Financial Letter First Quarter of 2019

Market review

By Louis Lizotte, CFA, FRM, Vice President, Investments, FÉRIQUE Fund Management


Source: MSCI

Sources: Bank of Canada, St.Louis Fed, U.S. Energy Information Administration



The quarters follow one another but each one is different. The stock markets had a rather rough end to the year, as portfolio statements dated December 31, 2018, no doubt attest. But let me reassure you: the statements for the quarter ended March 31, 2019, will probably be a much more pleasant experience for certain investors.

Such is the nature of the beast. Generally speaking, extreme movements in one direction create a pendulum effect. Even though we lost sight of this phenomenon in the past decade, periods of volatility are part and parcel of investing in the stock market. So it’s best to have a long-term investment horizon. Above all, such fluctuations reveal the risks of trying to time the markets by buying or selling in a tactical manner. For example, people who liquidated their investments in the fourth quarter of 2018 missed out on the upturn in the first quarter of 2019. Even so, given that we don’t know how things will play out, such a strategy could prove useful in the event of future declines. But no one knows.

In brief, the sharp upturn at the start of the year is due mainly to the about-face by the main central banks, combined with progress in the United States (U.S.) – China trade talks.. Let’s take a closer look at this context.


Source: National Bank Trust


The first factor that changed is highly significant: the U.S. Federal Reserve (Fed) stopped short in its movement toward an equilibrium rate, estimated to be 3%. During their first meeting of 2019, the Governors set the tone for the year: not only would there be no increase in the key rate, but the speech by Fed Chair Jerome Powell revealed a policy of patience not seen in the comments he had made scarcely three months earlier.

When the European Central Bank announced in the first quarter that it would not raise rates until December, it fell into line and also adopted a patient approach, as did the Bank of Canada to a certain extent. This change of monetary policy reduced the pressure on the stock markets, with the consequences we now know. Another obvious impact is that interest rates generally fell, pushing bond returns up.

In this context, the FÉRIQUE Bond Fund returned 3.3% on the quarter. As for the Diversified Income Fund, it had a return of 3.9%. Such high returns on bonds over such a short period are rare and reflect the sharp decline of interest rates, including corporate credit spreads.



Despite the solid quarterly results, several events made the markets nervous. First, the conclusion of the second meeting of 2019 by Fed officials, combined with worrisome data from the European manufacturing sector, contributed to the return of a phenomenon that had been absent from the economic landscape since 2005: the inversion of the yield curve. In the U.S., 10-year bond yields fell below the three-month yields.

In the Financial Letter for the third quarter of 2018, I referred to the inversion phenomenon as being one of three factors1 that, together, have preceded all recessions since the 1950s. If we concentrate on the yield curve, because the two other factors are not in the critical zone for now, the inversion was clear before each of the recessions. However, before panicking, we should clarify the situation:

• The two-year and 10-year yields are not inverted, which was the case of the inversions that preceded the recessions;
• There is strong investor demand from outside the USA for 10-year bonds because European and Japanese bonds offer lower yields;
• The yield curve has inverted twice, in 1966 and 1998, without a recession occurring;
• Historically, after the yield curve inverted, it took five to 24 months to trigger a recession, so it may take quite some time for one to occur;
• The duration and scope of the inversion have an impact on the signal’s predictability.

As a reminder, the key interest rate is set by the Fed. The level of longer-term interest rates tends to reflect expectations of the key rate at maturity, plus a term premium, which reflects such factors as the inflation expected during the period in order to compensate investors prepared to purchase a longer-term bond.

If the economic growth outlook is weak and tame inflation is expected, the long-term yield gradually falls. This may also reflect investor expectations of a rate cut by the Fed over the medium term, as is currently the case. The following graph shows the yield curve on January 1, 2018, then on March 29, 2019. The key rate was raised four times between the two dates. The longer-term segment, namely that beyond five years, rose gradually and considerably during the year. Currently it is back where it was at the start of 2018.

U.S. Yield Curve

Source: Bloomberg

Another factor that contributed to the inversion of the curve is President Trump’s announcement that he wanted to appoint Stephen Moore or Herman Cain to the Fed’s Board of Governors. Both have the reputation of being willing to carry out the President’s wishes to the letter. Undoubtedly, they would apply pressure to keep interest rates as low as possible. Fortunately, the Fed’s voting system prevents one or two individuals from dictating monetary policy, but the President’s views are ever-present just the same. Mr. Trump has frequently and unambiguously expressed his discontent with the increases in the key rate. The reason is simple: their purpose is to moderate the hobbyhorse he wants to ride to victory in the next election, namely economic growth.

