Aside from the occasional wobble, investors exercised patience and caution despite the apparent threats of military conflict and outright whimsical bluster. The global economy appears to be in much better shape than just three months ago, with clear signs of a synchronized global expansion. The financial markets were propelled higher by steady earnings growth and continued low interest rates, with little indication that a widespread capitulation is on the horizon.
Canada’s economy is leading all major developed nations in terms of growth with the rate of expansion approaching an 18 year high. Yet there remains an excessive level of pessimism among investors as to the longevity of this economic cycle. While jobs are being created at almost an all-time record rate and nearly every province is growing, the Bank of Canada still feels the need to put the brakes on a bit. Meanwhile, Canadian companies are in very good condition and if there is any sort of commodity-based rally and only moderate interest rates increases, then beaten down Canadian stocks (which are extremely cheap by global standards) would be poised to outshine their international peers.
The U.S. economy remains in good shape, as Americans got out and spent more which is nursing the economy back to health after a feeble start to the year brought about by seasonal quirks like poor weather and late tax refunds. Its economy has expanded for eight straight years in the wake of the 2007-09 recession energized by an extremely strong labour market, which has driven the unemployment rate down to a nearly 16 year low. Inflation has slowed dramatically. In fact, U.S. employment and inflation today are amongst their least volatile in the past 50 years.
What a difference a year makes. All economies in Europe are improving which is a first in the post-crisis period. Europe is the last of the world’s major regional blocs to recover and may be finally entering a sustainable period of recovery. The nature of this recovery is different compared to previous short lived global recoveries as conditions are improving, monetary policy remains supportive, labour productivity has improved, capital investment is strong and populism appears contained for now. The U.K. economy on the other hand is becoming increasingly sluggish largely due to the uncertainty about its divorce terms with Europe. Britain’s suffering is likely to grow as the benefits of extremely low interest rates and a devalued currency wane.
Asia has entered a period of resurgence with Japan’s economy growing for the sixth straight quarter, backed by strong domestic demand, an upswing in exports, weaker currency and very low inflation. China continued its expansion but the economy has become increasingly reliant on new debt to foster growth which has led to several downgrades by bond rating agencies. India is expected to resume faster growth as the government’s de-monetization move last year led to several months of acute shortages which are now easing.
Currently, it is a very favourable environment for equities with the usual factors that warn of a bear market or recession have gone missing. This has led to another winning quarter for stocks as indices around the world hit new highs. Canadian stocks gained 3.7% while U.S. equities were up 0.7% (all returns in Canadian dollar terms). International stocks climbed 1.7% with European stock leading the way, up 2.3% followed by Asian stocks eking out a 0.4% increase. Emerging markets climbed 3.3% in the quarter. Interest rates are rising gradually which has made bonds a dark spot, losing 1.8%.
The recovery in global growth is on firm footing and the broader based upswing should be sustainable for now. There could still be any number of policy missteps or miscommunications which might negatively impact financial stability mid-term, but as of right now they are all known complications.
The third quarter saw a stew of major geopolitical developments including tensions between the U.S. and North Korea, as well as the protracted war in Syria. Also during the quarter, Hurricanes Harvey and Irma dominated the news as they caused unprecedented flooding in Texas along with major disruption to refineries, pipelines and fuel storage facilities. Global markets in general brushed off the bad news and maintained the momentum from previous quarters. The Canadian stock market, on the contrary, performed worst amongst G7 countries although Canada’s GDP growth has been the strongest.
It has been a difficult year for Canadian investors so far as the TSX’s downward spiral has been discouraging, with a mostly negative technical pattern amid lower highs and lower lows. However higher oil prices later in the quarter, mostly due to natural disasters, brought the TSX back to levels not seen in months. It ended the quarter with a respectable 3.7% gain on a total return basis and was up 4.4% year to date. This is a remarkable improvement from previous quarters although still at the bottom of the pack vis-a-vis other global markets.
After a robust first half, the Canadian economy might take a breather for the rest of the year but is still expected to deliver about 3% GDP growth for 2017, the best projected performance in six years. The job market has been the natural beneficiary with nine straight monthly gains that pushed the unemployment rate down to 6.2%, a nine year low.
