In June we carried the outlook forward from May with Growth in the first half of the twelve-month time horizon heading toward Inflation in the back half.
World trade weakened slightly in Q1 2018 to 4.4% compared to 4.7% in 2017¹. The global economy was handed a curve ball in May as the U.S. unilaterally and simultaneously confirmed tariffs on China, Europe, Canada and Mexico including $50 billion on Chinese imports and new duties on foreign steel and aluminum across all countries who import to the United States. IMF Director Christine Lagarde announced that a trade war would lead to “losers on both sides”. This comes as the IMF also announced their forecast of U.S. growth declining in 2022 as the initial boost of tax cuts is offset by the drag of the greater debt burden associated with lower tax revenues².
U.S. tariffs have prompted Europe, Mexico, Canada and China to introduce or announce plans retaliatory for counter-measures. Due to China’s pivotal role in the global supply chain, a fall in Chinese exports related to the U.S. trade conflict could inflict collateral damage on other economies and thus enhance macroeconomic risk.
The eurozone had been identified as the stand-out performer going into 2018 as eurozone data was consistently above expectations at the start of the year but it has surprised to the downside in recent months. The European Central Bank and Bank of Japan are both still engaged in quantitative easing (QE), although Europe is expected to wind down its QE program by the end of the year.
U.S. GDP growth is expected to rebound in Q2 2018 following growth of 2.3% in Q1. The fiscal stimulus (tax cuts and increased spending) extends the duration of the U.S. cycle. The Federal Reserve is still on course to raise interest rates four times this year. With the budget deficit expected to rise in coming years, passing $1 trillion in 2020, according to Congressional Budget Office estimates, the government has been issuing debt heavily³. The total for 2018 has been $443.7 billion, a nearly nine-fold increase from the same period a year ago, according to the Securities Industry and Financial Markets Association.
We are watching the recent trend of foreign governments that have pulled back their purchases of longer-term U.S. debt as trade tensions have escalated. Foreigners held $6.17 trillion of the total $14.84 trillion of Treasury debt outstanding through April. China, the largest owner of U.S. debt, reduced its level in April by $5.8 billion to $1.18 trillion, while Japan, the second largest, cut its holdings by $12.3 billion to $1.03 trillion. Ireland, the U.K. and Switzerland also pulled back. When counting all securities (including T-bills), the April decline came to $47.6 billion, a 0.8% reduction from March⁴.
The month of May provided strong returns for US equities, with the S&P 500 gaining 2.4%, and S&P MidCap 400 and S&P SmallCap 600 gaining 4.1% and 6.5%, respectively. Canadian equities did well, with the S&P/TSX Composite up 3.1%.
The S&P Europe 350 ended the month down 1.2% after a strong start due to a more co-operative tone between the U.S. and China, and indications that Italy would finally have a government. A re-emergence of trade tensions and an increase in Italian and Spanish political risk later in the month weighed on the European equity benchmark. Emerging and frontier markets posted losses, with the S&P Emerging BMI and S&P Frontier BMI down 3.5% and 7.5%, respectively. Performance influences include the dollar’s strong performance. Performance in U.S. fixed income was mostly positive with S&P Municipal Bond High Yield Index leading the pack with a gain of 1.7%.
As we are cautious of the direction that a trade war is taking the U.S. economy and the ripple effect to trading partners, we made a major shift in asset allocation away from Canada, Europe and the Pacific Region and into short-term U.S. bonds across all models. We allocated equal amounts to Municipal Bonds, the 3-7 year U.S. Treasuries and U.S. Small Caps in the Tactical Conservative and Tactical Moderate Growth Models. We allocated proportionally more of the 3-7 year U.S. Treasuries in Tactical Growth and Tactical Aggressive Growth Models.
We continue to monitor the data for growth signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.
Deborah Frame, President and CIO
¹ World Trade Organization. 2018 Press Release: Strong trade growth in 2018 rests on policy choices. April 12, 2018.
² IMF. World Economic Outlook Update, January 2018: Brighter Prospects, Optimistic Markets, Challenges Ahead.
³ Congressional Budget Office. The Budget and Economic Outlook: 2018 to 2028. April 2018.
⁴ CNBC. Russia cuts Treasury holdings in half as foreigners start losing appetite for US debt. June 18, 2018.
Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Europe, Fixed Income. May 31, 2018. Index performance is based on total returns and expressed in the local currency of the index. European regional index returns are expressed in Euros.