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May 2018

In May, we continued our Growth Outlook for the next six months followed by Inflation for the following six months. The global economy is running at its fastest pace since the very early days of the current economic recovery. The IMF upgraded its outlook for 2018 and 2019, calling for the world economy to achieve closer to 4% growth during those periods, nearly matching the pace set in the prior decade¹. The details of the IMF report reveal that every major economy is expected to remain in expansion mode, a synchronicity not seen since the 1990s. This broad strength is a key factor driving global yields and commodity prices higher.

In the euro area, 2018 got off to a disappointing start as real GDP growth slowed to 0.4% in the first quarter, the weakest performance since the third quarter of 2016. Both headline and core inflation were soft in April, slipping back to 1.2% and 0.7%, respectively².

In Japan, the expansion became shakier, while growth in China took a stronger start this year, after solid data reported on industrial value-added, fixed asset investment, and steel and electricity output. World output has powered through trade uncertainty, initial Fed tightening, rising fuel costs, and a return of some market volatility.

U.S. economic data released in April reflect a slowdown in the rate of growth during the first quarter. Unemployment has reached a multi-decade low and is likely to push still lower in the coming months. Combined with U.S. fiscal stimulus, support for household consumption is anticipated. The IMF estimates that the structural budget deficit among advanced economies will widen 0.3 percentage points as a share of GDP this year, and another 0.6 ppts in 2019 – a rough measure of the net fiscal stimulus to growth, with almost all coming from the U.S. tax and spending steps¹. Headlines around U.S. trade policy and general political dysfunction are a persistent feature but have so far not been significantly disruptive to the economy.

The Canadian economy continues to perform well despite some volatility early this year. Rising commodity prices and the solid outlook for Canada’s major trading partners provide support. The March 2018 job numbers came in at a loss of 1,100, well below consensus expecting a 20,000 gain³. With inflation close to the Bank of Canada’s target, the case for rate hikes is high and the BOC is expected to keep pace with the Fed. Aside from the housing market, the primary economic risk remains the turbulence related to ongoing NAFTA negotiations.

For the month of April, U.S. large-cap equities returned to positive territory, with the S&P 500 up 0.4%. S&P Small Cap 600 gained 1.0%. Energy was the top performing sector, up 9%, aided by rising oil prices. Canadian equities gained, with the S&P/TSX Composite up 1.8%. Europe had a strong start to the earnings season, while easing geopolitical tensions competed with concerns of a trade war. Despite tensions, S&P Europe 350 gained 4.8%, pushing the European equity benchmark into a positive YTD for 2018. The S&P Emerging BMI posted a loss of 0.8%, due to headwinds including rising rates and the dollar’s strong performance. Bond yields have been creeping up so far in 2018, leading to a significant shift in the relative attractiveness of equities versus bonds. With bonds yielding less than equities for most of the post-2008 cycle, equities have enjoyed a yield advantage for nearly a decade. Now, rising yields are levelling the playing field. The S&P 500 Bond Index was down 0.8% in April, as both investment-grade and high-yield issues were negative for the month.

We carried the outlook from April through to May with Stagnation in the first half of the 12-month time horizon heading toward Inflation in the back half. We maintained the fixed income exposure in all models while shifting some equity exposure from the Pacific Region and Europe back to the United States. We added U.S. Small Caps in the same weights that Asia was reduced across all models. We added U.S. Midcaps in the same weights that Europe was reduced across all models.

We will continue to monitor the data for growth signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

 

Deborah Frame, President and CIO

 

¹ IMF. World Economic Outlook. Cyclical Upswing, Structural Change. April 2018.

² Alliance Bernstein. Global Macro Outlook. May 2018.

³ Scotiabank. Strategic Edge Weekly. May 14, 2018.

 

Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Europe, Fixed Income. April 30, 2018. Index performance is based on total returns and expressed in the local currency of the index. European regional index returns are expressed in Euros.  

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April 2018

In April we continued our Growth Outlook for the next six months followed by Inflation for the following six months.

Global momentum remains strong as the IMF forecasts 3.9% growth this year and next, the fastest since 2011 thanks to increasing investment and trade. The strength of global demand is leading to a significant increase in most commodity prices relative to last year. This is benefitting commodity exporting nations, such as those in the Pacific Alliance, where growth is expected to be much stronger than in 2017. While monitoring this we are also watching the intensifying standoff between the United States and China that threatens to flare up into the biggest trade confrontation since WWII. In addition, record levels of global debt could become a destabilizer and at the very least will lead to higher levels of interest rates around the globe.

China’s economic outlook is favourable. While we expect growth to decelerate gradually in 2018–19, China is aiming for 6.5% expansion this year. The Euro area has been running a primary fiscal surplus since 2014, which moved close to 1% of GDP in 2017. Over the past five quarters, nominal GDP growth averaged 4% annualized, compared with an average of 2.7% in the prior three years. Germany continues to lead with growth of almost 3% y/y by the end of 2017. A question on the monetary policy front is whether the ECB will make further asset purchases once the current round of QE comes to an end in September, or whether the program will be phased out more gradually.

