Report Highlights Global Macroeconomic Outlook Portfolio Strategy Global Equities Global Fixed Income... 6

Transcription

1 : Q4 2018

2 Contents Report Highlights... 3 Global Macroeconomic Outlook... 4 Portfolio Strategy... 5 Global Equities... 6 Global Fixed Income... 6 Macro Technical Outlook... 7 Disclaimers... 8 Q

3 Report Highlights < Global Macroeconomic Outlook: While global economic growth remains solid, we are mindful of potential headwinds that could dampen growth next year. Chief among these are the U.S.-China trade dispute, monetary policy tightening by the world s major central banks, and European political risks. < Portfolio Strategy: Our tactical asset allocation model includes overweight exposure to equities and underweight exposure to fixed income relative to our long-term strategic asset allocation model. Tactically, we also recommend a small allocation to alternative assets, exposure we believe will prove beneficial as financial market volatility picks up. We intend to maintain our asset allocation recommendations so long as our recession probability indicator remains at or around current low levels. On account of heightened global macroeconomic and geopolitical risks, we continue to stress the importance of diversification across asset classes and geographies. < Global Equities: Our preference for U.S. equities is supported by strong U.S. corporate earnings growth, which has been driven by tax cuts, deregulation, and healthy consumer spending. We believe Canadian equity market prospects improved after Canada signed a new trade agreement with the U.S. and Mexico. Political uncertainties in Europe and a lack of significant growth catalysts in Japan could hinder equity market performance in these two regions. < Global Fixed Income: We expect bond yields to continue rising alongside monetary policy normalization in major developed markets. Our portfolios include short-tenured, floating rate securities that benefit from rising interest rates. Within credit markets, we continue to prefer investment grade over high yield debt, and we expect credit fundamentals to remain strong for the foreseeable future. < Macro Technical Outlook: Technically, the best-case scenario for 2019 equity markets is a repeat of 2018, although recent declines could improve return prospects. The dominant technical risks to positive equity index performance in 2019 remain prevailing bull trends in the U.S. dollar and global bond yields. Q

4 Global Macroeconomic Outlook Global economic growth remains robust, but various headwinds could temper growth next year. We expect growth rates to moderate given the maturity of the business cycle, tighter monetary policy among the world s major central banks, and ongoing trade tensions - particularly between China and the United States. European political uncertainties (Brexit, Italian budget woes) and the adverse effect of U.S. dollar strength on emerging markets may also weigh. The course of the U.S.-China trade dispute is likely to be a key determinant of global economic growth next year. A prolonged trade war between the world's two largest economies (combined, they account for roughly 34% of global GDP) could drive higher input costs for producers, higher prices for consumers and more frequent bouts of financial market volatility. In our estimation, current and potential U.S. tariffs on Chinese imports could trim U.S. GDP growth by as much as 1.5% if fully implemented. However, we do not believe the U.S. will impose tariffs on a final ~US$267bn worth of Chinese imports because doing so could significantly depress U.S. consumption and investment activity. For an example of a constructive conclusion to a trade dispute, investors need look no further than the United States-Mexico-Canada Agreement (USMCA), the renegotiated trade pact among the three countries. The updated agreement includes new rules of origin for automobile content, greater access to Canadian dairy, poultry, and egg markets for U.S. farmers, and better protection for intellectual property. However, execution risks remain given the agreement needs to be ratified by the new U.S. Congress. Even so, we believe the agreement improves Canada s economic prospects. In 2019, we expect the Canadian economy will be characterized by steady real GDP growth, slightly lower unemployment, higher inflation and tighter monetary policy. We expect the Canadian housing market to cool further and Canadian heavy oil to continue trading at a wider than normal discount to the West Texas Intermediate crude oil price benchmark. However, we see neither of these factors derailing the country s current economic expansion. With respect to monetary policy, both the U.S. Federal Reserve and the Bank of Canada raised policy interest rates this fall and signaled to financial markets that future rate hikes might come at a faster pace than previously expected. The European Central Bank (ECB) is planning to wrap up its asset purchase program at the end of 2018 and intends to keep its policy interest rates unchanged until at least the summer of 2019 (Exhibit 1). The Bank of Japan (BoJ) has slowed the Exhibit 1: Central banks target inflation through policy changes INFLATION POLICY RATE IMPLIED POLICY CHANGE TARGET ACTUAL 2YR EST. ACTUAL 1 YEAR 2 YEAR Sources: Bloomberg, Scotia Wealth Management Q

