In August, we maintained our outlook to reflect the impact of the escalating global trade wars. We are currently factoring in a six-month period of Stagnation followed by six months of Inflation. While the baseline forecast for the global economy continues for 2018 and 2019, the potential for disappointment remains. Tariffs generate what economists call a “deadweight loss,” with the impact on prices and consumption that results usually larger than the tariff revenue that is generated.
In June, the U.S. government announced its intention to apply tariffs on an additional $200 billion of imports from China and threatened tariffs on imports of autos and parts in the future. This news follows earlier imposed tariffs on a variety of imports including solar panels, washing machines, steel and aluminum. Retaliation was swift, as the European Union, Canada, Mexico, and China imposed tariffs on imports from the United States. China is struggling to balance several challenges to its economic health with high levels of indebtedness. Euro area GDP growth fell short of expectations with a 0.3% increase in Q2, down slightly from the Q1 0.4% gain1. That leaves Euro area growth over the first half of the year at roughly half of 2017’s pace. A slowdown in France, the currency bloc’s second largest economy, was partly to blame. Euro area inflation rose above 2% for the first time since 2012, though core inflation remains well below the European Central Bank’s target. From the Central Bank’s policy path for the coming months, we expect net asset purchases trimmed to zero by the end of 2018 and rate hikes off the table at least through next summer.
In the U.S., Q2’s advance GDP report came in at 4.1% annualized, one of the highest quarterly growth rates in the last decade1. The economy was performing very well, with domestic demand up almost 4%, led by a rebound in consumer spending and another solid increase in business investment. However, tariffs imposed by the U.S. on imports is expected to raise prices and lower real disposable incomes for consumers, jeopardizing the livelihoods of American workers. U.S. tariffs threaten consumer spending going forward since nearly 11 million jobs are supported by exports and millions of additional jobs directly depend on imports.
Protectionism could also hurt corporate profits. The “rest-of-the-world” component has been driving U.S. profit growth the past few years, increasing its share of overall U.S. corporate profits to 20.3% in Q1 this year, a four-year high2. Continuing protectionism from Washington can potentially harm corporate America’s profitability, offsetting some of the benefits from tax cuts. The U.S. President initiated an investigation into imports of motor vehicles and parts from Canada on national security grounds – the same justification used for steel and aluminum tariffs. If the ultimate outcome of the investigation is the imposition of tariffs of a similar magnitude, the impact to Canada would be significant, potentially reducing growth in 2019 growth by 0.5%.3 Business investment would be the most significantly impacted, reducing Canada’s long-run economic capacity.
Global financial markets reacted negatively to apparently souring trade relationships. The MSCI All-Country World index was down significantly after U.S. tariff announcements. In July, U.S. equities gained across all cap sizes. The S&P 500 gained 3.7%, while the S&P MidCap 400 gained 1.8% and the S&P SmallCap 600 gained 3.2%. Canada and Europe were also positive, with the S&P/TSX Composite up 1.1% and the S&P Europe 350 up 3.2%, with nearly all countries contributing positive returns. June’s focus on trade tensions and political risk largely gave way to positive earnings figures, economic data, and central bank guidance in Europe.
Asian equities also enjoyed a positive month, though China and Korea contributed negatively to the region as lingering trade tensions continued to have an impact on markets. U.S. fixed income performance was mixed with high yield corporate bonds the strongest sector.
In August, we shifted a portion of our fixed income exposure to U.S. equities in both the Growth and Aggressive Growth models, resulting in equity exposure shifting from 50% to 60% and from 53% to 65%, respectively. The shift was out of the existing U.S. municipal bond position and into U.S. mid-caps.
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 RBC Economics. Financial Markets Monthly. August 10, 2018.
2National Bank of Canada. Monthly Economic Monitor. Economics and Strategy. July/August 2018.
3 TD Economics. Potential U.S. Auto Tariffs: Canadian Scenario Analysis. June 18, 2018.
Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Europe, Asia, Fixed Income. July 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.
