After a remarkably calm period, capital market volatility made a comeback in the first half of 2018; stocks, bonds and currencies were each dealt their fair share.
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We’re up. We’re down. We’re up… So now what?
The year began with enthusiasm for global stock markets. Strong corporate earnings and positive economic data helped many indices hit multiple new all-time highs in the first few weeks of 2018, but sentiment shifted quickly. Anxiety over rising bond yields was a key driver for an early-year equity market correction in all major markets.
By March, stock markets settled down. Corporate earnings remained strong, allowing stock prices to rise again, albeit slower, modestly, and with greater volatility.
It has been a wild ride for Canadian bond investors. Trade fears and shifting expectations for the Canadian economy, coupled with rising inflation, resulted in significant intra-period moves – twice the index dropped more than 1.5%, each time recovering by 1.75% and 2.37% respectively.
Ultimately, the bull market run remained intact.
■ Canadian equities and bonds eked out a mildly positive return.
■ US equities produced modest year-to-date gains.
■ International equities were modestly negative on a local currency basis, but Canadian investor returns got a currency boost from a weak loonie.
Not (yet) getting the love we deserve
Sentiment toward Canadian equities remained generally weak. Concerns over trade issues, weak domestic energy prices and highly levered consumers facing heightened borrowing costs and tighter mortgage rules have taken their toll on investors’ view of Canada. The Canadian dollar fell over 4% versus the US dollar.
At a sector level, here’s how the start of 2018 played out:
■ While information technology was the standout sector performer in Canada, it failed to have a significant impact on overall benchmark returns given its relatively small sector weight.
■ The industrial sector carried its weight and then some, as companies with significant foreign revenue gained on the Canadian dollar’s weakness.
■ The energy sector managed a small positive gain (finally pushing through some of the negative sentiment with gains in Q2), but disappointed by significantly lagging the gains made by oil prices. Canadian oil producers suffered from wider and more volatile oil price differentials (Western Canadian Select vs. US WTI) due to a lack of pipeline access, while natural gas-weighted producers continued to suffer from weak Canadian natural gas prices.
■ The heavy-weight financials sector lagged as concerns over a slowing domestic housing market outweighed solid financial results for the banks.
■ Interest rate sensitive sectors utilities and telecom were notably weak, suffering from the rise in North American bond yields.
Despite a brief hiccup in momentum during the first quarter, mega-cap tech stocks continued to lead the S&P 500. All of the FAANG stocks (Facebook, Amazon, Apple, Netflix, Google) produced solid returns, led by Netflix’s remarkable 104% YTD return. Meanwhile, rising bond yields weighed on the defensive, yield-oriented sectors, such as telecom and consumer staples.
Two US benchmark indices stood out: the NASDAQ led gains, benefitting from its large tech weighting; and, after lagging throughout much of 2017, US small caps (Russell 2000 Index) outperformed large caps. The market is recognizing that smaller, domestically-focused US companies are somewhat insulated from trade and currency volatility, benefit from tax reform, and are mostly levered to a strong US economy.
Did you know?
The S&P 500 bull market sits at 111 months old and is the second longest on record.
Modest markets and volatile politics
Some moderation in economic growth and continued political tensions weighed on European equity markets during the period.
■ Italy struggled to form a government and finally did, but not before eliciting fears of a euro-crisis/Brexit redux and uncertainty/skepticism over potential fiscal plans.
■ UK equities were weak, despite some positive progress on Brexit negotiations, where an initial agreement was struck on the terms of a transition period.
A strengthening Japanese yen was a headwind for Japanese equities, hurting competitiveness for the Nikkei’s heavy weighting in export firms.
After strong returns in 2016 and 2017, emerging markets (EM) have lagged in 2018. EM has been weighed down by tighter global liquidity (stemming from higher US interest rates and US dollar appreciation), and signs of a moderation in economic growth in China, Europe and Japan. Furthermore, political and currency turbulence in regions such as Turkey, Argentina and Brazil shook investor confidence.
