Star Wars Market Commentary 2017 and 2018 outlook.

“The force is strong with this one.”

Darth Vader, A New Hope

In recognition of the 40th anniversary of the launch of the Star Wars film franchise, and release of the latest Star Wars movie (The Last Jedi), let’s take a look at the forces that pushed markets higher this year. Several major developed and emerging markets surged more than 20% in 2017 – breaking records along the way.

Just like the plot of a Star Wars film, the market began the year mired in conflict. Would newly elected President Donald Trump be able to deliver on the policy initiatives that were the cornerstone of his election platform? Would his administration be able to repeal Obamacare, pass tax reform and rewrite NAFTA?

Political conflict was also sweeping through Europe. Scrappy negotiations on the terms of Britain’s exit from the European Union set the tone. The surprise outcome of the Brexit referendum stoked fears that populist political parties in other European countries, France and Germany in particular, would seize power in major elections. As each of these potential conflicts was resolved, equity markets marched higher.

In the end, the conflict that grabbed the most attention was real: the escalation of the militant rhetoric between U.S. and North Korean leaders. President Kim Jong-un continued to test nuclear weapons and long-range missiles, threatening to launch a strike on the continental U.S. Responding to the threat, the U.S. government increased economic sanctions and called upon South Korea and China to stand against North Korea. Yet, even the fear of nuclear war only briefly interfered with the forceful uptrend in equities.

From conflict, we shifted to controversy. Tempests swirled around President Trump’s Twitter feed, the investigation into Russia’s meddling in the U.S. election, and the meteoric ascent of cryptocurrencies – specifically Bitcoin’s rise of over 1,000% during the year. Low inflation, even in the face of declining unemployment, perpetuated the Goldilocks environment that prevailed in 2017. Central banks across the globe were puzzled that core inflation remained below 2%. The historically inverse relationship between unemployment and inflation (a decline in unemployment has traditionally caused a rise in wages and inflation) didn’t seem to apply. Various transformative factors in the labour markets are the reason, including globalization, technological change and increased flexibility of today’s work force. World GDP continued to trend upward throughout 2017, providing a nice tailwind for equity markets across the globe.

United States – May the Force Stay With You

The S&P 500 enjoyed 12 straight months of positive returns in 2017 when dividends are included. At last, the Trump administration could claim a victory when it forced through tax reform right before Christmas. Although tax reform was viewed as the first major policy win for the Republicans, no one can say for sure that the move will stimulate economic growth. Nor is it clear how the tax cuts will be financed. By some estimates, the value of the tax package will increase annual GDP growth by up to 1%. On the other hand, even Federal Reserve officials were cautious about predicting the effects.

In December, the Fed announced a rate hike of 25 basis points, the third increase in 2017. During Fed Chair Janet Yellen’s final press conference before handing over the reins to Jerome Powell, she indicated that we can expect another three rate hikes in 2018. This is based on a median expected GDP growth increase of 0.4%, from 2.1% to 2.5%. The Federal Open Market Committee believes that the announced tax reform will deliver some benefits to the U.S. economy, but it’s not likely to translate into direct dollar-for-dollar economic impact.

Canada – Competing Forces

One major force that shaped Canadian investments this year was the Bank of Canada’s surprise hike of the overnight interest rate – not once, but twice. Although the Canadian economy led the G7 in growth in 2017, which would normally prompt the BoC to raise rates, there are no guarantees the economy can sustain this trend. Add this to uncertainty over the survival of NAFTA and the average Canadian’s heavy indebtedness, and market forecasters wrongly concluded our central bank would remain on hold for 2017.

Bank of Canada Governor Stephen Poloz acknowledged all their concerns. He countered by saying that raising interest rates would merely remove monetary stimulus put in place to offset the oil-price crash of 2015. Although the U.S. has communicated its own interest-rate path for the next year, rate hikes in Canada will depend heavily on several factors. The most significant will be the outcome of NAFTA negotiations and the state of the exuberant Canadian housing market, plus the impact of new, tougher mortgage rules designed to ensure that all homeowners would be able to stay afloat when mortgage rates rise.

