In July, North American equity indices rose while international and emerging market indices declined. Canadian equities returned +0.3% (S&P TSX in CA$), US large cap +1.4% (S&P 500 in US$), technology stocks +2.2% (NASDAQ in US$), international equities -1.3% (MSCI International in US$) and emerging market equities -1.1% (MSCI emerging in US$). US stock indices reached new records as the S&P 500 broke the 3,000-point mark while the Dow Jones did the same with the 27,000-point mark. Growth-style global equities outperformed value-style equities by +1.3% bringing the underperformance of value versus growth to -9.5% year to date. On the foreign exchange market, the Canadian dollar lost -0.5% against the US dollar but gained +1.8% against the euro. In the bond market, interest rates rose slightly throughout the curve in Canada and the United States. The Canadian Bond Index returned +0.2% while the Corporate Bond Index returned +0.4%.
Several issues caught investors’ attention in July including US 2nd-quarter earnings season. As ¾ of S&P 500 companies reported their performance, 78% of them beat earnings forecast while 60% exceeded sales expectations. Year on year, earnings growth was reported at +2.0%. The price-earnings multiple expansion to 18.0 times profits (15.4 times at the beginning of the year) remains the main contributor of the S&P 500 year to date performance. International (14.1), emerging (12.9) and Canadian (15.2) equities are dealt at smaller earnings multiples.
Nevertheless, US economic growth for the 2nd quarter grew faster than expected (+2.1% versus +1.8%). Upheld by a strong labor market, the American consumer, which accounts for 70% of the economy, increased its spending by +4.3% during the quarter. The US economy created 164,000 new jobs in July reducing the unemployment rate to 3.7% and pushing the consumer confidence index to a very high level of 135.7. In Canada, economic growth at the end of May was estimated at +1.4%. 24,200 jobs were lost in July, raising the unemployment rate to 5.7% (5.5% in June).
As for the Federal Reserve, it modified its fed fund rate on July 31st. The Fed cut its rate by -0.25%, a first decrease in more than 10 years (2008). Although not surprised, the market would have preferred a -0.50% cut and a more dovish statement from Jerome Powell, the bank’s president.
As to the trade saga between the United States and China, despite a positive meeting at the G20, President Trump announced on July 16th that the two nations were still far from an agreement and that additional tariffs on Chinese goods could be implemented. This forewarning broke momentum for the S&P 500, which was up +2.6% (US$) for the month beforehand.
August 1st, Trump detailed his tariff threat, he announced 10% tariffs on all remaining untaxed Chinese goods as of September 1st. The stock market responded negatively, losing -2.3% (in US$) as of Friday, August 9th.
In June, most stock market indexes recovered the May losses. Canadian equities earned +2.5% (S&P TSX in CAD), US equities +7.0% (S&P 500 in US$), international equities +6.0% (MSCI International in US$) and emerging market equities +6.3% (MSCI Emerging in US$). Growth-style global equities (+6.9% in US$) slightly outperformed value-style equities (+6.3% in US$). The VIX “fear” Index closed the month of June at 15.1 points, down from a high of 23.4 points in May. On the foreign exchange market, the Canadian dollar appreciated by +3.4% against the US dollar and +1.4% against the euro, in turn reducing the returns for Canadian investors on their foreign assets.
Helped by the Federal Reserve and the Chinese Ministry of Commerce, the stock market took a shape uptrend in early June. The S&P 500 index ended the first week of the month up +4.5% (US$). The Chinese Ministry of Commerce issued a press release on the trade dispute with the Americans. It stated that both parties would benefit from resolving their differences through dialogue, with respect and mutual benefit. It was viewed as a step forward towards the resolution of this conflict. Also, Jerome Powell, President of the Federal Reserve, stated that the governors were closely monitoring trade disputes between the United States and their main partners and were ready to intervene to maintain economic growth. Although this message came as no surprise and no direct reference was made about interest rate reductions, it was regarded as a safety net for the economy or what the market also called “The Powell Put”.
After which little news had the grip to undermine the market euphoria. The disappointing job creation statistic released in June for the month of May (75,000 new jobs versus 175,000 expectations) was counterintuitively seen as good news, reinforcing the likelihood of the Federal Reserve supporting the economy. This type of reaction is not uncommon at the end of an economic cycle as market mood sways between euphoria, denial and fear.