The U.S. was already on a path toward rising fiscal deficits before the introduction of limited tax reforms. Unfunded social security obligations and health care expenditures were the main driver. Adding an extra U.S.$1.5 trillion to cumulative deficits over the next decade further erodes the deficit outlook. The current earnings season is expected to show significant support for equities as companies deliver on shareholder return from the tax windfall. Based on the recent FOMC minutes a rate hike at the June policy meeting is expected.

The Bank of Canada faces similar conditions to the Fed. Economic growth is solid, unemployment is low, and core inflation averaged 2% on an annual basis for a second straight month in March.

For Q1 2018, the S&P 500 ended down 1.2%, the first negative quarter in 9 quarters. The S&P TSX Composite fell 5% over the quarter and rates rose across the board. Gold held steady, rising 1.7%.

The month of March was challenging for U.S. large-cap equities, with the S&P 500 down 3%. Smaller caps performed better, as the S&P MidCap 400 and the S&P SmallCap 600 registered gains of 1% and 2%, respectively. International markets declined, as the S&P Developed Ex-U.S. BMI and the S&P Emerging BMI posted March losses of 2% and 3%, respectively.  Canadian equities were slightly negative in March, with the S&P/TSX Composite down 0.16%. The S&P 500 Bond Index gained 0.15% in March, as high-quality and long-duration bonds outperformed for the month. The S&P U.S. High Yield Corporate Bond Index was down 0.45% for March as investor sentiment favored safer, higher-quality bonds.

Our outlook did not change from March and as a result we maintained our asset allocations across all models. U.S. Equity exposure ranges from 12% in Conservative, to 25% in Moderate Growth, Growth and Aggressive Growth while International equity allocations are 41%, 38%, 50% and 53% respectively. This highlights our view that Europe and the Asia Pacific regions are expected to perform well because of issues highlighted in the update.

We will continue to monitor the data for growth signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

 

Deborah Frame, President and CIO

 

Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Europe, Fixed Income. March 31, 2018. Index performance is based on total returns and expressed in the local currency of the index. European regional index returns are expressed in Euros.

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March 2018

In March, we continued our Growth Outlook for the next six months followed by Inflation for the following six months. Fundamentals (job growth, corporate profits, corporate and consumer confidence) remain very strong globally for now even as manufacturing downshifts. The commitment by President Trump to impose tariffs on China would be the main driver of U.S. inflation by way of higher prices on all goods subjected to these tariffs coming into the U.S. from China. Any retaliation by China would negatively impact exports from the U.S to China and collateral damage to other economies would most likely have a negative impact on growth globally.  Independent from the tariffs, we expect China will continue to lose momentum through 2018.  The news that North Korea, South Korea and the U.S. may meet to discuss reducing tensions on the peninsula has contributed to lower volatility in March. In Europe, retail sales and Industrial production data have disappointed in January and the subdued pace of core inflation and wage growth has kept the ECB moving very slowly toward the end of easing. Global growth is still expected to come in at 3% for 2018.

The U.S. economy is now in the late stages of the business cycle. Employment growth has been decelerating for several years and productivity growth is sluggish. Any boost from Trump’s fiscal stimulus would be short lived and the cumulative effects of monetary policy tightening would take a toll. The U.S. Federal Reserve raised the prime lending rate by 0.25% on March 20. The new Fed Chair, Powell’s, first conference largely echoed the messages of his predecessor, Janet Yellen.

During March, a seventh round of NAFTA talks concluded in Mexico City. Negotiations are advancing slowly with only 6 out of 30 chapters completed. Tensions continue to flare regarding Trump’s plan for steel tariffs. Progress was not made on more controversial issues such as dispute resolutions, national content, and the sunset clause. The decision to exclude NAFTA countries from steel and aluminum tariffs was encouraging, even if its conditionality on NAFTA being completed was ill-received by Mexico and Canada. If limited progress continues, it is unlikely NAFTA negotiations will be completed until 2019, especially with elections approaching in both Mexico and the United States.

Global equities had a rough ride in February. The S&P 500 ended the month down 3.7% while the S&P MidCap 400 and the S&P SmallCap 600 lost 4.4% and 3.9%. Canadian equities were negative with the S&P/TSX Composite down 3.0%. International markets performed poorly as the S&P Europe 350 lost 3.9%, and the S&P Developed Ex-U.S. BMI and the S&P Emerging BMI posted losses of 4.6% and 4.1%, respectively.

Interest rates rose across the board, negatively impacting February performance in U.S. fixed income. The S&P 500 Bond Index lost 1.5% in February, as the pull back in corporate bonds extended throughout the credit spectrum.  For the first time in four years, the yield on the 10-year U.S. Treasury hit 2.90%. Commodities were also down in February, with the S&P GSCI and the DJCI down 3.3% and 1.9%, respectively.

Due to the updated outlook that adds Inflation in the back half of our twelve-month forward time horizon, we shifted within the U.S. equity market cap exposures in all models. We reduced exposure to the S&P 500 across all models and shifted that exposure to different equity segments. In Tactical Conservative, we shifted to the S&P MidCap. In Tactical Moderate Growth, we shifted to the S&P MidCap and the S&P SmallCap. In Tactical Growth and Tactical Aggressive Growth, we shifted to S&P SmallCap. Over the twelve-month time horizon used in our model creation, we expect global growth around 3% and inflation in the G7 economies close to 2%.

