In June, we continued with our global Stagnation Outlook for the twelve-month forward period. Although growth was lower than expected in Q1 in several G7 economies, a slow expansion is now well established across the board. That said, some of these economies have made a much better recovery from the crisis than others.
The European Central Bank’s dovish policies have depressed the value of the euro and boosted German manufacturing. Germany has diffused its inflationary pressures by outsourcing jobs and production to central Europe. As a result, wages in central Europe are rising and inflation is accelerating.1
Meanwhile, global core inflation, which has remained stable at a 2% pace in recent years, also slipped this quarter to an estimated 1.7%, raising concerns that it will be more difficult to lift inflation back toward central bank targets. The recent downshift in China has been a source of concern particularly as it has been mirrored across Asian industry. Global credit conditions remain supportive despite a slowdown in the United States. The latest data on bank lending point to downward pressure on GDP growth in advanced economies, although the slowdown in credit growth has been concentrated almost exclusively in the United States.
After a disappointing 1.2% annualised gain in Q1, U.S. GDP is on track to rise in the second quarter. Industrial production has rebounded in recent months, helped by the continued turnaround in activity in the mining sector. After hitting a 5-year high of 2.7% earlier in 2017, headline CPI inflation has fallen back to 1.9%, due mostly to the recent decline in energy prices. Core inflation has also slowed in recent months with the annual rate falling to 1.7% in May and the 3-month annualised rate plunging to a 7-year low of zero. There is widespread weakness in core inflation. Despite the Fed raising interest rates again in June and reiterating its plans to continue gradually tightening policy, it appears that markets are pricing in only one 25bp rate hike by the end of 2018. The 10-year Treasury yield has declined even though there were three rate hikes since December last year. The dollar has also continued to decline, with the Fed’s trade-weighted dollar index having now completely reversed its prior surge following last November’s presidential election. Furthermore, the stock market has continued to weather the Fed tightening.
The month of May saw mixed results across U.S. equities. The S&P 500 gained 1.4% while S&P SmallCap 600 lost 2.1%. International equity markets performed well as the S&P Europe 350 gained 4.9%, S&P Asia 50 gained 4.8% and S&P Emerging BMI gained 1.7%. Meanwhile in Canada, the S&P/TSX Composite lost 1.3%. U.S. fixed income markets were positive in May. Municipal bonds were the top performer with the S&P National AMT-Free Municipal Bond Index returning 1.4%. Commodities ended May poorly with the S&P GSCI losing 1.5%. The combination of the lukewarm investor response to OPEC extending its restriction on production and the news that a rise in Libyan output had increased production among OPEC countries for the first time this year sent the S&P GSCI Crude Oil index down 2.8%.2
We rebalanced in June to reflect our continued Stagnation outlook. Across all models, we replaced U.S. Small Caps with U.S. Large Caps in response to the postponement of corporate tax reform that is now better reflected in Large Cap valuation. We maintained Canadian and European Equity exposure as well as the long-term U.S. Treasury Bond. Financial conditions appear more accommodative since late last year due to lack of evidence of inflation in the U.S. despite Fed rate hikes. Our shift to long bonds reflects our view that this may not reverse in the near-term. For more insight into our views on the changing impact of inflation, see our most recent White Paper: A Regime Change Underway, available on our website.
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
Data Source: Bloomberg
[1] BCA. Emerging Markets Strategy – Central Europe: Beware of An Inflation Outbreak (Special Report), June 21, 2017.
[2] Index Returns: S&P Dow Jones Indices Index Dashboard: U.S., Canada, Fixed Income. May 2017.
