Read on for a technical look at what’s happening in the financial markets.
- U.S.-centred trade disputes remained a pressing macroeconomic concern and driver of market sentiment during the quarter
- Equities generated positive absolute returns, helped by moderate inflation, low interest rates and encouraging corporate earnings results
- However, there was some evidence of investors also moving into “safe-haven” assets like gold, government bonds and currencies like the Japanese yen
- While Canada has enjoyed strong employment numbers, oil prices remain a concern, as do consumer debt, productivity and export levels
- Investor sentiment suggests an increasingly differentiated view of emerging market equities, with the asset class relatively stable during the period despite issues in individual economies (such as Turkey)
U.S. trade issues impact the world
During the second quarter of 2019, the U.S. remained at the forefront of trade disputes with China, Canada, Mexico and Europe. These ongoing disputes not only affect the economies of the countries involved, but they also have a contagion impact on the rest of the world. U.S. trade disputes remain the most dominant driver of global market sentiment.
The confrontation with China has morphed from tariff negotiations to concerns about national security, cybersecurity and who will dominate evolving technologies.
Over the past quarter, these standoffs severely affected global trade, with flows of capital down significantly across most major economies, leading to a sharp decline in manufacturing activity.
Equity markets bend but don’t break
Risk assets, such as equities, largely performed well over the period. In the U.S., the Standard & Poor's (S&P) 500 Index crept within 1% of its all-time high in April and ended the quarter up 3%. The story was similar in Canada, where the S&P/TSX Composite Index returned 8% for the quarter and has gained approximately 16% year-to-date.
Inflation was, by and large, contained and interest rates remained historically low, which helped equities mitigate trade tensions. Another support for equities were the solid profits generated by most companies as they look to minimize trade disruptions.
Negotiations between the U.S. and China have been “stop and go.” Recently, President Trump and his Chinese counterpart, Xi Jinping, restarted talks, and markets applauded. Meanwhile China continues to stimulate its economy. A vibrant Chinese economy is essential for global growth, particularly for major trading partners like Europe.
However, with re-intensified trade disputes, exports from Europe and Japan (among others) weakened. Surprisingly, equity markets did not buckle. For example, the MSCI Europe Index returned 1% over the period and the MSCI Japan Index returned 0.4%. Investors appeared to assume that trade deals would emerge and central banks would maintain accommodative monetary policy to nudge the global economy past the rough patches.
A mixed showing by Canada’s economy
The Canadian economy remains solid as employment stays strong. Volatile energy markets are a concern, although Western Canadian Select (WCS) is up about 46% year-to-date after having declined significantly in recent periods. A barrel of WCS was trading at roughly US$43 at quarter-end as Canada experienced issues bringing supply pipelines online. Other oil benchmarks like Brent crude oil and West Texas Intermediate (WTI) are trading at a premium to WCS.
The Canadian consumer remains one of the world’s most indebted, with a debt-to-income ratio of about 178%. While concerning, it has been gradually coming down. But the Bank of Canada (BoC) has always pushed to pivot the economy from its heavy reliance on consumers and the housing market. Canada has been working to push greater business investment, improve productivity and increase export levels. The results to date have been mixed. Canada could hit a slowdown or recession in 2021 (as could the U.S.) if trade issues are not resolved.
Relative stability in emerging markets
Once viewed as a monolithic asset class, individual emerging markets are maturing and carving out their own economic paths. For instance, there is a significant difference between the economies of South Korea and Turkey, just as there's a notable difference between Mexico and Venezuela. Now, it becomes glaring when one of these emerging markets is under economic duress or poorly managing its currency or deficits. For example, Turkey has increased spending on social programs, but has grown its debt as well. In turn it has been forced, by markets, to raise interest rates, tame inflation and get its fiscal house in order.
Yet, investors have viewed the stress in Turkey as a local issue independent of other emerging markets, as they recognize Turkey’s idiosyncratic economic drivers. Emerging markets have been predominantly stable through Turkey’s debt issues. The top equity performers in emerging markets over the period were Argentina and Russia, with gains of 25% and 13%, respectively.
Interest rates poised to decline
Another critical market driver is the U.S. Federal Reserve System (Fed). Expectations are that it will reduce interest rates to sustain the economy. The yields on the U.S. 10-year Treasury bonds declined roughly 40 basis points in the quarter, which represents a significant risk-off move, pushing bond prices higher and yields lower.
Corporate bonds typically provide yield premiums over government bonds, given the added risk that investors assume. Surprisingly, yield spreads remained at reasonable levels instead of widening under these choppy economic conditions. The key reason: while investors are worried about the growth hits from trade issues, they seem comfortable that any stress emanating from these issues would not be enough to undermine their solvency or debt rating.
When the Fed held its Federal Open Market Committee meeting on June 19, it signaled its intent to be accommodative and potentially move interest rates lower in July. Right before that, the European Central Bank indicated it would adopt a more accommodative stance, staying flexible regarding interest rate cuts and resuming bond purchases. And not to be out done other global central banks show a willingness to be accommodative as they all stay committed to growth.
The BoC is in a different situation than other central banks. Interest rates are relatively low in Canada and the country’s main concern has been containing the hot housing market and avoiding a major economic downturn. Policies and regulations have been put in place to manage the real estate market, such as curtailing foreign investment.
Given that the efforts have succeeded in targeted regions, interest rate cuts (which tend to spur real estate investment) appear less likely. For now the BoC’s overnight rate remains at 1.75% while inflation moves closer to its 2% target.
Investor sentiment should improve if the U.S. and China show progress toward a sustainable agreement.
Enforcing intellectual property rights continues to be a critical issue. Any protracted trade standoff would likely have a significant impact on economic growth.
Before the quarter began, the consensus investor view was that the second half of 2019 would be relatively strong, but now that view is under siege. The next several months will dictate where investor sentiment is headed and could have a major bearing on near-term market performance.
Canada typically benefits from having the U.S., the world’s largest economy, as a major trading partner. If global trade issues persist as the year unfolds, that relationship with the U.S. will become a double-edged sword. Canada clearly prospers from strong U.S. trade demand, but if the U.S. starts to slow, Canada will be hard- pressed to avoid the same economic ramifications.
In coming months, a significant level of geopolitical risk will play out, which will have meaningful consequences for the momentum of capital markets.
Dec Mullarkey is Managing Director, Investment Strategy at SLC Management. He is also an adjunct professor at Boston College.
SLC Management is the brand name for the institutional asset management business of Sun Life Financial Inc. and offers products and services to institutional investors only.
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