We will continue to monitor the data for growth signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

 

Deborah Frame, President and CIO

 

Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Europe, Fixed Income. February 28, 2018. Index performance is based on total returns and expressed in the local currency of the index. European regional index returns are expressed in Euros. 

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February 2018

In February, we continued our Growth outlook for the next three months. The data coming in from 2017 confirms that the synchronized world economic recovery also contributed to global EPS growth across most markets in 2017.

China continues to grow but a slowdown is underway, resulting from policy tightening as the authorities became more concerned about financial stability risks. Local governments have imposed restrictions on property sales and on lending to property developers, which led to a sharp slowdown in property construction in recent years.

Euro area GDP rose 0.6% in Q4/27, the fifth consecutive quarter of above-potential growth. Early indicators point to continuing momentum at the start of 2018¹. January’s composite purchasing managers’ index rose for a third straight month, hitting its highest in more than a decade thanks to further improvement in the services sector.

The U.S. economy is now in the late stages of the business cycle, employment growth has been decelerating for several years with sluggish productivity growth. Any boost from fiscal stimulus is not expected to be sustained as dividends and share buybacks don’t lead to long-term capital investments that are required to support sustainable long-term growth. In the recent months, there have been close to $200 billion of buyback announcements, over double from a year ago².  Also, the cumulative effects of monetary policy tightening will likely take a toll with the Fed raising its policy rate three times over the past year and begun the process of balance sheet reduction while more Emerging Market central banks have loosened policy rather than tightened over this period. Following consecutive gains of over 3% in Q2 and Q3, headline U.S. GDP growth slowed slightly to 2.6% in Q4 of 2017. With the U.S. economy already facing capacity limits and tax cuts set to push demand even higher, inflation risks are tilted to the upside.  Market-based inflation expectations rose to three-year highs and energy prices have picked up, putting upward pressure on nominal yields. The rollover of government debt maturing in 2018 and promise of increased Treasury supply to finance tax cuts have contributed to the rise in bond yields.

In Canada, solid economic data and a positive tone expressed by Governor Poloz raised market expectations that the Bank of Canada may hike rates at the start of 2018. On January 17, the Bank of Canada raised the overnight rate by 25 basis points to a post-crisis high of 1.25%. The bank kept a balanced tone and their forecasts unchanged despite including a modest downturn of business investment and exports related to NAFTA uncertainty.

U.S. equities had a strong start in 2018. In January, the S&P 500 gained 6%, marking the best opening month since Jan 1997. The S&P MidCap 400 and the S&P SmallCap 600 each gained 3%. Equity volatility rose with the VIX passing the 14 level on January 30th for the first time since August 2017. Internationally in January, the S&P Developed Ex-U.S. BMI and the S&P Emerging BMI gained 5% and 9%, respectively. U.S. fixed income was negative across the board in January, driven by the rise in Treasury yields. Commodities also started the year positive with the S&P GSCI and the DJCI both up 3%.

At mid-month in February we chose to maintain portfolio weights across all models. This was based on our view that the outlook in January continues to reflect the recent fiscal and monetary policy developments in the United States. This would result in economic growth for the U.S. in the next twelve months while there is growing awareness that these policies will front-end load growth, leading to inflation in 2019. We expect to address inflation in our outlook in the coming months.

We will continue to monitor the data for growth signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

 

Deborah Frame, President and CIO

 

¹RBC Economics. Financial Markets Monthly. February 9, 2018.

²Gluskin Sheff. Breakfast with Dave. Economic Commentary. David A. Rosenberg. March 2, 2018.

Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Fixed Income. January 31, 2018. Index performance is based on total returns and expressed in the local currency of the index. European regional index returns are expressed in Euros.

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January 2018

In January, we continued our Growth outlook for the next three months. Global growth has become more trend line in 2018, led by global demand and a revival in commodity prices, allowing most policymakers the flexibility to pursue much-needed reforms without stifling growth. A few developed market central banks are facing conflicting signals as economic growth has moved decisively above trend, driving unemployment rates to lows not seen since the early 1980s, while core inflation has remained stuck at levels still well below target. As we advance through the year we will likely see a sustained move up in wage and price inflation that would prompt faster and more broadly-based policy normalization. Rate hikes in the U.S., the U.K., Canada and Australia are expected while the European Central Bank is expected to leave rates unchanged but begin to taper asset purchases as the Eurozone’s big three economies continue to diverge: Germany’s unemployment at 5.7% continues to fall to levels not seen since before unification, while unemployment in France has risen to 9.2% and Italy is struggling with the highest of the three at 11.2%¹. Japan still struggles with demographics that constrain GDP growth even though Japanese equities were one of the best performing asset classes in 2017. New governance incentives have motivated companies to focus on returns, dividends and repurchasing shares. China’s performance, which has been better than expected, indicates an orderly deceleration of growth and a slowing of credit expansion, suggesting a deceleration to 6.4% growth for 2018 from 6.8% last year¹. The Bank of Canada seems cautious, emphasizing uncertainty surrounding the ongoing NAFTA negotiations, so the risks are likely tilted toward fewer hikes.

