Equity Markets

We can draw a parallel between our equity markets and the weather. This market is a like a warm and dry summer that doesn’t want to end. We can appreciate it but also must realize that winter will return at one point. Winter is volatility and stocks are still wearing their shorts. In calm fashion, all important equity markets for Canadian investors offered good quarterly returns to close out a profitable 2017. The most important themes are a return to a solid economic backdrop post energy crisis for Canadian equities, a corporate tax boost for US equities and improving economic strength for EAFE equities.

The second half of the year continued to be more rewarding than the first for Canadian equity investors. A strong performance of +4.5% in the final quarter of the year brings the 2017 return to +9.1%. While the Canadian market is often known for and strongly influenced by its resource sectors, the strength was very much broad-based this quarter. All eleven sectors generated positive returns. In fact, Energy (+0.7%) and Materials (+4.9%) experienced rather uneventful quarters in this market context despite generally improving commodity prices. After we set aside the very strong Health Care sector performance (+47%, driven by one stock), we note the best performance came from Financials, Real Estate and Technology, all climbing 6%. For the full year, we had ten of eleven sectors contributing positively to the annual return with Energy (-7%) being the exception.

The S&P 500 index posted a strong final quarter, delivering a 6.8% total return in CAD terms. For the year 2017, the S&P 500 returned 21.8%, which translated into 13.8% in CAD terms given the strength of the loonie. The market saw a continuation of earlier trends, including strong domestic and global economic signals, record low volatility, and faith that the Trump administration will continue to stoke economic growth. The year was capped off with the passing of tax reform legislation, a boon to some as the corporate tax rate has been cut from 35% to 21% as of January 1, 2018. Growth continued to dominate value in the quarter, but not as heavily as earlier in 2017. The interest sensitives (utilities, REITs, and telecoms) underperformed, while technology (+9%) continued its strong run (though less FANG-y), and consumer discretionary (+10%) shone with the positive economic backdrop. Financials (+9%) continued to reflect the prospects for higher interest rates and friendly legislators in Washington. For the full year, Technology led the way with a robust 38.8% return while only two sectors were negative: Telecom at -1.3% and Energy at -1.0%.

This was another strong quarter for EAFE equities with a positive 4.4% return, finishing the year with a total return of 16.8% in CAD terms. The themes were generally the same as the previous few quarters with economic data continuing to be encouraging and corporate earnings exceeding expectations. Some of the highlights of the quarter were Prime Minister Abe’s election victory in Japan, which was well received by investors and some of the noise related to the Brexit negotiations. All key countries were in positive territory this quarter, but Asia Pacific was the clear leader. Australia (7%) and Japan (9%) were the strongest performers as the former benefited from the recovery in base metals and the latter from the general election. On a sectorial basis, we continued to see money flowing to more economically sensitive sectors with Materials (9%) and Energy (10%) outperforming the other sectors this quarter.

Our weather analogy does suggest that we feel volatility will return at some point, which means more frequent market corrections than what we have been experiencing. Still, we believe the environment remains positive for equities. The normalization of interest rates is being executed in a gradual prudent way. Economic conditions continue to improve with mild inflation. Equity valuations remain reasonable as corporate profits have mostly followed the pace of the rising markets. We are overweight the equity asset class for clients. Interest rates are moving higher and we have a positive economic backdrop. Within our equity strategies, we favour cyclical sectors to the detriment of the defensive and interest rate sensitive sectors.

Fixed Income Markets

The Canadian economy continued to benefit on many fronts as positive market conditions and risk sentiment remained extremely constructive. Following the exceptional performance in the second quarter, with GDP growth of 4.3%, the Canadian economy slowed somewhat but met expectations in the second half of the year, with an overall growth of 3% for the full year, outperforming the US which had growth of 2.3% for the year. The strength of Canadian job growth also took the market by surprise as Canada produced strong gains in full time jobs and wages. The Canadian unemployment rate reached a multi decade low of 5.9% and 2017 proved to be the best year for job growth since 2002. Several factors have helped contribute to the outperformance of the Canadian economy including the stabilization of oil prices, improving business investments and retail sales, strong global growth and stimulative monetary conditions. Over the quarter, the Bank of Canada maintained their overnight lending rate at 1% while the US Federal Reserve raised rates in December by 0.25% to a target range of 1.25% to 1.50%. Going forward, growth is expected to moderate in 2018 and both the Bank of Canada and US Federal Reserve are expected to increase rates by 0.25%, three to four times in 2018. The uncertain outcome of the North American Free Trade Agreement (NAFTA) remains an overhang for Canada but to date, the economy has proven resilient and has several levers including a generous fiscal spending program to help withstand any impact such changes to the trade agreement might entail.

The Canadian yield curve flattened considerably over the quarter as strong economic data increased the likelihood of rate hikes, while long duration buyers such as life insurance companies and pension plans, continued to step into the market, primarily purchasing long Canada and provincial bonds. In the fourth quarter, two-year yields increased 17 basis points to 1.69% while five-year bond yields increased 11 basis points to 1.86%. During the same period, Canadian ten-year bond yields declined 6 basis points to 2.04%, while the thirty-year Canada yield declined 21 basis points to 2.26%. This flattening of the yield curve has increasingly garnered attention as inverted yields curves are often a potential indicator of a recession. The US Fed Chair, Janet Yellen, alluded to this flattening of the curve, however, in her December market statement where she noted “the yield curve is likely to be flatter than its been in the past”, acknowledging that stimulative monetary conditions were still in place and not restrictive compared to other recessions.