Capital Markets – Three Quarters in Review

December 2019

Capital markets in 2019 have continued to move forward but not without periods of volatility as geopolitical factors weighed on global economies. Some of the volatility no doubt reflects the ongoing concerns for the longevity of not just the bull market in equities but also in bonds. Defying conventional thinking, and despite their extraordinarily low levels, global interest rates at various periods throughout the year did decline resulting in bond returns that over the past one year have rivaled the returns from equity markets – a phenomenon that rarely happens but which reflects the extraordinary period for capital market returns since the Great Financial Crisis in 2008.

First Quarter: January – March 2019

Following on the heels of a volatile (and negative) fourth quarter of 2018, capital markets roared back in the first quarter of 2019. Markets were buoyed by a combination of the easing of monetary policy by the US Federal Reserve (an easing which was echoed in Canada by the Bank of Canada) and by constructive discussions between the US and China on trade. As a result, for the first three months, the Canadian equity market (S&P/TSX Composite) was up 13.3% while the US market (S&P500) in Canadian dollars was up a more modest 11.2% (13.6% in USD). In both markets, the returns in the first quarter effectively nullified the negative returns of the previous quarter.

Fixed income markets in Canada continued to experience modest positive returns in the first quarter. Going into 2019 there was much concern that the yield curve on the short end was inverting (meaning that short-term interest rates were higher than the rest of the yield curve). An inverted curve is often considered a harbinger of a forthcoming recession (historically 9 – 24 months after inversion). However while there was inversion at the short end, the yield curve also steepened in the middle. This dichotomy is reflected in the returns for the two fixed income indices – the FTSE TMX Canada Short Term Bond index was up 1.7% for the three months, while the FTSE TMX Canada Universe Bond index was up a more robust 3.9%.

Second Quarter: April – June 2019

Equity markets started strong in April 2019, took a breather in May and came roaring back in June. As the quarter closed out, expectations that the US Federal Reserve would lower interest rates (which did occur in late July) fueled equity markets at the same time as causing corporate spreads to tighten.

For the quarter, the S&P/TSX provided investors with a return of 2.6% while the S&P 500 in $CAD returned 2.0% (versus 4.3% in USD). International markets were also strong with the MSCI World Index returning 4% in USD versus 1.7% in CAD. The strengthening of the Canadian dollar against the USD over the quarter caused the erosion of USD returns when translated into Canadian dollars.

Bond markets were also positive for the quarter. Bond yields fell once again with long bonds falling the most relative to shorter maturities. The fall in yields coupled with tighter corporate spreads resulted in the FTSE Canada Universe returning a healthy 2.5% for the quarter – virtually matching the return of the Canadian equity market! The FTSE Canada Short Term Overall Bond Index offered a more modest return of 0.9% reflecting the more subdued decline in yields at the short end of the yield curve.

Third Quarter: July – September 2019

Capital markets were relatively quiet in the third quarter. Bond markets were effectively flat while the equity markets were up modestly, mostly as a result of positive returns in September. The relative quiet belied the underlying geopolitical tone and temperament; at times, the capital markets were whipsawed by global trade “discussions” out of Washington, Brexit “negotiations” by Boris Johnson in the UK, and ongoing tensions in the Middle East, including the recent incursion by Turkey into Syria against the Kurds. Overall, geopolitical tensions continued to weigh on and sometimes dominate the markets. However, in September when it appeared that the trade fight between the US and China was close to ending, “risk on” became the theme for the month, indicating an appetite by investors for riskier assets. And with the more favourable tone, bond yields actually rose late in the month resulting in negative returns for bonds in September.

For the quarter, the S&P/TSX provided investors with a return of 2.5% while the S&P 500 in $CAD returned 3.0% (versus 1.7% in USD). International markets were also strong with the MSCI World Index returning 1.9% in CAD versus 0.5% in USD. The Canadian dollar, like most global currencies, depreciated against the USD over the quarter accounting for the stronger returns in $CAD for US and international markets.

For the first nine months of 2019, equity markets shrugged off discussions of global slowdowns, looming recessions and a long in the tooth bull market to produce strong positive returns. Canada, in particular, led the pack with a return of 19.1% for the YTD followed by the U.S. (S&P 500 $CAD) at 16.9% and MSCI World at 14.0%.

Despite the temporary rise in bond yields at the end of September, for the overall quarter bond returns were positive. The FTSE Short Term Overall Bond Index returned a modest 0.3% for the quarter while the FTSE Canada Universe Bond index returned 1.2%. Throughout 2019 the inverted shape of the yield curve in Canada and elsewhere (inversion happens when short rates are higher than longer-term rates) has been a focal point of discussion. The two charts below highlight the current differences between the Canadian yield curve and the US yield curve following the recent cuts in rates by the US Federal Reserve – cuts that were not matched by the Bank of Canada reflecting a stronger Canadian economy.

The Canadian labour market is creating jobs, wages are rising and inflation is on target – providing the Bank the opportunity to maintain a steady hand on rates. It is also worth noting that, unlike in the US, the Governor and the Bank of Canada do not come under overt pressure by politicians. With the rate cuts in the US, the Federal Reserve has limited their ability to use monetary policy in the event of a US recession; Canada on the other hand has left that arrow in the quiver.

The Canadian labour market is creating jobs, wages are rising and inflation is on target – providing the Bank the opportunity to maintain a steady hand on rates. It is also worth noting that, unlike in the US, the Governor and the Bank of Canada do not come under overt pressure by politicians. With the rate cuts in the US, the Federal Reserve has limited their ability to use monetary policy in the event of a US recession; Canada on the other hand has left that arrow in the quiver.

But as we were reminded by the economists at AllianceBernstein in their September Global Macro Outlook, Canada is not isolated from global economic events. So, while economists are generally positive about Canada’s economy and its management by the Bank of Canada, Canada will not be spared in the event of a global downturn. The primary risks to the Canadian economy lie outside the country. Therefore, keeping a few monetary policy arrows in the Bank of Canada’s quiver is beneficial for Canadians.

Conclusion

Overall, 2019 is shaping up to be a strong year for investors. November has continued the trend of positive returns for equity markets in Canada and globally; a decline in yields at the long end of the yield curve is also giving positive momentum to the broad Canadian fixed income market. However, one is reminded that stock markets were roiled in December 2018 by many of the same factors that continue to be problematic today – geopolitical tensions, in particular, continue unabated including the US/China trade war, Brexit and the UK election, populist uprisings in South America, and pro-democracy protests in Hong Kong.

Canada came through the election period relatively unscathed and eyes are on the Bank of Canada to see whether they stay the course on interest rates. As noted above, Canadian is not immune to global events and tensions and consensus seems to be building among economists that the global economy is entering a period of weakness. If that happens, we would look to the Bank of Canada to take advantage of the flexibility it gave itself when it stayed the course on interest rates in the third quarter.