Q3 2018 | Market Update
Sadiq S. Adatia, Chief Investment Officer
Opinions as of October 1, 2018
Canada signs trade deal, tariff wars continue
Canada, the United States and Mexico signed on to a new trade deal to replace NAFTA. But just days before, U.S. President Donald Trump ratcheted up pressure on China, placing a 10% tariff on a further $200-billion worth of Chinese goods entering the U.S. China immediately countered with a 5 to 10% tariff on $60 billion in U.S. imports. This is a significant escalation. And it won’t be easily resolved, with trade negotiations between the two countries breaking off at one point.
The new NAFTA pact called the United States-Mexico-Canada Agreement (USMCA) appears to be a good one for our country. Most of the previous NAFTA agreement remains as it was, with only minor changes. In addition, it keeps important elements like the dispute mechanism firmly in place.
The new pact will span 16 years, with a review after six years. This may create stability. And that should remove some of the uncertainty around the Canadian economy, which has dampened foreign and domestic capital investment since the negotiations began 14 months ago.
U.S. EQUITY MARKET CONTINUES TO LEAD
Despite the ongoing trade dispute with China and endless controversies swirling around Trump, U.S. economic fundamentals continue to win out, with the S&P 500 rallying to a record high (Chart 1).
In Canada, even with a new trade deal in place other concerns remain, with housing sales slowing and consumer spending softening. This weakness was reflected in the performance of the S&P/TSX Composite Index, which was down 0.57% in the second quarter.
In Europe, two key risks remain: political instability in Italy and uncertainty around Brexit, with the European Union largely rejecting the U.K.’s latest separation proposal. As a result, even though the Eurozone economy looks good, the market was up just slightly.
Emerging markets, battered by a rising U.S. dollar and trade uncertainties, were down for the second consecutive quarter. India and China led declines in emerging markets. India’s growth has been stalled in the short term by a selloff in the financial sector, while the trade dispute with the U.S. is hurting China.
Overall, we still feel that equity markets can go higher by year end. But after the S&P 500’s 10-year bull run, perhaps it won’t be the top-performing index in Q4. As a result, we are looking to rotate some of our money to other geographies.
CHART 1: S&P 500 RALLIES TO RECORD HIGH
INTEREST RATES CONTINUE TO MOVE HIGHER
On the interest rate front, the U.S. Federal Reserve Board raised rates in September after pausing in August. The Fed’s so called dot plot shows where each member of the Federal Open Market Committee believes interest rates are headed. It suggests that we are likely to see one more hike in 2018 and three more in 2019.
On the other hand, the Bank of Canada raised interest rates in July but paused in August. The BoC is expected to raise rates again in October and then wait to assess economic data. It will also now have to consider the positive impact of the new trade deal in its economic outlook.
NORTH AMERICAN BOND YIELDS CLIMB
Canadian bond yields moved sharply higher in Q3 as Canada’s economy continued to hold up well. The yield on Canadian 10-year bonds started the quarter at 2.14% and ending at 2.42%. The yields on U.S. 10-year Treasuries also moved higher and was once again over 3.0%, ending the quarter at 3.05%, up 20 bps. The move higher in the U.S. reflected continuing confidence in U.S. fundamentals and higher interest rates. We expect yields in both markets to continue to move higher in Q4.
NEW TRADE DEAL REDUCES RISK TO CANADA’S ECONOMY
Risks to Canada’s economy may have been reduced with the new trade pact, which could boost Canadian equities. And with less uncertainty, foreign and domestic capital investment in Canada may increase. Still, there are weak spots in the economy with higher interest rates starting to weigh on both consumer spending and the housing market with sales slowing (although prices continue to rise).
However, higher oil prices could also continue to help the Canadian economy with OPEC committed to holding the line on supply. OPEC’s resolve is keeping the price trading in the US$70 a barrel range. Unfortunately, gains in energy shares have not kept up with increases in the price of oil (Chart 2).
That said, equity valuations on the S&P/TSX Composite Index look more attractive than in many other parts of the world. And we think the index, buoyed by the new trade pact, could be up slightly in Q4.
CHART 2: TECH AND FINANCIALS MOVE HIGHER, ENERGY LAGS
U.S ECONOMY: HOW LONG CAN THE STRENGTH LAST?
How long the U.S. economy can continue to grow at its current pace is a question we have been asking ourselves a lot these days. We believe that there are very few signs suggesting that economic fundamentals are deteriorating and at the same time consumer confidence remains near record highs. High-paying jobs are being created, and although Trump’s trade policy may be disruptive, it will likely give the U.S. an edge over the short term. Earnings also remain strong, but valuations look a bit stretched.
How long the rally in U.S. equities will last really depends on what happens on the global trade front, in particular with China. For now, we remain slightly overweight in U.S. equities.
INTERNATIONAL MARKETS MAY MOVE HIGHER
The Eurozone economy remains stable, with decent growth. But it has not seen much improvement recently. There has been increasing concern over how Brexit will ultimately play out, and issues surrounding Italy’s eurosceptic government and fragile banking system remain unresolved.
However, these markets have lagged the U.S. and we could see a rotation into international markets based on lower valuations and a potential uptick in growth. Consequently, we have increased exposure to a slight overweight.
EMERGING MARKETS: STILL TRAPPED IN A TRADE WAR
Emerging markets may offer some of the strongest growth over the longer term, but current trade issues are weighing heavily on these markets. With the trade dispute between China and the U.S. escalating, it is hard to see an immediate upside in these markets. It’s also difficult to know when the dispute will end, but a resolution could result in a major spike in returns. We remain slightly underweight emerging markets, but could increase it over time.
OUTLOOK: MARKETS SHOULD CONTINUE TO MOVE HIGHER
We are slightly bullish on equity markets, although we have made a slight change to our geographic positioning.
We still feel confident about the U.S. given the strong economic fundamentals. But with mid-term elections around the corner and the trade dispute with China escalating, we have slightly reduced our weighting after a strong run.
We are growing more confident on Europe. And we have rotated some of our money out of the U.S. into this market. Although the outcome of Brexit negotiations and political issues in Italy remain, we think they’ve been priced into the market. Furthermore, the economy is holding up well with potential to surprise on the upside.
In Canada, many economic risks have been priced into the market, which has been under pressure for the last few years. However, with NAFTA resolved, there could be a move higher in the markets. Higher oil should also support the economy and the housing market may have a soft landing. We remain neutral on Canada for now.
Emerging markets have been weighed down by trade issues, and in our opinion are looking to break out. We see good longer-term opportunities. As such, we are looking to increase our position on further pullbacks.
Following the announcement on the new trade deal, the Canadian dollar surged to a four-month high, climbing to just over US$0.78. We now expect it to be range-bound in the coming months.
Canadian and U.S. bond yields should continue moving higher throughout 2018, which could be negative for bonds. However, we are starting to see more attractive yields and that may cause investors to move more more bonds.
Overall, our view on fundamentals for the global economy has not changed but despite the new USMCA deal, trade tensions have intensified with China. We continue to remain slightly bullish on equity markets with a bias to foreign markets. We remain underweight bonds. And with valuations stretched, we are still worried about high yield corporate bonds and we see better opportunities elsewhere.
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