Global markets surged in October setting a series of records throughout the month. For many investors, the question now is whether the current valuations are stretched or if there is still room to go. While there is no shortage of black swan events that could derail the current rally (i.e. North Korea and Washington), market fundamentals support the current valuations.
*Equity Indices - FTSE Global Indices in CAD, Bonds - Barclays Global Aggregate Canadian Float Adjusted Bond Index
We’ll take a closer look at the current conditions that corroborate bond and equity valuations today.
At the start of 2017, the Bank of Canada had indicated that there would be a gradual increase to the overnight rate over the course of the next few years. However, after a few strong months of data, it appeared there was a risk of the market overheating, and the bank quickly raised interest rates in two successive months, catching many off guard.
In October, the Bank changed course again, dialing back the aggressive strategy, citing several factors as potential headwinds to Canada’s growth. The first was the effect the surprise rate increases had on the Canadian dollar, causing it to rise relative to other currencies and hurting exports. In addition, NAFTA discussions have stirred uncertainty with the US threatening to disband the free trade pact. Canadian consumer debt levels are also near all-time highs (see chart below), and with a significant portion of that debt in variable rates, Canadian consumers are at risk of default with each uptick in the overnight rate.
Canadian Debt to Disposable Income
While global markets are still quite hot, and even picking up steam in some regions, there is likely enough of a downside effect of a rate increase to keep Canadian bonds in check for the time being.
Developed economies have had strong results and emerging economies are continuing to expand. Q2 results showed that all 45 OECD economies had positive growth, with Japan showing the strongest growth among the G7 countries. In addition, Eurozone GDP had its best quarter in six years.
The US economy grew at an annualized rate at or above 3% over the past two quarters, and US manufacturing was at its second highest level in 30 years. While the hurricanes and fires in the US should dial back strong US quarterly GDP numbers, corporate earnings have kept the world’s largest economy moving forward.
As mentioned previously, the Canadian economy does face some headwinds, but a stronger global economy and a stronger US dollar will also provide the tailwinds to support growth in the Canadian equity market.
The Road Ahead
Despite the strong economic fundamentals, it is unlikely that the global market will continue to accelerate at the pace it has this past month. There are some catalysts that could push the economy even further ahead like the proposed tax changes in the US, but it’s likely that US rates will increase in step to cap any excessive runaway in growth. In fact, more hikes from the US Fed are expected with the upcoming changing of the guard, as the current Chair, Janet Yellen’s term ends in February of 2018.
The road ahead further stresses the importance of keeping a well-diversified portfolio. Although the summer of 2017 saw odd correlation of asset classes, we would expect the behaviour of bonds and equities to normalize and provide an environment where relative portfolio risk can be lowered by balancing their respective weights with target objectives.