Mackenzie Asset Allocation Team
Markets were heavily influenced in the first quarter by political factors revolving around U.S. President Donald Trump. Equity markets were powered to new highs during the quarter in what has been called the “Trump Trade” or “Trump Bump”, but perhaps more accurately reflects ongoing improvement in the U.S. and global economy. On balance, that mix of factors pushed risky assets up and led to the first U.S. Fed rate hike of 2017 in March.
The Canadian equity market posted another positive quarter to open 2017. The S&P/TSX Composite Index gained 2.4%. The U.S. market outperformed Canada with the S&P 500 Index returning 5.5% in CAD terms. In both markets, large caps outperformed small caps in Q1. The MSCI EAFE Index gained 6.7% in Canadian dollars. Europe as a whole gained 6.9%, powered by Germany (+7.8%), Switzerland (+7.7%) and France (+6.7%). The UK posted positive return of 4.5%. Japan rose 3.9% in CAD terms. Emerging markets were strong, with a 10.8% return in Canadian dollars led by India (+16.5%) and China (+12.3%). Brazil posted a more modest 9.8% gain in CAD terms while Russia slipped 5.1% after a staggering 21% the previous quarter.
In general, optimism remains strong based on recent consumer and business confidence indicators. Positive economic surprises already stand at multi-year highs, perhaps limiting the scope for further upside surprises. Moreover, sentiment indicators contrast with other “hard” data that give a less encouraging picture-- for example, the Atlanta Fed’s real-time forecast of real GDP in the first quarter currently predicts disappointing growth of just 1%. Looking ahead, higher growth based on stronger US business investment and consumer spending will depend on translating optimism into actual policies.
Fixed Income markets were modestly positive for the quarter. The Canadian fixed income market (FTSE TMX Canada Universe Bond Index) returned 1.2%. Global bonds, as measured by Citigroup WBIG Index (C$), returned 0.8% over the quarter. High Yield bonds were the strongest bond sector in this generally positive quarter for most risky assets, with the BofAML US HY Master Index (C$) up 2.1%.
All told, our moderate overweight in stocks versus bonds that we initiated in Q4 last year has rewarded our investors.
Outlook & Strategy
What are key risks that need to be managed?
The ‘Trump reflation trade’ has wavered as markets reassess President Trump’s ability to advance his pro-growth agenda, especially after the failed US healthcare reform. The failed healthcare reform revealed deep divisions amongst Republicans in Congress, as even reforming ‘Obamacare’ -- a core Republican priority in the last 7 years – proved to be unworkable.
The deal-making president will face another litmus test in late April. The government will run out of money on April 28 when the current funding resolution expires, at which point Congress will have to turn its attention to passing a new continuing resolution to fund government spending. To do so, Congress will also have to approve another increase in the debt ceiling. This sets the stage for another episode of political brinkmanship and last-minute deal-making to prevent a government shutdown.
An expansion in the budget deficit to pay for tax cuts and higher spending on infrastructure and defense seems politically infeasible. President Trump will need to find other measures to pay for his pro-growth policies.
All this means that at the very least, implementing President Trump’s pro-growth agenda will be further delayed. The difficult political context may require the president to accept less ambitious tax and infrastructure reforms, leading to a smaller expected boost in US growth and inflation compared to the original Trump plan. Unfortunately, much of today’s current market optimism has been founded on expectations of significant new spending and tax and regulatory reform in the U.S..
Finally, current high market expectations and rich asset valuations also limit the room for further upside surprises. Today’s high asset prices have set the stage for a prolonged period of generally lower returns in the decades ahead. Popular valuation models for US stocks, such as Shiller’s cyclically-adjusted P/E ratio, indicate that equities have rarely been so expensive. Record low yields on high-quality government bonds also suggest historically rich valuations. Mackenzie's comprehensive valuation model – the Multi Asset Class Valuation Model (MACIV) – estimates the fair value of global stocks and government bonds by forecasting trends over 40 years in productivity, demographics, real interest rates and economic growth. Based on the MACIV estimates, we expect today’s high asset prices to be a significant headwind for expected returns over the next market cycle of seven to ten years.
What are the key opportunities you see? How are you positioning portfolios in response to this outlook?
In contrast to looming challenges in the U.S., global economic indicators point to a resilient economic outlook for the Eurozone, Japan and Canada. Global indicators of manufacturing activity have picked up in recent months compared to US activity. Inflation in major economies has also moved closer towards central bank targets. Stabilizing oil and commodity prices compared to early 2016 are expected to benefit Canada and other major resource economies, including Australia, Brazil and Russia. Policymakers in China are also set to deliver steady growth of about 6.5% this year -- drawing on China’s ample reserves and policy tools if needed – to ensure a stable backdrop for the 5-year National Party Congress. Political risks in Europe are also subsiding with populist forces losing momentum following the Dutch election and stalling support for Marine Le Pen in France.
Stock markets in the UK, Europe and Canada appear more attractively valued, providing opportunities for longer horizon investors. These markets may also benefit if investors reassess the relative cyclical and policy outlook in the US versus other regions. As global reflation gathers momentum, we also expect global stocks to continue outperforming government bonds.
Entering Q2, we maintain our overweight stocks versus fixed income. Based on our valuation models, both stocks and bonds appear expensive with fixed income being relatively pricier. That said, we don’t believe valuation alone is sufficient in making effective tactical decisions. Core to our belief is the importance of overlaying other inputs, including an assessment of the macro-economic environment and market sentiment. Sentiment in particular tends to have good predictive power over shorter horizons. Currently, our models of market sentiment for equities are strong, while those for bonds are weak. All together, this leads us to have a positive view on equities relative to fixed income.
In terms of relative equity, we see the best opportunity from UK stocks. They look attractively valued and have additional support from our macro and sentiment models. While volatility has certainly spiked as a result of British PM May’s snap election call, we believe that she has called the election because right now seems to be the best time to solidify her mandate for a hard Brexit—in other words, looking back in July little will have changed versus March provided the election outcome is as expected, other than markets having experienced a brief period of temporary uncertainty.
Eurozone and Emerging Market equities have positive valuations, but do not receive much support from macro and sentiment models, especially the Eurozone, where market sentiment is among the most negative. We are most bearish on Japanese equities, which are expensive and have attracted high negative sentiment. We believe Canadian and US equities are also overvalued, but our assessment of market sentiment is stronger for both.
Within currencies, we see fewer opportunities than usual given a high degree of conflicting forces, and we are therefore neutral in most of our currency views. We are slightly bearish on the British Pound. Negative market sentiment has weighed heavily on the Pound, as the ramifications of Brexit work itself out, even though valuation is somewhat positive versus the Canadian dollar.