Weekly Market Update (February 19 – February 23, 2018)

By Craig Fehr February 23, 2018

Stocks finished modestly higher on the week as volatility persisted: in three of the four trading days, the S&P 500 moved by more than 0.5%, including a 1.6% rally on Friday. Rising interest rates and other economic policy uncertainties are likely to result in more episodes of market volatility, including big stock market moves both up and down. Improving fundamentals, including economic and earnings growth, can support rising stock prices over time, both here and in the rest of the world. You can’t control market volatility, but you can control the actions you take to stick to your long-term investment strategy.

Stock Market Swings Continue - Key Takeaways From Last Week

There was no shortage of market moves in last week's holiday-shortened session. All told, Canadian stocks were higher as oil prices rallied, and U.S. stocks posted modest gains, breaking the recent trend of sharp swings which produced the worst week in two years and the best week in five years in succession. The dust has appeared to settle a bit, but volatility is likely to persist as markets adjust to evolving economic and interest rate conditions. To that end, last week's action produced the following three takeaways:


  1. Stocks still trying to make up their mind – After the one-way move higher through 2017, the market has been on a zig-zag path more recently. Last week saw a smaller version of that, with the S&P 500 declining on Tuesday and Wednesday, followed by an upswing on Thursday and Friday. The market's focus is now swinging between the optimism of strong economic/corporate fundamentals and the anxiety of rising interest rates. The result has been larger swings in stock prices, with the Dow moving by triple digits in 12 of the last 15 trading days. The average daily change in the U.S. stock market so far in February has been 1.3%, compared with an average daily move of 0.3% for all of 2017.1 We expect the swings between optimism and skepticism to continue in the near term, as markets adjust to the progressing economic and interest rate cycle. We still think the broader direction is higher, but suggests investors prepare for a bumpier ride along the way. 
  2. The rate relationship is evolving – The relationship between stocks and interest rates is beginning to change – a trend that is likely to remain behind the wheel as the key driver of short-term market moves. The backdrop of ultra-loose (stimulative) central bank policies around the world and the prospects of faster economic growth has progressed into the reality of faster growth and the prospects of tighter policies. In other words, the nearly decade-long bull market has been supported by extraordinarily low rates, and now that rates are rising, some are growing increasingly worried that this will remove the fuel for the bull market. We'd note that 
    • Rates are moving higher for the very reason that the stock market had been rising: a stronger economy. U.S. GDP growth has averaged 2.9% over the past three quarters, compared with an average of 2.1% since 2010. This, along with a 17-year low in U.S. unemployment, rising consumer confidence, and increasing business investment is spurring higher inflation expectations, which in turn is leading to expectations for potentially faster rate hikes from the U.S. Federal Reserve. While many of the same fundamental factors exist in Canada, including an unemployment rate that is near a 40-year low, headwinds including high household debt and possibly slower economic growth could keep the Bank of Canada from hiking short-term interest rates in tandem with the Fed. Historically, stocks do quite well in the early phases of Fed rate hikes, a phase we think we are still within. 
    • Interest rates are still quite low. Rates have risen materially in recent months, with the U.S. 10-year rate reaching a four-year high last week, but some context is required. 10-year rates rose from 2.04% to 2.95% in the past several months, but still are not back to the highest levels of this expansion. In the second half of 2013, U.S. rates nearly doubled from 1.63% to 3.0% - a move that did not kill the bull market in stocks. In fact, the U.S. market delivered a return of nearly 14% and the TSX posted a 10.6% return in 2014.2 We expect the U.S. Federal Reserve to raise rates several times this year, but it is starting from an artificially low level. Think of this more as letting off of the accelerator, not slamming on the brakes. Moreover, the earnings yield on stocks (earnings divided by stock price) still compares quite favourably with the yield on bonds in both Canada and the U.S., suggesting to us that the lift in rates is not yet threatening a mass exodus from stocks into bonds. Which brings us to our next takeaway... 
  3. Earnings remain poised to carry the load – The safety net underneath the recent sell-off in stocks, in our view, is the corporate earnings picture, which continues to be quite healthy. In the most recent quarter, S&P 500 revenues rose by 7.7%, up 32% over the average of the past four quarters. Revenues are expected to grow by another 7% in 2018 versus last year. With companies exercising cost discipline amid the sluggish economic growth of the past several years, revenue growth is fueling the bottom line, as evidenced by 15% earnings growth this quarter – the strongest in four quarters. Earnings are estimated to grow by 18% in 2018, which would be the strongest annual earnings growth since 2010.3 TSX earnings are expected to outpace S&P 500 earnings this quarter as tailwinds including higher rates and commodity prices have given a lift to financial services and energy sectors, which make up more than 50% of the index. While rising earnings won't lead the market higher every day, we believe history shows that corporate earnings are one of the most powerful drivers of stock market performance over time.


Craig Fehr, CFA
Investment Strategist


Sources: 1. Bloomberg, average daily price change in the S&P 500 index. 2. Bloomberg, S&P 500 total return, S&P/TSX Composite total return. 3. Bloomberg, based on 91% of S&P 500 companies that have reported fourth-quarter results. 2018 estimates based on Bloomberg consensus for the S&P 500.

The Stock & Bond Market

Index Close Week YTD
TSX 15,638 1.2% -3.5%
S&P 500 Index 2,747 0.6% 2.8%
MSCI EAFE 2,058 -0.9% 0.3%
10-yr GoC Yield

2.25%

-0.07% 0.20%
Oil ($/bbl) $63.56

3.0%

5.2%
Canadian US $0.79 -0.8% -0.6%
Source: Bloomberg, 02/23/2018. Past performance does not guarantee future results.

The Week Ahead

Following a holiday-shortened week that featured very little economic data, reports next week include the Finance Minister publishing the federal budget on Tuesday, Manufacturing PMI on Thursday, and the GDP report for the fourth quarter on Friday.

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