BMO Private Investment Counsel Inc.

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1 Market Commentary Goldilocks Meets the Three Bears If you want your children to be intelligent, read them fairy tales. If you want them to be more intelligent, read them more fairy tales." Albert Einstein T he children s story about Goldilocks and the three bears has frequently been used as a metaphor to describe the economy. We have been enjoying an economic backdrop that is just right neither too hot nor too cold. Moderate growth, high employment and low inflation are in balance. Investors have profited from this economic stability, which fuelled equity markets and supported bonds. Fairy-tale Goldilocks enjoys a nice nap after eating a bowl of porridge, only to be frightened awake by three bears. In our economic story, the three bears are trade policy, inflation, and bad news from the technology sector. Our three bears showed up at various points over Q1. They created increased global volatility in stock, bond and currency markets. Negative headlines made markets gyrate, then recover when cooler heads prevailed. United States Don t Wake the Sleeping Bear U.S. equity prices fell after President Donald Trump proposed $60 billion in tariffs on Chinese imports as a way to address a trade imbalance of $375 billion. At one point stocks retreated by almost 5% because markets feared that China would retaliate. Trade tensions escalated when China fired back with a list of U.S. products it would tax in return. This is an overriding concern for U.S. companies that rely on China as an export market. Stocks staged a recovery after the two countries began trade negotiations. Although the U.S. has stood on its own in taking aim at certain sectors and countries, it has found some common ground with its allies regarding how the World Trade Organization (WTO) should function to benefit its members. Renewed discussions around the WTO rules could, in fact, improve the economic outlook for many major economies.

2 Major events in the technology sector caused a reversal of fortune for some market darlings, collectively known as FAANG stocks (Facebook, Apple, Amazon, Netflix and Google). Facebook shares posted large declines of almost 20% of its market value, or $80 billion in market capitalization, following news that a firm tied to President Trump s election campaign used unauthorized data from millions of Facebook profiles. Then Mr. Trump took aim at Amazon through his regular Twitter feed, attacking the online retail giant for not paying its fair share in taxes while putting American retailers out of business. Trump tweets spooked markets once again. Inflation remains a concern for U.S. stocks and bonds. In January, markets reacted negatively to a jobs report that indicated wage inflation was rising. But markets swiftly reversed course when new data revealed that inflation was under control. February s jobs report led to a recovery in stock prices. It showed the strongest jobs growth in nearly two years, along with only a moderate increase in average hourly earnings. Concerns surfaced again in February, however, as inflation made its biggest surge of the last year. Although inflation remains below the Fed s 2% target rate, market onlookers are still concerned that the central bank will need to move more quickly to contain inflation. They worry it will need to increase short-term interest rates at a faster pace than originally expected. In March, new Federal Reserve Chair Jerome Powell announced a benchmark rate increase of 25 basis points that had been widely anticipated. It now stands at 1.75%, the highest level since 2008, but still low by historical standards. Policymakers also maintained the outlook for a total of three rate hikes this year, easing fears that they would hike four times. In the news conference following the March meeting, Fed officials provided a hawkish commentary. They believe that unemployment will continue to drop well below 4% in 2018, a level not seen since the 1960s, and this very low jobless rate will nudge inflation higher. Rising rates will also lead to higher borrowing rates for businesses and consumers, which could curb economic growth. Canada Blowing Hot and Cold We can blame the trade policy bear for negative performance in Canadian markets. A poor showing in Canada s energy sector also contributed to a market downturn. South of the border a tech sell-off didn t damage Canadian stock benchmarks because they don t have major exposure to that sector. Thus, Canadian equities actually started to outperform global markets in the most recent sell-off. Although oil prices have been firm, our energy sector has suffered from a lack of available pipeline capacity, which prevented Canadian companies from exporting their oil. The inflation bear could become a problem in Canada since we have a tight labour market. In a break from recent trends, Statistics Canada s latest labour force survey indicated job creation had slowed. Even so, our national unemployment rate sank to 5.8%, matching the lowest level since Statistics Canada started measuring in Wages showed continued firmness, rising 3.1% year over year. Page 2