5 pace of its asset purchases, but we expect the bank to maintain relatively easy monetary policy and its yield curve control practices. Japan's GDP growth remains low, and inflation is below the BoJ's 2% target. Idiosyncratic risks exist across emerging market (EM) economies, though contagion has been limited thus far. Financial crises in Argentina and Turkey earlier this year were met, respectively, with an emergency International Monetary Fund financing package and a dramatic policy interest rate increase by Turkey s central bank. The People's Bank of China (PBoC) has responded to U.S. trade tariffs and a slowing economy with looser monetary policy, while Chinese fiscal authorities have ramped up infrastructure spending and cut taxes. In Europe, the heightened possibility of a "hard- Brexit" is weighing on economic data and growth prospects. Both sides remain at the negotiating table, yet issues such as the border between Ireland and Northern Ireland and future relations between the European Union (EU) and the United Kingdom remain unresolved. Brexit will occur on March 29 th, 2019, irrespective of the existence of a formal exit agreement. Italy, Europe's fourth-largest economy, is at odds with the European Commission. The new populist government's proposed budget has breached EU fiscal rules and would likely add to the country s rising level of public debt, already the third-highest (relative to GDP) among developed economies. Portfolio Strategy Our tactical asset allocation model continues to call for overweight exposure to equities and underweight exposure to fixed income relative to our strategic asset allocation model. Consistent with late-stage business cycle dynamics, we expect bouts of financial market volatility to occur more frequently over the coming year. Accordingly, we recommend exposure to alternative assets, which typically exhibit low correlation to traditional asset classes (such as bonds and equities) and can help investors reduce portfolio volatility, improve portfolio diversification, and enhance risk-adjusted return potential. We intend to maintain our asset allocation recommendations so long as our recession probability indicator remains at or around current low levels (Exhibit 2). On account of heightened global macroeconomic and geopolitical risks, we continue to stress the importance of diversification across asset classes Exhibit 2: Low likelihood of U.S. recession until % 80% 70% 60% 50% 40% 30% 20% 10% % Sources: Bloomberg, Scotia Wealth Management Q

6 and geographies. At present, we favour developed market (DM) over EM exposure owing to EM countries relatively higher indebtedness and the debt servicing challenge this could present in a rising interest rate environment. EM economies are also susceptible to capital flight in view of the strong U.S. dollar. We prefer to gain EM exposure through well-capitalized multinationals domiciled in advanced economies. Nevertheless, we acknowledge the uniqueness of emerging markets and would consider opportunistically capitalizing on potential weakness in specific regions. Global Equities We continue to suggest investors focus on companies with sustainable competitive advantages and low levels of debt that generate substantial free cash flow. Our preference for U.S. equities is supported by strong U.S. corporate earnings growth, which has been driven by tax cuts, deregulation, and healthy consumer spending. In Canada, we believe equity market prospects improved after the country signed onto the USMCA. Forecasts for U.S. and Canadian equity indices imply 2019 YOY earnings growth in the upper-single-digit to low-teens percentage range, supportive of equity market returns of a similar magnitude presuming valuations remain fair. We believe political uncertainties in Europe and a lack of significant growth catalysts in Japan could hinder equity market returns in these two regions. Global Fixed Income We expect bond yields will continue to move higher in the coming months alongside monetary policy normalization in major developed economies. We expect short-term bond yields, which are relatively more sensitive to central bank policy rates, to rise faster than long-term yields, which are relatively more sensitive to long-term inflation expectations. Our portfolios positions in short-tenured, floating rate securities should benefit from this trend Should our recession probability model start to indicate increased risk of a U.S. recession and, accordingly, the end of the current policy rate-hiking cycle - we would consider extending the duration of our portfolios. Within credit markets, we continue to prefer higher quality investment grade credits and expect default rates to remain low in the near future as corporate credit fundamentals remain strong. Corporate issuers were able to take advantage of easy money conditions over the past decade and have been able to borrow heavily irrespective of credit rating, eroding the corporate universe s credit quality (Exhibit 3). Exhibit 3: Leverage metrics for BBB-rated corporate credits have deteriorated Debt to EBITDA (LHS) FOCF = Free Operating Cash Flow Sources: S&P Capital IQ, Scotia Wealth Management FOCF to Debt (RHS) Looking ahead, as monetary conditions tighten and interest rates rise, we expect financial markets to more acutely discriminate between high and low quality corporate credits. Increased financial market volatility could make it more difficult for companies with weaker credit profiles to refinance maturing debt, leading to an uptick in default rates. Recent volatility has led to weakness across the credit spectrum, with high yield debt suffering the most Q