The U.S. economy continues to show strength, despite a soft patch in early 2017, as tax cuts of about $1.0 trillion (or about 0.5% of GDP) over the next decade could help lower the unemployment rate further to 4.0%¹. In 2018, growth of 2.7% is expected¹. Consumer spending and business fixed investment continue to be major drivers of growth and would benefit from lower personal and corporate tax rates. Corporate earnings growth continues to drive equity market multiples. Cold weather in North America played a role in boosting oil prices recently, with the 40% jump in Brent crude since June 2017 owing to more fundamental demand and supply dynamics.

2017 was an outstanding year for U.S. equities. Large caps stood out, with the S&P 500 Index up 22%, marking 14 consecutive months of gains. The S&P MidCap 400 and the S&P SmallCap 600 gained 16% and 13%, respectively. The S&P/TSX Composite was up 9%. The S&P Europe 350 ended the year at 11% while the S&P United Kingdom gained 12%. The index benefitted when market participants deemed a so-called “hard Brexit” less likely, however this was offset by the positive impact on Pound Sterling. The S&P China 500 had the highest total return in 2017, gaining 35%. The government’s attempts to control rising debt may restrict short-term growth. The S&P 500 Bond Index gained 0.9% in December and 6% for 2017. Continued curve flattening drove long-duration bonds. The 10+ year sub index returned 12% for the year. The S&P U.S. Aggregate Index lagged investment-grade corporate bonds, returning 0.4% for the month and 3.3% for 2017.

In January, we shifted exposure from the U.S. mid term treasury bond to European and Pacific equities across all models. This is in line with our extended Growth outlook, recognizing strength in Europe and Asia while avoiding growth challenges in other economies and markets. Tactical Growth and Tactical Aggressive Growth models saw exposure to the midterm treasury bond eliminated, reducing fixed income exposure from 38% and 33% to 23% and 20% respectively.

We will continue to monitor the data for growth signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

 

Deborah Frame, President and CIO

 

¹ State Street Global Advisors. 2018 Global Market Outlook. Step Forward, Look Both Ways.

Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Fixed Income, Europe. December 29, 2017. Index performance is based on total returns and expressed in the local currency of the index. European regional index returns are expressed in Euros.

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December 2017

In December, we continued our Growth outlook for the next three months, reverting to Stagnation for the following nine months as we see the initial impact of U.S. tax reform on consumer and business behavior contributing to short-term U.S. growth. Global growth is expected to return to its trend rate of 3.7% in 2018 as GDP improvements spread around the world¹. The IMF expects only 6 of the 192 economies it covers to fail to grow in 2018¹. The end of the energy and commodities recession is a favorable trend. Capex is bottoming out and commodity exporters are doing better on stronger terms of trade.

This year should build on improvements we saw last year in developing and advanced economies. Brazil and Russia emerged from deep recessions, fiscal stimulus supported Japan and domestic demand buoyed the Eurozone. French President Emmanuel Macron announced structural reforms to the EU last year, aimed at addressing the tension between a single monetary policy and varying fiscal conditions among EU member states. Without reform, strong members like Germany would continue to boom, while weaker members like Italy would struggle. Negotiation outcomes regarding NAFTA will impact the U.S., Canada and Mexico and global trade. Both NAFTA and the WTO established new rules and standards for global trade upon which trade and financial globalization are now based. The demise of the deal and a view to bilateral agreements between the U.S. and it’s trading partners suggests that greater trade conflicts will become the norm, not only within NAFTA but also with China and others.

In China, domestic macro signals and international dynamics suggest moderate deceleration of GDP growth of 6.4% in 2018 from 6.8% in 2017¹. The threat of U.S. trade protectionism is a real concern, but the immediacy of the North Korea crisis may drive a more collaborative and less confrontational U.S.-China bilateral relationship in coming months.

As we enter 2018, U.S. GDP growth is experiencing a strong upswing, borrowing costs remain low, the dollar has been trending lower and despite the low unemployment rate, inflation and wage growth have not picked up. Tax reform will add to this but only in the short-term. The stimulus, worth $1.5trn over the next decade, equivalent to about 0.8% of GDP per year, is expected to contribute a moderate boost to GDP growth, which is projected at 2.5% for 2018². Meanwhile the stimulus would add to the budget deficit that was already projected to widen over the next decade, due to a rebound in interest costs and the impact of the aging population on mandatory spending. With the weaker dollar pushing imported goods prices higher and domestic economic conditions strengthening, an increase in core inflation in 2018 and a Fed hike in interest rates by a cumulative 100 basis points in 2018 is expected.

In November, U.S. equities were up again with the S&P 500 gaining 3.1%, its 13th consecutive month of gains. The S&P MidCap 400 and the S&P SmallCap 600 both registered gains of 3.6%. Canadian equities were positive, with the S&P/TSX Composite up 0.5%. The S&P U.S. Aggregate Bond Index outperformed investment-grade corporates but was in negative territory, down 0.03%. The S&P Taxable Municipal Bond Select Index was the top-performing component, returning 0.5% in November. Longer duration bonds continued to outperform short and intermediate duration.

In December, we shifted exposure within the fixed income allocation, removing all model exposure to 20+ Year Treasury Bonds. We believe that the flattening of the yield curve that benefitted the long end has played out.  This exposure was added to the 3-7 Year Treasury in the Tactical Conservative Model and to the Municipal Bond for all other models.

 

We will continue to monitor the data for growth signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

 

Deborah Frame, President and CIO

 

¹ State Street Global Advisors. 2018 Global Market Outlook.