3 Despite this upward pressure, the Bank of Canada (BoC) appears to have backed off from its monetary policy tightening stance of just two months ago. It held benchmark rates steady at its most recent meeting in March. In a speech at Queen s University, BoC Governor Stephen Poloz said our economy has untapped potential and room to grow before inflation becomes a problem. He estimated an additional 500,000 workers are available to join Canada s labour market, a sign that unemployment can continue to decline without sparking higher inflation. Ongoing anxiety over NAFTA s future is another reason for caution. Although Canada received a Trump reprieve on proposed steel and aluminum tariffs, he tied it to continued NAFTA talks. Canadians whose livelihood depends on these manufacturing sectors took minimal comfort from his words. On the bright side, it seemed to indicate a significant pivot away from targeting Canada since this news was followed by tariff announcements aimed at China. Given that Canada and the U.S. have a roughly balanced trade relationship, by rights we should be of secondary concern to our big neighbour. Europe and the U.K. Grin and Bear It Recent data suggest eurozone GDP growth may have peaked. February s Purchasing Managers Index (PMI) fell to a three-month low. A weak showing in this measure is significant since it tracks future intentions for business spending. Soft expectations for exports seemed to be causing a slump, likely due to a stronger euro that makes European goods more expensive in other countries. Domestic demand seems robust as the job boom is still going strong. Loose monetary policy will help maintain this strength. Brexit s divorce deal passed a key hurdle in March. The European Commission signed off on a transition agreement that will last for 21 months after Britain formally exits the European Union. Companies in the U.K. and EU will have temporary continued access to each other s markets. Although regional news was a mix of positive and negative, European equities sold off as did other equities globally. China Goldilocks and the Pandas Accused of intellectual property theft and blamed for most of the U.S. trade imbalance, China was a direct target of a series of proposed U.S. tariffs. In late March, President Trump announced new tariffs on $60 billion on Chinese goods, with potentially many more to come. According to a recent report by Capital Economics, China s total exports to the U.S. in 2017 were $506 billion, representing 2.5% of China s GDP. It was thus not shocking that Chinese stocks retreated on this news and delivered negative returns for March. Although Beijing quickly retaliated with $3 billion in additional penalties on U.S. imports, from China s perspective it s better to avoid a trade war Page 3

4 entirely. Time will tell how much real action China is willing to take to address President Trump s concerns. Japan Bears on the Doorstep Surprisingly, Japan was left off the list of countries exempt from President Trump s tariffs on steel and aluminum imports. This unexpected turn of events likely contributed to poor performance from Japanese stocks. Japan suffered one of the worst performing equity markets through Q1 of The Japanese yen extended its gains against the greenback since it is traditionally viewed as a safe-haven currency. The yen s appreciation, combined with trade frictions, raised concerns about downside effects on Japan s export-reliant economy. A strengthening yen won t help Japan achieve its 2% inflation target either an appreciating currency makes a country s imports cheaper, therefore putting downward pressure on inflation. Our Strategy This quarter, we saw three bears attack equity prices. Even so, conditions that provide a positive fundamental backdrop still prevail. Yes, interest rates have risen steadily since January in anticipation of a future uptick in inflation. Yet, we see no substantial evidence that inflation is threatening to surpass 2%, an ideal number set by the world s major central banks. Employment growth also remains healthy in the key developed economies, creating a nice tailwind for consumer spending. Businesses are also well supported by policies such as tax reform and increased fiscal spending in major economies, providing a boost to corporate earnings. Markets react to headlines in the short term, but as long as these trends continue, equities will perform better than bonds. The Last Word While economic growth is providing a positive backdrop, restrictive trade policies and rising interest rates in the world s largest economy represent a potential threat. We can t be sure how the three bears (trade, inflation and industry-specific risks) will impact our story. We ll just have to wait for the next chapter to unfold. Information contained in this publication is based on sources such as issuer reports, statistical services and industry communications, which we believe are reliable but are not represented as accurate or complete. Opinions expressed in this publication are current opinions only and are subject to change. accepts no liability whatsoever for any loss arising from any use of this commentary or its contents. The information, opinions, estimates, projections and other materials contained herein are not to be construed as an offer to sell, a solicitation for or an offer to buy, any products or services referenced herein (including, without limitation, any commodities, securities or other financial instruments), nor shall such information, opinions, estimates, projections and other materials be considered as investment advice, tax advice, a recommendation to enter into any transaction or an assurance or guarantee as to the expected results of any transaction. You should not act or rely on the information contained in this publication without seeking the advice of an appropriate Page 4

5 professional advisor. BMO (M-bar roundel symbol), BMO Private Banking registered trademarks, and BMO Wealth Management trademark are owned by Bank of Montreal, used under licence. BMO Wealth Management is a brand name that refers to Bank of Montreal and certain of its affiliates in providing wealth management products and services. BMO Private Banking is part of BMO Wealth Management and is a brand name under which banking services are offered through Bank of Montreal, investment management services are offered through, a wholly-owned indirect subsidiary of Bank of Montreal, and estate, trust, planning and custodial services are offered through BMO Trust Company, a wholly-owned subsidiary of Bank of Montreal. Page 5