As for the bond market, US interest rates declined throughout the curve but more sharply in the short- and medium-term issues. In Canada, rates remained relatively stable, rising slightly in the short to medium term and slightly falling in the long term. The Canadian Bond Index returned +0.9%, while Corporate Bonds returned +1.1%. Inflation in Canada move up to 2.4% (2.0% for the previous month) while the 10-year bond rate is at 1.5%.
Tensions in the middle east pushed oil prices up by +9.3% in June as two oil tankers (Japanese and Norwegian) were attacked in the Strait of Ormuz on the 13th of the month. Held responsible by the Americans, Iran, hurting from the US withdrawal of the Iran nuclear deal, is threatening to close off this vital marine access to the Middle East oil trade. This is a delicate matter as Iran shot down a US military drone June 20th “in or near” their air space.
Among financial superstitions is the well-known adage of sell in May and go away. This year it would have been wiser to sell in April. As noted in our letter last month, performance since the beginning of the year was particularly high and the month of May corrected all this. Among the main indices, Canada fared relatively better with a performance of -3.06% for the S&P/TSX followed by the MSCI EAFE which did - 4.66% (US$, developed countries ex-North America). For the US and emerging markets, more specifically China, it was more difficult with returns of -6.35% (S&P 500, US$), -7.23% (MSCI Emerging, US$) and -13.05% (MSCI China, US$), respectively. Seeing such figures, it is easy to see that uncertainty related to the impact of the US -China trade dispute took over in May. It seems that we will have to get used to it for the next few months, if not for the next few years. It is worth remembering that since the onset of friction on this front in early 2018, most markets have not climbed past their peaks reached at that time apart from the US.
This nervousness is also illustrated by the downward pressure on interest rates as government bonds are perceived as a safe haven. The yield curve for maturities ranging from 1 to 10 years was inverted in Canada at the end of May. As an example, the 5-year rate for Canadian Federal Bonds fell by -0.18% in May to close the month at 1.36%, a level below inflation which stood at 1.9%. This strong downward shift in rates obviously affected positively the performance of the Canadian bond universe and the universe of corporate bonds which returned 1.69% and 1.31% respectively during the month.
In the US, the reversal in rates is particularly notable. At 1.91% at the end of May, the US 5-year rate fell by -0.37% in 1 month and -0.83% in 12 months. It is currently difficult to assess the impact of the various tariffs and other measures put in place by the Americans and the Chinese. Conventional economic theory states that the impact of tariff barriers is passed on to consumers through price increases which ultimately should have a negative impact on consumption. Thus, price increases should be reflected in the inflation measures, but as of now this is yet to be case. However, more volatile economic data such as PMI or job creation figures point to slower growth. The bond market has therefore taken a stand and clearly anticipates a negative impact on the economy that would lead to a Fed intervention. The market therefore expects that the Fed, starting this summer, will lower its key interest rate by 0.25% between 2 and 3 times by the end of 2019 in order to support the economy. Like the Fed, both the Chinese and European Central Banks have indicated their readiness to act.
It should be noted that at the end of May, US authorities also indicated that they were evaluating antitrust measures against major technology groups (Alphabet, Apple, Amazon, Facebook, etc.). It is still too early to know whether concrete actions will be taken, but the effect on their stock prices was immediate. However, these companies have demonstrated an ability to bounce back quickly and maintain momentum over the last few years.
In April, major stock market indices produced excellent results. Canadian equities returned +3.2% (S&P TSX in CAD), US equities +4.1% (S&P 500 in USD), international equities +2.9% (MSCI International in USD) and emerging market equities +2.1% (MSCI emerging in USD). Again, global growth stocks (+4.2% in USD) outperformed global value stocks (+3.0% in USD). Oil prices continued their path upwards, increasing by 6.3% in April, and over 50% since their December 24th low. As for the foreign exchange market, the Canadian dollar lost -0.4% against the US dollar and -0.4% against the euro. Rates in Canada and the US increased slightly throughout the curve and the flagship Canadian Bond Index returned -0.1% while the Corporate Bond segment returned +0.3%.
