Both Canadian and U.S. stocks were higher in the first week of the third quarter's earnings season. While most of the companies that have released earnings so far are from the financial services sector, 81% have reported better-than-expected results. With stock valuations well above historical averages, we expect market gains will be driven by increasing corporate profits. This can come to fruition as U.S. earnings are expected to rise by 3% in the third quarter. Headlines from Washington remained in the spotlight as President Trump signed an executive order to cut off subsidy payments to insurance companies that provide Obamacare health plans, along with heightened concerns that the U.S. will leave the North American Free Trade Agreement.
Canada logged the fastest growth among the G7 economies in the first half of the year, expanding by an impressive 4%. We don’t think this pace can continue given economic imbalances and heavy reliance on consumer spending. While consumer spending and housing investment have risen by more than 4.5% so far in 2017, we believe conditions will begin to change. Household debt is nearly 170% of disposable incomes, wages are rising at less than 1.5%, and interest rates have risen; all of which will combine to drive a slowdown (but not a crash) in housing activity and consumer spending, which have accounted for two-thirds of GDP. We expect GDP growth to moderate back toward 2%, with underlying conditions suggesting a recession is not likely in 2018.
Equities broadly have turned in a strong performance in 2017. The TSX has largely moved sideways, while U.S. and global markets have logged double-digit gains. A chaotic political atmosphere and shifting monetary stimulus are likely to stoke volatility, but fundamentals are signaling more room for the bull market to run.
This bull market is more than 3,100 days old, making it the second-longest on record. With a total return of 342% for the S&P 500 and 165% for the TSX since the bull market began, the market’s highest returns are likely behind it. We expect market gains will be driven by increasing corporate profits. TSX earnings face some challenges given the dependence on bank performance and commodity prices; however, a more sector-balanced measure provides a positive outlook. Broadly, profit margins remain above-average and economic growth supports rising revenues. Corporate tax reform in the U.S. would also provide a boost for S&P 500 profits, though we continue to believe comprehensive tax cuts face delays amid the political climate.
Stock market volatility has been near record lows lately, but we caution against complacency. The VIX (volatility) index has been below 10 recently, compared to a 20-year average of 20.6. Since 1997, when the VIX fell below 10, volatility rose, on average, by 25% within the following three months.
After years of increasing stimulus, we think the Bank of Canada (BoC) and U.S. Fed will continue to slowly raise rates with the economy demonstrating less need for extraordinary central bank support. Nevertheless, rates overall remain relatively low and are likely to rise gradually, limiting the threat to bond returns and economic growth.
There is a potential for one more rate hike this year, but we think the BoC should take a cautious approach to further policy tightening in 2018. While a growing economy warrants more normalized rates, very high levels of consumer debt and above-average contribution from housing investment in recent years suggest that rate hikes may represent a more acute headwind to the pace of GDP growth. Additionally, subdued inflation provides the BoC with breathing room for gradual rate increases.
We expect the Fed to withdraw stimulus through rate hikes and a reduction in its balance sheet (bond holdings), slowly removing the cushion it has put under the markets in recent years. In the last 60 years, Fed tightening cycles included an average increase in the federal funds rate of more than 4%, roughly four times what we’ve experienced over the past two years, leaving room for the Fed to tighten before it begins to take a bite out of economic growth.
The U.S. economy is poised to deliver better growth ahead. The base of growth should come from the consumer, as labour market conditions are healthy. Stronger wage growth should emerge amid tighter employment conditions, which combined with improving housing market trends and rising consumer confidence, should support household spending growth. That said, Canadian and U.S. stocks still trade at above-average valuations (above 17 times expected earnings), though we slightly favour the earnings growth outlook for the S&P 500. Overseas markets remain at more compelling valuations, with the price-to-earnings ratio of overseas developed-market equities 15% below the S&P 500 and emerging market equities at a 30% discount.
Don’t avoid U.S. investments on the basis that it’s too expensive to purchase them with a cheap loonie. One year ago the CAD was near US$0.76. Since then, the TSX has a total return of 9.2% versus a total return of 12.9% for U.S. stocks after converting back to Canadian dollars (18.6% in U.S. dollars). Global equities have been strong performers, with overseas large-, mid- and small-cap equities and emerging market equities delivering an average Canadian dollar return over the past year that was 2.3 times that of the TSX.
|S&P 500 Index||2,553||0.2%||14.0%|
|10-yr GoC Yield||
In a busy week of economic releases, existing home sales will be reported on Monday, manufacturing sales will come on Wednesday, and inflation data along with retail sales are set to be released on Friday morning.
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Diversification does not guarantee a profit or protect against loss.
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