Q4 2017 | Market update
Sadiq S. Adatia
Chief Investment Officer
Opinions as of January 5, 2018
The commentary in this grey box was added on January 17 in response to the Bank of Canada’s rate decision. The Q4 Market Update starts at the “Highlights” section below (opinions as of January 5).
Before its decision to raise interest rates on January 17, it appeared to us the Bank of Canada was trying to balance the country’s current economic standing against an uncertain outlook. According to a release from the central bank:
“Recent data have been strong, inflation is close to target, and the economy is operating roughly at capacity… Consumption and residential investment have been stronger than anticipated, reflecting strong employment growth. Business investment has been increasing at a solid pace, and investment intentions remain positive.”
Based on this and other factors, the BoC raised its key lending rate 25 basis points to 1.25%, matching the consensus estimate of analysts polled by Bloomberg as well as our own projection. But we think the increase is premature.
While we agree that certain aspects of the economic picture are showing decent health, we don’t expect the situation to last. We’re concerned about the impact this rate hike will have on our economy.
Our worries include the fact that consumers are saddled with record household debt, and there are indications the overheated housing market is cooling. That could make it difficult for homeowners to absorb higher borrowing costs, not to mention a more vigorous mortgage approval process. As well, U.S. President Donald Trump has threatened to tear up NAFTA, which would certainly have a wide-ranging impact, including potentially on monetary policy.
From a market perspective, we remain moderately bullish on equities overall compared to bonds, and within equities, we’re bullish on global markets and bearish on Canada.
EQUITY MARKETS SURGED TO RECORD LEVELS
Equity markets continued to surge in Q4 with most ending 2017 near record levels (Chart 1). It truly was an incredible year with strength across all global equity markets. And even though interest rates were increased multiple times in Canada and the U.S. in 2017, they remain at relatively low levels and continue to fuel growth.
In the U.S., President Donald Trump was finally able to get his tax cuts through Congress, which should boost consumer confidence and spending in 2018. However, tensions over North Korea’s nuclear buildup remain, and could have a negative impact on the market if the standoff escalates.
In Canada, job creation and growth were both strong in 2017, with oil prices moving significantly higher into the end of the year. With the Bank of Canada holding off on raising interest rates in Q4, the Canadian equity market had its best quarter of 2017. However, we did start to see some economic weakness as the year ended, with housing prices starting to decline in the important Toronto market while consumer debt continued to move higher.
In Europe, the economy improved, with consistent growth and higher consumer confidence allowing the increase in consumer spending to continue.
Emerging markets were the strongest performers in 2017, with growth remaining significantly above developed markets, with no signs of that trend changing.
Overall, strong global economic fundamentals helped push equity markets significantly higher across the board.
EQUITY MARKETS HIT RECORD LEVELS IN 2017
CANADIAN ECONOMY: WILL 2017'S STRONG PERFORMANCE REPEAT?
In our view, 2017 was quite the surprise as far as the Canadian economy was concerned, with growth and job creation better than expected. As a result, the Canadian equity market had a strong second half of the year, although it still ended 2017 trailing most foreign markets by a wide margin.
However, as the year closed off, we started to see some evidence of weakness, which could cause 2018 to look quite different. Growth in Q4 was lower and housing prices declined, particularly in the booming Toronto real estate market. Perhaps the BoC’s two rate hikes in 2017 are starting to take their toll.
Oil was an interesting story as crude prices rebounded but oil stocks had a negative year (Chart 2). The question remains: will oil stocks play catch up or will oil prices retreat? This will be an important factor in deciding whether returns on the S&P/TSX Composite Index will be positive or negative for 2018.
Another important factor to keep an eye on is whether the BoC will raise rates again in 2018, after doing the right thing and pausing in December. Any additional strain on Canadian consumers might have negative consequences for consumer confidence, and in turn, the Canadian stock market.
ENERGY SECTOR LAGGED DESPITE OIL PRICES MOVING HIGHER
CANADIAN BOND YIELDS ON A ROLLER-COASTER RIDE
Canadian bond yields moved lower early in Q4 before starting to rise again near year-end, with the yield on Canadian 10-year bonds starting the quarter at 2.13% and ending at 1.98%. The yields on U.S. 10-year Treasuries, on the other hand, increased steadily throughout the quarter ending 2017 at 2.40%, up six basis points. The move higher in Canada near the end of Q4 was tied to improving economic data, while in the U.S., the expectation of further interest rate hikes and tax cuts pushed yields higher. We expect yields in both markets to continue to move higher in 2018.
