December 218 Highlights After a promising rebound in November, global equity markets fell back early in December. The outlook for earnings growth remains uncertain. The good news is that at the G2 meeting in Argentina December 1, the U.S. and China agreed to a trade truce. The bad news is that 9 days is an extremely short time to negotiate a new trade agreement between two superpowers. Despite a fairly benign economic outlook in the U.S., equities continue to tread water at this writing. What gives? Markets were taken aback by the inversion in December of the 2-to-5-year portion of the U.S. yield curve, a first since 26. Historically this is a signal of economic slowdown or contraction in the subsequent 12 to 18 months. False alarms of recession have happened but in these cases, the curve righted itself after a Fed rate cut. So we cannot exclude a turnaround by Mr. Powell in the coming months, or at the very least a much more dovish tone. At this writing the S&P/TSX is down more than 8% from the beginning of 218. As long as Energy (18% of the index) and Banks (23%) continue to struggle, the Canadian benchmark will remain challenged. On the energy front, the spread between WTI and WCS has narrowed quite significantly in recent weeks with the end of temporary shutdowns at key U.S. refineries and the announced production cuts ordered by the Alberta There may still be light at the end of the tunnel. Our asset allocation is unchanged this month. We prefer at this point to remain cautious in the run-up to the December FOMC meeting. We would be ready to redeploy more of our excess cash position if the Fed would first set the stage for U.S. dollar depreciation and a steeper yield curve by turning more dovish. Our sector allocation is also unchanged this month with a bias towards resources. Stéfane Marion stefane.marion@nbc.ca Matthieu Arseneau matthieu.arseneau@nbc.ca
Truce or dare? After a promising rebound in November, global equity markets fell back in December (chart). The outlook for earnings growth remains uncertain. The good news is that at the G2 meeting in Argentina December 1, the U.S. and China agreed to a trade truce. Also, the White House has appointed Robert Lighthizer, the man who recently negotiated a new trade deal between the U.S., Canada and Mexico, as head of the U.S. trade delegation. The Middle Kingdom finally has a credible vis-à-vis to deal with. The bad news is that 9 days is an extremely short time to negotiate a new trade agreement between two superpowers. The current game of truce or dare between the world s two largest economies, coming at a time when global growth is decelerating, is likely to keep markets on edge for the foreseeable future. World: December relapse MSCI AC as of Dec. 8, 218 64 62 Index 6 58 56 54 52 5 48 An equity market on edge, however, is not necessarily a bear market. At this juncture we take comfort from markets in Emerging Asia, still trading 5% above their recent lows (chart). 46 44 42 4 214 215 216 217 218 219 Unsurprisingly, financial markets have reacted negatively to this development. A 9-day deadline to avoid the introduction of additional tariffs on U.S. and Chinese products does little to improve the visibility of corporate earnings in 219. As the chart below shows, global forward earnings are being revised down for the first time since 214. World: Negative revisions to earnings 12-month forward EPS for the MSCI AC 38 EPS 36 34 32 3 28 Ditto for base metal prices, an all-important gauge of global economic momentum (chart). The continued resilience of the CRB base metals index is consistent with our forecast of a 3.5% expansion of global GDP in 219 (more details in our Monthly Economic Monitor). 26 24 22 2 18 16 26 27 28 29 21 211 212 213 214 215 216 217 218 219 2
World: Perspective on commodity prices CRB metals vs. Brent 1,4 index 1,3 1,2 1,1 1, 9 8 7 6 5 4 3 2 1 USD/barrel 26 27 28 29 21 211 212 213 214 215 216 217 218 219 CRB metals (left) Brent (right) 15 14 13 12 11 1 9 8 7 6 5 4 3 2 S&P 5 composite index: Price Performance Month to date Quarter to date Year to date S&P 5-4.6-9.6-1.5 UTILITIES 1.3 6.4 6.4 REAL ESTATE.3 3.8 2.7 CONS. STAP. -3.1.7-4.9 ENERGY -3.1-16. -11.6 TELECOM -4.1-1.5-13.5 CONS. DISC. -4.2-12.9 4.1 HEALTH CARE -4.6-5. 