Weekly Market Update (October 15 – October 19, 2018)

Canadian and U.S. stocks finished mixed this week after three consecutive weeks of declines. As the third-quarter earnings season picks up steam, the focus is shifting to corporate fundamentals. With the exception of a few negative surprises in the industrial space and with European luxury goods manufacturers, early indications point to strong sales and earnings growth in aggregate. Increased volatility was still prevalent this week as investors remained cautious. Global growth concerns, along with worries about rising interest rates, were once again the main sources of volatility. Canadian inflation, reported on Friday, slowed to 2.2%¹ in September, indicating an economy operating near potential, but not overheating. Modest inflation suggests that short-term interest rates will increase gradually. Markets are frequently choppy short term, but we believe the positive fundamentals of economic and earnings growth can keep supporting rising stock prices over time. We don't think this ongoing volatility signals the end of the bull market, but a return to volatility is typical later in the market cycle.

After strong gains in the third quarter, stocks have been on a much choppier path recently as worries over rising rates and global growth have shared the spotlight with still-positive Canadian and U.S. economic and earnings growth trends. Both the TSX and S&P 500 have declined more than 6% from their recent highs, reflecting this balance. We think the bull market has life left, but conditions are shifting. Here are our thoughts on the progressing investment outlook:

Economic Outlook

• We expect domestic growth to remain modest – in the 1.5%-2.0% range – as household spending faces headwinds from rising interest costs and softer housing conditions. However, the deal for a new North American trade agreement, along with higher oil prices, should spur renewed business investment, helping cushion slower consumer spending.
• The U.S. economy continues to be powered by consumer spending aided by sub-4% unemployment and modest wage increases. We think U.S. economic growth will slow slightly in 2019, as some effects of the fiscal stimulus from the tax cut and budget agreement fade and higher tariffs bite. We continue to believe negotiations will avoid an escalating trade war with China, but the risk remains.
• Rising wages and higher tariffs raise the potential for increasing costs and prices for some products.  In addition, supply disruptions could push oil prices higher, all of which could add to inflation expectations. That said we think fierce competition and cost-cutting efforts are likely to keep inflation near current levels, which is within the Bank of Canada’s comfort zone near 2%.

Equity Outlook

• After more than nine years without a bear market or recession, we think U.S. stocks are moving into the later part of the market cycle but aren’t nearing a downturn. Instead, stocks appear well-positioned to continue to rise, based on our outlook for modest U.S. economic growth and strong earnings growth through the end of next year. Valuations however are above-average, and high valuations have been followed by below-average long-term returns in the past.
• TSX and S&P 500 earnings are forecasted to grow by an average of roughly 10% over the next year, according to Bloomberg. While this is about half the rate of growth of the past few quarters, double-digit earnings growth should be supportive of stock market returns. U.S. tax cuts and higher oil prices have contributed to recent earnings growth and revenue growth has also been strong, suggesting companies have the flexibility to continue to grow earnings.
• Small- and mid-cap U.S. stocks appear to be more attractively valued than large-cap stocks and should continue to benefit from the tax cuts and solid domestic economic growth. They are also likely to be less affected by higher tariffs or trade disruptions.

Fixed Income Outlook

• We think stable economic growth and a moderate pickup in inflation suggest that short-term interest rates will increase gradually, with the Bank of Canada (BoC) likely pursuing a slightly slower pace to rate hikes versus the U.S. Federal Reserve (the Fed).
• When the yield curve flattens, short-term bonds provide a rate that is close to long-term bonds without the additional interest rate risk. We recommend appropriate allocations to GICs to take advantage of the increase in short-term rates.

International Outlook

• Upward momentum in the global economy stalled recently, with U.S. strength offset by a soft patch in Europe and China. Rebounds followed similar soft patches in 2012 and 2016, and positively, recent data are signaling some stabilization. Though we don’t anticipate a rebound as synchronized as in 2017, we think global growth remains supportive to international markets ahead.
• While global risks remain, we believe many are already reflected in international equity markets. Developed market stocks are trading at a 20% discount to the U.S., while emerging-market equities are at a 29% discount². Lower valuations, along with fundamental help from still-stimulative global central bank policies and less mature economic and profit cycles, make international equity investments attractive, in our view.

Kate Warne, PhD, CFA - Investment Strategist
Nela Richardson, PhD - Investment Strategist
Craig Fehr, CFA - Investment Strategist

^{Source: 1. Bloomberg, 2. FactSet, forward P/E for the MSCI EAFE, MSCI Emerging Market and S&P 500 indexes.}

The major economic event next week is the Bank of Canada's interest rate decision on Wednesday. While it's a quiet week for economic data, earnings season picks up as companies report third quarter results. In the U.S., there are a number of key data releases including PMI indicators and GDP numbers on Friday.