Knowledge Centre

The world is entering a period of synchronized economic expansion that has a long way to run, albeit with less scope for upside surprises. Markets will likely not continue to be as stable as last year, but there are a few signs of leverage building in the financial system which could trigger significant economic risk. Earnings will likely continue to be on an upward trend, although the growth rate could wane. With global savings still plentiful, only small increases in long term bond yields are expected.

Yield curves have been flattening but this is a normal late cycle phenomenon. Insatiable global demand for income has held down long-term yields across the world. The flattening has been mostly driven by rising short term rates as central banks start to take away the cookie jar. During 2018, investors should brace for the biggest tightening of monetary policy in more than a decade as the global economy heads into its strongest period since 2011. It is going to be challenging for central banks to continue pulling back without rocking asset markets.

The Canadian economy is running at close to its full potential though we need to consider the stalemate in NAFTA talks, large minimum wage increases and new mortgage rules as risks. Oil prices have rebounded to reach their highest levels since mid-2015 providing some much needed additional stimulus for the economy. This strength in oil prices will offset the likely rate hikes in 2018 as the Bank of Canada takes a cautious stance on monetary policy despite two interest rate hikes already. The strength in oil prices also had the added benefit of propelling the Canadian dollar higher as it gained 6.3% for the year.

The U.S. economy continues to grow at a very brisk pace and the recent tax cuts could boost near term growth even more. The labour market has continued to strengthen to its best level since 2001 and economic activity has been rising at a solid rate despite hurricane related disruptions. What will likely slow the economy eventually are increases in interest rates by the U.S. Federal Reserve, beyond those that have occurred already, in an effort to prevent a potentially raging economic expansion
from developing.

International economies are humming along with only small clouds on the horizon. After a decade of crises almost tore Europe apart, the region has emerged more in sync than ever. The European Central Bank’s stimulus brought the monetary union back from the brink and should continue to keep interest rates at their historic lows to further power the economies ahead for a sixth year. The Japanese expansion has now stretched into seven consecutive quarters for the first time in 29 years. Britain’s economy is slowing as a jump in inflation is pinching spending by consumers. China is undertaking significant economic reforms which could cause a slowdown in growth and trigger temporary credit crunches.

Stock markets around the world ended the year on a high note, propelling equities to record highs almost everywhere. Emerging markets once again led the way with a significant quarterly return, 7.7% (all figures in Canadian dollar terms) and 19.5% for the year. International stocks were paced by Asia and were up collectively 4.9% for the quarter and 19.0% for the year. U.S. stocks were close behind, gaining 7.3% for the quarter and 15.5% for the year. Unfortunately, Canadian stocks were once again amongst the laggards, only climbing 4.5% for the quarter and a reserved 9.1% for the
year. Bonds were most definitely the weakest asset class, gaining a paltry 2.0% for the quarter and 2.5% for the year.

While the length of the current cycle is quite extended, investors should be focused on the synchronized nature of global growth. Certainly, valuations are elevated, but the underlying fundamentals are showing no signs of recession. Perhaps returns may not be as generous going forward, but that does not mean the markets will not go up. There are going to be periods of volatility, but those should be viewed as buying opportunities, especially with the economy and earnings growth expected.

2017 saw strong global economic momentum across the board albeit on the backdrop of unfavourable geopolitics and natural disasters. These negative events were largely ignored by financial markets as volatility for most of the year fell to unprecedented historical levels amid renewed consumer confidence, improving earnings and persistent support for easy financial conditions.

The Canadian economy started the year with above average growth versus its global peers but took a breather after the first half. Yearend data suggests that the pause was short lived and that the economy is still on pace to post about 3% annual GDP growth – the best in six years. However this did not translate into a stellar year in the equity markets as it did in 2016.

After a flat first half to the year, the Toronto Stock Exchange (TSX) surged back with strong gains in the second half to close the year at an all-time high of 16,209 points, well above the 14,951 low in August. This was largely due to a rebound in Health Care, IT and almost every other sector. In total return terms, the index was resilient with a decent 9.1% return despite the weak start. Still that was not enough to make 2017 a blockbuster year for Canadian markets.

The strong GDP growth in 2017 and the outstanding momentum of the TSX versus its global peers during the second half of the year seems to indicate that Canadian markets are poised to be among the global leaders. One advantage of the TSX is its relative discount to other markets, especially relative to the U.S

Although the TSX rallied to a record high, its relative earning yield valuation versus the U.S. S&P 500 index leaves the TSX at its widest discount since the financial crisis. Future TSX earnings will depend largely upon the global economy, as well as commodity prices, and if the recent rally at current levels persists the TSX will be positively impacted.