9.4 IT -5.1-14.6 2.1 MATERIALS -5.2-1.9-14.7 INDUSTRIALS -6.3-13.6-1.7 FINANCIALS -7.1-9.3-1.5 12/7/218 NBF Economics and Strategy (data via Datastream) U.S.: Yield curve inversion The U.S. economy continued to expand at a more-thandecent pace in the final quarter of 218. At least that s the message of purchasing-manager indexes well above 5 and employment reports showing continued gains in cyclical sectors such as manufacturing and construction, as well as record temporary employment. Looking ahead to Q1, the leading economic indicator, despite some loss of momentum, remains consistent with continued expansion. U.S.: Outlook still positive Six-month change in the leading economic indicator Markets were taken aback by the inversion in December of the 2-to-5-year portion of the U.S. yield curve, a first since 26. Historically this is a signal of economic slowdown or contraction in the subsequent 12 to 18 months. False alarms of recession have happened before (arrows in chart below), for example in 1995, in 1998 (Asian crisis) and in 1967 (when we use the 1-year/3-month differential because the 2-year Treasury was not available at the time). In these three cases, the curve righted itself after a Fed rate cut. So we cannot exclude a turnaround by Mr. Powell in the coming months, or at the very least a much more dovish tone. 9 8 % (annualized) U.S.: Perspective on yield curve inversions Yield on 1-year note minus 3-month vs. 5-year minus 2-year treasury yield 7 6 6 % 5 5 4 4 3 3 2 1-year minus 3-month 2 1 1-1 21 211 212 213 214 215 216 217 218-1 -2-3 5-year minus 2-year Despite this fairly benign outlook, U.S. equities continue to tread water at this writing. Only a few defensive sectors (Utilities, Staples) are showing gains (table). What gives? -4 1965 197 1975 198 1985 199 1995 2 25 21 215 22 We say this because the yield curve has suddenly become very flat for this point in the cycle. So much so that in the past month the chances of a U.S. recession over the next 12 to 18 months have surged to a cyclical high of 27% (chart). Where we go from here is no longer as dependent on White House trade rhetoric (though calmer talk on that front would certainly help). We also need the Fed to act. 3
U.S.: Recession probability on the rise Probability of recession based on the slope of the yield curve (1 year yield 3 month yield) S&P 5 : change in 12-month forward earnings 1 % 9 8 7 6 5 4 3 2 1 1965 197 1975 198 1985 199 1995 2 25 21 215 NBF Economics and Strategy (data via Refinitiv and Fred of St-Louis) 27% 3-month change 3-month change 1 year historical average NBF Economics and Strategy (data via Datastream) 1-month change 1-month change 1 year historical average 1-month diffusion (% up) 1 month diffusion 1 year historical average S&P 5 -.8-1.4 -.7 -.4 46% 48% ENERGY 1.5-5.5-3.9-1.9 28% 41% MATERIALS -3.6-3.1-1.1 -.9 38% 44% INDUSTRIALS -1.9-1.4 -.4 -.4 48% 47% CONS. DISC. -.8-1.4 -.3 -.4 47% 49% CONS. STAP. -1.3 -.9 -.3 -.3 35% 47% HEALTH CARE.3 -.2.1. 45% 52% FINANCIALS. -2.2.1 -.6 5% 47% IT -1.3.2-1.4.1 52% 53% TELECOM -2.7-1.5 -.6 -.4 38% 38% UTILITIES.6 -.6.2 -.2 59% 46% REAL ESTATE -2.9 NA. NA 5% NA 12/7/218 Canada: Light at the end of the tunnel? At this writing the S&P/TSX is down more than 8% from the beginning of 218. As long as Energy (18% of the index) and Banks (23%) continue to struggle, the Canadian benchmark will remain challenged. U.S. dollar strength, wider corporate bond spreads and ebbing momentum in emerging economies continue to weigh on profit expectations. U.S.: High-yield corporate spreads Option adjusted spreads On the energy front, the spread between WTI and WCS has narrowed quite significantly in recent weeks with the end of temporary shutdowns at key U.S. refineries and the announced production cuts ordered by the Alberta government (chart). These developments, together with recently announced OPEC production cuts and a more dovish Fed, could go far to stabilize the price of Canadian oil. There may still be light at the end of the tunnel. Canada: Better spreads WTI-WSC spreads: USD per barrels -5 USD -1-15 2,2 Basis points -2 2, 1,8 1,6 High Yield Total High Yield Energy -25-3 1,4-35 1,2-4 1, -45 8-5 6 4-55 28 29 21 211 212 213 214 215 216 217 218 219 2 2 22 24 26 28 21 212 214 216 218 NBF Economics and Strategy (Source ICE BofAML Bond Indices) 218-12-7 High Yield Non distressed As the table below shows, analysts continue to revise down the earnings outlooks of most industries. These projections need to stabilize if investor confidence is to improve. But what about the banks? In Q3 of this year their earnings per share rose to a new all-time high (chart). For 219, the bottom-up consensus of equity analysts projects EPS growth of 5.9%, the weakest since 215-16 when oil prices were collapsing and the Bank of Canada was cutting interest rates (table). So the consensus call for 219 is quite conservative given the strength of the labour market and the continued 4