² Capital Economics. US Economic Outlook Q4 2017.

Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Fixed Income. November 30, 2017.  Index performance is based on total returns and expressed in the local currency of the index.  European regional index returns are expressed in Euros.

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November 2017

In November, we continued our Growth outlook for the next three months, reverting back to Stagnation for the following nine months. Synchronous global growth is expected to remain in place for 2017. Contributions to this growth include inflation standing below most central banks’ 2% objective, G3 capital goods orders climbing at the fastest pace since 2014, and 68% of OECD nations have unemployment rates under the organization’s assessment of “global NAIRU” (Non-Accelerating Inflation Rate of Unemployment) ¹. Either aggressive central bank actions, a worldwide trade war, escalating tensions in Northeast Asia or a combination of all three are risks to this synchronized global growth.

The recent upswing in euro area growth indicates that factors are well positioned to continue to drive growth although labor market slack will need to be absorbed. The Japanese economy is growing at the fastest pace in several years, while Prime Minister Abe’s election victory guarantees the continuation of expansive monetary and fiscal policy for the future. China’s economy continues to defy expectations for a sharp slowdown and has been in stabilization mode, and is on its way to meet the government’s growth target this year of 6.5% or above.

The U.S. economy proved resilient to hurricane distortions in August and September and rose at a 3.0% annualized rate during the third quarter². Improving economic activity outside the United States is a tailwind for U.S. economic growth and profits of American firms with significant foreign business while overseas demand and a softer greenback have helped the U.S. manufacturing sector. The consumer continues to thrive in the environment of strong job creation while higher stock values and business investment are also contributing positively.

The Federal Reserve is expected to pursue its plan to raise interest rates once again in December although the flattening of the yield curve over the past couple of months has sent a message that the market does not agree with the Fed regarding the strength of the current economic cycle. The flattening yield curve has historically been a signal that a recession is on the way but the decline in the 10-year Treasury yield since the start of this year is due to a drop back in the term premium component, with the implied risk-free short rate expectations component continuing to trend higher. This reflects foreign interest that results from less attractive options abroad due to the continuing expansion of other major central banks’ balance sheets, low and stable inflation and a rebound in global savings.

After a strong first half to 2017, the Canadian economy moderated towards more sustainable levels in Q3. The Bank of Canada has reduced expectations for further rate hikes in the near-term as the economy adapts to previous rate hikes and new mortgage rules, while downside risks pertaining to NAFTA negotiations and elevated consumer debt levels also warrant some caution.

Global equity markets were broadly higher in October. U.S. equities rose again with the S&P 500 up 2.3%, the S&P MidCap 400 up 2.2% and the S&P SmallCap 600 saw smaller gains of 1.0%. Canadian equities have been performing well, with the S&P/TSX Composite Index rising 2.7% for the month. Equity gains extended to overseas markets, with the S&P Europe 350 rising 2.0%, MSCI Japan Index up 5.6% and MSCI Australia Index up 3.8%.

North American fixed income markets diverged in October as the S&P 500 Bond Index gained 0.37% for the month and stood at 5.23% for the year ending October. In currency markets, the U.S. Dollar strengthened for the month as speculation mounted regarding the Federal Reserve chairmanship and specifics on plans for tax reform. However, since the start of 2017 to the end of October, the U.S. Dollar Index (DXY) is down 7.5%.

In November, we added exposure to the broader Pacific Region including Australia, Hong Kong, New Zealand and Singapore, by replacing direct exposure to Australia. We also added exposure to Asia ex Japan. Under fixed income, we reduced exposure to Long Treasury and Muni bonds in the Conservative and Moderate Growth models and reduced Muni Bonds in the Growth model.

 

We will continue to monitor the data for growth signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

 

Deborah Frame, President and CIO

 

¹ BCA Research. U.S. Investment Strategy. November 13, 2017.

² Capital Economics. U.S. Economics. U.S. Rapid Response. October 27, 2017.

 Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Fixed Income. October 31, 2017.  Index performance is based on total returns and expressed in the local currency of the index.  European regional index returns are expressed in Euros. 

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October 2017

In October, we changed our outlook to Growth for the next three months, reverting back to Stagnation for the following nine months. The economic expansion in advanced economies seems set to continue for the next year, led by rising household consumption and business investment. Although most economies are approaching full employment, inflation has remained below targets.

The ECB is likely to taper its asset purchases during 2018 and raise rates to around 1% by the end of 2019. Inflation is likely to remain below the ECB’s target. Prospects for emerging economies have improved, as Brazil and Russia have come out of recession. China’s economy is likely to slow gradually. In Australia and New Zealand, GDP growth is steady however, inflation remains very weak. We expect the Reserve Banks of both countries to hold rates until 2019.

Having raised interest rates twice this year, we don’t expect the Bank of Canada to move again this year. The economy is benefiting from a rise in business investment and exports, however, there is a risk of downturn in consumer spending next year as household debt weighs and house prices may start to fall.

The U.S. Fed is expected to continue to unwind QE slowly while raising rates. After a slow start to this year, the economy benefitted from looser financial conditions, as bond yields and the dollar have fallen. Since the relationship between spare capacity and inflation has weakened since the financial crisis, average earnings growth should remain very subdued. The recent economic growth was driven by consumer spending and business investment, while exports contributed meaningfully on the back of a softer dollar and firming global demand. The Fed is likely to look through any storm-related economic weakness and seems commitment to one more rate hike this year.

