Equity Markets

Last quarter, we commented on the unusual low-level of volatility. As this is no longer the case and market gyrations are more commonplace, it’s important to remember that volatility is the historical norm and not the exception. Investors continually worry, rightfully so, about macroeconomic and company specific risks. The worries of the day are global trade and the pace of interest rate increases. We feel it is healthy to have corrections, to consider risks, in what we feel is a generally positive investing environment. In this environment, Canadian equities started off the year limping for investors. US and International equities were volatile but performed better than domestic equities and were helped by a weakening loonie for Canadian investors.

Canadian equities were not spared by the rise in market volatility we experienced to kick off 2018. In fact, the daily debates surrounding the consequences of rising interest rates and trade disputes had a bigger impact on Canadian equities than some of its developed market counterparts. The S&P/TSX Composite began the year with a weak quarterly return of -4.5%. This weakness was broad-based with nine of eleven sectors generating negative returns. The Energy sector (-9%) managed to stand out negatively despite crude price climbing 8% during the quarter. Weakness around interest sensitive sectors such as Utilities (-6%) and Telecommunications (-7%) reflect investor concerns around rising rates. The Technology sector (+10%) was alone in offering material upside during the period.

In the US, the S&P 500 index posted its first negative return quarter since the third quarter of 2015, delivering -0.8% total return in USD. The loonie continued to weaken, leading to a 2.1% total return in CAD terms. Year end 2017 financial results were strong, and this is expected to continue with first quarter results to be reported in April. Growth stocks continued to dominate value names in the quarter, and interest rate sensitives (Utilities, REITs, and Telecoms) continued to underperform. Those three sectors generated returns of -3%, -5% and -8% respectively. Consumer Staples (-7%) and Energy (-6%) were also weak, with the latter a bit hard to explain given the rally in the price of crude oil. Technology (+4%) remains on a bull run, despite much greater volatility in key mega cap names late in the quarter. Consumer Discretionary (+3%) performed well as hope for tax dollars finding there way into the sector prevails. Financials (-1%) took a breather, with treasury rates taking a hit over trade concerns.

EAFE equities started strong on positive momentum from the US corporate tax cut until volatility picked up as investors worried about inflation and global trade. The end-result for Canadian investors can still be viewed favourably with a positive 1.15% return, which generally came from the weakening Canadian dollar versus the other major currencies. While the performance across all major countries in Canadian dollars was mixed, the differences were mainly explained by fluctuations in currencies. In Asia Pacific, Japan stood out as an outperformer with a positive 3% return but was helped by a significant strengthening of the Yen given its perceived defensive characteristics. European countries offered mixed results with France up 3%, but Germany, Switzerland and the UK all down by approximately 1%. They were all helped by the strengthening of their respective currencies given further monetary policy tightening on the horizon. On a sectoral basis, the more economically sensitive sectors generally outperformed with Consumer Discretionary and Technology both up 3%. Utilities, despite its sensitivity to interest rate, had a good quarter as M&A activity helped the sentiment on the sector, pushing it up 4%.

Global trade is important to growing economies and we are in an environment where monetary conditions are being tightened. We also have central banks reducing their asset buying programs, which has been supportive of asset prices. As such, it is fair to have concerns and normal to experience a reasonable level of volatility within financial markets. However, interest rates are being moved higher because economies are progressing well, and this is being done ahead of inflation pressures. Also, we are beginning to get used to how President Trump negotiates, and we may just be experiencing his style of brokering a deal. Developments in global trade agreements nevertheless must be monitored closely. In summary, we believe the environment remains positive for equities. We are overweight the equity asset class for clients. Within our equity strategies, we favour cyclical sectors to the detriment of the defensive and interest sensitive sectors. Macro backdrop is still generally supportive and valuations remain within historical ranges. Equities also benefit from money flows given impact of rising interest rates on bond prices.

Fixed Income Markets

The first quarter of 2018 proved turbulent in terms of the wide trading range of interest rates experienced throughout the period, but this market volatility was belied by the small absolute change in overall yield levels. Interest rates rose sharply during the first half of the quarter and then declined with added volatility during the month of March. The cause for the abrupt change in the rising interest rate trajectory was largely due to weakening economic data, and the uncertainty and potentially negative impacts related to NAFTA negotiations and other trade related protectionist efforts by the US, particularly with China. While NAFTA negotiations are continuing, the trade related rhetoric of the US with its trading partners has placed an overhang to business and investor confidence due to rising concerns of a global trade war. To date, the trade related statements by both China and the US have not been implemented but if such duties were applied, it could have a significant impact on US GDP growth and potentially trigger a recession in the country. Notwithstanding the outcome of such trade related posturing, the US will lead North American growth in 2018, forecasted at 2.8% while Canadian growth is expected to be 2%.

Economic data in Canada has continued to weaken since late in the last quarter of 2017 as the Canadian economy faces headwinds including weakening exports, uncertainty related to NAFTA negotiations, and a sharp correction in major housing markets due to federal changes in lending measures. Despite weakening economic growth indicators, Canadian capacity utilization and labour markets continue to improve and inflation pressures have also shown signs of intensifying with headline inflation now at 2.2% (Feb/18). As a result, the Bank of Canada is expected to complete two additional rate hikes later this year bringing the overnight rate from 1.25% to 1.75% by the end of the year.

The Canadian yield curve once again flattened over the quarter as the sharp rise in rates early in the quarter was subsequently offset by concerns of an impending trade war and a flight into lower risk assets including fixed income. In the first quarter of 2018, two-year yields increased 9 basis points to 1.78% while five-year bond yields increased 10 basis points to 1.96%. During the same period, Canadian ten-year bond yields increased by 5 basis points to 2.09% while the thirty-year Canada yield declined 4 basis points to 2.22%. This flattening of the yield curve has increasingly garnered attention as inverted yield curves are often a potential indicator of a recession. As Central Bankers continue to follow a path toward normalization following the last several years of unprecedented intervention, the yield curve is expected to continue to remain exceptionally flat.