A Most Volatile Year

What a roller coaster 2018 turned out to be. We predicted volatility, but who could have predicted one of the most volatile years ever in the stock market? There was a definite tug and pull last year that we haven’t seen in the market for some time. With common intraday reversals and markets dropping on good news and rising on bad news, making it difficult to pick a side. Let’s take a look at the year that has passed and discuss why 2018 was so full of ups and downs.

With 2017 ending as one of the calmest years in recent memory, we can take a look at the chart below of the S&P500. You can see there was very little to complain about in 2017 and it seemed like any concern the market came up with, it became a “2018 problem”.

Starting in 2018, the US passed a brand new tax bill to reduce personal taxes and bring tax benefits to American companies. This resulted in the best January since 1997 and a wonderful start to 2018 with the S&P 500 gaining 5.22%. The upward trend of 2017 seemed to continue into the New Year muting talk of any concerns in the global economy.

After that piece of good news, more and more headlines caused the markets to become volatile in 2018. At the end of January, President Trump introduced his first round of trade tariffs, initially just on solar panels, stating that China has been dumping solar panels in the US for years and this is to help the US solar producers. This was quickly followed up by the first round of large tariffs on steel and aluminum imports, while this was directed at China, other countries were caught in the crossfire, mainly Canada. This was quickly followed by an investigation into putting tariffs on $50-$60 billion dollar worth of Chinese goods coming into the United States. Also, the threats to cancel NAFTA if a new deal couldn’t be reached, the S&P500 started its journey of losing all its January gains in February and March 2018. As an added bonus, the US Federal Reserve increased rates (as planned), and put more fear into the markets.

In those two months, all of a sudden we had an imminent withdraw from NAFTA, a global trade war, and more interest increases than investor would have liked.

The events we highlighted at the beginning of the year, were now staring directly at investors faces and everyone began to fear the worst. China had responded with tariffs of their own in April and everyone began to wonder how long this could go on. The coming months gave a little relief, on many of these issues.

1. NAFTA – while there was a lot of back and forth all three sides (US, Canada, and Mexico), they were meeting periodically to work out a new deal. With pressure being put on by the US to get it done sooner rather than later. Once Mexico and the US agreed on terms, it took a few more months for Canada and the US to reach terms with each other. This gave a little relief to the market over the summer months and while a deal was reached early, it was eventually signed in on November 30th, 2018 as expected.
2. US/Europe trade – In the first barrage of trade wars, President Trump announced new tariffs on European items such as German cars. They responded with tariffs on US items such as blue jeans and Harley Davidson motorcycles. This was quickly put to bed as the sides negotiated and the EU even agreed to increase their order of soybeans which was a headline item, as it was a large export to China, which China had tariffed a few months before.
3. US/China trade – While getting off to a rampant start, the US and China began talking about a resolution. With Chinese officials agreeing to reduce the trade deficit with America and committed to “purchasing a significant” amount of US goods. Treasury Secretary even announced that “We are putting the trade war on hold” in May. This gave everyone hope the trade war would not happen or appeared a solution could be found in the future.
4. Interest rates – The US Federal Reserve continued to raise rates, but this was justified as all the major issues were being worked out and the underlying economy continued to show strength.

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During these events, there were also a few political issues that arose.

1. Canada and Saudi Arabia – Many Canadian civil rights activists were arrested in Saudi Arabia for protesting women’s rights, resulting in imprisonment. Canada condemned the arrests and Saudi Arabia quickly retaliated with a harsh reaction. Demanding Saudi patients be transferred out of Canadians hospitals, pulling Saudi scholarship programs in Canada, temporarily suspending trade between the countries and demanding pension funds to dump all Canadian assets at whatever the cost. Prime Minister Trudeau stood behind the comments and refused to apologize for the comments. Personally we are not big Trudeau supporters here, but we do appreciate him standing up for this cause, even when no allies publically defended him.
2. Mueller Investigations – These investigations have been ongoing since 2016 and began to bear fruit in 2018. It included the issues of the Stormy Daniels accusations, collusion with Russia, the Trump family, misappropriation of campaign funds, his lawyer Michael Cohen, friend Paul Manafort, etc. While his allies were being given jail time (Michael Cohen and Paul Manafort), Trump went through the summer unscathed and while the headlines were bad, no charges have been laid.
3. Jamal Khashoggi killing – While they claimed Canada’s claims were unjustified, it does appear they have a few snakes in their closet. 11 Saudis are being put on trial for the killing after he was last seen in the Saudi Consulate in Istanbul. The crown claimed they knew nothing of the attack which claimed Mr. Khashoggi’s life. However, many top CEOs pulled out of their most recent conference “Davos in the desert” held in Saudi Arabia, which included the CEOs of JPM Morgan, Blackrock, Ford, Mastercard, Google, HSBC, Credit Suisse, the list goes on. Shortly after Saudi Arabia signed a $110 billion dollar weapons agreement with the United States to mend some disagreements.

