Q4 2016 Commentary

Mackenzie Asset Allocation Team

Market Review

The last quarter of 2016 was full of surprises. First, similar to Q2’s surprise Brexit result, Q4 saw Donald Trump’s surprise victory in the US Presidential election. Leading up to the election, volatility increased and equity markets were pulled downward as the odds of a Trump victory increased. This was expected. The second surprise was how markets reacted after his victory—equity markets rose, equity volatility fell, and bond prices declined as yields rose on the expectation that the Trump campaign promises would lead to higher growth and inflation and, ultimately, higher interest rates.

In Canada, the equity market continued to post positive returns in the fourth quarter. The S&P/TSX Composite Index returned 4.5%, buoyed by Financials, which experienced a positive effect from the Trump victory, and Energy, as oil prices stabilized and increased during the quarter. These sectors returned 11.5% and 7.0% respectively. The S&P 500 Index outperformed major equity market indices with a return of 5.8% in CAD terms. Financials was the biggest winner, posting a dramatic 21.1% return in USD over the quarter followed by Energy (7.3%) and Industrials (7.2%). Internationally, many of the developed equity markets gained in local currency terms (with the MSCI EAFE Index returning 7.1%) but Canadian dollar strength offset some of that return resulting in a net positive 1.3% in Canadian dollars. Emerging markets were down for the quarter with China and India contributing a significant portion of the negative return.

In response to the election result, bond yields jumped which resulted in fixed income markets declining during the quarter. The Canadian fixed income market (FTSE TMX Canada Universe Bond Index) returned -3.4%. Global bonds, as measured by Citigroup WBIG Index, returned -2.7% in local currency terms. High Yield bonds, on the contrary, had another strong quarter, and posted a 1.9% return in USD as measured by the BofAML US HY Master Index.

In currencies, the US dollar appreciated 2.4% against the Canadian dollar, however other foreign currencies weakened. The Yen, euro, and British Pound all fell against CAD; -11.3%, -4.1%, and -2.1% respectively.

Outlook & Strategy

What are key risks that need to be managed?

Looking ahead to 2017, three themes stand out for the global economy and markets. President-elect Donald Trump’s pro-growth and reflationary policy mix with its focus on large tax cuts, infrastructure, and deregulation will remain a dominant theme for markets. Second, political risk is likely to remain top of mind for investors, particularly as a busy election calendar risks opening the door to more populist policies in Europe. Third, emerging markets (EM) are likely to remain under pressure, especially as China continues rebalancing its highly over-leveraged economy.

Ever since the surprise election of Donald Trump, markets have appropriately priced-in higher growth and inflation in 2017. Term spreads have widened, equity markets have rallied and expected inflation has increased to about 2%. However, the outlook remains highly uncertain given the lack of specifics about concrete policies and the timing of implementation, and controversial, potentially growth dampening policies that include trade protectionism and curbs in immigration. The details will be important for asset prices as the market judges the short- and long-run impacts on growth and inflation. In other key regions around the world, the Euro Zone and Japan are likely to continue relying on loose central bank policies and a weak currency to support growth as both regions face challenges in enacting supply-side reforms.

Populist sentiment may spread to Europe in 2017 as France, Germany, and the Netherlands hold national elections. Increasing support for populist candidates and policies threatens to test European cohesion and renew concerns about the euro’s future.

While overall EM growth should improve in 2017, performance across countries will differ. Many EM economies could remain under pressure due to a perfect storm of high global interest rates, falling trade growth, and the strong US dollar. These factors weigh most heavily on countries with weak balance-of-payment positions and overleveraged corporate borrowers. This includes China, which faces mounting concerns over the value of the Yuan, slowing economic growth, a mountain of corporate red ink, and a heavy debt load.

What are the key opportunities you see? How are you positioning portfolios in response to this outlook?

We are positioned overweight in stocks relative to bonds. Though stocks appear expensive from a long term valuation perspective, our stock view has been boosted by strong market sentiment. Global central banks are also expected to maintain accommodative financial conditions that benefit stocks. Both equities and bonds have unattractive valuations although bonds look particularly rich as market sentiment continues to be negative.

We recommend an overweight exposure to Canadian stocks as investor sentiment is strongly positive. The macroeconomic environment has also improved with the Bank of Canada expected to keep interest rates low while oil prices have stabilized.

We continue to be bullish on UK stocks, as they look relatively attractive from a valuation standpoint and market sentiment remains positive. We maintained our bearish view of pound-sterling. About three quarters of the earnings of FTSE 100 companies originate from outside the UK. The weaker pound supports UK stocks by increasing the value of foreign earnings in local currency terms and boosting the UK’s international competitiveness.

We continue to be bearish of U.S. equities. Despite strong sentiment, valuations for US equities are rich and macro conditions are unattractive as the Fed remains the only major central bank in tightening mode and the cycle looks increasingly mature with earnings and profit margins turning downward. Finally, Japanese stocks appear very unattractive at the moment because of rich valuations with highly negative sentiment that more than offset the impact of monetary stimulus. In Japan, the cyclical slowdown also makes us more bearish.

With currencies, we remain underweight in the US dollar relative to the Canadian dollar given strong market sentiment and macro conditions. We are underweight the Euro and GBP relative to the Canadian dollar on negative sentiment and less favourable macro conditions in the euro area.

In the longer term, the success of Donald Trump’s economic reform package in lifting growth will depend on boosting the supply-side of the economy. Tax cuts, infrastructure and deregulation have this potential. However, three factors would offset the expected benefits: curbing immigration and trade protectionism, deleveraging debt due to America’ growing twin budget and current account deficits, and continued politicizing of major business decisions about investment and jobs. While things remain unpredictable, we believe global diversification remains the best defense against shorter term political risks, particularly for longer horizon investors.

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