Going forward, risks are slowly rising

Date postedFeb 13, 2018

At the start of the year, the stock market was very strong as corporate earnings were revised upward on the back of the approval of US tax cuts. Global trade improvements and more synchronized global expansion from Europe and Asia furthered the positive trend. 

Going forward, risks are slowly rising, but not enough to cause an extended bear market:

  1. Rising bond yields for G7 countries – Positive US employment and wage price reports could rekindle inflation pressures in the US, which would push up long-term bond yields. Global yields have been extremely low but if the European Central Bank also signals that their economy can withstand a return to “normal” rates, then the highly accommodative monetary policy that the world has experienced since 2009 will soon conclude. We believe it will take at least 1-2 years for bond yields to reach a level that could choke out economic growth, but we are monitoring. 
  2. Protectionism – The escalation in trade tariffs between the US and China are immaterial in the total scheme of things, as the combined economies are $30 trillion. The risk is that these Trump-style negotiating tactics will escalate into an actual trade war and NO ONE WINS in a trade war. Tariffs are a form of tax that directly burden both countries by adding costs to production, increasing bureaucracy and preventing effective long-term investment by corporations, all of which result in lost jobs and productivity. The initial aggressive negotiating tactics now need to be played out. This also occurred with NAFTA negotiations which Trump denounced as “the worst trade agreement in history,” but progress is now being made. Trump is likely motivated by upcoming mid-term elections, so his actions are hopefully temporary. We believe that cooler heads will prevail in trade negotiations as the basic economics does not add up.
  3. Unstable USD – The USD has declined by 10% versus a global basket of currencies this past year. This has been absorbed by the global economies. However, a precipitous drop in the USD would create imbalances and uncertainty in global economies. 

We believe none of these risks are at the point of destabilizing the global economy or materially affecting corporate earnings. Non-US economies are now strong enough to withstand a moderately lower USD as the increased cost of exports can be absorbed by productivity gains and domestic growth. The exception to this outlook is Canada as it is reliant upon a weak CAD to restructure and deleverage its economy.  

Current market valuations are supported by stable US economic growth that is expected to increase from 2.3% in 2017 to over 3% in 2018 spurred higher by the recent tax changes, fiscal stimulus, stable oil prices and a weaker USD. This comes with rising US government deficits which will eventually have a crowding-out effect on the economy. In the meantime, US business investment and housing continues to look positive. 

Importantly, earning forecasts project growth of 18.3% and revenue growth of 6.7% for 2018, plus continued higher growth for 2019 (FactSet). The potential for rising interest rates brings a higher risk premium so market growth will be more moderate than we experienced in the 2nd half of 2016 and 2017 but still positive.

Canada’s stock market appears fairly-valued but the fundamentals are not as attractive as elsewhere due to slower expected growth. Canada is highly sensitive to rising interest rates due to high household debt and stretched home valuations. The Canadian equities we hold have a large foreign revenue component, so they are less dependent on the Canadian economy.

Europe is in its 6th year of economic recovery and is following a path similar to the US of improving job growth with housing and consumer spending supported by highly accommodative monetary policy. Japanese corporate earnings and revenues are improving with the increase in global trade, while Abenomics is helping to reflate their economy. Chinese infrastructure, manufacturing and housing sectors are slowing but overall economic growth is holding steady at above 6%. Synchronized global growth and a relatively stable Chinese economy bodes well for emerging markets, which will also be aided by a weaker USD.

The US Fed intends to stick to its gradual hiking path for interest rates and reducing its reserves as the US economy is strong enough to withstand a “normal” central bank rate. This could be in the 3.25% range; currently it sits at 1.5%. Other major central banks are expected to start following the US Fed by next year, namely the European Central Bank but for all the right reasons, namely a strong economy and employment situation. 

We remain fully invested as we expect that the fear of trade wars will turn into a more constructive negotiation process. The markets should then refocus on the fundamentals which are still positive on many fronts, with no real recessionary risks in sight. 

Kinsted Wealth