Equity Markets

Well that was helpful! Equity investors were treated to a miserable quarter to finish 2018 but saw their patience well rewarded as we kicked off 2019. Strong returns were widespread across all major equity asset classes. Central banks signalled to investors that rate hikes were done for the time being. This should help economies continue to grow with access to inexpensive capital. Furthermore, the US and Chinese governments are both signalling that trade disputes between the two countries are slowly getting sorted out. As such, investors feel better about economic prospects going forward.

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Canadian equities experienced a dramatic rebound with the S&P/TSX Composite delivering a quarterly return of 13.3%. All eleven sectors posted gains for the period. Several securities with speculative characteristics performed very well, which led to Health Care (+49%) and Technology (+26%) sectors offering the best returns. Interest sensitive sectors also reacted to the falling rates by offering abnormally high returns in relation to their ability to grow. Real Estate (+18%) and Utilities (+16%) experienced very strong quarters. Even the worse performing sectors, Consumer Staples (+8%) and Consumer Discretionary (+10%), were still very strong in absolute.

In the U.S., as is the case worldwide, Q1 demonstrated why we preach staying invested for the long-haul. The S&P 500 roared back from the difficult Q4 to post a Q1 total return, in USD, of 13.6%. The loonie strengthened a bit, leading to an 11.2% return for Canadian investors. Oil rebounded strongly through the first quarter, though we note the energy sector returns have not fully matched the move. Once again, the Technology sector retook its leadership position, posting a nearly 20% gain in the quarter. But strength was widespread, with the worst performing sector, Health Care, still returning 7%. Q1 returns were as follows: Technology +20%, Real Estate +18%, Industrials +17%, Energy +16%, Consumer Discretionary +16%, Communication Services +14%, Consumer Staples +12%, Utilities +11%, Materials +10%, Financials +9%, and Health Care +7%.

International equities also participated in the market rebound with the MSCI EAFE index returning 7.6% in Canadian dollars. While most economic data points were sluggish during the quarter, the market’s optimism about a US-China trade deal was enough to drive equities higher. Sector performance was unexpected as there wasn’t a clear rotation to defensive or cyclical. The IT sector (+13%) led the way after what we believe was unwarranted under-performance in the last quarter. Materials (+11%) also performed well on some micro and macro events helping commodity prices. Real Estate (+12%), Consumer Staples (+10%) and Health Care (+9%) all outperformed which we would attribute to lower interest rates. On the flip side, Financials (+5%) lagged the benchmark given the weak economic data leading to lower interest rates, Consumer Discretionary (+5%) was impacted by weak guidance from auto original equipment manufacturers (OEMs) and Communication Services (+2%) underperformed on soft performance from telco companies.

Last quarter, we suggested that the Fed could act as a positive catalyst by signalling an end to the tightening cycle. It did end up playing out this way and investors cheered the change in stance by buying equities. Today, we have more supportive monetary conditions, which are beneficial for the economy and for equities. The trade off is that valuations have climbed back to previous levels. Valuations do remain reasonable from a historical and interest rate perspective, but we must be mindful that we are in the latter stages of an economic expansion. Volatility will surely return. We continue to recommend carrying a healthy weight in equities but feel we should incrementally favour more defensive business models and stronger balance sheets.

Fixed Income Markets

Following a dismal conclusion to the year for financial markets, the first quarter of 2019 has demonstrated that the issues that drove a widespread market correction are nowhere close to being resolved. The first quarter of 2019 proved to be notably divergent in terms of price direction, with a concerted recovery in Q1 across many asset classes including equities, commodities and bond credit spreads, while at the same time, global bond yields continue to drop precipitously. The persistent global rally in bond prices during Q1 was supported by both a sharp reversal in policy views by central bankers due to the declining projections in fundamental economic data and the overhang from several risk factors overshadowing the outlook for global growth. Fundamentally, inflation has been tracking weaker than the 2% policy target with Canadian Core CPI of 1.8% (February) and US Core PCE of 1.8% (January). In addition, the outlook for GDP in 2019 has remained weak as negative revision to the Q4 growth data and the absence of a positive catalyst present a bleak picture for 2019. In Canada the growth outlook for 2019 was revised up to 1.5% following a strong upward surprise in January. Growth in the US slowed in Q4 to 2.6% (versus 3.4% in Q3), while the outlook for GDP growth in 2019 is 2.3%. The risk of a recession at these levels is remote as positive gains remain acceptable. The ongoing trade negotiations and looming deadlines represent a key risk to global growth outlook as US/China, USMCA, UK/EU Brexit, US/EU trade negotiations dominate headlines with the potential to significantly impact trade flows. Global trade combined with the US Government shut down and the resulting delay in economic data released contributed to the risk off sentiment and uncertain outlook. The convergence of risk factors and slowing global growth experienced in Q4 led to an abrupt reversal in policy stance by central bankers as the US Federal Reserve, the Bank of Canada and the EU rapidly changed course in January from anticipated rate hikes for 2019 to none. Following this reversal in policy, bond markets started to price in rate cuts further out the curve, largely contributing to the inversion in the short term (2-5 year) segment of the yield curve.

The decline in bond yields across the curve was largely parallel in nature as the rapid move to a dovish stance by the US Fed and Bank of Canada should eliminate the flattening trend we have experienced since 2014, replacing it with a steepening outlook for the curve as central bankers have proven their willingness to support growth through policy rates. During the quarter, the Bank of Canada held the overnight rate to 1.75% while the US Federal Reserve also held their policy rate at 2.25%-2.50%. Further out the term spectrum, two-year Canada bond yields declined 31 basis points to 1.55% while five-year yields dropped 37 basis points to 1.52%. Ten-year Canada yields declined 35 basis points to 1.62% while thirty-year bonds declined 29 basis points to 1.89%.

Ultimately, the risk environment and concerns surrounding the trajectory for global growth cannot be dismissed, particularly given the weakening economic data and sharp decline across the yield curve in both Q4/18 and Q1/19. The inversion in yields is less of a concern in terms of indicating a recession is imminent as it remains specific to the shorter-term segment of the curve and is more a reflection of the sharp reversal in the outlook for policy rates by the market: from rates hikes directly to rate cuts getting priced in. The immediate support shown by central banks to support global growth and the ultimate resolution of several risk factors (trade agreements) is expected to circumvent recession risk. The current outlook is for a slowing in growth and for central banks to remain on pause with the potential to stand in with further measures if necessary.