November 2018
The global economy has delivered above-trend growth and a modest rise in inflation this year. This trend is expected to end, as increasing dependence on U.S. demand should not be capable of carrying the rest of the world. We expect that the combination of the escalating trade dispute with China and monetary tightening by the Federal Reserve will start to weigh on U.S. growth in 2019. In November, we evolved our twelve-month forward-looking outlook to reflect our view that we are moving closer to a U.S. inflationary environment that will likely precede a recession in the U.S. in late 2019 or 2020. The current outlook now factors in three months of growth followed by nine months of inflation over the twelve-month forecast period.
Third quarter GDP reports point to Developed Market divergences, as U.S. GDP grew at a 3.5% annualized rate with a greater than 9% gain in import volumes.1 Meanwhile, Germany and Japan’s GDP rates both contracted.2 Due to the size of these latter two economies – the third and fourth largest in the world respectively – they play an important role in driving global growth. In addition, the political and economic weakness of Italy, the Eurozone’s third-largest economy, is a concern. Data announced towards the end of the month showed that Italy’s GDP growth rate had fallen to zero in the third quarter, adding further pressure to the political impasse over the budget.2 The 2.4% budget deficit proposed by the new Italian government creates the risk that Italian government debt may be downgraded to sub-investment grade.
The trade war is showing early signs of affecting the U.S. economy, which has so far had a strong 2018. In October, a net number of 250,000 jobs were created and wage growth continued to accelerate to 3.1%, the fastest annual gain since 2009.3 In contrast, the trade tariffs that the U.S. imposed on Chinese imports and Chinese retaliation to the U.S. have impacted the U.S. manufacturing and agricultural sectors, and rising interest rates are beginning to cause private consumption to slow. In Canada, the NAFTA (renamed the USMCA) resolution paves the way to potential additional Bank of Canada rate hikes.
In U.S. equity markets, low stock correlations typically favour stock pickers, but do not address the opportunities to take advantage of the magnitude of dispersion. It is notable that in October, the odds of picking a large underperformer were greater than those of selecting a large outperformer. Volatility, correlation, and dispersion all rose in the S&P Global 1200 Index in October. U.S. equities ended the month with a loss of 6.8% for the S&P 500, loss of 9.6% for the S&P MidCap 400, and a loss of 10.5% for the S&P SmallCap 600. The S&P/TSX Composite lost 6.3%, bringing it into the red for 2018 year-to-date. Latin America was the sole region to post a positive return, with the S&P Latin America BMI up 4.9%, driven exclusively by Brazil, as the S&P Brazil BMI gained 18.4%, while Mexico’s fell by 11.2%. The S&P Europe 350 posted its worst month since January 2016, falling 5.3% in October. The S&P United Kingdom fell similarly in local terms. Trade tensions and concerns regarding the outlook for global growth in China rattle nerves through the Asian markets, with the S&P Pan Asia BMI down 9.8%. Japanese equities erased their gains in September, with the S&P/TOPIX 150 down 9%. Though there were few safe havens left, the S&P GSCI Gold Index gained 2% in October.
In November, we decided to maintain our current asset allocation across all models. Allocation to Equities will remain at 30% in Tactical Conservative, 40% in Tactical Moderate Growth, 60% in Tactical Growth, and 70% in Tactical Aggressive Growth, providing 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 relative attractiveness of interest rates in the U.S. versus the rest of the world.
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 Bureau of Economic Analysis. National Economic Accounts. Gross Domestic Product, Third Quarter 2018 (Second Estimate).
2 Trading Economics. Third Quarter 2018 Germany, Japan, Italy GDP Estimates.
3 Bureau of Labour Statistics. Current Employment Statistics Highlights. November 2, 2018.
Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Europe, Asia, Fixed Income. October 31, 2018 and November 21, 2018. Index performance is based on total returns and expressed in the local currency of the index. Returns for European regional indices are expressed in Euros.
