Financial Letter Fourth Quarter of 2017

Market review

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

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Source: MSCI

 

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

SUMMARY

It’s time to look back on another year. What are the takeaways from 2017? Endless tweets from President Trump fed the news cycle. And even though he promised a wave of growth that failed to materialize, we had an excellent year in terms of the economy and the stock market – a situation that prevailed around the world. 

It took nine years and $12 trillion of monetary stimulus to bring about economic growth and rising corporate earnings on a global scale.  

But these efforts paid off. Looking back at the forecasts by economists and pundits at the start of 2017, we essentially experienced the optimistic scenario put forward by most of them. Even so, there was one surprise: Canada had one of the best-performing economies but its stock market underperformed the markets of the other developed countries.

Source: FERIQUE Fund Management
Note: Conservative and Aggressive Growth Portfolios don't have a year.


RESULTS AND EXPLANATIONS

Canadian and global bonds generated modest but positive returns last year, with assistance from an especially positive fourth quarter. Central bankers continued to preach patience, justifying their stance by inflation remaining below target. As a result, despite a favourable economic context and increases in key rates (two in Canada and three in the United States), medium and long-term interest rates reflected moderate optimism. Bonds with longer maturities generated the best returns during the quarter. Exposure to corporate securities was beneficial internationally, while provincial securities played that role in Canada. 

In this context, the FERIQUE Bond Fund returned 2.0% for the quarter and 2.2% for the year. For its part, the Diversified Income Fund returned 1.1% for the quarter as a result of its shorter duration and greater exposure to international bonds, which underperformed Canadian bonds. The fund’s return for the year is 3.8%.  

OUTLOOK AND ISSUES

What will interest rates do in 2018? As we have already pointed out, a great deal depends on inflation (or the lack thereof). The following chart shows how synchronized global growth is.

Growth in the World's 45 largest economies

 

Source: Connor, Clark & Lunn.

This scenario is increasing the demand for workers, with the result that we now see full employment in many regions of the world. Beyond this threshold, inflation should increase according to the Phillips curve economic theory. 

The following graph shows the percentage of countries with full employment.  

World’s full employment situation 

 

Source: BCA Research inc.
Note: NAIRU refers to the non-accelerating inflation rate of unemployment.

Currently, everything seems to indicate that, from the economic standpoint, 2018 will be another prosperous year. Even so, the employment situation, combined with the rising oil price, means that inflation will potentially reach the central bankers’ targets in a number of countries, including Canada and the United States. In a context in which rate hikes expectations are modest, the central banks’ response will be a determining factor.

RESULTS AND EXPLANATIONS

The Canadian stock market, as measured by the MSCI Canada Index, returned 4.7% in the fourth quarter. The annual return was 9.2% as at December 29, 2017.

As a result of a strong second half, the Canadian stock market partially caught up to its foreign counterparts. The main reason for its performance is the energy sector, which was hit at the start of the year and then recovered, although not as much as the commodity price itself.

OUTLOOK AND ISSUES

In Canada, two factors are worthy of note. First, in the wake of the rate hikes by the Bank of Canada, mortgage rates began to rise. In recent years, rising household debt and soaring house prices have been engines of Canada’s economic growth. As an increasing share of the family budget is taken up by interest payments, various sectors of the economy will be affected. According to data published by the Bank of Canada, about 47% of Canadian mortgages will be up for renewal in the next year. Let’s hope these borrowers have taken higher interest rates into account in their budgets.

The other factor to be monitored is the tax cuts in the United States. They represent a victory for President Trump and could be an encouragement for him to make good on other election promises, including those concerning trade agreements, such as NAFTA.  

The negotiations to date are such that we cannot really speculate on the outcome. Obviously, the Americans are hardening their tone, but what else would we expect from the team of the Dealmaker-in-Chief?

According to BCA Research, if the United States withdraws from the agreement, the short-term impact will be more significant for Mexico than for Canada. The automobile industry as a whole will be affected because it is integrated across North America’s three countries. The Canadian dollar would decline, and the Bank of Canada could respond by lowering its key rate. Finally, such a development would affect the Canadian stock market, particularly those companies that export to the United States. Even so, it should be noted that almost 20% of Canada’s exports to our neighbour south of the border are related to the energy sector and it would be surprising if they were subject to higher tariffs. In short, the negative impact could gradually dissipate, given the strong potential of a bilateral agreement between Canada and United States, such as the one signed in 1988.

Ultimately, the risk extends well beyond our borders. Depending on how events play out, the negotiations could set the tone for further talks with the Americans, giving impetus to global protectionist tendency that has been latent since 2016.  

RESULTS AND EXPLANATIONS

In the United States, the stock market returned 6.7% (MSCI USA Index in Canadian currency). For 2017 as a whole, the return is 13.9% (MSCI USA Index in Canadian currency). The loonie’s appreciation against the greenback reduced the return by almost 8.0%.

