Global stocks turned in a strong performance in the front half of 2017 despite geopolitical and monetary policy risks. The question, of course, is whether this performance trend can continue in the second half. I believe these two risks will cast an even longer shadow over markets going forward – making concepts such as diversification and risk management even more important for investors’ portfolios.
The first half in review
Canadian stocks, as represented by the S&P TSX Composite Index, underperformed U.S. stocks, as represented by the S&P 500 Index, and international stocks in general, as represented by the MSCI EAFE Index. The yield on the 10-year Canadian government bond moved lower for much of the first half of the year and then rose significantly near the end of the period, similar to the yield behaviour of the 10-year U.S. Treasury bond, the 10-year U.K. gilt and the 10-year German bund.1
Looking ahead: Seeing the world in 3D
As I look to the back half of the year, there are three themes that I believe remain critical for the economy and markets:
- Demographics. Developed markets are aging and emerging markets have younger populations. This has important implications for economic growth as well as debt levels for governments and individuals
- Deceleration. We are seeing the potential for a deceleration in economic growth in Canada. Most indicators suggest the economy is growing nicely. However, storm clouds have formed that increased the downside risks to this base case
- Disruption. I believe that there is growing potential of disruption impacting markets – specifically two key areas: geopolitical risk and monetary policy risk
Canada has experienced solid economic growth in the first half of 2017, helped by strong consumption and residential investment. However, Canada’s economy is facing several different headwinds. One threat is the housing situation in key regions. Vancouver’s housing market may have stabilized following last year’s tariff on non-resident buyers, but we are unlikely to see significant improvement in the near term given greater regulation around mortgage financing. In addition, price growth in the larger Toronto housing market slowing after the introduction of recent regulations, primarily the 15% Non-Resident Speculation Tax (NRST), and will likely take months to stabilize. This will have a negative impact on the residential investment component of GDP growth, but may also affect household borrowing and spending behaviour.
Another threat is the potential for protectionism – a threat deemed significant enough for the Bank of Canada (BoC) to include a special section on it in its April 2017 Monetary Policy Report. As the BoC aptly pointed out, “An increase in protectionist policies could, depending on their degree and extent, have a significant impact on the Canadian and global economies.” Depending upon the types of protectionist policies, lower income Canadians could be hit the hardest, which could negatively affect key areas of the economy, such as retail spending. In fact, some economists have argued that the global trend towards protectionism in the 1930s may have helped create – or exacerbate – the Great Depression. We will be following developments in both these areas closely.
Finally, the Canadian economy could also be negatively impacted if the BoC moves “ahead of the curve” and goes too far in tightening monetary policy in the near term. It could be a policy error – and create another headwind – to prematurely raise rates at a time when the economy is facing other threats from within and outside Canada.
There is certainly a risk of geopolitical disruption in the U.S. On November 9, 2016, America woke to the surprising reality that, after years of government gridlock, the legislative and executive branches would be led by the same party – one with a very pro-growth agenda. The stock market rallied dramatically in the ensuing months, helped by an improvement in earnings but largely buoyed by optimism regarding the positive economic potential that President Donald Trump’s agenda could have, particularly from tax reform and infrastructure spending.
However, despite the fact that Republicans control the House, the Senate and the White House, this agenda has not yet come to fruition – and, in my estimation, it may never meet initial expectations. One problem is prioritization: Congress has become mired in the massive effort to repeal and replace the Affordable Care Act (ACA), which had been placed first on the agenda. That has set back the timeline for other items on the agenda, particularly tax reform.
More specifically, both the breadth and timing of tax reform are at risk. Recent intel suggests the House will require a revenue-neutral tax reform bill, which could dramatically limit its potential to stimulate the economy because it would require additional taxes or government spending cuts in order to pay for the tax cuts generated. This would likely result in no material cuts in income taxes – with whispers that some in the White House are actually proposing an increase on the highest income tax bracket. We also may not see the sweeping corporate tax reform that arguably is largely priced into the U.S. stock market already.
It is worth noting that every day that the passage of tax reform is delayed in the U.S. is a day that companies may forego significant spending decisions – such as capital expenditures (capex) and hiring – because they are waiting to see what is contained in the tax legislation. Inaction can be dangerous, given that there has historically been a close inverse relationship between economic policy uncertainty and business investment spending. And this slows down the rest of the queue, including any kind of infrastructure spending legislation.
