Financial Letter Third Quarter of 2017

Market review

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

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Source : MSCI

 

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

SUMMARY

The markets continued to rise in the third quarter despite the many events that made headlines. The North Korean situation, hurricanes, the U.S. debt ceiling, central banks, the Canadiens’ training camp – any of these certainly could have shaken up the stock markets, but they barely dipped in July. Synchronized global growth that is generally leading to higher corporate earnings took precedence, and justifiably so. 

That being said, some asset classes did have negative returns in the past three months, essentially Canadian bonds and some foreign equities. The reason can be found in a single source: the Bank of Canada.

Generally speaking, the context is positive. But, obviously, it isn’t quite that simple and several risks are ever present. 

Source : FÉRIQUE Fund Management

RESULTS AND EXPLANATIONS

The two increases in the Bank of Canada’s key rate were the major development for the Canadian bond market. The first hike, which was expected, did not have any real impact; it was already priced into the market because the Bank of Canada had telegraphed its intentions. But the second hike, which took the key rate to 1.0%, came as a surprise. These increases caused yields to rise all along the curve during the quarter, with the result that bonds generally recorded negative returns.  

In this context, the FÉRIQUE Bond Fund returned -1.7%. As for the FÉRIQUE Diversified Income Fund, it returned 0.1% as a result of its exposure to sources of income other than Canadian bonds.

 

OUTLOOK AND ISSUES

The Canadian economy offered real signs of an upturn in the first half of the year, with GDP expanding by 4.1%. Rising retail sales, employment and consumer confidence were definitely the reasons for a higher key rate. But did these factors justify back-to-back increases? In Canada, as in the other developed countries, inflation remains below target and, as everywhere else, our central bank thinks it’s only a matter of time until it reaches the expected level.  

 

 

Sources : BCA Research inc., Bank of Canada

 

According to Stephen Poloz, Governor of the Bank of Canada, the reason for the second increase was that the Bank had to avoid falling “behind the curve.” All the central banks are concerned about losing control over inflation. Will there be further rate hikes? The current level of household debt and the strength of the Canadian dollar could become problematic; so, unless we experience runaway inflation, we could see a pause in the monetary tightening cycle.

What about elsewhere in the world? The situation is similar. Short-term rates did not go up, although longer-term rates did, in certain countries (ex: USA, UK). Above all, there was talk of reducing the bond-buying programs in the United States and Europe. 

It appears that we are experiencing synchronized global growth – the positive scenario of many economists at the start of the year. For example, the 35 OECD countries will all record positive growth in 2017 for the first time since 2007. The Purchasing Managers Index (PMI), a widely followed leading economic indicator, has turned green throughout the world.

 

Sources : BCA Research inc., Institute for Supply Management for the United States, Markit Economics for United Kingdom, Euro area and Japan.

 

In this context of sustained global economic growth, monetary conditions are still accommodative. But the cloud on the horizon is the degree to which the central banks will accelerate their monetary tightening. Of course, such acceleration is positive because it confirms an advantageous business climate. But the risk is that the central banks will push too hard, too fast, bringing the engine of growth to a standstill.  

RESULTS AND EXPLANATIONS  

The Canadian stock market, as measured by the MSCI Canada Index, returned 4.1% in the third quarter, making up for the ground it lost during a difficult start to the year. As at September 30, 2017, the return was 4.4%. 
Are we seeing an upturn for Canadian equities? After an excellent 2016, the first half of 2017 was not especially favourable, so the recent performance was welcome. It was due to the increase in the crude oil price during the quarter and the positive economic environment.  

 

OUTLOOK AND ISSUES  

The Canadian economy is definitely showing signs of strength but is still dependent on the energy, materials and banking sectors. Moreover, growth related to the real estate sector is now limited. The recent interest rate hikes and the government’s measures to slow the rise of house prices are having the intended effect. The sector is looking somewhat fragile.  
Ultimately, this situation may put pressure on household spending and by extension on economic growth.  

 

RESULTS AND EXPLANATIONS  

As for the U.S. stock market, despite the appreciation of the loonie (causing a decrease of about 4.0% on the quarter), it had a positive return of 0.6% (MSCI United States in CAD).

As the market continues to rise, the technology sector is still leading, with the usual names in front of the pack: Facebook, Apple, Amazon, Netflix and Alphabet (Google).

In recent years, these stocks have made robust gains. Should we expect a correction? Who knows? Their rise is so remarkable that their combined stock market capitalizations exceed France’s GDP! Future earnings will have to be substantial to maintain their valuations.  

OUTLOOK AND ISSUES  

In fact, the U.S. market is generally regarded as expensive. Earnings will have to be real and abundant to keep market valuations at current, or even somewhat lower, levels. That is the reality to date. After several years of rising equity prices without profits, we are now in a context in which earnings are exceeding expectations.  

 

Source : BCA Research inc.

 

The United States is ahead of the other regions in terms of its economic cycle, but global growth and the weak greenback are doing a great deal to sustain the U.S. stock market. This situation could continue for a while.

Finally, after several failures, will the Trump administration succeed in getting the Republicans to agree on tax reform? It’s easy to doubt their ability to do so, but the administration and its party want to be able to declare victory before the midterm elections. Moreover, the expectations are so low that any tax measures will be received favourably by the markets. 

RESULTS AND EXPLANATIONS 

The impact of the loonie’s strength detracted from returns on foreign investments. The table below shows the impact on the main currencies.

Source : Bloomberg

As already noted, economic growth and rising earnings are occurring on certain markets that are more affordable than the United States.

In Canadian currency, the MSCI Europe Index, the MSCI Asia Pacific Index and the MSCI Emerging Markets Index returned 2.6%, 1.4% and 4.0%, respectively, for the quarter ended September 30, 2017.

OUTLOOK AND ISSUES

On the markets outside North America, the strong performances by the European and Japanese economies stand out.

Since the French election, political risk seems to have abated considerably in Europe, allowing the various economies to advance. Even so, the fate of Spain, with the independence referendum in Catalonia, as well as Italy, with its forthcoming election, are raising questions. But the positive momentum does seem difficult to stop.

An important event to watch is the 19th Congress of the Communist Party of China.  The twice-a-decade congress will set the agenda, in economic and other areas, for the next years. Because of its size, China has a substantial influence in the global arena. As a result, what happens in China is significant. Its debt level is very high, as the authorities try to maintain a certain level of growth. After the Congress, we will know more about the direction that the country will take in the years to come under President Xi Jinping and we will be in a better position to assess the impact on the rest of the world. 

Conclusion


Globally, most of the economic indicators are flashing green, inflation is tame, monetary conditions continue to be accommodative and market volatility is still historically low. So why do we have a persistent feeling of unease? Is it the high stock market valuations? Earnings that just keep going up? The beginning of the end of quantitative easing? Geopolitical tensions? Or all of the above?

The reality is that everyone is looking for signals announcing the market’s next decline. But it appears the current climate will continue for some time and will remain positive for the year to come. 

Have a nice day!

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