Multi-Asset

Multi-Asset Solutions Team (MAST) Asset Allocation Outlook - March 2019

To paraphrase Mark Twain’s famous quote, the death of this nearly 10-year long stock rally has been rumoured ad nauseam with several market commentators calling the top. With investors failing to embrace the rally, it has even been called ‘the most hated stock market rally of all times’.
March 2019
  • Global equity markets extended their solid year-to-date rally, helped by a dovish Fed and a U.S. President happy to delay additional tariffs on Chinese imports. Near-term economic outlook nevertheless softened, but the economic expansion and stock rally still have room to grow.
  • Major central banks have adopted a more cautious tone and it will take a solid flow of macro-economic data to reboot the rate hiking cycle. Investor confidence that the Fed will be patient should remain a tailwind to stocks this year.
  • Bank of Canada’s (BoC) extended hold and another round of fiscal stimulus in Canada should limit risks of a recession by 2020, but we continue to think Canada will lag the U.S. in this cycle, which should weigh on the loonie and take it closer to $0.73.
  • We reduced our equity overweight; waiting for more evidence that U.S. growth will re-accelerate later this year. In fixed income, duration remains unattractive given the flatness of the yield curve and our constructive outlook for growth.
“The reports of my death are greatly exaggerated” – Mark Twain

To paraphrase Mark Twain’s famous quote, the death of this nearly 10-year long stock rally has been rumoured ad nauseam with several market commentators calling the top. With investors failing to embrace the rally, it has even been called ‘the most hated stock market rally of all times’.

If you think the nearly 20% rebound for the S&P 500 from the December low feels too good to be true, you wouldn’t be completely alone. But in reality, we’re merely back to November highs and still 5% below the 2018 high. From that angle, this is hardly an overbought market. It’s been mostly a repricing of risk as share prices have rallied on the back of higher earnings valuations, whereas earning expectations have been slightly trimmed during the last couple months (Chart 1). S&P 500 2019 analyst earnings expectations are now in the low single digits, a low bar considering the health of the U.S. economy.

With investors failing to embrace the rally, it has even been called ‘the most hated stock market rally of all times’.
Chart 1: S&P 500

Chart 1: S&P 500

Source: Bloomberg

Key Market Risks Turning to Tailwind

Disappointing global economic indicators were not enough to stop the 2019 rally. President Trump happily kicked the can on additional tariffs on Chinese imports. Investor confidence that the Fed would not whack the economic expansion and the accompanying stock rally helped drive the S&P 500 higher by 3.2% in February, lifting 2019 gains to a solid 11.5%. European shares led the way in February with a 3.9% bounce, whereas Canada’s S&P TSX rose 3.1%. Despite the parabolic gains in Chinese shares, the MSCI EM index was flat as several emerging countries continue to suffer from domestic headwinds and a sharp slowdown in global trade.

Global equity factors also performed in a tight range in February. Investors were best rewarded by Quality stocks (+3.7%), and Momentum (+3.5%), whereas Value (+2.2%), continued to underperform in this sharp repricing of risk*. Our favourite late-cycle factor tilt, Low-Vol (see, Factor-based Investing), performed middle of the pack (+3.0%). Unsurprisingly, the best performing global equity factor so far this year is Growth (+11.9%), with Quality (+11.6%) closely behind. The performance of Low-Vol (+8.3%), lags behind Value (+9.7%). In Canada, low volatility stocks (ticker: ZLB, +9.7%), have also lagged the broad market (ticker: ZCN, +12%), this year.

While interest-rates markets have effectively priced out rate hikes in Canada and the U.S., yield on U.S. 10-year treasury notes climbed 9bps as fears of an imminent recession abated, resulting in a marginally steeper 2-10 yield curve. In our view, delaying the inversion, which usually leads a recession by 12 to 18 months, should help reboot growth later this year. The yield on 10-year Government of Canada notes rose slightly less (+6bp), as evidence of soft economic performance is catching up to a rosy economic consensus and the Bank of Canada. Our cyclical thesis that Canada’s economic performance will lag that of the U.S. was again confirmed with a large growth differential between the two countries in Q4. U.S. real GDP growth ticked at a decent 2.6% clip, whereas Canada’s growth came to a near stall, only rising 0.4% – the softest quarter since 2016. There was no silver lining in Canada’s GDP report; weakness was well outside of the energy sector. *Factor returns based on MSCI Indices.

Disappointing global economic indicators were not enough to stop the 2019 rally.

Canadian Economic Outlook: Loss of Growth Leadership

Global growth is decelerating after peaking early in 2018 (Chart 2), most notably in Germany, Europe’s economic engine. For Canada, being a small, open economy with significant exposure to global trade and commodities, the softening of the external environment, especially with respect to U.S. activity, is a significant headwind.

Chart 2: Global PMIs

Chart 2: Global PMIs

Source: Bloomberg, Marki. Composite Index used for all regions excluding Canada, where manufacturing is used.

Global growth is decelerating after peaking early in 2018, most notably in Germany, Europe’s economic engine. For Canada, being a small, open economy with significant exposure to global trade and commodities, the softening of the external environment, especially with respect to U.S. activity, is a significant headwind.