7 due to its relatively low liquidity. Despite the selloff, we find the valuations of such high yield credits unappealing and continue to prefer the more liquid bonds of investment grade issuers. Our preference for U.S. securities extends to the fixed income arena. Interest rate hikes by the Federal Reserve have driven potential risk-adjusted returns in the U.S. to levels above those in other jurisdictions. This has prompted capital flows away from those regions (notably EM) and toward the United States. Macro Technical Outlook North American stock indices encountered multidecade resistance projections in 2018, and the result has been a significant uptick in volatility compared with past occurrences. The implication for 2019, particularly given this technical structure aligns with late-stage business cycle characteristics, is that a repeat of the 2018 market environment is liable to be a best-case scenario. That said, index declines late in 2018 have set the stage for a potential recovery to existing highs that, when combined with even modest extensions in resistance, could imply 2019 returns equivalent to long-term averages. The dominant external technical risks to positive equity index performance in 2019 remain the prevailing bull trends in the U.S. Dollar Index (DXY) and U.S. and global bond yields. Emerging markets are particularly vulnerable, and this is visible in the chart of the ishares MSCI Emerging Markets ETF (EEM-US). It is also visible in the chart of the ishares JP Morgan USD Emerging Markets Bond ETF (EMB-US), which is slowly encroaching on significant support levels otherwise intact since the beginning of central bank quantitative easing in 2009/2010. Q

8 Disclaimers This material does not include or constitute an investment recommendation, and is not intended to take into account the particular investment objectives, financial conditions, or needs of individual clients. Before acting on this material, you should consider whether it is suitable for your particular circumstances and talk to your investment advisor. The author(s) of the report and the supervisors of the may own securities of the companies included herein. Scotia Capital Inc. is what is referred to as an integrated investment firm since we provide a broad range of corporate finance, investment banking, institutional trading and retail client services and products. As a result we recognize that there are inherent conflicts of interest in our business since we often represent both sides to a transaction, namely the buyer and the seller. While we have policies and procedures in place to manage these conflicts, we also disclose certain conflicts to you so that you are aware of them. Please note that we may have, from time to time, relationships with the companies that are discussed in this report. The prepared this report by analyzing information from various sources. Information obtained in the preparation of this report may have been obtained from the Equity Research and Fixed Income Research departments of the Global Banking and Markets division of Scotiabank. Information may be also obtained from the Foreign Exchange Research and Scotia Economics departments within Scotiabank. In addition to information obtained from members of the Scotiabank group, information may be obtained from the following third party sources: Standard & Poor s, Morningstar, Bloomberg, Credit Suisse AG, Macrobond and FactSet. The information and opinions contained in this report have been compiled or arrived at from sources believed reliable but no representation or warranty, express or implied, is made as to their accuracy or completeness. While the information provided is believed to be accurate and reliable, neither Scotia Capital Inc., which includes the Global Portfolio Advisory Group, nor any of its affiliates makes any representations or warranties, express or implied, as to the accuracy or completeness of such information. Neither Scotia Capital Inc. nor its affiliates accepts any liability whatsoever for any direct or consequential loss arising from any use of this report or its contents. This report is provided to you for informational purposes only. This report is not intended to provide personal investment advice and it does not take into account the specific investment objectives, financial situation or particular needs of any specific person. Investors should seek advice regarding the appropriateness of investing in financial instruments and implementing investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Nothing contained in this report is or should be relied upon as a promise or representation as to the future. The pro forma and estimated financial information contained in this report, if any, is based on certain assumptions and analysis of information available at the time that this information was prepared, which assumptions and analysis may or may not be correct. There is no representation, warranty or other assurance that any projections contained in this report will be realized. Opinions, estimates and projections contained herein are those of the as of the date hereof and are subject to change without notice. For that reason, it cannot be guaranteed by The Bank of Nova Scotia or any of its subsidiaries, including Scotia Capital Inc. This report is not, and is not to be construed as: (i) an offer to sell or solicitation of an offer to buy securities and/or commodity futures contracts; (ii) an offer to transact business in any jurisdiction; or (iii) investment advice to any party. Products and services described herein are only available where they can be lawfully provided. Scotia Capital Inc. and its affiliates and/or their respective officers, directors or employees may from time to time acquire, hold or sell securities and/or commodities and/or commodity futures contracts mentioned herein as principal or agent. Sharpe Ratio is the measure of risk-adjusted return of a financial portfolio. A portfolio with a higher Sharpe Ratio is considered superior relative to its peers. Standard Deviation is a statistical measurement calculated to indicate the extent of deviation for a group as a whole. The greater the standard deviation of an investment, the greater the investment may range in price. Trademarks are the property of their respective owners. Copyright 2018 Scotia Capital Inc. All rights reserved. Q

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