Invisor Economic Update Image Jan 2018

Economic Update January 2018: US Equities Are at All-Time Highs – Where Do We Go From Here?

by Josh Miszk Last updated on February 01, 2018 Tags: Market & News Updates

Global equity markets have had a solid start to the year, particularly outside of Canada. Even with the stronger Canadian dollar offsetting some gains, most developed markets still performed very well. Emerging markets have also kept a strong pace as the China’s response to tighter credit quieted doubters as the market has chugged along.

Short term bond yields have followed suit, pricing in moderate expectations of rate hikes, while longer-term rates are suggesting that significant hikes are unlikely.

Index performance graph January 2018*Equity Indices - FTSE Global Indices in CAD, Bonds - Barclays Global Aggregate Canadian Float Adjusted Bond Index

With US equities near all-time highs, global equities surging, and bond traders expecting more growth, many investors are asking where we go from here. We’ll touch on some of the root questions in this month’s outlook.

Are Current Equity Values Supported?

Yes, they are. Despite all the headline risk around the world – international conflict, protectionism, and over-confidence –  from an economic standpoint, the world economy today is driving forward at a solid pace.

Jobs are being created in the US, and tax cuts should stimulate both investment and consumption in the near term. In Europe, manufacturers’ confidence is surging; in China, the economy has forged ahead despite tighter credit conditions. 

Even though America has leaned more towards protectionism, the rest of the world is encouraging trade. The TPP or CPTPP is carrying on despite America’s withdrawal from the pact. China and India are looking to create a free-trade area known as the Association of South-East Asian Nations; Japan and Europe are also in talks to develop a mutual trade agreement. Free trade is a significant driver of global economic growth, and a more connected world is a more stable one.

Are Current Bond Yields Supported?

Yields have been at historic lows since 2009 and have been kept low by the massive expansion of global central bank balances sheets, which flooded bond markets with capital. This “quantitative easing” was used to encourage risk taking and protect the economy from stagnation when expectations of long-term growth were low.

Globally, the trend is ending as central banks scale back their programs, and yields are naturally feeling upward pressure. As we mentioned above, there are many macro-economic forces and domestic policies, like tax reform, that support higher yields. But investor’s trepidation of the uncertainties and the risks of rising yields have kept long-term yields at bay.

The risk with lower long-term rates is that a sharp rise in bond yields would cool the economy faster than expected, and perhaps prompt central banks to step in once more. So, although the current yields are supported, there is a risk long-term interest rates not keeping up with the increase in the short-term rates and encouraging volatility.

What’s Next?

There really is no way to tell what is around the corner. Unpredicted changes happen every day, some good and some bad. But we can still make an educated guess as to how the market may react, fundamentally, if all else is held constant (which it’s not!)

A world with lower bank regulation, lower taxes, and rising confidence is a world where capital moves away from safety and into riskier assets (see chart below).  Considering this trend, central banks are unwinding their easing programs, but are doing so carefully, given the downside effects of being too restrictive. It’s a very delicate balance. 

US Bank Savings Deposits 2008 - 2018

With low long-term bond rates, the chief risk today seems to be on the side of growth outpacing the offsetting effect of rising yields, resulting in a situation where inflation gets out of hand. 

Two likely outcomes are that growth will slow and the bond market had it right; or growth will increase, and with it, inflation, drawing volatility in bond yields and then weaker growth in equities. Either way, the likelihood that equity valuations continue to grow at the current breakneck pace is low. 

In a market that reacts to future expectations, corrections are inevitable. When and how they happen is hardly ever predictable with the information available at the time. The proven strategy time and time again is not to try and predict the future, but to create a portfolio that’s built to handle corrections. Simple guiding rules – like a having diversified portfolio that rebalances during pricing swings – often prove to be successful if we stick to the plan and stay invested. Keep your eye on the horizon and control what you can.

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