Equity Markets

In a repeat performance from last quarter, investors are accumulating nice gains from their equity investments without having to suffer much in volatility. Over the last few months, most of the morning meetings at Louisbourg have started with a statement suggesting that equity futures were slightly higher. This can continue as long as corporate profits continue to progress alongside equity prices and that the central bank remains gradual in its approach to reducing monetary stimulus. All major equity asset classes performed well in their local currencies. However, a fair amount of the benefit was lost for the US and International investments as the Canadian dollar strengthened.

Canadian equities have climbed 3.7% this quarter after muted progress during the first half of the year. Sector breadth was solid with seven of eleven sectors offering positive returns. As crude oil price recovered from its recent weakness, the always volatile Energy sector was the top performer with a +6.6% return only, thus highlighting the dispersion of the market strength among various sectors. Financials (+4.5%) offered a nice contribution with its significant weight as investors become less fearful of commercial and personal credit in Canada. Consumer Discretionary (+4.7%) was also strong while Health Care (-10.2%) and Consumer Staples (-2.7%) were the weaker sectors within the S&P/TSX Composite.

The S&P 500’s winning streak continues, notching its eighth consecutive quarterly gain, with a +4.5% total return in USD during the third quarter. Once again, a stronger Canadian dollar limited gains for Canadian investors, with the index returning just +0.6% in CAD terms. Despite the typical summer slowdown, the market continued to grind higher with seemingly little drama. Economic indicators remain positive and investors are willing to pay up for growth. These same trends have largely been in place all year. In fact, large cap growth stocks outperformed large cap value stocks a staggering 1,280 bps year-to-date. As we come into the third quarter earnings season, consensus estimates are for 4.2% earnings growth, a slower rate of growth than we saw in the first half of 2017 but still healthy. In terms of sector performance, we saw ten of the eleven sectors post positive results. In rank order, the gainers were Technology (+8.6%), Energy (+6.8%), Telecom (+6.8%), Materials (+6.0%), Financials (+5.2%), Industrials (+4.2%), Health Care (+3.7%), Utilities (+2.9%), Real Estate (+0.9%), and Consumer Discretionary (+0.8%). The lone decliner was Consumer Staples, down 1.3%.

While the gain was more modest than the last couple of quarters given the strength of the Canadian dollar, this was another steady quarter for EAFE equities with a positive 1.5% return in Canadian dollars. We’ve seen continuous improvement with most economic indicators across the Eurozone and Japan and the reflation trade picking up again as data continues to suggest strong demand for the commodities. European countries were once again the leaders this quarter, helped by the Euro currency, which held up well against the Canadian dollar. This is due to the possibility that the ECB could reduce its stimulus measures. France (+4%) and

Germany (+4%) fared the best while the UK (0%) and Switzerland (-1%) lagged with both the British Pound (-1%) and Swiss Franc (-5%) weakening against the Canadian dollar. Currency is also the story for Asia Pacific with both Australia (0%) and Japan (0%) flat in Canadian dollars as their currencies depreciated 2% and 4% respectively. On a sectoral basis, we’ve seen the reflation trade picking up again with more economic sensitive sectors performing well with Energy (9%), Materials (7%), Technology (5%), Consumer Discretionary (3%), and Industrials (2%), all outperforming the benchmark. There was clearly a rotation from more defensive sectors with Consumer Staples (-3%), Health Care (-3%) and Telecommunications (-2%) all lagging the benchmark.

Equities are performing well as major market economies continue to progress nicely. This translates into improving profits at the corporate level. Valuation levels are reasonable and conditions suggest a positive environment for equities. We do remain mindful that while monetary conditions are easy, they are getting less accommodating. This tightening is also happening at a time of unusually low volatility in the equity market. With interest rates moving higher, we are generally positioned lightly in interest sensitive sectors. This is the case across all our equity strategies. We continue to favour equities over bonds in our balanced mandates.

Fixed Income Markets

The Canadian economy delivered exceptional results during the quarter, with economic growth dramatically exceeding expectations. Canadian data released in the third quarter was very strong with above average second quarter GDP growth of 4.5% year over year (3.8% year-over-year growth in July), wage growth of 2 % year over year and a decline in the jobless rate to 6.2%. Inflation pressures continue to remain well under control with August CPI at 1.4% year over year. Economic performance has been led by consumer spending with strong auto sales and durable goods leading the economy. The tightening in labour market conditions and the stabilization in oil prices also contributed to confidence, while at the same time a rise in consumer debt-to-income levels helped finance the increase in expenditures over the period.

The Bank of Canada acknowledged the unexpected surge in growth by implementing two consecutive 25 basis point rate hikes during the quarter, raising the overnight lending rate to 1%. As a result, the Canadian yield curve rose and flattened during the quarter due to the market pricing in further rate hikes. The market is expecting at least one additional rate increase by the end of the year, resulting in at least three or four potential rate hikes this year, which is in sharp contrast to an ultra dovish Bank of Canada that began the year. Higher interest rates, weakening in the housing sector and a return to average consumer spending levels is expected to temper growth in Canada going forward although government and business spending, and strong global growth should help keep performance stable. During the third quarter, the Canadian two-year yield increased 42 basis points to 1.52% while five-year bond yields increased 36 basis points to 1.75%. During the same period, Canadian ten-year bond yields increased 34 basis points to 2.10% while the thirty-year Canada yield increased 33 basis points to 2.47%.

Globally, bond yields remained within a tight range among the G7 countries throughout the quarter with most economies performing better than expected. The US recovery continues to progress although the timing of the Federal Reserve “Dot Plot” was extended slightly. The impact of the hurricanes this quarter should slightly slow US growth in the second half of 2017, although this is regarded as a short term transitory effect. Inflation in the US has remained weak and could allow the US to pause in raising the Fed Funds rate until the December meeting or longer, as policy will be increasingly data dependent going forward.