In short, the inversion is significant, but very few experts expect a recession in the short term. The Fed’s drastic change of tone provides a degree of respite. Moreover, global growth, although slowing gradually, is still positive. On the other hand, the potential impact of an inverted curve that should not be overlooked is the self-fulfilling prophecy. The behaviour of consumers and investors changes along with their awareness of the inversion: if they become more cautious, they can help cause a recession.

1 According to BCA Research.



If one asset class exemplifies a rebound, Canadian equities take the prize this time! The factors affecting the Canadian stock market were all advantageous in the first quarter, lifting all sectors into positive territory. It was a definite contrast to 2018, when returns were positive for only four sectors accounting for a combined weighting of slightly more than 16%.

As measured by the MSCI Canada Index, the Canadian stock market returned 13.1% in the first quarter.

Canadian Market Returns in 2018 and Q1 2019

Source: MSCI


In Canada, as in the USA, the accommodating tone adopted by the Bank of Canada (BoC) contributed to the market’s upturn. Concerns about debt levels and real estate prices have abated along with the decision to put rate hikes on hold. Even so, the decision is due to concerns over economic growth and is therefore justified. At the end of March, Canadian GDP for January was announced and, at 0.3%, exceeded expectations. It is interesting to note that the result was spread throughout the economy, with 18 of the 20 industrial sectors advancing. Growth was weaker in February, but the quarter could see economic growth significantly higher than in the last quarter of 20182. Nevertheless, Canadian GDP growth is expected to be below its annual potential of about 2%, which justifies the BoC’s decision to keep the key rate stable, or even to lower it.

The two other factors that helped get the year off to an excellent start were progress in the U.S.-China trade talks and the pronounced increase in the oil price. West Texas Intermediate (WTI) was up more than 25% in the first quarter, and Western Canadian Select (WCS) was up more than 30%. It is not surprising that, globally, the energy sector is one of the best performers so far in 2019.

Finally, a comment about the two best Canadian sectors, Information Technology (IT), which returned 27% on the quarter, and Health Care, with a 50% return for the first three months. Although not negligible, the total impact of these sectors on the Canadian stock market is not enormous, given their size. In Canada, IT represents about 4% of the stock market, while Health Care (mainly cannabis stocks) represents about 2%. The contribution of these sectors to the index’s overall return for the quarter is therefore about 1%. One important detail: on the basis of the forecast price/earnings ratio relative to the benchmark index, these sectors are very expensive – as much as three times the level of the index. As the saying goes, Caveat emptor (let the buyer beware)!

2 The February growth rate will be announced on or about April 30, and the rate for March on or about May 31.



The return on the U.S. stock market was less than the return on the Canadian market, but the difference is due mainly to the currency effect. During the first quarter, the Canadian dollar (CAD) was up against all the major currencies.

The following chart shows the CAD against the US dollar (USD) since the beginning of 2018. It clearly shows the depreciation of this currency pair in 2018 as a result of a few factors, including the Fed’s rate hikes and the lower oil price. We can also see their appreciation in 2019, especially in January and February.

CAD/USD Rate Since January 2018

Source: Bloomberg

The U.S. stock market returned 11.4% (MSCI USA Index in CAD). The CAD’s weakness against the USD decreased the return in Canadian currency by about 2%.


There are a number of topics of interest in the USA, including the markets’ reaction to the Fed’s new posture and the publication of Special Counsel Robert Mueller’s report.

The markets’ reaction to the Fed’s new tone was prompt and positive. The next chart shows two important things: the Fed is planning no further rate hikes in 2019 and only one in 2020; and investors are expecting a rate cut of 25 basis points in 2019 and another in 2020!

It honestly seems a bit excessive to expect a rate cut when the U.S. economy is far from struggling. Are the President’s criticisms and wishes gradually taking root in the markets, giving rise to this context? As discussed in the previous Financial Letter, changes in investors' expectations towards interest rates obviously have an impact on stock market returns.

The long-awaited Mueller report was finally submitted. The revelations in it are sensational – or not. In fact, William Barr, the Attorney General appointed by Mr. Trump, was quick to issue a memo that essentially said, “Nothing to see here, so move along!”. But it appears that the strong anti-Trump arguments expected in the report aren’t there.

