Mackenzie Asset Allocation Team
The first quarter of 2018 proved to be significantly different from the last few years, as volatility returned to markets. Equities started the year on a strong footing, continuing on the path of the last two years, as investors cheered solid growth numbers and positive corporate earnings releases. However, developed market equities sold off by about 10% in early February and the VIX index of implied equity volatility spiked to a reading of 50, ending the period of low volatility investors had enjoyed since the end of 2016. For the quarter, the MSCI World Index ended down 2.1% in local currency terms. In Canadian dollar terms, the index ended higher (+1.6%) as the Canadian dollar depreciated against all major currencies.
In bonds, there was little movement in Canadian bond yields, resulting in the FTSE TMX Canada Universe Bond Index rising a very modest 0.1%. As investors moved away from riskier assets, high yield bonds fell 0.9%, as represented by the ICE BofAML US High Yield Bond Index.
Outlook & Strategy
Q1 2018 – A Rocky Road
Monetary policy and trade concerns became prominent headlines in Q1. Market participants continue to be concerned by the Fed’s ongoing normalization of monetary policy as it continues raising short-term interest rates and begins reducing its balance sheet. This led to negative returns for U.S. bonds in the first quarter. Sentiment was also impaired by the fears of protectionist trade policy, with the Trump administration targeting China’s perceived unfair trade practices. This led investors to question the viability of the 18-month-old synchronized surge in global economic growth.
In Canada, the strong recovery began to moderate. The Bank of Canada responded to the gradual increase in inflation by raising rates in January, but did so while sounding cautious about the future pace of increases. The housing market also showed signs of slowing down, with sales falling relative to last year in response to heightened macroprudential regulation by the federal government. As a result, the TSX continued to underperform global stocks and the loonie lost ground against the US dollar.
Internationally, global growth was a key theme in 2017, but so far this year, there have been signs of moderation. Eurozone and Japanese manufacturing activity is decelerating and industrial metals prices, a good gauge of global growth momentum, have topped off. Global demand appears to be moderating to levels that are more sustainable when entering the mid-to-late stages of an expansion.
Q2 2018 – Continued Global Growth with Risks Ahead
While we think that global growth will remain strong (though not as robust as 2017), some risk factors have emerged. In the U.S., fiscal deficits are expected to rise due to the Tax Cuts and Jobs Act instituted by the Trump administration, which has put upward pressure on Treasury yields. This fiscal stimulus takes place amid a strong U.S. economy, which appears to be at, or close to, full capacity in its output and employment, and could lead to faster-than-expected inflation. The Fed’s rate hike in March was accompanied by slightly more hawkish guidance for the path of interest rates, as FOMC members grew more confident in their outlooks. In addition, rhetoric surrounding trade policy has escalated recently, with the NAFTA negotiations in focus. The implementation of significant trade policy restrictions and tariffs could also disrupt global trade and the economic cycle.
Global trade should continue benefiting Emerging Markets. China is now leading the rebound in global trade and Emerging Market economies continue to experience a synchronized recovery. Chinese import growth is strong, but more interestingly, export growth is accelerating while the Chinese currency is strengthening. China’s transition to a slower but more sustainable level of growth is proceeding in a relatively smooth way, as authorities ensure that financial conditions remain accommodative. We expect Emerging Market economies to remain on their recovery path, as many of them are much earlier in the economic cycle than developed economies such as the United States.
In Canada, we expect growth to gradually return to its long-term trend. Uncertainty around NAFTA negotiations have clouded the growth outlook, and the Bank of Canada acknowledged this risk in its March monetary policy decision. Despite the dovish guidance, inflation data has beaten expectations for the first two months of the year, employment remains strong and the Bank of Canada is expected to continue hiking short-term interest rates in 2018. GDP growth moderated in January and is expected to continue to slow, relative to last year’s above-potential growth rate. Key risks include the elevated level of household debt, which stands at over 170% of disposable income, and the slowdown in the housing market because of foreign buyer taxes and macroprudential measures undertaken by the federal government.
Investment Views for Q2 2018
Our key tactical views include the following:
- Asset mix: neutral position on stocks, underweight bonds, overweight cash.
- Overweight emerging markets equities relative to the rest of global equities.
- Moderate overweight position in the euro relative to other world currencies.
We reduced our overweight in global equities and returned to a neutral position. This overweight was a profitable position that was added to Symmetry in Q2 of 2016. Since then, equities significantly outperformed bonds (MSCI ACWI +35% in CAD, Bloomberg Barclays Global Aggregate Bond Index Hdg to CAD +2.7%). However, the recent signs of a moderation in global growth stands in contrast to the synchronized improvements that proved to be a powerful tailwind for global equities over the past 18 months. Meanwhile, bond yields have increased and financial conditions have tightened somewhat. This reduces the relative appeal of equities. Further upward pressures on long-term interest rates should remain gradual and limited by structural factors, such as demographics and still-low rates of productivity growth. This change in the macro environment has led to a change in our view of market behavior. Our sentiment models, which have been strongly supportive of equities for the last couple of years, started to weaken in Q1, enough to go to a neutral view.
We are maintaining our underweight to bonds. Despite recent bond yield increases, yields remain at historic lows, leading to rich valuations. In addition, our gauges of investor sentiment are negative, supporting the negative view on bond valuations.
Within the regional equity space, EM stocks are now our only overweight position. Emerging market corporate earnings are still significantly below their long-term trend, as EM economies are still early in their recoveries. The gradual rise in commodity prices is proving to be a tailwind for many emerging economies. Meanwhile, EM financial conditions remain supportive, with many EM central banks continuing to cut interest rates. In an environment where valuations for EM equities remain more subdued than for developed market equities, we believe this provides an attractive backdrop for equity investors.
We continue to hold an overweight position on the euro relative to the Canadian dollar. In March, the ECB moved closer to the end of ultra-easy monetary policy by removing from its statement the reference to a possible extension of its QE program beyond September 2018. Meanwhile, Germany continues to benefit from the strong performance of global trade, and the peripheral Eurozone economies are posting better growth numbers on the back of a recovery in household spending. Unemployment rates, a long-standing issue in the Eurozone, are also falling across the board. The euro also benefits from stronger sentiment readings, based on our models, and as such, we maintain an overweight position in the currency.
Key risks to our outlook include higher-than expected increases in inflation and interest rates or a policy accident by a government or central bank.