Equity Markets

This last quarter was simply an awful period for equity investors. The weakness was pronounced and spread across all equity asset classes. This is the result of a falling investor sentiment during the period as investors worried about slowing growth and trade tensions. While there is evidence that growth is slowing, the US economy continues to perform relatively well. For this reason, the Fed is normalizing interest rates higher. Equity investors are worried about interest rates slowing down the economy in the latter stages of a business cycle.

Canadian equities, like all major equity asset classes, were very weak during the last quarter of 2018. The S&P/TSX Composite was down 10.1% for the quarter, which brings the annual performance to a disappointing -8.9%. This was the worst calendar year since 2008 but we did experience similar setbacks in 2011 and 2015. For the quarter, investors were looking for places to hide as only 3 of 11 sectors posted gains. Consumer Staples (+6%), Communications (+2%) and Materials (+1%) were all seen as safe havens. Cannabis momentum finally stalled, resulting in Health Care (-35%) being the weakest sector. However, more important sectors by size did most of the damage with Energy (-17%), Industrials (-12%) and Financials (-12%) all experiencing a very difficult quarter. For the year, sector breadth was equally weak with only Technology (+13%), Real Estate (+2%) and Consumer Staples (+2%) generating gains. Energy (-18%), Health Care (-17%) and Consumer Discretionary (-15%) were the weakest performers.

The S&P 500 index tumbled 13.5% (total return, in USD terms), leading to a negative full year return of -4.4%. The loonie weakened in the quarter, providing some cushion to Canadian investors, with a Q4 CAD return of -8.6% and full year positive return of 4.2%. A confluence of factors, from global trade/tariffs, to peaking US GDP growth, to the oil price collapse, to another Fed interest rate hike (4x raised in 2018) have all driven the equity market narrative. During the quarter, we saw oil prices plunge as supplies built and growth concerns heightened. Notably OPEC announced supply cuts in December, with little effect. This led to carnage among Energy names (-24%) and capped a very difficult year for that sector. There was considerable weakness among Technology names (-17%) and Communication Services (-13%), led by the FAANG players all entering bear market territory. Industrials (-17%) and Consumer Discretionary names (-16%), many of which are considered highly cyclical, were also sold mercilessly in the quarter. We saw a defensive sector rotation, with Real Estate (-4%), Consumer Staples (-5%) and Utilities (+1%) outperforming. For the full year, the best performing sector was Health Care, followed by Utilities and then Consumer Discretionary.

International equities were not spared with the MSCI EAFE down 7.58% in Canadian dollars, finishing the year down 6.03%. Increasing concerns about trade tensions, political uncertainty, tightening monetary policies and the ultimate impact it could have on global economic growth, caused a very visible rotation to more defensive sectors with Utilities (+6%), Real Estate (0%), Consumer Staples (-3%), Communication Services (-5%) and Healthcare (-5%) all outperforming the market. On the contrary, the cyclical sectors like Energy (-13%), Information Technology (-12%), Materials (-10%), Consumer Discretionary (-10%) and Industrials (-10%) were all down double digit. No country was spared from the carnage this quarter, but Switzerland (-4%) which is more exposed to Healthcare and Consumer Staples and Australia (-5%) with its more defensive banks and base metals managed to outperform. Germany (-11%), France (-10%) and Japan (-9%) were the biggest laggards as those countries are generally more exposed to Consumer Discretionary, Industrials and Technology. All major currencies were stronger relative to the Canadian dollar improving performance by 3% (Australian dollar) to 10% (Japanese yen).

Generally, we feel investors should continue to have positive exposure to equities. While recent volatility seems overdone, it is healthy that investors have become less complacent about the markets. We are in the latter stages of an economic expansion. We expect volatility to remain and it’s impossible to predict short term returns given the tug of war between the current negative sentiment and attractive asset valuations. However, we don’t foresee an imminent economic recession and equity valuations are the most attractive they have been in some time. We believe the Fed could act as a positive catalyst by signalling an end to the tightening cycle.

Fixed Income Markets

The final quarter of 2018 capped the year on a downbeat note as market volatility increased, driven by growing concerns of slowing global growth amid rising interest rates and hawkish central bankers. Weakening economic data, particularly in China, was one of the primary catalysts for the sharp equity/commodity sell off in December, while other contributing headlines included a US Government shutdown and dysfunctional Government, global trade tensions and weakening consumer spending due to higher interest rates. In North America, yield curves continued to flatten as central bankers on both sides of the border continued to hike rates. The flattening and inversion due to declining longer bond yields further contributed to negative risk sentiment as the inverted yield curve, as an indicator of a recession, permeated the market. Contributing to the flattening of the yield curve during the quarter was the hawkish rhetoric of key central bankers as they proceed on the path toward policy normalization. During the quarter, the Bank of Canada hiked the overnight rate by 25 basis points to 1.75% while the US Federal Reserve hiked their policy range to 2.25%-2.50%. Further out the term spectrum, two-year Canada bond yields declined 35 basis points to 1.86% while five-year yields dropped 45 basis points to 1.88%. Ten-year Canada yields declined the most over the quarter, declining 46 basis points to 1.96% while thirty-year bonds declined 24 basis points to 2.18%. Going forward, both the Bank of Canada and US Federal Reserve are expected to proceed toward their desired neutral policy rate of 2.50%-3.50% but will likely be more cautious going forward with the pace of further rate hikes subject to the outlook and strength of economic data.

Fundamentally, Canadian economic data released during the quarter has been strong and the economy continued to perform well, generating above trend growth of 2.1% in 2018. On the downside, growth in Canada should moderate to 1.7% in 2019 due to low oil prices, higher interest rates, trade tariffs and the overall slowing in global demand growth. The impact of higher short-term interest rates on consumer spending and housing remains a concern and may contribute to a slower pace in rate hikes by the Bank of Canada in 2019. During the quarter, the unemployment rate improved to 5.6% while inflation remained subdued at 1.7% year-over-year which could give the Bank of Canada added room to slow the pace of any further rate hikes.