U.S. ECONOMY: FUNDAMENTALS CONTINUE TO DRIVE THE MARKET
The U.S. equity market rallied throughout 2017 based purely on fundamentals. Job creation continued, consumer sentiment and spending was strong and economic growth continued.
The Trump administration delivered very little in 2017 but in December they were finally able to push through the tax bill, which was quite significant. This should help markets get off to a strong start in 2018. And while there is no doubt that valuations look more expensive, we expect the bullish rally in U.S. markets to potentially continue for at least the first half of 2018.
INTERNATIONAL MARKETS LOOK PROMISING
Economic improvements continue in the eurozone and we do not see any signs of this changing. Growth is stable, consumer confidence is high and the unemployment rate continues to improve. Some small political issues may pop up in 2018 and we are watching the troubled Italian banking sector, but do not anticipate any major market distractions. As well, valuations still look reasonable compared to other markets and given that the European economy still has lots of room to improve, we think this market can still enjoy above-average returns in 2018.
EMERGING MARKETS: STRONGER LONGER-TERM PROSPECTS
Emerging markets were the top performers in 2017. We like their prospects for 2018, but it may be a bit rockier given the recent run-up and potential distractions from North Korea.
China and India had a great year, but India may be the better story in 2018. Longer term, emerging markets will likely remain the highest growth region and an asset class that could help deliver strong returns.
OUTLOOK: FIRST HALF OF 2018 SHOULD BE STRONG
The markets hit record levels in 2017, but we still see potential upside in 2018 – at least in the first half of the year. As such, we remain comfortable with our overall stance, which is slightly bullish.
On the U.S. front, the tax cuts passed by the U.S. Congress should help boost corporate earnings, add to already high consumer confidence and keep consumers spending. Although we expect multiple rate hikes in 2018 and valuations are expensive, we still see growth continuing with markets moving higher. Accordingly, we remain slightly bullish on U.S. and global equity markets.
Europe has stabilized and has plenty of room to improve. We see more upside in this market as jobs continue to be created and remain slightly bullish.
In Canada, we cannot ignore the potential risks. Housing prices may have started their decline, consumer debt continues to be worrisome and the fate of NAFTA is still not resolved. The only positive we see is some upside in energy stocks if they play catch-up with oil prices. Not surprisingly, we continue to remain less optimistic about this market.
Emerging markets have been spectacular, and we are still comfortable with the valuations. Outside of North Korean tensions, we do not see much to worry about, and, as such, we are maintaining our current position.
The Canadian dollar ended the year just under US$0.80, which was slightly above our forecast, but we do not see it holding there for most of 2018. With the U.S. raising interest rates and Canada possibly having to deal with a slower economy, we see pressure on the Canadian dollar versus its U.S. counterpart.
Canadian and U.S. bond yields should move higher in 2018, which could result in a tougher environment for bonds. However, it is still important to remember that if volatility increases, bonds may still help stabilize a portfolio.
Overall we are optimistic, but we do see the second half of 2018 being different than the first half. For now, we remain slightly bullish on equity markets with a bias to foreign markets and less positive on bonds.
This commentary contains information in summary form for your convenience, published by Sun Life Global Investments (Canada) Inc. Although this commentary has been prepared from sources believed to be reliable, Sun Life Global Investments (Canada) Inc. cannot guarantee its accuracy or completeness and is intended to provide you with general information and should not be construed as providing specific individual financial, investment, tax, or legal advice. The views expressed are those of the author and not necessarily the opinions of Sun Life Global Investments (Canada) Inc. Please note, any future or forward looking statements contained in this commentary are speculative in nature and cannot be relied upon. There is no guarantee that these events will occur or in the manner speculated. Please speak with your professional advisors before acting on any information contained in this commentary.
© Sun Life Global Investments (Canada) Inc., 2018. Sun Life Global Investments (Canada) Inc. is a member of the Sun Life Financial group of companies.