Yields rose during September, with the 10-year Treasury increasing to 2.33%¹. The move up in yields resulted in weak bond returns with the S&P U.S. Treasury Bond Index down 0.77% and the S&P U.S. Investment Grade Corporate Bond Index down 0.24%. The search for yield led the increase in the S&P U.S. High Yield Corporate Bond Index, up 0.87%.

During September, U.S. Equities were strong performers, led by the S&P SmallCap 600 Index gaining 7.7%. The S&P Midcap 400 returned 3.9% and the S&P 500 returned 2.1%. The S&P/TSX Composite was up 3.1% with the Energy sector as the top performer gaining 7.7%.

The Eurozone also posted strong gains in Euro terms, with the MSCI EMU Index returning 4.4%, however, recent Euro weakness weighed on gains. The MSCI EAFE Index of developed market companies returned 2.5%. Emerging Markets, measured by the MSCI EM Index, came under slight pressure from a strong U.S. Dollar, as the index dropped 0.3%.

Unlike the strength seen in September, US dollar weakness was a key highlight in 2017. In the third quarter, strong gains were posted by the euro, up 3.4%, British pound, up 2.9%, Brazilian real, up 4.6%, and Canadian dollar, up 4.0%.  The Mexican peso, down 0.7%, and Japanese yen, down 0.2%, slightly depreciated. From the start of the year to September, the US dollar is down 8%. Commodities broadly rallied in Q3 with oil finally joining metals in positive territory. WTI, up 12%, copper, up 9.5%, and gold, up 3.1%, all posted gains in Q3.

In October, we revised our asset allocation, adding currency-hedged exposure to Canadian equities across all models. Asia ex Japan and currency-hedged Australian equity exposure were added to Growth and Aggressive Growth at 5% and 10% each. We reduced 3-7 Year Treasuries in all models and reduced European equities in Growth and Aggressive Growth.

 

We will continue to monitor the data for growth signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

 

Deborah Frame, President and CIO

 

¹Treasury.gov. Resource Centre. Daily Treasury Yield Curve Rates.

Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Fixed Income. September 29, 2017.  Index performance is based on total returns and expressed in the local currency of the index.  European regional index returns are expressed in Euros. 

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Q3 2017 Report

Market Priced Volatility and Real-World Uncertainty

Economic expansion in advanced economies is expected to continue into next year, led by rising household consumption and business investment. The U.S. Fed is expected to continue slowly unwinding QE while raising rates, and the ECB is likely to begin to taper its asset purchases during 2018. Prospects for emerging economies have improved as Brazil and Russia emerged from recession. China’s economy is likely to slow, but only gradually.

While the world is experiencing synchronous growth, record low volatility has created low correlations within and among asset classes. What appears to be a Goldilocks economy is coexisting in a low volatility environment that may be a trap, a situation where excessive monetary stimulus keeps asset prices rising and volatility low across markets even though real economic risks are rising. Central bank stimulus directly lowers risk premiums and volatility in rates and credit markets, pushing investors into riskier assets to generate sufficient returns.  However, the inequality resulting from this stimulus has increased geopolitical instability.

Concern remains low as markets continue moving higher and volatility remains at record lows. The gap between soft economic data (survey-based) and hard data (official data releases) has widened. Optimistic soft data and low inflation have helped produce positive returns while hard data has detracted. Meanwhile, we haven’t seen emotional reactions to geopolitical risks that have unknown consequences. The U.S. is an open economy and foreign capital flows will go where conditions are most attractive and geopolitical risk and policy errors will at some point be reflected in markets, eventually bringing volatility back.

Though efforts to reduce leverage and capitalize banks since the crisis have resulted in a safer financial system, we currently have more indebted governments, higher inequality and increased geopolitical risks. These opposing factors have created a divergence in market volatility and real-world uncertainty.

Rising wealth inequality coupled with lack of social mobility provides the economic conditions for a rise in protest politics. The Brexit referendum and the U.S. and French presidential elections spurred protests. Unexpected results from the UK referendum and U.S. elections triggered an increase in global economic policy uncertainty. Neither event sparked a market selloff, thanks to quick easing actions from the BoE and an improvement in U.S. growth and fiscal policy. Future risks may be the catalyst for a market response. These risks include tensions in the Middle East and between the U.S. and North Korea and investigations over President Trump’s Russian links.

Currently, foreign money is making its way to the U.S. bond market suppressing long-term U.S. rates, causing the yield curve to hold at some of its narrowest levels in a decade while inflation remains dormant. Although the Fed can continue raising short-term rates, long-term yields would remain low until inflation accelerates. This relationship could be tested in 2018 as the Fed plans to begin reducing its balance sheet assets. We will continue to monitor this and the apparent disconnect between geopolitics and the markets.

 

 

Four Themes

1.The Puzzle of Low U.S. Inflation

There is concern that central bankers and creating uncertainty regarding the sustainability of the recovery by steering the economy without the benefit of a reliable theory of what drives inflation today. Inflation has been lower than expected for several years, explained by lower growth. Central banks can more slowly normalize policy and reduce the risk of a policy mistake that would cause a recession if inflation is low and there is less economic overheating. Equities prefer low inflation, since low rates on cash and bonds make stocks look more attractive.