In 2017, housing prices rose almost 10% year over year. This was down from peak market increases in the mid-teens during the summer.

Europe and the U.K. – A Force of Circumstance

Although no right-wing political party toppled the status quo in major European elections this year, rising support for populists played out at the Dutch, French and German polls. A newly energized populist wave made it much more challenging for leaders to form alliances such as Germany’s Angela Merkel and her CDU-CSU coalition. The ascendance of anti-immigrant, anti-EU forces created insecurity around an incumbent party’s ability to govern effectively. On balance, however, the decline in the perceived political risk from the far-right and the region’s strongest growth in a decade helped bolster European equity markets.

At a year-end press conference, European Central Bank President Mario Draghi confirmed that the European economies were recovering nicely. The ECB added to the Christmas cheer for European equities by confirming that it will continue to gently decrease bond purchases in the eurozone economies, a policy called tapering. The ECB has wisely suggested it will take a very slow and moderate pace in removing monetary stimulus. The slight reduction in planned bond purchases for 2018 will remain the key monetary policy tool. Thus, it’s unlikely we’ll see rate hikes in 2018.

China – A Force to be Reckoned With

For China, 2017 marked another key milestone as the country continued to expand its global presence. In contrast to the protectionist views of President Trump, Chinese President Xi Jinping placed a strong emphasis on globalization: China will play an increasingly significant role as a leading economic power. Under Mr. Xi’s leadership, China started engaging in climate discussions, announced ambitions to invest heavily in artificial intelligence, and continued to champion the One Belt, One Road (OBOR) initiative, a highly ambitious project to build a China-centred trading network.

On the economic front, China’s official GDP is tracking at around 6.8%, in line with Mr. Xi’s announcement that the country is entering a “new normal” in the pace of economic growth. The target is 6.5% annual growth through 2020. China’s unemployment rate remained below 4% and inflation below 2%. This year, the Shanghai Composite Index experienced muted but positive returns. The government’s strategy of tightening rules on lending was the reason for the relative underperformance of this market. Hong Kong’s Hang Seng Index was one of the top performing Asian markets. It was driven by strength in a few of the larger Index weights such as technology company Tencent Holdings.

Japan – The Force Awakens

With the successful implementation of Abenomics (the economic policies of Japanese Prime Minster Shinzo Abe), Japan has finally emerged from the era of deflation. The Japanese economy is trending toward growth above 2% against the backdrop of a Goldilocks environment: unemployment has fallen below 3% and low inflation has prevailed. Consequently, the Nikkei 225 Index was also a strong equity market over the last year. The improving prospects in Japan helped Mr. Abe win a decisive election victory in October.

Looking ahead, I expect Japanese leadership to continue its pro-growth agenda of structural reform and fiscal and monetary stimulus, which will create a favourable environment for Japanese equities.

My Strategy

Although 2017 provided a winning environment for investors around the globe, there was a wide range in market performance between equities and bonds, and across the various geographies.

Favouring equities over bonds rewarded investors as central banks gradually pared back the monetary stimulus they introduced to offset the dire effects of the financial crisis. Although interest rates appear to have hit their bottom for this cycle, I remain convinced that further increases will be slow, inflation will remain low, and economic growth will continue to fuel the outperformance of equities over bonds for the time being.

Because U.S. stocks maintained their upward march through the last quarter of the year, the valuation gap favouring international markets such as Europe and Japan is now greater than it was earlier in the year. This supports my decision to continue to favour these equities over U.S. equities.

The Last Word

As we all know, the only constant in life is change. Thus, 2018 will likely be filled with many new conflicts and competing forces that are difficult to anticipate, whether geopolitical, economic or trade related. And many of 2017’s familiar areas of conflict and contention will linger: the NAFTA negotiations; political upheaval over the U.S. mid-term elections; decisions on central bank policy; and the trading value of Bitcoin.

Overall, I look forward to 2018 with optimism. Just like the plot of The Last Jedi, 2017 left a lot of threads dangling. But also like the movie’s theme, we can expect central bankers and most world leaders to focus on keeping all the competing forces in harmony.

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