The solid start to the US 1st quarter earnings season captured most of the market’s attention. 76% of companies beat earnings forecasts while 55% exceeded sales expectations. Indication of future consumer spending, the resilience of the US labor market is noteworthy while +196,000 new jobs were created in March and +263,000 new ones in April. Economic growth for the 1st quarter of the year was reported at +3.2%, beating the most optimistic forecasts. Moreover, encouraging economic statistics from China (+8.5% industrial production, +6.4% economic growth) and modest (+0.4%) but higher than expected (+0.3%) economic growth in the euro zone also helped pursue the strong upward trend. This was more than enough to raise the level of the S&P 500 index to a record closing price of 2,945 points (+18% return year-to-date). Let’s recall that at the end of last year, general return forecasts for this index (+16%) seemed quite optimistic, but here we are already.
However, if we dig a little deeper, the consensus remains that the global economy is slowing down, there is still no China-US trade agreement and it is “kick the can down the road” as to Brexit. Furthermore, the S&P 500’s performance this year mostly results from an earnings multiple expansion now at 17.7 times profits (15.4 times profits at last year’s end). As previously mentioned, despite better than expected earnings, their growth was weak during the quarter (+2%). Also, breaking down US economic growth (+3.2%), some strong contributing components may not repeat in the next quarter(s). The increase in inventories (+0.7%) and the improvement in the trade deficit (+1.0%) are particularly volatile factors that tend to revert rapidly. In addition, the most important component of economic growth, consumer spending, has been soft in this quarter (+1.2%) and will need to contribute more if growth is to remain at this level.
All in all, the stock market returns accumulated this year are certainly pleasant. But the latest end-of-year market reversal reminds us that trends can change directions abruptly, a sign of late cycle volatility.
In March, stock markets continued the beginning of year upward trend. US equities led the group with a +1.9% return (S&P 500 in US$), followed by Canadian equities at +1.0% (S&P TSX in C$), emerging market equities at +0.9% (MSCI Emerging in US$) and international equities at +0.7% (MSCI EAFE in US$). As the U. S. dollar appreciated +1.5% against the Canadian dollar, the return of foreign equities in U. S. dollars must be increased accordingly when converted into Canadian dollars.
Once again, growth stocks outperformed value stocks. This trend, which began in January 2007, has gained momentum in recent years. The MSCI World Growth Index, whose five largest holdings are Apple, Microsoft, Amazon, Facebook and Alphabet, returned +2.5% for the month (+6.3% for these five holdings). The MSCI World Value Index, whose five largest holdings are Johnson & Johnson, Exxon Mobil, JP Morgan, Procter & Gamble and Bank of America returned +0.3% (+0.4% for these five holdings). Over the last two years, the performance gap is significant, growth style dominates value by 6.8% annually. This performance gap is 3.0% annually since 2007. This market preference for growth securities explains in large part the difficulties of many portfolio managers advocating a value style.
Concerned by the ongoing commercial and geopolitical tensions, central banks are closely monitoring their economies. In the United States, the U. S. Federal Reserve reduced its estimate of economic growth for the year to 2.1% (previous estimate 2.3%). It does not expect any increase in its key policy rate in 2019. China has set its growth target for the year between 6.0 and 6.5% (6.6% last year), which would be its lowest growth rate since 1990. For the European Union, economic growth has been revised to +1.1% for the year (previous estimate +1.7%). Germany narrowly avoided a technical recession in the fourth quarter of last year, and its vulnerability to the global economic slowdown has been reflected in the price of its 10-year bond, which was trading at an expected annualized yield of -0.07% at the end of March.
The equity market is rather optimistic that a favorable trade agreement between the United States and China will arrive soon. This does not seem to be the case for the bond market, where interest rates have fallen sharply. The U. S. yield curve inverted on March 22nd for both three-month and ten-year maturities (the three-month rate, +2.46%, paying more than the ten-year rate, +2.44%). The inversion of the yield curve illustrates that investors prefer holding long-term bonds over shorter maturities and is a classic signal that a recession is approaching. Rates in Canada fell similarly and the flagship Canadian bond index returned +2.4% in March.
