters have struggled to benefit from the weak currency. The Conservative government lost its parliamentary majority which raises a great deal of uncertainty over Brexit policy. It is too early to judge how large and persistent this slowdown might be so the Bank of England is keeping monetary policy very supportive for now. While there is slack in the labour market, the acceleration of inflation to a near four-year high of 2.9% intensifies the debate about how long interest rates can stay low. This uncertainty is tarnishing the long term growth outlook and could increase the pressure on struggling consumers.

Japan’s industrial production rose thanks to increases in the production of automobiles for the domestic market and electronic parts for export. Consumption-related indicators are also robust. Inflation remains near zero, despite extensive efforts to improve wages and retail activity. So the prospect is very high that continued stimulative financial support will be maintained, putting Japan on the outside looking in as the rest of the world’s central banks take away the cookie jar. China on the other hand is actively trying to slow down growth targets as the government strives to change the country to a more domestically focused nation. Beijing has continued to tighten the screws on riskier financing which is expected to drag on the world’s second largest economy in coming months.

For the most part the second quarter was very good for international stocks as the market as a whole climbed 6.4% (all figures are in U.S. dollar terms). This, on top of a very strong first quarter pushed the year-to-date returns to a very impressive 14.2%. Overall, European stocks increased 5.9% last quarter, which is better than Asian stock markets which only gained 3.3%. Emerging Market stocks continue to produce stellar results, climbing 5.5% despite increased volatility.

Some parts of the world are out of sync with the general positive economic prosperity that is unfolding, but they are in the minority as sustainable growth is now in vogue. Europe in particular is only just beginning to hit its stride. Assuming that this worldwide pattern continues, it should entrench itself in investors’ mindsets and the prospects for a bright outlook could improve even further.