4%-plus growth of labour income in the three most populous provinces. Canada: Perspective on labour income Wages and salaries growth, Q3 218 vs. Q3 217 7 %y/y Canada: Record earnings for banks Earnings per share, S&P/TSX Banks 32 EPS 3 28 26 6 5 4 3 2 5.6 4.9 4.2 4.2 4. 4. 2.9 2.9 2.7 1.9 24 22 1.6 2-1 -.6 18 16 14 12 27 28 29 21 211 212 213 214 215 216 217 218 219 S&P/TSX composite index: EPS Performance 217 218 219 22 12 months forward S&P TSX 3. 12.9 12.3 12.1 12. ENERGY 444.2 29.4 31. 15.5 3.9 MATERIALS 66.4.1 16.4 21.5 15. INDUSTRIALS 16.2 1.8 17.5 17. 17. CONS. DISC. 15. 15.1 1.4 1.5 1.9 CONS. STAP. 11.9 1.3 9.3 12.1 1.6 HEALTH CARE -3.2-27.3 73.2 15.4 32.3 FINANCIALS 15.4 12.5 5.9 8.9 6.1 BANKS 1.4 12.2 5.9 6.8 6. IT 12.4 17.3 13.5 13.7 13.4 TELECOM 5.9 7.4 7.4 7.5 7.4 UTILITIES -8.6 8.5 16.2 9.2 16.7 REAL ESTATE 21.4 14.3-11. 7.7-9.2 12/7/218-2 BC ON US NB QC CA NS MB PEI AB SK NFL NBF Economics and Strategy (data via Statistics Canada 36-1-25-1 and U.S. BEA) Asset allocation Our asset allocation is unchanged this month. The recent inversion of the 2-to-5-year portion of the U.S. Treasury yield curve has come much sooner than we expected. As noted in our Fixed Income Monitor, this signal may be less ominous than might appear at first sight. Still, we prefer at this point to remain cautious in the run-up to the December FOMC meeting. We would be ready to redeploy more of our excess cash position if the Fed would first set the stage for U.S. dollar depreciation and a steeper yield curve by turning more dovish. Sector rotation Our sector allocation is unchanged this month with a bias towards resources. Our conviction, though somewhat diminished, remains that long-term interest rates will rise and the yield curve steepen with a rise in inflation expectations. 5
NBF Asset Allocation Benchmark (%) NBF Recommendation (%) Equities Canadian Equities 2 24 U.S. Equities 2 16 Foreign Equities (EAFE) 5 8 Emerging markets 5 6 Fixed Income 45 39 Cash 5 7 Total 1 1 NBF Economics and Strategy NBF Market Forecast Change (pp) NBF Market Forecast Canada United States Actual Q4219(Est.) Actual Q4219(Est.) Index Level Dec-7-18 Target Index Level Dec-7-18 Target S&P/TSX 14,795 16,6 S&P 5 2,633 2,97 Assumptions Q4219(Est.) Assumptions Q4219(Est.) Level: Earnings * 147 11 Level: Earnings * 16 173 Dividend 486 511 Dividend 54 58 PE Trailing (implied) 14.1 15.1 PE Trailing (implied) 16.4 17.2 Q4219(Est.) Q4219(Est.) 1-year Bond Yield 2.7 2.95 1-year Bond Yield 2.85 3.48 * Before extraordinary items, source Thomson * S&P operating earnings, bottom up. NBF Economics and Strategy 6
NBF Fundamental Sector Rotation - December 218 Name (Sector/Industry) Recommendation S&P/TSX weight Energy Overweight 18.% Energy Equipment & Services Overweight.5% Oil, Gas & Consumable Fuels Overweight 17.5% Materials Overweight 1.8% Chemicals Market Weight 2.3% Containers & Packaging Market Weight.5% Metals & Mining * Overweight 2.5% Gold Overweight 5.% Paper & Forest Products Market Weight.5% Industrials Underweight 1.9% Capital Goods Market Weight 2.1% Commercial & Professional Services Underweight 2.6% Transportation Underweight 6.2% Consumer Discretionary Underweight 4.2% Automobiles & Components Underweight 1.1% Consumer Durables & Apparel Overweight.8% Consumer Services Underweight 1.3% Retailing Underweight 1.% Consumer Staples Overweight 3.9% Food & Staples Retailing Overweight 3.1% Food, Beverage & Tobacco Overweight.8% Health Care Underweight 1.6% Health Care Equipment & Services Underweight.2% Pharmaceuticals, Biotechnology & Life Sciences Underweight 1.4% Financials Market Weight 33.1% Banks Market Weight 23.6% Diversified Financials Market Weight 3.4% Insurance Market Weight 6.2% Information Technology Underweight 4.% Software & Services Underweight 3.9% Technology Hardware & Equipment Underweight.1% Telecommunication Services Market Weight 6.% Utilities Market Weight 4.2% Real Estate Market Weight 3.3% * Metals & Mining excluding the Gold Sub-Industry for the recommendation. 7
Economics and Strategy Montreal Office Toronto Office 514-879-2529 416-869-8598 Stéfane Marion Matthieu Arseneau Warren Lovely Chief Economist and Strategist Deputy Chief Economist MD & Head of Public Sector Strategy stefane.marion@nbc.ca matthieu.arseneau@nbc.ca warren.lovely@nbc.ca Krishen Rangasamy Paul-André Pinsonnault Marc Pinsonneault Senior Economist Senior Fixed Income Economist Senior Economist krishen.rangasamy@nbc.ca paulandre.pinsonnault@nbc.ca marc.pinsonneault@nbc.ca Kyle Dahms Jocelyn Paquet Angelo Katsoras Economist Economist Geopolitical Analyst kyle.dahms@nbc.ca jocelyn.paquet@nbc.ca angelo.katsoras@nbc.ca General This Report was prepared by National Bank Financial, Inc. (NBF), (a Canadian investment dealer, member of IIROC), an indirect wholly owned subsidiary of National Bank of Canada. National Bank of Canada is a public company listed on the Toronto Stock Exchange. 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