Low inflation results in a weakening economy, lower earnings growth, and a future problem with central bank’s ability to raise the economy out of the next recession. Central banks in developed markets collectively identified this concern and have committed to do everything they can to bring inflation up to their target rates.

Since the beginning of 2017, U.S. growth has improved while inflation remains below target. The Fed and other central banks have set their inflation targets too low given the realities of their economies. There has been downward pressure on the long-term neutral rate of interest applied by rising inequality, growing regional savings gluts and aging populations that slow demand. The ability to lower rate, which has been a primary tool for fighting recession, has become less effective.

Part of the low inflation problem relates to the dollar. Large, abrupt swings in the dollar tend to be more correlated with large, abrupt swings in import prices with much less pass-through to inflation.

The broad dollar index is now at its lowest since April 2016. Fed models indicate that for every 10% trade weighted appreciation in the dollar, core PCE inflation is reduced by 0.5% in the two quarters following the dollar’s move and the four-quarter effect is to reduce core PCE inflation by about 0.3%¹. Therefore, it is conceivable that much of the deceleration in core PCE inflation from 1.9% at the start of this year to 1.4% as of August was due to the dollar’s prior appreciation¹.

 

2. The Unknown Impact on the Yield Curve with the Reversal of Unconventional Monetary Policy

A gradual normalization of bond yields as growth improves and central banks exit QE should be positive for financial stability. By next year most central banks are expected to begin the process of unwinding the $20 trillion in financial assets that they purchased over the past decade.  These outflows could lead to asset declines and liquidity disruptions.  The timing would be determined by the pace of central bank normalization. While policy rates are rising in the U.S., Canada and U.K., financial conditions remain loose due to demand for bonds, creating headwinds for those central banks who are moving in the tightening direction.

The Federal Reserve has begun to unwind the massive balance sheet that grew significantly following the financial crisis of 2008, to above $4.5 trillion. The process of shrinking the balance sheet would be gradual and take many years, initially reducing at $10 billion a month.

The added complication is that it is impossible to know exactly what impact QE has had, in part because it is impossible to disentangle it from all the other forces affecting the economy. QE has boosted equity prices but the ripple effect on household spending and GDP has been small.  The marginal effects of QE diminished as the program expanded. There is debate about whether it is the stock or flow of purchases that matters. It is unlikely that the Fed will be able to cheapen the Treasury curve through raising the term premium via reduced reinvestment. Unconventional policy tightening is not a substitute for conventional policy tightening.

The view that the Treasury term premium will rise less materially than it fell is based on many other considerations affecting the Treasury market. They include:

 

  • Balance sheet reduction may be slowed or reversed at some point due to late cycle concerns and uncertainty around timing the business cycle.
  • The actions of other major QE central banks whose balance sheets wouldn’t be shrinking for years or would continue to expand even at a slower pace in future.
  • The Fed has very limited ability to cheapen the Treasury market on its own. If foreign central banks hesitate to allow their own yields to rise materially, connected carry trades adjust for FX hedging risks.
  • Improved stock markets may merit a safe-haven bid that preserves demand for Treasuries.

 

An additional consideration is that the initiative was more than offset by increased public-sector borrowing. Continued demand among mutual funds, pensions and insurance companies for fixed income created the opportunity for non-financial companies to ramp up issuance. It’s one of several supply factors that have been identified explaining why bond yields globally remain historically low. The large portfolio rebalancing in fixed income was a switch within private sector securities. There was a shift from financial securities into Treasuries, along with non-financial corporate and overseas debt. That is changing as financial institutions are back issuing more and keeping their supply of securities to the market stable.

 

3. Global Growth is not Synchronized – The World is Out of Step with U.S. Monetary Policy

Global growth is accelerating and the OECD estimates that all 46 of the economies that it tracks will see positive growth this year for the first time since 20072. Weak productivity across most of the world is likely to create congestion that would increase inflation  and reduce business investment spending. Since the U.S. currently leads this growth in advanced economies, a U.S. slowdown would have a significant impact on growth in the rest of the world.

The growth in most global economies have been supported by monetary stimulus may be causing some side-effects, including asset bubbles, worsening wealth inequality and misallocation of resources. Persistent low interest rates resulting from monetary stimulus have rolled forward a growing amount of private and public debt to future generations. Technology is deflationary and there are fewer young people able to carry a higher debt burden in the future.

The boost in growth has taken long to materialize and is occurring in the context of muted financial volatility. As we discussed earlier, the recovery still falls short in delivering the high inclusive growth that is needed to deal with a long list of accumulated economic, financial, institutional, political and social challenges.

 

4. Protectionism in Developing Countries

The economics behind the North America Free Trade Agreement (NAFTA) are powerful. Trade is a high priority for the President, who has unilateral executive powers to effect change. Revisiting NAFTA will be an important test of direction for the United States and on their willingness to use trade as a bargaining chip regarding geopolitical tradeoffs.

