Q4 2019 | Market Update
Written commentary by Sadiq S. Adatia, Chief Investment Officer
Opinions as of December 31, 2019
Markets climb on tariff war truce
Brexit paralysis and the U.S./China trade war have dragged on the global economy for months. Remarkably, we saw at least a partial resolution of both in the final days of 2019, when British voters said goodbye to Europe and the first phase of a potential deal to end the tariff battle with China was reached. And while investors were digesting those events, the U.S. House of Representatives quietly ratified the USMCA – a trade pact critical to Canada’s economic growth.
Even after all that, one potentially disruptive issue remained: the formal impeachment of U.S. President Donald Trump. Still, the market appeared to believe that there is little chance he actually could be removed from office. In fact, when the gavel fell, possibly sending Trump on to trial in the Senate, the S&P 500 Index reached yet another record high.
In addition to a partial easing of trade tensions and increased clarity on Brexit, there were other positive signs for the market. The U.S. continued to put up strong job numbers. And the U.S. Federal Reserve Board indicated that after cutting interest rates three times in 2019, it would remain on hold in 2020. As well globally, Purchasing Manager Indexes (key measures of business activity) have been rising. A reduction in tariffs may further stimulate growth and support corporate earnings.
Given the reduction in background risk, we believe there is a path for equities to move higher over the short term. We’re now moving from being generally underweight equities in the Sun Life Granite Managed Portfolios to an overweight position. But we will still be watching the U.S. political situation, Brexit and global trade.
With respect to the U.S., we believe it is still the world’s strongest economy, which could improve with the removal of tariffs and continuing low interest rates. To that end, we’ve added to our overweight position, but may move to a slight overweight exposure by year-end.
We are less positive on Canada. The economy has slowed with consumer spending and retail sales falling off – suggesting a broader economic chill may be coming. And we maintained our underweight exposure in Q4.
Emerging markets have been battered by the trade war as China’s economic growth slowed and the U.S. dollar remained strong. However, emerging markets could potentially outperform other markets if the global economy improves, and therefore increased our overweight position.
British Prime Minister Boris Johnson’s majority win in the U.K. general election went a long way toward resolving the economic uncertainty triggered by Brexit. We could now see the Eurozone economy start to improve – and with it, the equity market. We entered Q4 underweight EAFE equites, but late in the quarter, as clarity around Brexit emerged, we moved to an overweight position.
Bull market continues – S&P 500 at record high
With the U.S./China trade dispute hurting the global economy, central banks responded by cutting interest rates. Partially in response, most equity markets were higher at year-end. The S&P 500 led, climbing 9.1% (USD total return) in the quarter and 28.9% for the year – a record high, and its strongest performance since 2013 (Chart 1).
The MSCI World Index (USD) rose 8.6 % in Q4, while the MSCI EAFE Index (USD) climbed 8.23%. With a possible end to the trade war in sight, the MSCI Emerging Markets Index (USD) gained 11.74%. At home, the S&P/TSX Composite Index rose 3.2%, led higher by strength in utilities stocks (Chart 2).
North American bond yields range bound
Bond yields touched new lows in Q3 as risk-averse investors flooded into bonds, driving prices higher. In Q4 buying pressure eased, with yields range bound. And we don’t expect much movement in bond returns in the first three months of 2019.
In Q4, the yield on Canadian 10-year bonds started the quarter at 1.35% and ended at 1.70%. The yield on U.S. 10-year Treasuries, ended the quarter at 1.91%, up 24 bps.
Chart 1: Markets ride low interest rates higher
The Fed cuts, Bank of Canada holds the line
In response to a modest slowdown in economic growth, the Fed cut rates three times in 2019. The U.S. economy now appears to have stabilized. And at its last meeting in December, the Fed left its target interest rate unchanged at 1.75%. It also indicated that it would not raise rates in 2020 – a view supported by the majority of Fed governors. (A smaller number expect a 25 bps increase over the next 12 months.)
With the full stimulative impact of the rate cuts to come, the U.S. economy still expanded by 2.1% in Q3, and is expected to end Q4 at a slightly better pace. The consensus view now suggests that U.S. GDP will slow slightly in 2020. However, with the U.S./China trade war trending toward a resolution, the economy could be helped if business investment picks up.
That ongoing economic strength was reflected in the U.S. unemployment rate, which remained near a record low at 4% in Q4. At the same time, the inflation was running below the Fed’s 2% target. This suggests that the Fed may hold to its outlook and remain on the sidelines in the months ahead.
For its part, the Bank of Canada held the line on interest rates at 1.75% in 2019, while its global peers headed steadily lower. The bank has not raised its key interest rate since December 2018. To defend his decision, BoC Governor Stephen Poloz has been able to point to strong job growth.
However, it now appears as if job growth is slowing along with the economy. In fact, Canada’s GDP growth was flat at 0.0% and 0.1% in July and August respectively. And after growing by 0.1% in September, the economy contracted by 0.1% in October. As well, in November the economy lost 71,200 jobs, with the unemployment rate rising to 5.9%.
While employment numbers improved in December with the addition of 32,000 jobs, Poloz will have to continue to balance lower rates against a number of risks. For one, if the BoC cuts, it could drive up demand in some already inflated housing markets as lower mortgage rates kick in. As well, lower interest rates could entice Canadian consumers, already carrying near-record levels of debt, to go even deeper into the red.
However, if the BoC remains on hold, growth could soften further. But Poloz has stated that he believes the global economy is stabilizing, with growth expected to edge higher. That could mean he intends to remain hawkish on rates. We now believe (barring a sharp economic slowdown) that the BoC will remain on hold until later in 2020.