A bumpy ride
The FTSE TMX Canada Universe Bond Index produced a positive total return for the first half of 2018, but bond investors endured a high degree of market volatility. A shifting ‘risk-on’ versus ‘risk-off’ narrative resulted in significant intra-period moves; twice dropping more than 1.5% before recovering into positive territory. During the second quarter, the 10-year Government of Canada bond yield popped above 2.5% (the highest level in four years), but later retreated on global trade fears, returning the FTSE TMX Canada Universe Bond Index to positive territory. US 10-year bond yields broke above 3.0% during the period, but ultimately finished the quarter at 2.86%, 46 bps higher than where they started the year. When all was said and done, long-term bonds shone brighter than shorter term bonds, and corporate bonds bested their government peers. High-yield bonds and investment grade corporate bonds benefitted from their higher running yield as credit spreads oscillated, but ended largely unchanged.
A number of events moved markets and drew headlines in the first half of 2018:
Central bank action
Cheap money has been a hallmark of the current bull market and the sharp stock market correction early in the year was a clear sign that investors were hoping for more time with the punchbowl still at the party. The market response gave central banks pause, but most major central banks are moving forward on their rate normalization plans (i.e. rate hikes).
The US Federal Reserve (Fed) raised interest rates twice by 0.25% and continues to signal that further quarterly rate hikes are in the offing. The Bank of Canada (BoC) hiked rates 0.25% in January and is also signaling further rate hikes. Concerns over trade and household indebtedness have led to expectations that the BoC will lag the Fed in terms of further hikes. Recognizing the decent but moderating growth backdrop, and with inflation remaining below target, the European Central Bank announced that it would exit from its asset purchase program in December 2018 but leave interest rates on hold until the summer of 2019.
Trade uncertainty came to the forefront after President Trump announced the US would impose tariffs on steel and aluminum imports. The targeted countries responded with retaliatory tariffs on an array of US goods. NAFTA negotiations continue but with large differences remaining, especially over automobiles. It now looks like NAFTA negotiations may continue into 2019. Additionally, the US and China entered into a tit-for-tat match of proposed tariffs on a broad array of goods, leaving investors concerned about the potential negative effects that an escalating trade war could have on global economic growth. The trade uncertainty weighed on most equity markets and brought global bond yields down from their Q1 highs.
Price-to-earnings ratios (P/E) have contracted since the beginning of the year on the back of solid earnings. Many companies are exceeding expectations and raising forward guidance, resulting in upward revisions to consensus earnings’ estimates. The strength in earnings growth is being led by the US, where earnings are being boosted by tax cuts, reduced regulatory burden and fiscal spending.
2018 Mid-Year Capital Market Outlook
Time to adjust the sails
There are plenty of signs to suggest we are in the later stage of the business cycle; a period often characterized by heightened volatility, the potential for sharp, short run-ups in equity prices, fast-moving price corrections, and rising bond yields. We do not believe this is a time to overreach with aggressive, growth cycle positioning in an attempt to squeeze out every last drop of the ‘risk-on’ trade. We caution against extrapolating trends in the current ‘shining star’ performers (e.g. information technology, or high yield bonds).
While we see continued growth in corporate earnings, we expect the pace of earnings growth to slow. Within fixed income, we expect yields to move higher and continue to pressure overall bond returns, but at this stage we feel the attraction of fixed income as a risk-mitigation tool has, and continues to, increase.
Our capital market outlook for the second half of 2018 calls for single digit equity price gains. For fixed income investors, we see flat to 1% total returns in the back half of the year. We recommend a neutral stance (risk tolerance aligned) as most appropriate for today’s investors. A neutral stance provides exposure to participate in equity market growth without stretching one’s risk tolerance. For more on what capital markets may hold for the remainder of 2018 and beyond, please see GLC’s 2018 Mid-Year Capital Market Outlook.