Market Update April 2018
Challenges in the quarter
Wow! Volatility returned with a vengeance. After experiencing market pullbacks of less than five percent in 2017, we’ve already experienced two pullbacks of greater than five percent in 2018. This is still normal market activity considering 2017 and 1995 were the only two years in the past thirty without a pullback of greater than five percent. The increase in volatility was due to fears of a global trade war. However, the fundamentals of the global economy remain strong and over the long term, the capital markets will shift their focus to fundamentals and company earnings.
The S&P/TSX underperformed in the first quarter, falling nearly five percent on a broad-based sell off across most of the market. The S&P/TSX was dragged lower by concerns of a further weakening Canadian economy due to increases in interest rates, stricter mortgage lending rules, and increases in minimum wages across many provinces. Notably, the weaker Canadian dollar in the first quarter helped prop up global equity returns for Canadian clients.
The United States
There’s no doubt equity investors were reacting to the fear of a global trade war in the first quarter. The fear of a potential trade war between the U.S. and China, or other countries, drove selling pressure that resulted in the S&P 500 falling 1.2 percent in U.S. dollar terms. Looking at the numbers, the selling pressure may have been an overreaction. Bi-lateral trade between China and the United States amounts to low single-digit percentages of each country’s GDP. The tariffs would amount to a fraction of a fraction. Not to suggest the potential for a trade war is trivial but the magnitude of the reaction may have been greater than warranted.
In overseas markets, international equities rose 0.51 percent in Canadian dollar terms as measured by the MSCI EAFE Index. Setting aside the potential of trade wars, Europe and Asia’s economic outlook continues to be very robust and this will likely flow through company earnings. With accommodative interest rate policies, this part of the world will likely result in strong market returns.
Central Bank Policy
In the first quarter, the U.S. Federal Reserve saw a change in leadership with Jerome Powell taking over the helm from Janet Yellen. Jerome Powell continued Yellen’s rate hike policy in the first quarter by increasing the overnight rate once by an increment of 0.25 percent to 1.75 percent. The U.S. Federal Reserve is expected to continue to raise its benchmark rate another two or three times by the end of the year.
The Bank of Canada continued its interest rate increases from last year by increasing overnight rates by 0.25 percent to 1.25 percent. It’s expected rates will increase very gradually with one more increase this year.
Recent market volatility driven primarily on trade war rhetoric will subside as cooler heads prevail when it becomes evident there are no clear winners—only clear losers. Market returns are expected to be driven by fundamentals and interest rate policy. Fundamentals continue to be strong, likely resulting in higher interest rates. In this environment, equity markets will likely be positive but may not experience the above average returns we’ve seen in the past couple of years.
The Liberal government delivered its third federal budget on February 27. While you’ve probably seen plenty of media coverage, I thought you’d appreciate an overview related to your investments and taxes.
The budget had no new personal or corporate tax rate changes. Instead, the big news was the passive investment measures for corporations. Here’s an overview of some of the proposals:
Business tax measures
The government is particularly concerned with the rising number of business owners who hold passive investments inside corporations, benefitting from a tax deferral advantage instead of distributing the assets from the corporation and personally investing. Rather than following through with their stringent 2017 proposals, it appears the government listened to the 21,000 submissions and simplified and narrowed their approach. They propose two new measures that will apply in taxation years that begin after 2018:
- For federal tax purposes, the first $500,000 or small business limit of active business income is taxed at a reduced rate called the small business tax rate, which the government has proposed to reduce from 10.5% to 10% for 2018. Any active income above this $500,000 small business limit is taxed at the higher general business tax rate, which is 15% for 2018. The amount of active income eligible for the small business tax rate will be reduced by five dollars for every dollar of passive investment income earned by a corporation and its associated corporations, above $50,000 in a given year. This means the small business limit is reduced to zero if $150,000 of passive investment income is earned in a year. ($500,000-(excess of $50,000 x $5)). Any active income earned above the small business deduction, as reduced by this calculation, is taxed at the higher general business tax rate.
- Passive investment income is taxed at a high rate within a corporation with a portion of the tax refunded to the corporation when the passive investment income is paid out to shareholders. Currently, a corporation can pay out dividends from its active income and still claim a refund—providing a tax advantage. The government is changing the rules by restricting the ability of a corporation to obtain a refund of taxes paid on passive investment income while distributing dividends from active income.
The taxation of passive investment income isn’t changing, just the ability to benefit from the small business tax rate and claim the refundable tax. In terms of investment choices within a corporation, tax efficiency and tax deferral continue to be important considerations.
Personal Tax Measures
- Mineral Exploration Tax Credit for flow-through shares extended for another year.
- Registered Disability Savings Plan (RDSP)
- Where contractual capacity is in doubt for an adult entering into an RDSP with no provincially/territorially recognized legal representative; a parent, spouse or common-law partner can be the plan holder. This temporary measure was set to expire at the end of 2018 and the budget extends it by five years to the end of 2023.
- The Medical Expense Tax Credit is extended to include eligible expenses incurred for service animals that are specially trained to perform tasks for a patient with severe mental impairment.
As you can see, the announced proposals can have significant implications particularly for certain business owners and professionals. I hope you found these highlights helpful.
If you’d like to discuss these or other federal budget initiatives and how they affect your financial strategies, please don’t hesitate to contact me.
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