U.S. Key Rate Forecast


Source: BCA Research

*As discounted in the overnight index swap curve.
Note: The shaded boxes outline a ''gradual'' rate hike path of 25 bsp per quarter. Dashed horizontal lines denote FOMS's central tendency estimate of the neutral Fed funds rate*.

Moreover, in his book Fear: Trump in the White House, journalist Bob Woodward evoked the testimony of Mr. Trump's lawyer to the effect that the prosecutor Mueller had nothing truly damning to accuse the President of.

According to Capital Economics3, the likelihood that Mr. Trump would be re-elected is now 40%. Apart from the fact that the quantity of Democratic presidential hopefuls is diluting the impact of their efforts, they will also have to quickly find a new angle of attack if they want to unseat the President. Perhaps his old income tax returns can help them out? Mr. Trump seems to be made of Teflon, so only time will tell. Moreover, the likelihood that he will be re-elected will only increase if an agreement is reached with China and he convinces voters that he obtained winning conditions.

3 March 29, 2019 issue


Globally, the sectors that did best during the rebound are IT and Industrials, two major components of the MSCI World Index. The IT sector seems to dominate constantly, regardless of the context. The quest for growth appears to have no price. As for Industrials, the easing of tensions in the U.S.-China negotiations has reduced the pressure on this sector, which is highly dependent on global trade. As well, the rising oil price put the Energy sector among the leaders.

The graph of the MSCI World Index by sector shows that IT continues to lead the pack, while the dominant sectors in 2018 (Health Care and Utilities) are laggards so far in 2019.

The MSCI Europe Index, the MSCI All Country Asia-Pacific Index and the MSCI Emerging Markets Index returned 8.6%, 7.3% and 7.5%.

MSCI World Index by Sector

Source:MSCI World


Another region that had an interesting recovery is Europe. The Greek tragedy that goes by the name of Brexit did not overshadow the investors' positive sentiment based on accommodating central-bank policies and the easing of U.S.-China trade tensions. Specifically, the strong performance by Industrials, the second- largest sector of the European market, was clear after the potential for U.S. tariffs cast a shadow over 2018.

The possibility of a hard Brexit continues to increase, in other words an exit with no negotiated agreement, such that the rules of the World Trade Organization would apply, with management of tariffs and imposition of quotas. The other option, which does not seem completely far-fetched, is a new referendum. The surveys give a slight edge to “Bremain,” a situation similar to that prevailing in 2016 before the vote.

A large portion of the solid results for the first quarter of 2019, especially for emerging markets, is due to the strong advance by the Chinese stock market. It has been boiling since the start of the year, returning 27% in three months. The fact that the USA has indefinitely postponed the imposition of tariffs on $200 billion of Chinese imports undoubtedly contributed to the positive sentiment. Furthermore, the Chinese leaders have gradually adopted economic stimulus measures. They are starting to pay off, and the leading economic indicators seem to be pointing to a degree of success. China’s importance being what it is, these factors have an impact elsewhere in the world, especially in Europe, whose business links with China are substantial.

The situation offers a sharp contrast to 2018, when the same stock market fell by almost 27%. The following graph shows how the Shanghai stock market has performed since 1991. The annualized standard deviation of its monthly returns over that period is 55%.

Shanghai Stock Exchange Performance

Source: Bloomberg

To say that the local Chinese market is volatile is a euphemism along the lines of “winter was a tad long this year” or “it’s been a while since the Canadiens won the Stanley Cup.”

The graph also shows that, despite the increase at the start of the year, this market is still far from its previous excesses. At the risk of being repetitious: caveat emptor!


The various economic data that have been published since the beginning of April, including the Global Manufacturing PMI, are somewhat reassuring and seem to indicate that they have bottomed. The gloomy data for January and February are probably due partially to the intensely cold weather in various regions and the U.S. government shutdown. Now that the yield curve has inverted, it’s clear that we will be hearing about the possibility of a recession. However, it’s not imminent as the other signals aren’t flashing red for the time being.

Ultimately, recessions are an integral part of economic cycles. For the long-term portfolio managers we hire, these periods are generally an opportunity to load up on quality companies at attractive prices.

Lastly, even if the global economy is recovering, it would be surprising if the stock markets were very positive between now and year-end. Instead, we expect positive but more-modest returns.



To discuss the markets and your investment strategy, contact your Financial Planner and Mutual Fund Representative of FÉRIQUE Investment Services.


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