Though the economy has blown past expectations, uncertainties related to global trade negotiations including NAFTA, housing imbalances, and energy markets continue to pose potential risks to the recovery. In a recent report, the International Monetary Fund criticized the rapid interest rate tightening and suggested the continuation of expansionary fiscal policy was something they would rather see.
The performance of the TSX in the third quarter was the best in 14 months and seems to mark a trend reversal. Earning revisions have turned positive amid higher energy prices and manageable risks for the big six banks according to a recent Fitch report. Thus the TSX is in the position to recoup some of its past losses and be among the leading global indices in the upcoming months.
The Canadian FTSE TMX Universe Bond Index fell 1.8% in the third quarter of 2017. Year to date the index is barely in positive territory with a 0.5% gain. The Bank of Canada raised its target for the key overnight interest rate twice over the course of the summer by a quarter of a percentage point each time, The Bank’s two rate hikes erase the two cuts it implemented in 2015 in response to the oil price shock. The target for Canada’s overnight rate is back to 1.0%. In the U.S., the target range for the Federal Funds Rate is between 1.0% and 1.25% following the four increases in the target rate that began in December 2015. Each increase was for a quarter of a percentage point and marked rising confidence that the U.S. economy is poised for more growth. The U.S. central bank is expected to raise interest rates again in December and three more times in 2018, Higher rates are now a global trend as the Bank of England has signaled that it is about to make its own move and the European Central Bank has been talking about moving away from quantitative easing.
Canada is in the midst of one of its strongest growth spurts since the 2007-09 recession. While Canada’s gross domestic product was essentially unchanged in July, as the oil and gas, mining and manufacturing industries all shrank, the economy had been growing at a 4.5% annual pace at the end of June. That’s the fastest among Group of Seven countries and double what the central bank considers Canada’s capacity to grow without fueling inflation. The Bank of Canada said recent data has increased its confidence that the economy will continue to grow above potential, meaning excess capacity is being absorbed, and estimates that the economy will return to full capacity by the end of 2017. Governor Stephen Poloz has downplayed recent weakness in inflation, judging the sluggishness to be “mostly temporary” and predicted that inflation will near its target of 2% by the middle of 2018, which is later than was predicted in April.
The U.S. Federal Reserve Chair Janet Yellen suggested that the central bank is on course to raise interest rates in December, as well as three more times in 2018, and begin to reduce its balance sheet. She believes that the economy is robust enough to withstand further rate increases and the reduction of the Fed’s $4.2 trillion portfolio of Treasury bonds and mortgage backed securities as it exits the crisis era policy a full decade after the global financial crisis began. The central bank’s strategy represents something of a gamble because it risks keeping inflation well below the Fed’s 2% target. Core consumer price inflation has ebbed this year even as the economy and the labour market have improved. After briefly poking above 2% earlier this year, it has more recently fallen back to 1.7%.
The Standard & Poor’s 500 index rose 4.5% in U.S. dollar terms over the third quarter of 2017 and in Canadian dollar terms the index was up 4.0%. Year to date the benchmark is up 14.2% and in Canadian dollars it was ahead 13.8% as our currency recovered some of the ground it had lost to the U.S. dollar. Investors in the U.S. market continue to ride one of the longest bull markets since the 1940s as the S&P 500 index has more than tripled since bottoming out in March 2009.
U.S. Gross Domestic Product (GDP) expanded at a 3.0% annual rate, its fastest pace in more than two years, according to the Commerce Department in its second estimate of second quarter GDP. Businesses increased their investments and consumer spending remains healthy. Consumer spending, which makes up more than two-thirds of the U.S. economy, grew 3.3% which was the fastest in a year. It seems that the strong consumer spending came at the expense of savings, as the savings rate slipped and wage gains have been weak. Households will not be able to rely on savings indefinitely to fund consumption so any pickup in wages going forward would help underpin the economy. More recent retail sales and business spending data indicate that the economic strength continued into the third quarter. For the first half of the year the economy grew 2.1%. President Trump set an ambitious 3.0% growth target for 2017, to be achieved through a mix of tax cuts, deregulation and infrastructure spending. While many of these objectives have yet to be attained, the political gridlock in Washington does not seem to have hurt business or consumer confidence.
