No one wants to be a contrarian just for the sake of being one but right now it might pay to take advantage of the volatility. It feels like everyone involved in capital markets has turned more negative. While the investment outlook does feel a little less certain given the headlines on protectionist trade issues and foreign investment limitations on sensitive US technology that has resulted in a spike in volatility, volatility was at 20-year lows so some level of normalization should probably be expected. In Exhibit 1, we compare volatility as measured by the VIX, commonly referred to as the Fear Index, to high yield credit spreads (the interest rate demanded by investors in high yield bonds over similar maturity investment grade or government bonds).

The first quarter of 2018 seemed to have something for everyone involved in the capital markets. It started with a positive market reaction for the S&P500 in January from the US tax reform plan announced late in the fourth quarter of 2017, which drove some of the largest earnings increases for 2018 ever recorded in any quarter. The outlook for forward earnings growth for 2018 was 12% at December 31st and now sits at a whopping 19%. We then experienced one of the more anticipated market corrections in February, which was triggered by the sharp rise in bond yields resulting from the strong employment and wage data for January. In March we heard from the new Fed Chairman Jerome Powell who, as expected, raised interest rates a quarter of a percentage point marking the sixth rate increase since December 2015.

I can’t help but think back to a phrase I first heard in the early 1990’s, “the Goldilocks economy”, the reference is to the children’s story, The Three Bears. It best describes the current state of the US economy as being not too hot and not too cold or in other words an economy with moderate economic growth and low inflation. So far, it seems like everything is just about right. US GDP has continued to pick up through 2017 with the latest third quarter reading of 3.2% up from 1.2% and 3.1% in the first quarter and second quarters respectively. Inflation has remained in check notwithstanding the latest November reading of headline inflation, which climbed to 2.2% mostly due to rising energy prices. Excluding food and energy, core inflation is running at 1.7% and more importantly, the latest reading for the Federal Reserve’s (Fed) preferred measure of inflation, the Personal Consumption Expenditures (PCE), was only 1.5%, well below the Fed’s notional target of 2%. The other factor the Fed looks at in determining future interest rate policy is employment, which has remained solid so far in 2017 with the November unemployment rate at 4.1%, a 17-year low.

Even though the economies north and south of the border continue to muddle along, some economists are describing the current environment, particularly in the US, as one of the best in a long time. The combination of synchronized global economic growth, low inflation, a reasonably accommodative central bank and rising corporate earnings are quite a powerful combination that could keep this market going for a while yet. The final reading for US second quarter GDP ticked up to 3.1% from 3.0%. This would normally suggest a reasonably strong hand-off for the back half of 2017, although we may see a hit in the third quarter due to missing output caused by hurricanes Irma and Harvey. This may cause a bigger rebound in the fourth quarter as rebuilding and spending on reconstruction takes place.

Last quarter we talked about how soft sentiment data such as the survey of expected business conditions could be a leading indicator of a stronger US economy ahead. However, with US GDP coming in at 1.4% for the first quarter down from 2.1% in the fourth quarter as well as weaker industrial production and retail sales in May, the hard data is mixed at best. Nevertheless, this did not stop the US Federal Reserve (Fed) from increasing the federal funds interest rate again in June for the second time in 2017 citing the continued strengthening of the US labour market and expansion of economic activity including household spending and business fixed investment. It also appears there could be one more rate hike between now and year-end based on the Feds projections from its June meeting. The Fed also announced it will begin unwinding its $4.5 trillion in securities holdings by decreasing the reinvestment of the principal payments it receives from securities held on its balance sheet. Effectively, the Fed will cap (in graduated increments) the amount it will reinvest from maturing securities going forward, which equates to another form of monetary tightening, the exact impact of which is uncertain.

While I have been investing for over 30 years, which I guess still makes me a youngster compared to one other here at Cumberland, I must admit that coming to work has never been more interesting than it is now. While the S&P500 total return index (“S&P500 Index”) being up 11.3% since the election certainly is interesting, in reality it is the US President that is keeping us, and the rest of the world, on our toes.. Even the TSX index has increased 7.3% on a total return basis over the same time period.

During the first quarter of 2017, the S&P500 Index was up 6.1% . Adjusting for currency, the S&P500 Index returned 5.3%, as the Canadian dollar appreciated by about a half of a cent, closing the quarter at US$0.75.

The Trump presidential victory on November 8th, once again, demonstrated that anti-establishment politics appear to be becoming the new normal. The initial reaction, as the election results were being announced, was investor panic. The Dow futures were down 800 points overnight and the S&P500 futures down 5%. However, the S&P500 quickly shifted direction after the President-Elect’s acceptance speech and has generated a total return of 5.0% in US dollar terms from the election-day through to December 31st 2016. The TSX followed suit with a total return of 4.8% over the same period.

Unlike the first quarter of 2016 where we experienced a fairly swift correction on global growth concerns, fear of rising interest rates in the US, falling commodity prices and the second quarter Brexit surprise vote, the third quarter has been relatively quiet from an economic and political standpoint. Perhaps this lull, combined with a relatively benign quarter for earnings, was the right combination that allowed markets to grind higher.

The biggest news development during the quarter came in the final few days – this of course was Britain voting to leave the European Union (Brexit) on June 23rd. The S&P500 lost 133 points or 5.3% in two days, only to recover most of the losses (99 points or 4.9%) by June 30th. We published our thoughts on Brexit in a quick note at that time, but it’s probably worth a recap along with our subsequent thoughts. To simplify, Brexit probably means three things: reduced economic growth in the short term at least for the UK and the EU, greater uncertainty and possibly a stronger US dollar.

The North American equity markets were off to one of the worst starts to the year since 2009. We saw both the TSX and the S&P500 indices decline almost 9% and 11%, respectively, at their low points in January and February of 2016. In Canada, slowing emerging market growth, in particular China, as well as lower oil prices which hit a 13 year low and negative investor sentiment were the main factors driving the TSX Index lower. Oil, which began the year at US $37.04 hit a low in February of US $26 before bouncing back to close at US $38 on March 31st. In January, the Canadian dollar also hit a 13 year low of US $0.685 before recovering to almost US $0.77 by the end of the quarter. The recovery was initially triggered by news that the Bank of Canada (BoC) left its benchmark rate unchanged at its January meeting, rather than making the anticipated cut. In its January statement, the BoC said that inflation in Canada is evolving broadly as expected.