The United States sells more to Canada than it does to China, Japan and the U.K. combined. Contrary to recent rhetoric, the U.S. currently has a trade surplus with Canada. In negotiating NAFTA, the current list of U.S. demands opposed by Canada includes3:

 

  • A “sunset clause” that would automatically terminate the deal in 5 years if all 3 countries did not endorse it again at that time.
  • A rule requiring all cars to be made with 50% American content if they are to be exempted from tariffs.
  • Dismantling of Canada’s protectionist supply management system for dairy and poultry.
  • A “Buy American” procurement policy limiting Canadian and Mexican access to U.S. government contracts.
  • The end of the current independent tribunal system for resolving NAFTA disputes.

 

History has demonstrated that when there are trade restrictions, both countries get hurt. Countries are better off to use internal tax policies within their country to deal with the inequality within that country. For the same reason that there is no balanced trade among U.S. states, it is not realistic to strive for it among countries. We will be monitoring developments resulting from NAFTA negotiations as they will have a significant impact on not only Mexico and Canada but the entire global economy.

 

Frame Global Asset Management considers these trends and factors them into our outlook for the economy in our twelve-month forward period. We look back to periods of similar economic behavior and use this information to predict the future behavior of the asset classes that we consider. Our investment process allows us to adapt for non-traditional monetary policy and other exogenous variables.

 

Deborah Frame, CFA, MBA

President and Chief Investment Officer

October 19, 2017

 

1 Scotiabank Global Economics. Scotiabank’s Global Outlook. October 5, 2017.

2 BCA Research. Global Investment Strategy. Strategy Outlook Fourth Quarter 2017 Goldilocks And The Recession Bear. October 4, 2017.

3 TheStar.com. Donald Trump’s ‘outrageous’ demands put NAFTA negotiations at risk of collapse as talks resume Wednesday, experts say. Oct 10, 2017.

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September 2017

In September, we continued with our Stagnation Outlook for the twelve-month forward period. The global economy continues to chug along with the July IMF forecast for global economic growth of 3.5% for 2017 and 3.6% for 2018 looking attainable¹. All 46 countries monitored by the OECD are on a growth track this year for the first time since 2007².

Rising geopolitical risks including North Korean nuclear tests and American hurricanes have contributed to short-term offsets to this optimism. At his Jackson Hole address in late August, European Central Bank President Mario Draghi told the audience that U.S. protectionist policies also pose a serious risk for growth in the global economy.

Global central bank asset purchases, which have totaled almost $2 trillion this year alone, are the best explanation for money flowing into both bonds and stocks. Shifts in growth and central bank policies are likely to sustain flows away from the U.S. dollar and toward the euro and emerging market currencies. The dollar had acquired a premium in late 2014 and 2015 as it became clear that the Fed would be first to engage in tightening policy. At the same time, political turmoil in the Eurozone helped drive investors into U.S. assets in search of higher yields and better growth. The anticipated lower economic growth in the U.S. will not be enough to keep those flows while growth in Europe and emerging markets are much better.

Federal Reserve officials are reviewing their most basic inflation models. Minutes from the July FOMC meeting showed a revealing debate over why the economy isn’t producing more inflation in a time of easy financial conditions, tight labor markets and solid economic growth. The central bank has missed its 2% price goal for most of the past five years.

Sustained loosening of financial conditions is unique to this tightening campaign, driven in large part by persistently strong equity market returns and a weakening dollar. This behavior has confounded markets and Fed officials. Further tightening is coming as the Fed will soon start shrinking its balance sheet. Since 2008, the Fed has been buying assets resulting in about $2.5 trillion of Treasury bonds and $1.8 trillion in mortgage-backed securities on the balance sheet³. The Fed does not plan to sell these assets; however, as the securities mature, it will stop reinvesting the proceeds, with the permitted monthly run-off gradually rising. U.S. 30-year bonds are most impacted by tightening but the lack of inflation coupled with credit contraction creates a scenario of further flattening of the U.S. Treasury yield curve.

During August, investors nervous about North Korea and other geopolitical risks favored the relative safety of bonds, pushing bond yields lower and prices higher. Long duration government and agency bonds outperformed in that environment, while short duration securities underperformed. August results for U.S. Treasuries posted positive returns, as yields tightened across the entire curve. The S&P 500 gained 0.3% in August, outperforming S&P MidCap 400 (down 1.5%) and S&P SmallCap 600 (down 2.5%). Outside the United States, Canadian equities were positive with the S&P/TSX Composite up 0.7%, while the S&P Developed Ex-U.S. BMI was flat and S&P Emerging BMI gained 3%.

In September, we revised our asset allocation in the Conservative and Moderate Growth models while maintaining the Growth and Aggressive Growth models.  The changes reflect our view that we will continue to see a flattening of the U.S. yield curve and an opportunity in the long end of the yield curve.  In both Conservative and Moderate Growth, we eliminated U.S. Mid-Caps and added to long U.S. Treasuries. In Moderate Growth, we also added a portion to the S&P 500.

 

We will continue to monitor the data for growth signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

 

Deborah Frame, President and CIO

 

¹IMF. World Economic Outlook. July 23, 2017.

²BCA Research. Global Investment Strategy. Fourth Quarter 2017: Goldilocks And The Recession Bear. October 4, 2017.

³Federalreserve.gov. Quarterly Report on Federal Reserve Balance Sheet Developments. July 26, 2017.

 

Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Fixed Income. August 31, 2017.  Index performance is based on total returns and expressed in the local currency of the index.  European regional index returns are expressed in Euros.

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