On a more positive note, in March, 196,000 new jobs were created in the U. S., reducing the unemployment rate to 3.8%. Given that in February only 20,000 new jobs were created, this statistic uptick was well received by the markets. As for the conclusion of the Mueller investigation report, it was uneventful for the stock markets.
The rebound started at the end of December 2018 continued in February on the main stock exchanges. The pace of appreciation was generally less impressive than in January, but the markets still had a strong month. Indeed, it was a bundle for developed countries with the US S&P 500 ending February up 3.2% (US$), followed by the Canadian S&P/TSX at 3.1% and the MSCI EAFE at 2.6% (US$, developed countries ex-North America). The performance of emerging markets was more modest with the MSCI index for this region posting a slight gain of 0.2% (US$). The weak performance of the Emerging Countries Index may seem surprising at first glance when it is known that the Chinese CSI 300 stock index rose by 14.6% (CNY) in February. This disparity is simply due to limited access to the Chinese local market for foreign investors. The Chinese local market is therefore currently only a small fraction of the index of emerging countries. At the sectoral level, the technological and industrial sectors were the main contributors with a respective performance of 6.0% (US$) and 4.5% (US$) in the ACWI MSCI global index.
On the Canadian bond markets side, the month was quiet as Canadian rates rose slightly by 0.04% for 5-year rates and credit spreads remained essentially unchanged. Consequently, the universe recorded a modest performance of 0.2% while the corporate universe did slightly better with 0.3%. Until recently, the European Central Bank (ECB) was the last major central bank that had not explicitly softened its message and announced support measures. As a predictor and with his usual timeframe, it is now done. For its part, the Bank of Canada maintained its key interest rate at 1.75% when it announced in early March because of the difficulty to clearly glimpse the direction of the Canadian economy. This last point is valid for most of the major advanced economies for which it is difficult to get a clear picture of the current situation. Although manufacturing activity is generally more moderate or even slightly negative, services-related economic sectors remain supported by employment and consumption. This divergence can be seen through manufacturing purchasing indicators in Europe (49.5 in contraction) and those for services (52.5 in expansion) which point in different directions. This difference is observed to varying degrees overall.
The CSI 300 performances mentioned above illustrates in a fine way how the financial markets operate in advance. For example, exports falling from -20% to -9% in China, South Korea, Japan and Taiwan compared to the same period last year, can be seen as signs of an economic slowdown and should be reflected negatively in markets. Conversely, the announcement of support measures as outlined above combined with the hope of a trade agreement between China and the U.S. allow markets to contemplate that the difficulties are only transient.
At the end of February, the most positive scenario seemed to prevail, largely because of the real or perceived impact of the support of the various major central banks. However, with spring spinning its nose, a simple Trump tweet might be enough to change the wind direction…
Markets started 2019 in a much different way than they ended 2018. For example, after suffering its worst December since 1931, the US S&P 500 Index rebounded by +8.0% (US$) in January to start the year in a spectacular way and having its best January since 1987. This reversal illustrates two characteristics of the markets. First, changes in investor sentiment can be sudden and drastic when nervousness sets in. Second, predicting short-term market direction remains a risky and rarely successful exercise. This is when it becomes important to keep in mind its long-term target allocation and, if necessary, to make tactical changes in a gradual and methodical way.
The strong reversal previously illustrated by the US market was widespread in January. Among major markets, the MSCI Emerging Markets finished up by 8.8% (US$) followed by S&P/TSX and MSCI EAFE (ex-North American developed markets) which saw increases of 8.7% (US$) and 6.6% (US$), respectively. However, the best performance was recorded by US small cap stocks as the Russell 2000 index shoot up 11.25% (US$). Nevertheless, markets remain below their peak levels of 2018. In the Canadian bond markets, performance was more modest, but still significant for this asset class. The overall bond Universe closed by 1.3% while the corporate bond sub-index appreciated 1.7%.
What happened to cause this? Basically, little has changed in two months. Leading economic indicators such as manufacturing surveys and the level of exports of some Asian countries and Germany have been pointing since the middle of the 4th quarter 2018 towards a still-growing but decelerating global economy. This slowdown is also reflected in announcements by international companies such as Apple or major automotive manufacturers that are projecting declining revenues, mainly due to a slowdown in China. Nevertheless, employment numbers remain robust, especially in the United States, and quarterly results of companies revealed to date are broadly aligned with expectations.
