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Weekly Talking Points

October 12, 2018

Okto-bear-fest

 
Last week’s focus on rising yields and a potential bear market in bonds morphed into an entirely different layer of concern this week. In an eerie echo of February’s swift correction, equities were pummelled by a rapid two-day descent, which hit almost all sectors and almost all major bourses. By Thursday’s close, the S&P 500 found itself down 6.9% from the record high reached a mere three weeks earlier, while the Nasdaq was 9.6% below its late-August peak. Similarly, European markets ended the week down by almost 5%, even with a modest global bounce on Friday, while Asian markets took a bigger haircut—China’s main index fell almost 8%, while the Nikkei sagged 5.3% on the week.
 
Naturally, armchair detectives were out in force after the hit, looking for who/what was responsible for the swift turn of events. The President seemed to have little doubt, railing against the Fed’s tightening campaign over a 24-hour period. Running the gamut of calling the Fed “crazy”, “loco”, “ridiculous”, and “wild”, he also opined that “I think they are making a big mistake”. While far from a helpful intervention into the middle of a market maelstrom, most saw the rants as a continuation of earlier tirades in the summer and a fairly transparent effort to pin the blame elsewhere. Suffice it to say that it’s a minority opinion in the markets that the Fed’s rate hikes qualify as “crazy”—by the standards of any past tightening cycles, this one stands out as particularly leisurely at 200 bps, spread over almost three years and starting at extremely low levels.
 
Still, while we have no quarrel with the Fed’s moves so far, there is little doubt that rising rates are making life less comfortable for markets, in general, and equities, in particular. Recall that one of the smoking guns behind the February correction was also a rapid rise in long-term yields, which saw the 10-year Treasury surge 50 bps in a matter of weeks at the start of the year to nearly 3%. This latest episode saw 10s run more than 40 bps up from their late August lows to a peak on Tuesday of nearly 3.25%.
 
But that primary suspect was already backing away from the crime scene even before stocks began to swoon, as yields dipped back below 3.15% this week on calmer oil prices, a benign U.S. inflation result, and the market turmoil. The September CPI printed just 0.1% on both headline and core, holding the latter steady at a 2.2% y/y pace and trimming the 3- and 6-month trend to just 1.8% annualized. We suspect core inflation will grind higher in the year ahead, but the recent mild results reinforce the view that the Fed will not need to go “wild” (i.e., crank up the pace of rate hikes). Having said that, we remain quite comfortable looking for the Fed to continue bumping up rates by a quarter every quarter until the middle of next year. A flurry of Fed speakers this week cast little doubt on that view, with even the normally dovish Charles Evans chiming in that rates needed to get back to neutral, and soon.
 
The other prime suspect for the market downdraft was the rumbling trade battle with China. Beyond Treasury yields, markets have also been warily eyeing the steady rise in the US$/yuan exchange rate in recent weeks. Matching bonds, it also peaked early this week at just over 6.93/US$, a rise of more than 10% from the lows in April—just as trade hostilities first broke into the open. News late last week that the U.S. bilateral trade deficit hit a new record high of $397 billion in the past 12 months piled on. However, there was a double-dose of late-week relief on this front. Reports of a potential November meeting between Trump and Xi alongside indications that U.S. Treasury staff believe that China is not manipulating the yuan turned down the heat on the conflict, for now.
 
A third factor weighing on markets was a dimming global outlook for 2019 and any potential impact on earnings next year. The IMF’s semi-annual global outlook saw a small trim to both this year’s growth estimate and a shave to next year as well. The latest forecast was, in fact, unsurprising, given the strains in a variety of emerging markets, the weight of trade wars, and less-loose monetary policies globally. In that environment, the surprise would be if global growth did not cool over the next year. Following last year’s synchronized and solid global GDP growth of 3.7%, we now look for 3.6% this year and another small step down to 3.5% in 2019. True, that’s slower—but it’s not slow.
 
Meantime, back at the U.S. economy, a sparse week for data (aside from CPI) left Treasuries largely driven by the air pocket in stocks. We continue to believe that the domestic growth outlook is firm, with Q3 GDP likely to come in at 3% and staying close to that mark over the next two quarters as well. Amid all the market noise, keep in mind that we are looking for U.S. growth of 2.5% next year, inflation of little more than 2%, and a jobless rate of less than 4%; true, some of the cheery news comes courtesy of a budget deficit of almost $1 trillion over the next year, but the overall economic backdrop remains highly favourable.
 
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Proving the old saw that the TSX has never met a crisis it didn’t want to join, Canadian equities were also slammed by the broad-based selling. After dipping 0.8% last week (despite the new USMCA deal), the TSX fell almost 4% in the first three sessions of this holiday-shortened week. A rebound on Friday contained the damage, but still left the index down almost 7% from its summer highs. The Toronto retreat was in spite of the fact that the TSX had never really joined in the tech-led S&P 500 party this year—the TSX is trailing the S&P 500 by 8 percentage points in 2019, and by almost 12 ppts when the currency change is taken into account. Prior to last week, some of the blame for this woeful relative performance was pinned on NAFTA uncertainty. With that handy excuse now eliminated, the focus fell squarely on the energy sector this week. As we detail in this week’s Focus, the latest deep dive in WCS was yet another thorn in Canadian markets this week (and would have been the big story of the week at almost any other time). With a pullback in global prices compounding the sector’s woes, energy stocks fell 5% this week.
 
The collapse in Canadian oil prices even raised some doubts on the upcoming Bank of Canada rate decision. After all, the Bank was actually cutting rates last time WCS approached these levels in 2015. However, it is not just about WCS; WTI also matters for Canadian oil exports (in fact, according to the BoC commodity price index, it matters more than WCS). It also matters how long these low prices are sustained. We still look for the Bank to hike on October 24th, but the subsequent move expected in January may indeed be in doubt if prices stay anywhere close to these levels.
 
 
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Douglas J. Porter, CFA | Chief Economist | Managing Director, Economic Research