We are repeating ourselves, but the information technology (IT) sector is still leading the U.S. market, and the global markets as well. It now represents 16.8% of the MSCI World Index versus 11.0% only 10 years ago. 

In addition, the earnings of U.S. companies were very strong in the latest round of announcements and gave impetus to the markets at year-end.  

OUTLOOK AND ISSUES

President Trump finally succeeded in getting his “super mega” tax cuts passed.

As the negotiations progressed, a sector rotation occurred on the stock markets, especially toward financials, as well as on the consumer goods, telecommunications and industrial sectors, which could also benefit from the tax reform. For large IT companies and other multinationals, the effects will be rather modest because they have already been tax optimized. Even so, they could repatriate their enormous cash hoards to the United States at an advantageous tax rate and then use the funds to pay dividends or to buy back shares.

From current information, it appears that the impact of the tax cuts on U.S. economic growth will not be very significant over the short term (0.1% to 0.5% of GDP). Moreover, some of the measures, including those pertaining to individuals, will expire in 10 years.

How will the stock markets fare? Over the short term, the impact could be positive if a lighter tax burden drives consumer spending. Moreover, lower corporate tax rates should increase the earnings of many companies.

Over the longer term, the decrease in government revenue is difficult to justify. It is not clear that expansionary tax measures are required at this stage, when the economic cycle is advanced in the United States. The administration is needlessly increasing the U.S. deficit and using up ammunition that it will need in a future economic slowdown. As well, it is highly likely that the corporate tax cuts will go into shareholders’ pockets rather than into investments that will create growth. This scenario is good for shareholders but short-sighted.

Even though President Trump portrays himself as a populist, voters seem to be well aware that the tax cuts contradict this image. Surveys show that a majority of Americans would prefer that their government tackle the deficit. The mid-term elections in November 2018 will be revealing. To be continued!

RESULTS AND EXPLANATIONS 

For the year, the loonie’s weakness against the euro boosted the return on investments in Europe. Even so, its strength against the yen detracted from returns in Canadian currency. Here is how it performed against these currencies.  

The loonie versus major currencies

Source: Bank of Canada

The MSCI Europe Index, the MSCI Asia Pacific Index and the MSCI Emerging Markets Index returned 2.5%, 8.4% and 7.7%, respectively, in Canadian currency for the quarter ended December 29, 2017. For the year, their returns were 17.9%, 23.4% and 28.7%, respectively. 

OUTLOOK AND ISSUES

Europe had a positive year, as declining political risk gave the markets a lift. Moreover, Europe’s economy performed well and its market was attractive because it was less expensive. The economic and stock market conditions that generated positive results in 2018 are still present. Nevertheless, political risk is now underestimated: it is not clear what will happen in Spain, in Italy with its struggling banks and on the Continent after the Brexit negotiations.

In Japan, Prime Minister Shinzo Abe won an important victory by keeping the majority of his seats in the October election. The population voted for stability in a context in which North Korean missiles are landing dangerously close to Japan’s territory. The risk of escalating tensions is anything but negligible and would have major consequences. For the time being, as shown by the strong performance of the stock markets in Japan and elsewhere in Asia, it appears that this risk is not a concern for investors, who are focusing instead on economic indicators and market fundamentals, which remain positive.

Emerging markets had an excellent year. Generally speaking, they were the big winners in a context of global growth and firming prices for many commodities. The main actor was, of course, China. After the election in the fall, President Xi Jinping substantially consolidated his power and is now well positioned to put in place his vision of the future, which involves enhancing the prosperity of the middle class, fighting corruption and decreasing debt. The required reforms could limit growth, but the expected stability will be positive over the long run. The solid performance of emerging markets should now cause investors to become somewhat cautious. Their long-term potential is unmistakable, but traditionally this asset class does not respond well to a stronger U.S. dollar, which is a foreseeable scenario in 2018. 

Conclusion


Around the world, 2017 was a positive year with very appealing returns. As mentioned in a previous letter, we are in a “Goldilocks” scenario. However, the divergence between the returns on some asset classes and the fact that the winners are often not the same from one year to another are strong arguments in favour of diversified strategies and regular rebalancings.

A sense of unease persists, even though global monetary policies remain expansionary, global economic growth is positive, volatility is low and the stock markets continue to rise. It is simply difficult to imagine a better scenario. Still, we could definitely continue in the same vein. 

Finally, we have to be realistic about the potential for stock markets owing to high current valuations. Many exogenous factors could cause a correction. As for a bear market, it is generally accompanied by a recession, which does not seem to be on the horizon. We will be carefully monitoring this context in 2018. Hopefully, Goldilocks will not get eaten by a bear in the second part of the story.

A Happy New Year to all!

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