However, what has changed is the message coming from certain actors. As mentioned in our December letter, part of the fall in the 4th quarter 2018 came from the perception that the Fed would become too aggressive in 2019 and would thus dent the American expansion. Throughout his statements last Fall, the president of The Fed, Mr. Powell, seemed determined to continue his tightening program. In January, Mr. Powell strongly softened his message by indicating that the Fed would be patient with the future increases. In China, the government and the central bank announced additional measures of indirect support by injecting liquidity in the banking system to support lending to companies. In Germany, the government announced various measures to support corporate R&D and investments while indicating that an infrastructure plan would follow in the spring. All these announcements contributed to the market recovery and supported bonds with a slight flattening of the yield curve, - 0,1 % for the 5 years Canada, and by lowering the credit spread.
Henceforth the Market anticipates a certain support for 2019 through the various measures announced. It may bear fruit, like 2014 and 2015, and extend the expansion. However, structural issues such as high debt, or different geopolitical risks (US vs. China, Brexit, risk of another shutdown in the US) could reduce the impact of these measures. Caution is still warranted.
What a terrible stock market performance to close 2018! S&P/TSX lost -5.4% for the month (CA$), S&P 500 -9.0% (US$), Nasdaq -9.4% (US$), MSCI EAFE -4.8% (US$) and MSCI Emerging -2.6% (US$). The VIX “fear index” was elevated throughout the month, averaging 25 points daily, its worst month since December 2011. The depreciation of the Canadian dollar against the US dollar (-2.5%) and the euro (-3.5%) was insufficient to materially offset market losses. Clearly, the equity market was in “risk-off” mode as investors took refuge in bond securities. In Canada, interest rates declined throughout the yield curve and the bond universe returned +1.4% (CA$). As for the corporate bond universe, it returned +1.1% as credit spreads widened.
For the Dow Jones Index, 11 of 19 trading sessions produced negative returns in December. The worst of these sessions occurred early in the month, on December 4th, when the index lost 799 points (-3.1% of the US$). That morning, the White House issued a statement announcing the 90-day tariff hike with China had begun on December 1st, not January 1st (to the markets surprise). This statement caused confusion about the recent progress in trade negotiations with China. Several other events undermined market sentiment, including the arrest of the Huawei Chinese technology group’s CFO in Canada at the United States’ request, a disappointing US employment statistic (job creation in November), renewed fears of a slower growing global economy, a FED rate hike accompanied by a more hawkish than expected guidance for 2019 and the shutdown of government operations.
Overall, the stock market performance in 2018 was very disappointing. For the year, it returned -8.9% for the S&P TSX CA$, -4.4% for the S&P 500 US$, -8.2% for the MSCI World US$ and -14.2% for the MSCI Emerging US$. The S&P 500 had returned +10.6% US$ for the year, up to September, but the 4th quarter return of -13.5% (US$) was the worst quarterly performance of the index in seven years. Unfortunately, bond returns have been weak (+$1.38% CA$), returning less than a 3-month federal bond at the current rate of +1.65% CA$. The best return for a Canadian investor will have been the currency gain from the loss of the loonie against the US dollar (-8.0%).
What will 2019 have in store for the markets? According to a survey of major US banks and brokerage firms (including JP Morgan, Goldman Sachs, RBC Capital Markets and Bank of America), the S&P 500 index will end the year at roughly 2 900 points, generating a return of 16% (excluding dividends). At this level, the S&P 500 would be approximately 1% below its historic end of the day peak reached on September 20th, 2018. These forecasters argue that there is currently little evidence of a significant slowdown in the US. economy. Surprising labor market statistics in December (published at the beginning of January), +312,000 jobs and wage growth of 3.2%, tend to support this argument. However, in order to achieve a return of 16% without expanding the price-earnings ratio, corporate profits (including share buybacks) will have to grow at an equivalent rate, which is too optimistic. We believe more realistically that profits can grow by 5% to 10%. The recent market correction quickly tightened the price-earnings ratio, which is unpleasant but helpful in keeping a bull market alive.