Canada: BoC on hold as the economy slows
As the economy slows, Canadian consumers, weighed down with high personal debt loads, have little room to increase spending. Indeed, for every dollar of disposable income Canadians have, they owe almost $1.72.
This slowdown in consumer spending and retail sales could further dampen the economy and add to unemployment. As noted earlier, this has left the BoC on the horns of a dilemma – if it lowers rates to stimulate the economy, Canadians may take on even more debt. If it holds, the economy could worsen.
However, the housing market, which had been softening, may ultimately be a bright spot. Consumers tend to spend more when the values of their homes are appreciating. And house prices appeared to be stabilizing in Q4, including in Vancouver which had seen a deeper price drop. With continuing low interest rates, we could see prices move higher, providing a tailwind for the economy in 2020.
We may also see modest improvements in the Canadian energy sector with oil trading between US$55 and US$65 a barrel in the months ahead. But prices could be pushed higher by two factors. Tensions between the U.S. and Iran have reached a dangerous level. And demand for oil could trend higher if the economy improves as tariffs come down.
As well, by some estimates, over the next four years oil production in Alberta will increase by 4.2% annually. Both TC Energy (formerly TransCanada) and Enbridge are looking at capacity increases, which could boost flows by up to 150,000 barrels per day without additional pipeline construction. As a result, prospects for energy investment are looking somewhat more promising.
Chart 2: Utilities stocks lead S&P/TSX Composite higher
U.S. economy: a tale of interest rates and trade
As noted, the Fed cut interest rates three times in 2019. The stimulative affect from those cuts is not immediate, but could start to have a positive impact as they filter through the U.S. economy in the months ahead.
At the same time, the first phase of a trade deal with China is expected to be signed in Washington on January 15. The escalating tariff battle between the two countries has seen the U.S. slap tariffs on US$550 billion worth of Chinese products. China, in turn, has hit back with tariffs on U.S. goods, valued at nearly US$185 billion. As some of those tariffs are removed, and as we get greater clarity on where the U.S./China trade dispute ultimately goes from here, U.S. capital spending could rebound.
For now, the market appears to have priced in an end to the trade war. It is now looking ahead to the U.S. presidential election in November and the outcome of the Trump’s impeachment.
The U.S. House of Representatives has accepted two articles of impeachment. But at the time of writing, it had not sent them on to the Senate, which would trigger Trump’s impeachment trial. As noted earlier, judging by the S&P 500’s move to a record high in Q4, it appears as if the market believes impeachment will have little impact on the economy.
However, the market may react negatively to the outcome of the Democratic presidential primary. Senators Elizabeth Warren, and Bernie Sanders (both frontrunners), have been criticized by Wall Street pundits over what they see as their high-tax, interventionist policies. These include breaking up a number of leading technology companies and curbing the growth of the energy sector.
In contrast, markets may prefer former vice president Joe Biden, who has put forward more-centrist policies and has polled well in many swing states.
For now, we believe that the interest rate cuts and initial trade deal will have a positive effect on the U.S. economy. As a result, we remain overweight U.S. equities and added to our position in Q4. However, we may reduce our position by end of year to a slight overweight.
Brexit resolution could boost Eurozone economy
British Prime Minister Boris Johnson’s majority win in the U.K. general election has finally brought some clarity on Brexit, with the U.K. set to withdraw from the EU on January 31. But he must now negotiate a comprehensive free trade pact with the EU by the end of 2020, or risk triggering another major crisis over the economic dangers of leaving without a deal.
In addition to the risks of a hard Brexit, there has also been a sharp fall-off in trade between a number of EU counties and China. This includes Germany, the EU’s lynchpin economy, which has seen its economy slow, but appears to have avoided recession.
With the Brexit clouds starting to part, we may begin to see some improvements in the European economy as capital spending potentially increases. As well, the threat of the U.S. imposing tariffs on European car exports has eased for now, and we are more optimistic about the European banking sector. Equity valuations are also generally lower in Europe than in other markets – particularly the U.S. Hence, late in Q4 we moved from an underweight to an overweight position.
Emerging markets: rebounding on the trade deal?
China and other emerging market countries could be major beneficiaries as the U.S/China trade battle winds down. Higher tariffs have hurt China’s industrial production. However, November’s figures for industrial output and retail sales suggest China’s economy is strengthening. As well, the real estate sector, a critical part of the Chinese economy, also appears to be improving.
There are also signs of growth in other emerging markets. This strength was in part driven by U.S. and Chinese companies, which sourced products in other countries to avoid tariffs. Taiwan, Vietnam, Chile, Malaysia and Argentina were among the major beneficiaries of this trend.
Russia’s economy also improved with firming oil prices. As well, it has benefitted from lower interest rates and a massive $390-billion government-spending program that includes major infrastructure projects. Brazil’s economy also expanded at a faster pace, with consumer and business spending increasing.
Outlook: overweight equities and government bonds
With the exception of Canada, we have moved to generally overweight exposure in equites.
In terms of fixed income, we reduced our bond allocation during the quarter to increase our equity exposure. We prefer Canadian over U.S. bonds – and both versus global bonds. We also favour quality versus credit, but within the credit space, we favour emerging market debt over high-yield bonds.
- Added to overweight position in U.S. equities, but plan to reduce exposure later in the year.
- Remained underweight Canada, with consumer spending and job growth slowing.
- With Brexit nearing resolution and the Eurozone economy potentially improving, we moved to an overweight position in EAFE equities.
- Increased overweight position in emerging market equities, believing they could perform better than other markets in an economic upturn.
- Expect the Canadian dollar to stay range bound between US$0.73 and US$0.78 in 2020.
Overall, we are looking for ways to reduce risk and take advantage of investment opportunities. However, for now, we are comfortable with how the Sun Life Granite Managed Portfolios are positioned.
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.
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