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In the spring and summer tempers calmed down and some of the issues appeared to be resolved. Companies were declaring these as “temporary” issues and would not be making any rash decisions until an outcome was determined. The social and political issues were being pushed aside as the major economic fundamental issues were being taken care of. This resulted in a further climb in the stock market.

Until this point, 2018 has been an interesting year, so let’s recap. It had a great start to the year with tax breaks for US companies, giving them the ability to increase employee salaries, new capital expenditures and share buybacks, all of which are great for the company’s stock price and the overall market. By the end of September, the S&P 500 is up 8.99%.

The start of the most recent volatility began on September 17th, as the US announced 10% tariff on $200 billion of Chinese goods to begin on September 24th, this was accompanied by an increase to 25% if a resolution could not be met. After negotiations fell through, tariff mania hits all news outlets and is a mainstay discussion point. China retaliates with additional tariffs as both sides stand firm. Still in effect, are the steel and aluminum tariffs from prior in the year! Slowly each side begins to attack the other, China increasing tariffs on imported cars, US arresting the CFO and daughter of Chinese phone maker Huawei, China approving the decision to ban previous models of the iPhone made by Apple, the US and other countries issue a joint statement condemning the intelligence theft of the Chinese government. This continues to escalate over the final three months as companies begin to announce that a prolonged trade war will begin to hurt their bottom line. Economists begin to talk about global growth falling from 2.5-3% to a 2.0%-2.5% range instead. With a potential of an economic slowdown, the price of oil fell from its great ascent, crashing down to 2017 levels.

Previously, increasing rates were still suitable as the economic growth supported it. With these increased tensions and a potentially slower-growing economy, they become a very sensitive topic. The US Federal Reserve continued to raise rates in December, making it four rate hikes for the year (expected). Without the current trade war, this really would not have been much of an issue, but considering a potential slowdown for global companies, increasing rates once again becomes an issue. There is also an additional effect, as raising rates also increase the value of the US dollar. This hurts US business as their products are more expensive, while this should help Canada’s exports, it hurts Canada’s oil producers as all domestic oil is priced in US dollars.

The resulting drop in oil price has hurt the Canadian market once again, as oil is a great source of revenue for us. Canada, in turn, has announced a new budget plan to reduce Canadian corporate taxes over the next 5 years and committed $1.6 billion for the oil industry. This should soften some of the blow of dropping oil prices, and hopefully, help businesses operate more efficiently in order to stay globally competitive.

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This resulted in the worst December since 1920 and the worst month since the fall of Lehman brothers in 2008.

That was 2018 in a nutshell and now it is time to look forward and determine what 2019 will bring and what new issues we will have to overcome.

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We have a few predictions for the New Year

1. ‍‍Volatility is here to stay. Since 2008 there really has not been much volatility, as there really was not a more attractive place to be than the market due to low-interest rates. Over the last 10 years, savings accounts were only paying 1% while bonds were paying 1-3% as interest rates remained very low. The only place that offered a decent return were equities, as you could receive a higher dividend from companies than a bond and as long as you were receiving that dividend, there was not a reason to look elsewhere. Now with higher interest rates and savings accounts returning 2-3% and bonds returning 2-4%, investors can choose between keeping their money in the market or pulling it out and getting a slightly higher risk-free return.
2. Trade tensions will continue. With two very strong-headed individuals at the helm, it would be difficult to say that either side will back down easily, as there are many issues to work out. We may get a resolution in pieces throughout the year.
3. The world will not fall apart. The World Bank stated that global growth was 3.1% for both 2018 and 2019 and is expected to slow to 2.9% by 2020. While growth appears to be slowing this most likely is not the end of the world.
4. Commodity prices will rise. Given our current state, we are poised to see a rally in commodity prices. With a strong US dollar, low current prices, increased interest rates, etc. the stage has been set for an increase in commodities come 2019. This could be good for gold and oil especially, which would be positive for the Canadian market.

