Weekly Market Update (December 3 – December 7, 2018)

High volatility was the prevailing theme this week with trade uncertainty and worries about a flattening yield curve at center stage. Stocks finished lower, but bonds had their best weekly performance since May as investors fled for safety. The week started on a strong note after the U.S. and China agreed at the G20 summit to ceasefire and not to impose any additional tariffs for 90 days as they negotiate an agreement. The initial optimism later turned sour as investors realized that no substantive agreement was reached and a quick resolution is far from guaranteed. Adding to the uncertainty, news that a Chinese tech company's CFO was arrested in Canada on allegations of violating U.S. trade sanctions further complicated matters. The other key issue that unnerved investors was the U.S. and Canadian Treasury curves as the 3-year rates exceeded 5-year rates, raising fears of an inverted yield curve and the belief that it's signaling a downturn ahead. While we are not dismissive of the risks, we think that such predictions are premature. A more reliable measure to monitor is short-rates (3-month) compared to 10-year rates. This yield curve is flatter, but is still positively-sloped, not inverted. Finally, the action-packed week ended with an OPEC agreement to cut oil production and Novembers' job reports in both U.S. and Canada.

When it comes to the market, there are typically two sides to every coin. At times, one side can be much shinier than the other, or one side can turn up rather consistently for stretches of time. And then there are times when both sides – the good and the bad news – compete for the market's eye with every flip.

Trade, interest rates and jobs were all front and center last week, with each issue offering two sides of the story. The outcome was wide market swings, including

• A Monday rally on hopes of a trade deal,
• An 800-point drop in the Dow on Tuesday on yield curve worries and
• A 689-point swing from the low to the high on Thursday.

Last week, four key issues were in focus:

1. The yield curve inverted…sort of.

• The headlines: A portion of the yield curve (a spectrum of interest rates, more specifically a measure of shorter-term rates compared to longer-term rates) inverted last week in both the U.S. and Canada as three-year yields rose above five-year yields – the first time since 2007. When short rates exceed long rates, this can be interpreted as a sign of economic weakness and stocks sold off in response.
• The full story: We think the yield curve is a credible indicator and its warning signals should not be dismissed.  When short-term rates rise, that's an indicator that Fed policy is getting tighter (less stimulus). And when longer-term rates fall, that can be a signal of expectations for waning future growth. That said, we'd note two important points: first, 3-year rates slightly above 5-year rates is more of a kink than an inversion of the curve. Historically, this narrow segment of the curve has inverted many times without an ensuing recession. A more reliable yield curve measure is the difference between 3-month rates and 10-year rates, as these are more representative of Fed rate moves and long-term growth expectations. This measure has flattened (consistent with our view that we are in the latter stages of the cycle), but it has not inverted. And second, even an inversion of the broader yield curve (if and when this occurs) is not a signal of impending doom. Historically, when this yield curve inverted, it was an average of 16 months before a recession emerged. Moreover, the 3-month/10-year rate spread is currently 0.47% in the U.S. and 0.44% in Canada. When the measure first breached 0.50% historically, the average return in the stock market over the next year was 12% for the S&P 500 and 6.7% for the TSX since 1992¹.

• The headlines: Markets rallied on Monday as investors found some comfort in the verbal ceasefire on tariffs between the U.S. and China that came from an agreement at the G20 meeting. That excitement wore off quickly as concerns rose that a more lasting agreement may not emerge quickly.
• The full story: The tariff truce has a 90-day shelf life, so the G20 agreement between President Trump and Chinese President Xi Jinping is more of an agreement to potentially agree in the future. On the plus side, we think this signals that both sides are seemingly open to negotiation, raising the potential for a longer-term trade deal to be reached between the world's two largest economies. Nevertheless, we expect trade concerns to remain a source of market anxiety into 2019. We think an all-out trade war will be avoided, and recent global trade activity suggests the recent tension have not had a dramatically-negative impact on growth; however any further escalation in tariffs does run the risk of feeding through to consumer and business costs which could hurt economic growth down the road.

• The headlines: The U.S. economy added 155,000 new jobs in November, a bit below the consensus expectation and slower than the 200,000 average over the past six months. Unemployment held steady at a very low 3.7%. In Canada, the economy posted a record jobs gain of 94,100 in November and the unemployment rate fell to 5.6%, a four decade low¹.
• The full story: In both the U.S. and Canada the job reports had a little something for both camps, but we think the overall story is still a positive one. In the U.S. the deceleration in monthly hiring may feed into the worries that the economy is weakening. But we find it hard to dispute the fact that the labour market is quite healthy, and with consumer spending accounting for more than two-thirds of U.S. GDP, a healthy labour market is the key to a healthy economy. The unemployment rate is at a 49-year low, which is beginning to yield progress by way of stronger wage growth (up 3.1% over the past year)¹. So while a healthy labour market means a recession is unlikely in the coming year, the flipside to this coin is that as wage growth firms further, it could lead to firmer inflation, which would require more Fed rate hikes instead of fewer.  We don't think this is an imminent threat, but the wage-inflation-rate hike story will be a key theme for the market as we progress through 2019.
  
  In Canada, while monthly job growth has been choppy recently, November's gain of 94,100 jobs points to an acceleration from the 2018 average gains of about 60,000, and is an encouraging sign. However, the weakness in wage growth is somewhat concerning in that it represents a headwind to household spending growth (the largest contributor to GDP). We believe this is aligned with our expectation for modest growth ahead and inflation near the Bank of Canada's target, allowing the central bank to take a more gradual approach to future rate hikes.

4. Stock market pullback: ongoing or opportunity?

• The headlines: The 800-point decline on the Dow last Tuesday increased the anxiety level in the markets as it raised the question of whether this pullback is the beginning of the end for the bull market.  Volatility has made a dramatic return recently after several years of below-average market fluctuations, with 2018 enduring two separate 10% corrections in the U.S., the first calendar year to do so during this nearly decade-long expansion.
• The full story: Periods such as this require a dose of perspective. U.S. stocks fell 4.6% last week, but just gave back the prior week's gains, when the S&P 500 rose 4.9% (the best week for the market since 2011).  And while the market endured a 10.2% drop this fall, both U.S. and Canadian stocks are:
  • still higher than the late-October,
  • about 10% below the all-time high and
  • up 25% over the past two years and 63% over the past five years in the U.S. and up 4% over the past two years and 30% over the past five years in Canada¹.

We still think there is plenty of shine left on the positive side of the market's coin, but as we progress in the latter stages of this cycle, attention will shift between heads and tails. In other words, the path ahead for the market is not up to chance and we expect the still-positive fundamental backdrop to provide support against worrisome headlines. We don't think this is a prelude to a prolonged, severe downturn, but we haven't seen the last of these market swings.

Craig Fehr, CFA
Investment Strategist

Angelo Kourkafas, CFA
Associate Analyst

^{Source: Bloomberg, 12/07/18. Bonds represented by the iShares Core U.S. Aggregate Bond ETF. Past performance does not guarantee future results.}

Housing data dominate the economic calendar next week with starts and permits scheduled to be released on Monday and new home prices on Thursday. An important international event to pay attention to will be the Brexit vote in UK Parliament scheduled for Tuesday.