A long string of corporate takeover activity in the U.S. and a better than expected second quarter earnings season on Wall Street have pushed equity markets to lofty levels. Earnings of the companies that make up the S&P 500 index grew 11% in the second quarter, the second straight quarter of double-digit growth and the fastest two quarters of growth since 2011. More than half of S&P companies topped forecasts, (the highest percentage since the second quarter of 2010), although the average upside surprise was 4%, slightly below the long-term average of 5%. Looking forward, it will be more difficult for companies to achieve the same earnings growth in the second half of this year, as the earnings recovery in the second half of 2016 will be a higher hurdle but solid fundamentals should continue to support earnings.
There are a number of positive trends that continue to sustain the market, notably the strength of the U.S. consumer, supported by monthly job growth that this year that has averaged 175,000, wages that are indeed expected to rise as the economy nears full employment, business and consumer confidence that is at their highest levels since 2001 and household balance sheets that are the strongest since 1980. There are signs that we are in a classic late cycle expansion as we are seeing an economy with almost full employment and slowing momentum which tends to foretell a decline in corporate profit margins, but while the U.S. may well be in the mature stage of the economic cycle, there is still time and room for equity markets to run.
With major indices trading at near-record highs and equity valuations seen as stretched, many investors are worried that U.S. stocks are overdue for a correction. Because nearly everyone feels that way, it actually favours the market. Long time investor John Templeton famously stated that “bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.”
The international financial markets have surged as global economic growth is faster, firmer and more synchronized than it has been in years. For the first time in nearly two decades growth forecasts have been ramped up while the forecasts for inflation have been revised down. The threats of higher interest rates, geopolitical shocks and increasing valuation pressure are not likely to unhinge stocks in the near future and pain is likely only to be felt by those sitting on the sidelines.
After years of unprecedented stimulus, the upswing is finally starting to spread across all the nations in Europe. The recovery is stronger, broader and proving to be resilient to external shocks, especially after the past few misfired rebounds. Confidence in the economy rose to the highest level in a decade, as the overall unemployment rate dropped to its lowest level since 2009. Supported by ultra-low interest rates and other measures designed to boost activity, inflationary pressures remain minimal. France has had its strongest continuous expansion since 2011 and the Netherlands posted its fastest growth since the end of 2007. Italy, which has lagged its peers in recent history, is starting to shake off its reputation as the sick man of Europe. Even Spain’s economy keeps powering ahead. On the other hand, the U.K. is growing at half the rate of its soon to be separated neighbors and that seems to be the biggest problem. The messy business of splitting from Europe is taking a toll on the Pound, raising the
cost of imports, pushing up inflation and generally squeezing consumers’ pocketbooks.
Japan’s economy grew for the sixth consecutive quarter, as cautious consumers are starting to loosen up spending more and offering hope that domestic demand will be strong enough to continue to re-inflate the economy that has been sluggish for years. Private consumption, which accounts for almost 60% of the economy, rose at its fastest pace in more than three years. Japan’s inflation rate remains very low, enabling the central bank to sustain its current fiscal policies despite record low unemployment and rising wages which will be vital as the country’s population shrinks and ages.
China’s economic growth marginally beat expectations but future growth will likely be weaker. As the country grapples with the challenges of containing financial risks stemming from years of credit fueled stimulus, risks are increasing. There have been significant inroads in reducing the riskier aspects of the shadow banking system; unfortunately it has created a dangerous trajectory. So much so there have been several recent downgrades to China’s long term sovereign credit rating. This is still a big problem, one with which the soon-to-be reshuffled leadership will have to wrestle with.
Emerging Markets have continued their resurgence despite timid investor uptake. They have benefited from stable commodity prices, improving economic growth and balance sheet repairs since the bout of interest rate anxiety in mid-2013. The future is not without risk, including the outlook for Chinese politics, and a heavy electoral calendar next year from Mexico to Venezuela. Yet on a relative basis Emerging Markets will likely outperform most other markets over the next few years.
International stocks are having a very good year gaining over 20.4% (all returns are in U.S. dollar terms) so far and 5.5% on the quarter. They are being paced by the Emerging Markets, many of which are touching all-time highs after gaining 25.5% year-to-date; and 7.0% for the quarter. Not to be outdone, European stocks have gained 19.9% for the year and 6.0% on the quarter; while Asian stocks markets have climbed a respectable 16.2% for the year and 4.1% on the quarter. After many years of weak or mediocre results this performance is very welcome and hopefully will continue in the future, although not likely at such impressive rates.