As we enter 2019, there is a heightened focus on downside risks both domestically and globally in the markets and in the broader economy. A negative feedback loop has emerged that is centered in the U.S., linking bad policy choices to falling asset prices, tighter financial conditions, and weaker corporate earnings. In the short-term, the current U.S. government shutdown is having more than an impact of inconvenience on the U.S. economy. In January, we revised our twelve-month forward outlook to reflect the delayed impact of inflation on the U.S. economy. We believe that U.S. economic growth is moving toward stagnation and will be followed by an inflationary environment that will likely precede a recession in 2020. The current outlook now factors in six months of stagnation followed by six months of inflation over the twelve-month forecast period.
The IMF said in an update to its World Economic Outlook in October that it is now predicting 3.7% global growth in both 2018 and 2019, down from its July forecast of 3.9% growth for both years.¹ Across emerging market and developing economies, prospects are mixed. The downgrade reflects the introduction of import tariffs between the United States and China, weaker performances by Eurozone countries, and rising interest rates that are pressuring some emerging markets with capital outflows into the stronger U.S. dollar, notably Argentina, Brazil, Turkey, South Africa, Indonesia, and Mexico.
In conjunction with the global growth downgrade, the IMF downgraded the 2019 U.S. growth forecast to 2.5% from 2.7% and cut China’s 2019 growth forecast to 6.2% from 6.4%.¹ Our focus over the next six months is on the impact of tighter Fed policy that is likely to hit business investment and, in combination with the stronger dollar, weigh on industrial output too, causing GDP growth to slow sharply.
The Canadian economy is set to weather the current slump in global oil prices better than it did in 2015, but it will not escape unscathed. The 9,300 job increase in employment in December was better than expected and the unemployment rate held at a 40-year low of 5.6%.² The housing market is showing signs of weakness and higher interest rates are starting to weigh on consumer spending. With this considered, we expect the Bank of Canada to cut rates in 2019.
U.S. equities experienced a very disappointing year in 2018. The S&P 500 was down 4.4%, its first negative year since 2008, still better than the S&P MidCap 400 and S&P SmallCap 600 down 11.1% and 8.5%, respectively. In the month of December, the S&P 500 declined 9.0%, while Mid-Caps were down 11.3% and Small-Caps lost 12.1%. Canadian equities were negative, with the S&P/TSX Composite down 5.4% for the month and 8.9% for the year. The S&P Europe 350 fell 5.5% in December and 9.9% for the year, mostly due to Brexit tensions, global trade uncertainty, and sharp declines in commodity prices. Internationally, most markets underperformed the U.S., with the S&P Developed Ex-U.S. BMI and S&P Emerging BMI both down about 14% for the year. The S&P China 500 completed 2018 with a loss of 19%.
In January, we shifted our fixed income exposure out of 3-7 year Treasuries and into 7-10 year Treasuries in all models. In addition, in the Tactical Growth and Tactical Aggressive Growth models, an additional 10% was taken out of the S&P 500 and added to 7-10 year Treasuries. Allocation to Equities remains at 30% in the Tactical Conservative model and 40% in the Tactical Moderate Growth model, and decreased to 50% in the Tactical Growth model, and 60% in the Tactical Aggressive Growth model. We continued exposure to U.S. equities, with the balance in all models allocated to U.S. municipal bonds and mid-term U.S. treasuries. This asset allocation is reflective of the current concern that the U.S. economy is slowing while the relative attractiveness of interest rates in the U.S. versus the rest of the world prevails.
While the poor market depth and soft liquidity that marked December 2018 are beginning to fade, weak sentiment is likely to remain a prominent feature in the coming months. We will continue to monitor the data for growth, inflation, and recession 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 International Monetary Fund, World Economic Outlook. October 2018.
² Trading Economics, Canadian Employment. December 2018.
Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Europe, Asia, Fixed Income. December 31st, 2018. Index performance is based on total returns and expressed in the local currency of the index.