Despite a solid footing, the Canadian economy will face ongoing challenges. On one front the household debt-to-disposable income ratio remains a critical issue. That ratio keeps creeping up despite government efforts to curb it. The other major uncertainty is the potential change to the NAFTA agreement. So far the negotiations seem to have stalled but there is too much at stake to completely abolish it. Although the U.S. has some leverage in the renegotiations, its partnership with Canada has not been overly detrimental, as its trade deficit relative to Canada is small.Thus, NAFTA or not, there is some optimism that both countries will come to an agreement that will benefit both of our economies.

The Canadian FTSE TMX Universe Bond Index gained 2.0% in the fourth quarter of 2017 and was up 2.5% for the year. Over the course of 2017, the Bank of Canada raised rates in July and September in response to an impressive economic run that began in late 2016. The hikes took back the two rate cuts introduced in 2015 to help cushion and stimulate the economy from the collapse in oil prices. In the U.S., the Federal Reserve increased its benchmark interest rate in December. It was the third hike in 2017 and pushed the target range to 1.25% to 1.5%. The recent increase was the fifth rise since the U.S. began raising rates in December of 2015.

The Bank of Canada has left its benchmark rate at 1% for two straight policy announcements after the strengthening economy prompted it to raise rates twice in the summer. In announcing its latest decision, the bank pointed to several recent positives that could support higher rates in the coming months. They included encouraging job and wage growth, sturdy business investment and the resilience of consumer spending despite higher borrowing costs and Canadians’ heavy debt loads. The bank said inflation, a key factor in its rate decisions, has been slightly higher than anticipated and could stay that way in the short term because of temporary factors like stronger gasoline prices. Core inflation, which measures underlying inflation by omitting volatilei tems like gas, has continued to inch upwards.

The Bank of Canada’s Governor Stephen Poloz has been challenged by trying to increase interest rates as the economy runs up against capacity constraints while avoiding another economic downturn. In a December speech he noted that he was encouraged by this year’s strong performance and said that “we are growing increasingly confident that the economy will need less monetary stimulus over time.” At the same time the governor said that, “we will continue to be cautious in our upcoming policy decisions” which investors are taking to mean three more rate increases are likely in 2018.

If confirmed by the U.S. Senate, President Trump’s nominee to succeed Chairwoman Janet Yellen will be Fed Governor Jerome Powell. He will become the new Fed chair when Ms. Yellen’s four year term expires on February 3rd. Mr. Powell is viewed as a good replacement as he has voted in favour of every Fed policy decision since 2012. He will be taking office as the U.S. economy is poised for a solid rebound after a disappointing start to 2017. Gross domestic product grew at more than a 3% annualized pace in both the second and third quarters and is on track to expand in the fourth quarter by 2.9%, according to the Atlanta Fed’s tracking estimate.

The Standard & Poor’s 500 index climbed 6.6% in U.S. dollar terms over the fourth quarter and in Canadian dollar terms the index has gained 7.3%. For 2017 as a whole the U.S. equity benchmark gained a stellar 21.8% in U.S. dollar terms and was ahead a very respectable 15.5% in Canadian dollars. Going into 2017, the global investment community was concerned with the surprise win by Donald Trump but the U.S. stock market climbed steadily from one high to another over the course of the year amidst an unusual level of calm. Even the “tech heavy” Nasdaq Composite Index, that some thought would do poorly under President Trump, has surged 28.2% during 2017.

The most significant piece of legislature under the guidance of the Trump administration has been tax reform and while investors like the idea of corporate tax cuts because the companies in which they invest could become even more profitable, it is unlikely the tax changes are as important as some think as many companies had been taking advantage of deductions to keep their already low rates low. Republicans talk of sparking economic growth rates in the 4% range but models run by non-partisan forecasters, such as the Wharton business school at the University of Pennsylvania, predict only a modest increase over the short term. That is due to the fact that few companies actually pay the top rate. Once deductions and other legal loopholes are factored in the effective corporate rate is not very far off the 20% promised in the legislation.

Also, virtually all the objective analysis of the Republican plans suggest that the tax cuts will widen the budget gap and add to the fiscal deficit. The Wharton budget model predicts that the added debt will eventually reduce economic growth as money that might have been spent on productive investment ends up instead in government bonds.