What makes the current cycle even more challenging for Canadian growth is the household-debt overhang. Although Canada was long overdue for higher interest rates in 2017, the elevated debt load carried by households will weigh on the economic outlook for several quarters, as debt servicing costs gradually rise. Scope for an extended pause–or maybe even an end–in the BoC’s hiking cycle, along with a fiscal policy that has room to stimulate, should help prevent a recession. This is quite a change in relatively short time as not 6 months ago headlines were cheering Canada for leading growth amongst G10 countries, while now the focus has shifted to the loss of leadership (Chart 3). Given the upcoming October federal elections, we expect the next budget in Ottawa to deliver another round of measures which could quickly stimulate growth like they did in 2016. However, Canada’s deteriorating competitive position (see here and here) could benefit more from an investor-friendly fiscal-policy mix that could help stimulate long-term growth and productivity.

Chart 3: Y/Y % Change Real GDP

Chart 3: Y/Y % Change Real GDP

Source: Bloomberg

It’s getting hard to make the case that more rate hikes are needed over the next year in Canada.

The context of slower growth is even worse after factoring in that Canada has recently experienced population growth near 1.4% when real economic activity is close to a stall. It’s getting hard to make the case that more rate hikes are needed over the next year in Canada. Governor Poloz may squeeze one more hike in this year, but that case rests on rather optimistic assumptions as Q1 growth will struggle to print in positive territory. Although we think the ongoing winter weakness should mark the bottom for the year, we don’t see a strong case for above-trend growth in the second half of 2019 in Canada. This scenario would be necessary to justify more rate hikes.

Talks of rate cuts could soon emerge if the Canadian economy fails to rebound near its trend pace (1.75%) this summer, but it’s hard to assign a probability greater than 30% to such a bearish scenario. Considering the congressional gridlock in the U.S., we also see a remote risk for a delay in
the passing of USMCA, which would add gas to that rate-cut fire.

 

Too Early for Fed Cuts, but U.S. Growth under Significant Cyclical Headwinds

Although U.S. Q4 real GDP growth surprised to the upside (2.6%), early indicators for Q1 suggest the deceleration from 4-handle growth prints last summer is far from over, with Q1 growth tracking near 1%. We think a warming of U.S.-China trade negotiations, the scope for an extended Fed rate pause, and an upcoming announcement of the Fed halting its balance-sheet runoff program will help reboot growth in the second half of 2019. While Fed Vice Chairman Richard Clarida said the U.S. central bank can be patient with interest-rate adjustments given muted inflation, the bar to hike has moved up as investors happily discount a benign rates outlook.

We still think the Fed will see sufficient growth (2.5%) this year, allowing it to hike once more this year, but an on-trend pace of growth (2%) would probably leave the Fed on the sidelines this year. Rather than being a headwind to risk assets, the Fed has been clear that it won’t try to halt this economic expansion, which should support stocks.

The bottom line for monetary policy in Canada and the U.S. is that we can expect the PowellPoloz duo to stick to “cautious” and “patient” messaging. This will require more patience and observation rather than action.

For long-term investors, the timing of markets is rarely profitable.

The Most Hated Stock Market Rally of all Times: Learning to Overcome Fear of Uncertainty

For long-term investors, the timing of markets is rarely profitable. Arguably, the stock rally that began in March 2009 is far from ideal. For instance, the world’s major central banks have built massive balance sheets by purchasing financial assets to reflate their economy. Moreover, most developed economies were running large fiscal deficits while cheering the synchronized 2016-2018 growth burst. Although this is neither ideal nor sustainable, we think this dedicated reflationary effort is far from done. If it persists, as we expect, it should continue to support economic growth and stocks. Looking at 2-year rolling returns since 1923, investors have not experienced sustained drawdowns (Chart 4). Long-term investors should keep that in mind when the temptation to build up cash arises.

Chart 4: S&P/TSX Composite Rolling 2Y Total Return

Chart 4: S&P/TSX Composite Rolling 2Y Total Return

Source: Bloomberg

Our investment thesis remains slightly more optimistic than consensus, but by reducing our equity overweight and adding safer fixed-income assets, we will be better positioned heading into the spring and allow us to wait for signs that growth will re-accelerate.

Outlook and Positioning: Trimming Equities, but Still Overweight

Although we have steadily argued against playing defense with North American stocks, in late February we took a few chips off the table and trimmed our equity overweight. As much as we thought the selling of equity markets in December was greatly overdone, the near-term outlook remains clouded by uncertainty with signs of a faster-than-expected cooling. Our investment thesis remains slightly more optimistic than consensus, but by reducing our equity overweight and adding safer fixed-income assets, we will be better positioned heading into the spring and allow us to wait for signs that growth will re-accelerate.

Our duration call, however, is unchanged given our constructive outlook. Moreover, government yield curves in Canada and U.S. remain unattractive for duration. Although with U.S. 10-year yields creeping back up toward 3%, U.S. treasuries are an increasingly attractive hedge against stocks in case of another risk-off bout. Contrast this to last year prior to the Fed finally blinking; bonds are more likely to perform positively in a risk-off environment due to the diminished inflation outlook.

The greatly disappointing fourth-quarter GDP growth for Canada, while the U.S. economy showed more resilience than expected, took the loonie closer to our $0.75 call for the summer. Given that the soft patch is proving deeper than we and the markets expected, we now think the loonie will struggle to remain above $0.73 by the summer. For the greenback, the resilience of overall economic activity has kept it a bit stronger than expected. We still think we have seen the peak for the buck, though not vs the loonie.

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