In addition, the U.S. has the potential for a debt-ceiling crisis brewing. Treasury Secretary Steven Mnuchin has quietly been beseeching Congress to raise the debt ceiling before leaving for August recess, or else he fears the government could possibly run out of money in September. However, that might be difficult for legislators who are already working on health care legislation – particularly if the debt ceiling issue becomes politicized. If Congress does not raise the debt ceiling in time, the country would face another government shutdown, which could roil markets and significantly impact business and consumer confidence. (It would be the first time since the Carter administration that a government shutdown occurred with the same party in control of both the executive and legislative branches.)
Of course, geopolitical risk extends far beyond the U.S.:
- North Korea’s increasingly aggressive actions are a cause for grave concern, as the U.S., South Korea, Japan and other allies struggle with how to respond and contain this frightening threat
- In the U.K., Prime Minister Theresa May’s insistence on pursuing a “hard Brexit” despite her party failing to gain a majority in the recent parliamentary elections suggests the potential for some disruption, as the U.K. manages a tight timeline and economic pressures
- Russia’s manoeuvres over the last several years – from the annexation of a part of the Ukraine, to questions about its involvement in U.S. elections – are also a cause for concern
- Continued Middle East instability also presents some geopolitical risks
Monetary policy risk
Some major central banks, most notably the European Central Bank (ECB), appear to have signaled a turning point, as indicated by yields moving back up recently. It seems central banks are peaking in terms of monetary policy accommodation and will soon begin to proceed with monetary policy normalization, as the U.S. and Canada have already begun.
However, after such extreme policies as aggressive quantitative easing and negative interest rates, it will be difficult to normalize without potentially triggering some level of disruption. In the U.S., the Fed will soon begin the delicate task of balance sheet normalization while still in the throes of a rate hike cycle. While the Fed’s plans are measured and thoughtful – intended to create the least amount of disruption possible – there are always risks. The Fed therefore needs to be cognizant that its actions could have a serious dampening impact on credit growth. The Fed may find that balance sheet normalization cannot simply happen “in the background” and may instead become “front and centre.” Adding to the risk is that three vacant seats on the Federal Open Market Committee (FOMC) may soon be filled, and there may soon be a new FOMC chair. The new members could potentially hold more hawkish views and may try to move the FOMC to a more aggressive tightening stance.
Against this backdrop of potential risks, we continue to have a very accommodative monetary policy environment, albeit slightly less accommodative, and solid global economic growth prospects. I expect global growth to increase modestly, driven by strength in many emerging-markets countries and helped by improved economic growth in Europe. My base case scenario is that the Canadian economy will continue to experience solid economic growth, although risks to that scenario are increasing.
In terms of earnings growth, it is solid and improving in most major markets. This environment should be supportive for global stocks. The Canadian stock market is more attractively valued than that of the U.S.1, but there is still downside potential given the risks to Canadian economic growth. In this environment, investors could benefit from selectivity in their exposure to Canadian and U.S. equities – as well as broad diversification across asset classes and regions.
Takeaways for investors
At Invesco, we believe the greatest opportunity for clients to achieve their investment objectives is by using a well-constructed portfolio combining active, passive and alternative strategies allocated to meet their unique needs. Given all of the above, I believe portfolio-construction efforts should focus on seeking a balance between growth potential and downside protection. This means being sensitive to stock valuations, ensuring wide-ranging diversification and focusing on income.
In its broadest sense, diversification means exposure to a wide variety of asset classes that have historically had lower correlations to each other:
- For many investors, this could mean adding real estate, commodities and alternative strategies (such as long-short and market neutral strategies) to their portfolios
- Investors should also talk to their advisors about their ideal allocation to international equities, including both developed- and emerging-market stocks, as many may be underexposed to securities outside the U.S.
- Diversification can also include an allocation to stocks with lower valuations. That can be achieved through an actively managed or factor-based value strategy – or both
- Investors may also need to “think outside the box” to garner adequate income from their portfolio. That could mean the inclusion of dividend strategies, municipal bonds, convertible bonds, bank loans and “core plus” strategies that supplement investment grade bonds with other bond opportunities
Given that macro forces are likely to continue to dominate markets in the back half of the year, we could see rotations in leadership among asset classes and factors and sectors. Investors who seek to take advantage of this type of environment might consider an actively managed tactical asset allocation or factor strategy that has the flexibility to search out the best opportunities across these areas.
For investors with a long-term time horizon, fundamentals will matter. As Benjamin Graham said, in the short run the stock market is a voting machine but in the long run, it is a weighing machine. In other words, short-term market movements can be based on popularity, but longer-term trends have more to do with the actual value of a company. I believe it is important for investors to maintain adequate exposure to assets with growth potential, but they should do so with prudence, emphasizing diversification and income.