2018 Outlook: Will The Market Rally Continue?

by: Kurt Reiman

Kurt and Aubrey weigh in on the year ahead for stocks, bonds and the Canadian economy.

Are Canadian investors in for another lean year in domestic equity and fixed income markets? We believe the steady global economic expansion bodes well for equities in 2018, but we see less scope for positive growth surprises, both in Canada and the rest of the world, and a risk of trade tensions.

The Canadian economy will likely advance at a slower, but still respectable pace next year after having topped the G7's economic leaderboard in 2017. BlackRock anticipates growth of roughly 2.25% in Canada during 2018, consistent with current consensus and the Bank of Canada (BoC)'s estimates. The story is similar elsewhere, leaving less room for the upside growth surprises that powered global risk assets in 2017. We believe investors will still be compensated for taking risk in 2018 - but with potentially less reward.

Few anticipated the rapidity of Canada's economic turnaround in 2017 - or the Bank of Canada's two summertime rate hikes. We expect the BoC will likely raise rates in 2018 but at a slower pace than a U.S. Federal Reserve responding to an uptick in growth and inflation. This means the Canadian dollar could struggle to post another annual advance.

We anticipate higher interest rates across the yield curve as North American central banks normalise monetary policy amid slowly returning inflation. The path to higher interest rates will likely be uneven, creating opportunities for actively managing duration. Overall, this augurs for globally diverse fixed income exposures, including a preference for up-in-quality credit exposures and an allocation to emerging market debt for investors who can tolerate the added risk.

Modestly expansionary fiscal policy, rising wages and a central bank no longer in a hurry to raise rates are all positives for Canada's economy - and equities. Moderate inflation and more stable natural resources prices should help as well. Yet the economy also faces great uncertainties. Tense negotiations over the North American Free Trade Agreement (NAFTA) could cause market jitters and even delay a long overdue recovery in exports.

We debated such geopolitical risks and other vulnerabilities against a backdrop of eerily low market volatility (vol) at our 2018 Investment Outlook Forum in mid-November. We believe the low-vol regime can endure amid the stable economic backdrop. Only a rapid build-up of financial system leverage has historically resulted in a shift to high vol. Is Canada at risk here? Probably not. Financial leverage is actually declining a bit, according to a recent update from the Bank for International Settlements, although it's still at very high levels.

We prefer to take economic risk through equities rather than credit against a backdrop of low absolute yields, tights spreads and rising rates. We find the best opportunities in non-U.S. international stocks, given the cheaper valuations, robust earnings growth and positive earnings revisions. So Canadian investors are likely to once more find the most attractive investment opportunities in markets outside North America in 2018.

Momentum stocks such as tech have ruled the roost in 2017, but we see opportunities in value-sectors as well, as more investors gain confidence in the economic outlook. Canadian stocks are well positioned in that respect, with their heavy skew toward financials and energy. We could see Canadian stocks outperform their U.S. peers next year, provided the NAFTA negotiations aren't derailed. The S&P/TSX Composite Index now trades at a 10% discount to the S&P 500 Index based on forward price-to-earnings metrics, according to Thomson Reuters data at the end of November, which is one of the cheapest levels in the past decade.

On a sector basis, we see value in the consistently growing and high dividends from Canadian financials. We also favour energy stocks at a time when commodity prices are firming on supply/demand rebalancing, and the geopolitical risk premium is once again coursing through oil markets.

Kurt Reiman is BlackRock's Chief Investment Strategist for Canada.

Aubrey Basdeo is a Managing Director and Head of Canadian Fixed Income for BlackRock.

This post originally appeared on the BlackRock Blog.