The more plausible explanation for the stock market’s success in 2017 had less to do with President Trump’s policies and more to do with the Federal Reserve and its soon to depart chair, Janet Yellen. It took longer than anyone thought it would but the Fed’s post-crisis policy of putting maximum downward pressure on interest rates is finally paying off. The U.S. unemployment rate was at 4.1% in October, which is near its lowest level ever. Companies are broadly profitable and the world’s biggest economies are growing in sync for the first time in a decade. The ultra low interest rate policies of the Fed and other central banks have meant that there is a lot of money sloshing around and that has bid up the price of financial assets worldwide.

Some investors are concerned about the longevity of the current economic expansion and the age of the bull market which celebrated its eighth birthday in March of 2017. Bull markets do not die of old age but fall from economic excesses and the excesses that have heralded the demise of previous bull markets, namely overspending, overborrowing and overconfidence, have so far remained contained. Of course there is always the possibility of a recession in the next year or so due to an unexpected geopolitical shock or policy mistake. Excessive euphoria is more of a near term concern as sentiment indicators are suggesting too much optimism among investors.

A recent Bank of America survey showed that for the first time in six years a record high 48% of market participants are expecting above trend growth and below trend inflation. At the same time though there is not a huge flow of funds into stocks that often hints at a major peak.

The S&P 500 is trading near its all-time high and hasn’t seen a 5% pullback since the Brexit referendum in late June 2016. This extended period of tranquility may portend that the market is due for a near term pullback but the long term outlook remains favourable.

The global economic expansion is gaining momentum as the stimulus from monetary policy continues to reverberate. The U.S. economy has been pulling the world along with it for a while but now the world is starting to pull its own weight. Most central banks are keeping interest rates at rock bottom levels and are anticipated to hold rigidly to this script in 2018.

Europe has enjoyed its strongest and most sustained period of growth since a short lived bounce back following the global financial crisis. The Eurozone gained momentum in 2017 after sidestepping some potential risks with populist, Euro-skeptic parties losing elections in major economies such as France. Worries over Greece’s future in the single currency bloc have abated while the current tensions in Spain over Catalonia’s bid for independence do not yet appear to be shaking confidence. The robust growth has helped unemployment fall consistently over the past year to its lowest rate since January 2009. Inflation remains weak and consumer spending continues to be strong. The European Central Bank is sticking to its pledge to keep money pouring into the economy for as long as needed.

Britain’s economy has slowed sharply this year, falling behind a recovering Eurozone, and it is expected to lose more ground in 2018 as the effects of the Brexit vote are felt by consumers and companies. Inflationary pressures are likely to continue to build after hitting a five year high due to the fall in the value of the pound, while unemployment fell to its lowest rate since the 1970s. All of which caused the Bank of England to raise interest rates for the first time in more than ten years, although it is expected to only raise them gradually over the next few years.

Japan’s economy has expanded for seven consecutive quarters making this the first time it has gone that long without a contraction in eleven years. Unemployment is at a multi-decade low and corporations are experiencing near record profits. Prospects for workers look brighter as a tight labor market is beginning to push wages higher. Consumer prices and income are showing modest gains. Japan still faces deep structural problems. Its population is aging and dwindling but investors appear to be looking at the bright side as Japan’s main stock index rose to its highest level in almost 26 years.

The environment for emerging markets was great in 2017 as a period of strong growth, low inflation and economic reforms were key factors in allowing them to end years of underperformance versus their developed peers. High yields and buoyant growth prospects enabled emerging markets to rise despite the U.S.’s protectionist rhetoric and a swathe of geopolitical brush fires. They face several key challenges going forward such as maintaining domestic stability amid reforms and reducing financial leverage without upsetting financial stability.

Stock markets have been lifted by robust global growth and expanding corporate profits as the world finally appears to be shrugging off years of crises and sluggish growth. In addition, corporate profits in all major regions increased by more than 10% over 2017 which further amped up performance. International markets as a whole were up 4.3% for the quarter and 25.6% for the year (all figures in U.S. dollar terms). European stocks rose 2.5% for the quarter and 15.8% for the year. Asian stocks climbed 9.0% for the quarter and 19.5% for the year, while emerging markets led the way, up 7.7% for the quarter and 27.9% for 2017.

The economic and earnings backdrop is still quite positive for equities but we need to be mindful of risks to financial stability. In general, the stars should continue to align from a macroeconomic perspective with global growth expected to be steady and inflation subdued. Full valuations could be a potential drag and there is always the possibility of corrections however the markets still look well positioned for future increases.