Mackenzie Multi-Asset Strategies Team
After a long run of calm and generally up-trending equity markets, 2018 proved to be considerably more volatile, with three violent, successive selloffs in February, October, and December. The gradual return of inflation was an important theme throughout the first three quarters of 2018, but disinflationary winds began to blow again in Q4, with a large drop in crude oil prices sending ripples through the currency and bond markets. The MSCI ACWI Index lost 13.2% in local currencies over the quarter, and 7.2% in Canadian dollars. Of note was the underperformance of the U.S. S&P 500, which lost 14.2% over the quarter, reversing a trend of outperformance over the past several years. The Bloomberg Barclays Global Aggregate Bond Index Hedged to CAD gained 1.7% on the quarter, while Canadian bonds performed better (+2.3%).
Outlook & Strategy
As we pointed out in previous quarters, growth is decelerating globally. The U.S. was the last major economy to experience this deceleration in growth, as it appeared first in emerging markets and then in European and Asian developed markets. Until recently, U.S. resilience was underpinning an outperformance of U.S. assets relative to the rest of the world. As the Federal Reserve’s tightening campaign is now more advanced, interest rate-sensitive sectors of the economy have begun to slow down. This is the case, notably, of the housing sector, where activity has decelerated considerably. Indicators of growth in the manufacturing sector are also coming back down to earth, indicating that after a strong 2018, U.S. growth is joining the rest of the world in moderating.
Another break from 2018 trends has been the recent fall in inflation expectations. In fact, most of the reduction in bond yields experienced in the fourth quarter of 2018 was explained by falling inflation expectations. The collapse in crude oil prices (-40% on West Texas Intermediate (WTI) during the quarter), led markets to anticipate a more subdued inflation outlook. Market expectations for further Federal Reserve rate hikes are now much more muted than they were just a few months ago.
Canadian assets have been under pressure, as Canada’s energy woes have been compounded by a lower price for Western Canada Select (WCS) crude. While the decision by the Alberta government to curtail production helped close some of the gap between WTI and WCS, Canada’s energy exposure remains mostly a curse for now, as oil prices fall and Canadian oil continues to trade at a low price compared to global benchmarks. In this difficult environment, the Canadian dollar lost about 7% against the U.S. dollar in Q4, as the market began to doubt the likelihood of further immediate Bank of Canada rate hikes.
Q1 2019 Outlook – Risks Becoming More Apparent
Barring further fiscal stimulus, we expect slower U.S. growth in 2019. It has become apparent that the “sugar rush” experienced by the U.S. economy, following an unusual, late-cycle fiscal stimulus, is disappearing. As mentioned above, interest rate-sensitive sectors of the economy are also slowing. Corporate capital expenditures, an area of strength for the U.S. economy one year ago, are now softening considerably. This suggests that the interest rate normalization process is beginning to be felt in the real economy. We do not view the U.S. economy moving into outright contraction, but we think growth in 2019 will be much slower than the levels registered in 2018.
We also expect Canada to slow down. The Canadian economy has already begun this process. This has been particularly evident in Canadian consumer spending, which has come back down to earth from the elevated levels of growth reached in 2017. This has coincided with a topping out of housing markets in Toronto and Vancouver, suggesting that interest rate hikes by the Bank of Canada have begun to work their way through the system. In our view, this likely will continue into 2019.
China already has slowed down abruptly and is now considering applying stimulus—this will be something to watch in 2019. The Chinese economy responded negatively in 2018 to policy efforts to de-risk and de-leverage the financial system. The government cracked down on the shadow banking system, leading to much slower credit growth. Historically, after sharp economic slowdowns, the Chinese government has tended to stimulate to avoid a hard landing of the economy and maintain job and income growth, two key factors ensuring social stability in China. This would suggest that stimulus is now imminent. The Chinese government has, in fact, cut taxes in recent months, with a view to bolstering consumption. However, the results of this tax cut have so far been muted. Moreover, the efforts to de-leverage and de-risk the financial system are somewhat constraining the government’s ability to stimulate. We will be watching the evolution of this tension in China in early 2019. For now, it does not appear that China is re-accelerating meaningfully.
Europe remains stuck in the slow lane. Market participants had hoped that 2018 could build on a robust 2017 for Europe, with a stronger footing for more sustainable expansion. Once again, markets were disappointed, as European growth underwhelmed. Global trade tensions hurt export-driven European economies such as Germany, while political instability in Italy and the U.K. undermined domestic confidence. Several European equity market indices are now in bear market territory as a result, and forward-looking expectations for the region are much lower than they were at the beginning of last year.
Investment Views for Q1 2019
Mackenzie’s Multi-Asset Strategies Team’s key tactical views include the following:
- Asset mix: underweight position on equities relative to cash and underweight position in bonds relative to cash.
- Foreign exchange: slight overweight in the U.S. dollar relative to the G5 basket of currencies.
In Q1 of 2018, the Multi-Asset Strategies Team went to a neutral position on equities relative to cash. This was a significant change, as we had held a profitable overweight in global equities since Q2 of 2016. In recent outlooks, we wrote of several cross currents playing out in the markets, with positive and negative forces roughly balancing each other out. In early October 2018, the Multi-Asset Strategies Team began to see the balance of risks as having shifted to a slightly more negative side, pointing to the need for a cautious asset mix. This led us to shift to our underweight positions in equities and bonds relative to cash. These investment views are reflected in our Symmetry Portfolios, ETF Portfolios, Multi-Strategy Absolute Return Fund (MSARF) as well as our Private Wealth Pools.
This change has been driven by a few factors. Macroeconomic indicators, while remaining in expansion territory, are now pointing to slower growth ahead. With tighter monetary conditions and fiscal stimulus waning, we expect growth to remain positive, but to be considerably lower than in 2018. In our view, earnings growth will likely be slower in 2019, reducing the support to equity markets coming from macroeconomic factors. On the equity valuation front, the recent fall in share prices has improved the attractiveness of most metrics. However, our assessment of equity valuations remains somewhat expensive. Finally, our modeling of behavioral investor sentiment shows a recent deterioration relative to the last few years. All in all, we believe this warrants an underweight position in equities.
In terms of currencies, we continue to hold an overweight position in the U.S. dollar relative to the broader basket of currencies. Our FX views are out of consensus, as most strategists appear to expect the U.S. dollar to depreciate in 2019. While we recognize that the U.S. dollar valuation versus G10 peers appears to be high relative to historical averages, our macro and sentiment models for the currency are positive. On the flipside, we hold an underweight position in the euro. We continue to believe that the Eurozone will be challenged on the growth front, limiting the European Central Bank’s ability to normalize interest rates. We believe this could disappoint a consensus of strategists which persists in expecting Eurozone interest rate normalization and a rally in the euro.