Challenges in the quarter
There was a lot to digest over the past three months including NAFTA negotiations, trade tensions between the world’s two largest economies and geopolitical concerns relating to Emerging Markets. Investors were swayed by the 4 T’s – Tariffs, Trade, Turkey and Trump which provided headwinds for most global markets except for the United States. Despite the negative sentiment, the global economy remained strong which led to strong corporate profits during the period.
The Canadian stock market measured by the S&P/TSX underperformed its peers in the third quarter falling nearly 1.5 percent due to flat oil prices as measured by West Texas Intermediate (WTI) and uncertainty surrounding NAFTA negotiations. Moving forward, the path of least resistance for oil is upward with supply constraints likely from impending sanction against Iran and economic deterioration in Venezuela which should help the S&P/TSX. The recent resolution to NAFTA negotiation should increase investor confidence but confidence may be short lived as investor’s attention will focus on the impact of higher interest rates on the Canadian economy.
The United States
New rounds of tariffs between the U.S. and China did little to impact the S&P 500 which rose in the quarter by approximately seven percent in U.S. dollar terms. Investors focused on the continued strength in the underlying economy which led to strong corporate profits. The U.S. economy grew at 4.2% in the second quarter leading to strong year over year sales and earnings growth. Strong corporate profits were a result of higher business activity and favourable tax policy. The benefit from tax cuts will roll off in 2019 and given that manufacturing is showing signs of slowing, the rate of earnings growth has likely peaked for the current cycle.
Despite sales and earnings growth of approximately 5 percent, flat returns were driven by trade tariff fears, Italian political instability, Turkey and a strong U.S. dollar. International equities were down 0.8 percent in U.S. dollar terms as measured by the MSCI EAFE index. There has been some economic slowdown, but the underperformance has likely been overdone. Setting aside the potential for trade wars, Europe and Asia’s economic outlook continues to be robust and this will likely flow through to company earnings. Combined with accommodating interest rate policies, this part of the world will likely experience stronger market returns.
Central Bank Policy
In the third quarter, the U.S. Federal Reserve continued raising interest rates in one increment of 0.25 percent to 2.25 percent. The U.S. Federal Reserve is expected to continue to raise its benchmark rate one more time by the end of the year on the back of strong US economy. The Bank of Canada raised its interest rates during the third quarter by 0.25 percent to 1.50 percent. It’s expected that the Bank of Canada will raise one more time this year.
The ‘war of words’ that have been used as a negotiation tactics in trade discussions has led to an increase in volatility in stock prices globally. As we have witnessed with NAFTA negotiations, trade war rhetoric is likely to subside as cooler heads prevail. No one wins from a prolonged trade dispute. Over the long run, market returns will likely be driven by fundamentals and interest rate policy. Fundamentals continue to be strong—the likely explanation for 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 due to higher interest rates, oil and wages.
As always, if you have any questions about the markets or your investments, I’m here to talk.
Challenges in the quarter
Despite continued trade dispute chatter, North American equity markets finished the quarter in positive territory as investors focused on strong sales and earnings growth in the region. In Europe, political concerns in Italy bubbled to the surface as anti-Euro parties gained strength, creating concerns about more ‘exit’ talk like what we saw in Greece in 2011. Emerging markets weakened on concerns about the impact of a rising U.S. dollar on their fiscal positions. Looking forward, the market is likely to move sideways until the ‘tit for tat’ tariff policy settles.
The S&P/TSX outperformed in the second quarter, rising nearly six percent due to the increase in the price of oil. West Texas Intermediate (WTI) rose nearly 14 percent to finish the quarter at USD$74.15. Higher oil prices resulted from a lower-than-expected supply increase by OPEC and Russia and a continued draw on global oil inventories. In the coming months, attention will focus on the resolution to the North American Free Trade Act (NAFTA), and the impact on the Canadian economy of higher interest rates, stricter mortgage lending rules and minimum-wage-increases across many provinces.
The United States
There’s no doubt equity investors were reacting daily to news about tariffs between the U.S. and China or the European Union. Despite fears of potential trade wars, the S&P 500 rose nearly three percent in U.S. dollar terms. The impact that tit-for-tat tariffs between nations could have on global economic growth are concerning. Since it’s difficult to quantify geo-political chatter, until tariff measures are realized, investors would be better served to focus on the fundamentals.
In overseas markets, international equities were down 2.3 percent in U.S. dollar terms as measured by the MSCI EAFE index. Internationally, returns were driven by trade tariff fears, Italian political instability, and a strong U.S. dollar. Setting aside the potential for trade wars, Europe and Asia’s economic outlook continues to be robust and this will likely flow through to company earnings. Combined with accommodating interest rate policies, this part of the world will likely experience strong market returns.
Central Bank Policy
In the second quarter, the U.S. Federal Reserve continued raising interest rates in increments of 0.25 percent to 2.00 percent. The U.S. Federal Reserve is expected to continue to raise its benchmark rate two more times by the end of the year, on the back of strong US economy.
The Bank of Canada didn’t raise interest rates during the second quarter and the overnight rate remains at 1.25 percent. It’s expected rates will increase very gradually with one more this year.
Recent market volatility, driven primarily on trade war rhetoric should subside as cooler heads prevail. Market returns are expected to be driven by fundamentals and interest rate policy. Fundamentals continue to be strong—the likely explanation for 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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