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4th quarter 2017: the skeptics were confounded!

Financial letter
Richard Morin

Richard Morin

Update :
Update :
January 27, 2018

2017 was supposed to be the year of all dangers: Donald Trump, an oddball with a strong protectionist bent would mess up international trade. A similar leader in North Korea was threatening nuclear hostilities. The far right had the wind in its sails. There were fears that the tightening of U.S. monetary policy would signal the end of the playground, ending the bull market not only in stocks but also in bonds.

And yet!

Asset classes Returns in $C
  4th quarter (%) AÀD (%)
Bonds 2,02 2,52
- Canadian 4,45 9,10
- American women 6,68 13,15
- International (EAFE) 4,69 17,87
- Emerging markets 7,87 27,84
Real estate investments (REITs) 5,81 9,85

Instead, it was a great year in terms of returns. The U.S. stock market rose nearly 22% in 2017 (13% in C$) while European and Asian markets experienced increases of more than 25% in local currency. In emerging markets, the increase was 37% (28% in C$). Despite the negative impact of the decline of the C$ during the year, returns for Canadian investors in these markets remain high.

Canadian equities and real estate investment trusts also did well, particularly in thefourth quarter. Even the bond portfolio, against all expectations, ended the year up.

Canadian investors holding a balanced (stocks and bonds) and internationally diversified portfolio will therefore have realized an after fee return of over 8% for the year 2017.

The bull market that was born after the 2008 financial crisis is now almost 9 years old. Stocks - particularly in the U.S. - are trading at relatively high levels. Sooner or later, the markets will remind us that corrections are part of the market cycle. Although inevitable, these declines are completely unpredictable. Only a sound asset allocation and the discipline to stick to our long-term strategy can protect capital and generate optimal returns.

Canadian equities: a "meager" 9%.

As is often the case, Canadian stocks fluctuated with the price of oil in 2017. In mid-August, when oil was trading at $42 per barrel, the Canadian stock market was down 2% for the year. It was largely due to the price of oil rising to $60 per barrel that the Canadian stock market was able to make a comeback and end the year up 9%.

The sector concentration of the Canadian stock index - 20% energy and 35% financials - makes it particularly important for Canadian investors to diversify their portfolio by holding foreign stocks. For this reason, more than half of Archer's equity portfolio is invested in foreign markets.

U.S. stocks: "party like it's 1999"?

The S&P500 rose nearly 22% in 2017 (13% in C$). While all sectors (except energy) contributed to this performance, technology stocks, and particularly the FANGs (Facebook, Amazon, Netflix, Google/Alphabet) accounted for much of the rise.

Since the 2008 financial crisis, the U.S. stock market has now risen by 250%. In addition, the Cyclically Adjusted Price Earnings Ratio (CAPE) - which measures the ratio of stock prices to inflation-adjusted earnings over the past 10 years - is currently over 32, compared to its long-term average of 17. (However, when you factor in the historically low level of interest rates, the current CAPE ratio looks less extreme.) Finally, volatility in the market - as measured by the Chicago Board Options Exchange VIX index - is at an all-time low.

These factors may lead one to believe that U.S. stocks are "too expensive. Even if this were the case, it would be futile to try to predict when a correction will come and how big it will be: you simply cannot predict stock market movements. However, one can mitigate the impact on the portfolio with a sound asset allocation and even take advantage of corrections by rebalancing the portfolio at the appropriate time, as Archer routinely does.

International equities: rising profits and prices

International equities continued to benefit from the synchronized expansion of the global economy and its impact on profits. In all regions of the world, profits rose by more than 10% and drove stock prices sharply higher.

Anticipated risks - including the rise of U.S. protectionism and the European right - did not materialize, so developed market equities in Europe Australasia and the Middle East (EAFE) rose 25% in 2017 (18% in C$).

Emerging markets: a good year at last

Since 2013, emerging markets had accustomed us to significantly lower returns than developed markets. 2017 was a year of catching up. Despite poor performance from Chinese and Russian equities, emerging markets rose 37% in 2017 (28% in C$).

Bonds: a positive return

If there is an asset class that few expected to see a positive return in 2017, it is bonds. The yield on 10-year Government of Canada bonds started the year at 1.74% and there was a consensus at the beginning of the year that this rate would rise, driving prices down. Against all expectations, not only did the 10-year rate not rise much - it was 2.04% at the end of the year - it even briefly touched 1.39% in June.

If 10-year rates have risen little, it is because - despite the acceleration of economic growth - inflation has not increased. Although central banks largely determine the evolution of short-term interest rates, inflationary expectations are a determining factor for long-term interest rates.

The Canadian bond universe (which includes government and corporate bonds with an average maturity of 10 years) generated a return of 2.52%. This is the annual return we expect from Canadian bonds over the next 10 years (with of course significant variations from one year to the next).

Despite the rather modest expected returns, bonds are the best insurance policy against the ups and downs of the stock market.

Real Estate Investment Trusts (REITs): a great year

In 2017, the economic environment was favorable for REITs: growth in economic activity and profits without an increase in long-term interest rates. Indeed, like bonds, long-term interest rates have a marked influence on the performance of REITs.

Canadian REITs returned 9.85% in 2017.