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Potential market problems in the New Year

1. ‍‍A long-drawn-out trade war. This is probably the largest problem out there, a long term trade war will continue to hurt the company’s bottom line and force them to raise prices which in turn will hurt consumers. This is not an ideal scenario for the US (70% consumer-driven), China (moving towards a consumer-driven economy) or any developed nation. While this would temporarily hurt the economy, inflation would rise and cause the US Federal Reserve to raise rates to maintain pace, obviously not an ideal scenario.
2. US Federal Reserve raising rates too quickly. As stated above with a slowing economy, if rates rise too quickly it can bring many economies to a crawl. Higher rates deter businesses from borrowing, reduce profits in companies, also reducing business activity. The consumer would also feel the stress, as this would raise the cost of loans and mortgages at a faster rate than their wages are growing. This is not an ideal scenario.
3. Continued political instability. Instability is never good, whether it’s removing bonehead presidents or leaders making outrageous claims. Instability causes fear in investors, hopefully, 2019 will bring more stability than 2018 brought us.
4. Debt problems. While this has not been brought up as an issue and maybe it is not a 2019 problem, as we move forward this could develop. Governments, companies, and consumers have all been taking advantage of low-cost debt. Increasing rates will raise the cost of this debt making it less affordable to these debtors. Many developed nations are extremely high in debt and will need growth in their economies to support debt payments. This also applies to individuals as their mortgage interest rates increase, they will need their income to increase in line with their mortgage payments to afford their current debt loads, which are at their highest point in history in Canada.

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Potential catalyst to bring the market higher

1. ‍‍A solution to the trade war. This will be the largest catalyst for the market. Finding a solution that will reduce or eliminate tariffs around the world would significantly help companies reduce the extra interest cost brought on by increased rates. Also, it would open up new markets for companies around the world which will increase global GDP. This would also help the consumer, without tariffs they would not see as much inflation in the products they consume and therefore could handle higher interest rate costs.
2. Better market awareness around interest rate increases. Increasing rates are not a bad thing as long as the economy can support it. With an ongoing trade war, we can see the effects of increasing rates and bond selling, which isn’t pretty. The federal reverse does need to be more aware of the current state of the economy and potential risk in the future around increasing rates. Generally, they use data as it comes in, which is 1-2 months behind the current times. We would like them to be more aware of current events and be slightly forward-looking.
3. Political Stability. This is probably a long shot, but getting some political stability from our leaders (not just Trump, but Xi, Putin, Trudeau, May, etc.) would help tremendously in calming investor’s nerves.
4. Employment. This is one of the main drivers of almost every economy, and continued growth in these metrics would show there is still room for the market to continue to go higher. Mainly, we would love to see wage growth, which would give more disposable income to consumers.

In summary, 2018 was a bad year for many fundamental reasons. Trade wars and interest rates are not just bad headlines, but actually reduce the profits of companies and in term hurt consumers. These issues are real and justify a global slowdown, but a slowdown is not the end of the world. It is just growth at a slower rate with smaller profits and less disposable income. Although this does not cause a recession, it makes the market more susceptible to a recession as there is less room for mistakes. Combine this with instability from our leaders, it gives investors a bad feeling that anything can go wrong at any second. The good news is these issues are “not financial crisis” type issues, like the tech bubble in 2001 which could not be fixed with intervention or 2008 financial crisis where trillions were lost by selling worthless securities and an over-inflated housing market. The trade war can be ended tomorrow and immediately reduce that cost to consumers and boost company profits. Interest rates can be reduced or held flat to give relief. There are reasons to be positive about 2019, Happy New Year and thank you for investing with us!

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Sincerely,

Konrad, Justin, and Merriel

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Content Sources: Bloomberg, Trading Economics, Yahoo Finance, Reuters.

Disclaimer: This newsletter is solely the work of Konrad Kopacz and Justin Lim for the private information of their clients. Although the author is a registered Investment Advisor with Echelon Wealth Partners Inc. (“Echelon”) this is not an official publication of Echelon, and the author is not an Echelon research analyst. The views (including any recommendations) expressed in this newsletter are those of the author alone, and they have not been approved by, and are not necessarily those of, Echelon.

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