2018 market outlook

As we transition into 2018, the markets may be poised to deliver a bumpier ride than we experienced in 2017, which means more opportunities for skilled active managers. Our portfolio managers have assessed the market and economic signals and are positioning for:

  • A continuation of synchronized global economic growth
  • Pockets of opportunity in select areas of fixed income
  • Monetary policy normalization, which favours value stocks over growth

Get the full picture from our managers through our 2018 market outlook. See below.

Forstrong Global Asset Management Inc.
Tyler Mordy
IA Clarington Investments Inc.
Dan Bastasic Jeff Sujitno Terry Thib
Industrial Alliance Investment Management Inc.
Clément Gignac Pierre Trottier
Radin Capital Partners Inc.
Brad Radin
Sarbit Advisory Services Inc.
Larry Sarbit
Taylor Asset Management Inc.
David Taylor
Vancity Investment Management Ltd.
Andrew Simpson
Where are the opportunities?

Despite numerous recent geopolitical hurdles (Brexit negotiations, tensions with North Korea, Catalan secession efforts and a turbulent U.S. political backdrop, among others), global growth finally appears to have gained a solid footing. For the first time in a decade, all 35 Organization for Economic Co-operation and Development (OECD) member countries are growing their economies simultaneously. This has led to a resurgence in trade activity, as evidenced by emerging market exports exhibiting the fastest growth rate since 2011. Low commodity prices continue to provide a boost to consumption and feed into tepid inflation, permitting many central banks to maintain stimulative monetary policies.

Recoveries in Europe and Asia are still in their infancy relative to the U.S., which should allow for an extended period of catch-up growth. Pro-Euro political victories in the Netherlands and France have helped ebb EU dissolution fears. With the European Central Bank still highly accommodative, unemployment has been sharply decreasing and loan growth is finally starting to perk up. In Japan, return on equity has been quietly trending upwards and corporate profits just hit a record high relative to GDP. Japanese companies also happen to be sitting atop US$4 trillion in cash. That means capital expenditures can be radically increased without borrowing.

Given this backdrop, developed market equities outside of North America look attractive. As shown in the chart below, EAFE equities offer compelling valuations relative to their North American peers, and appear to be forming a bottom after underperforming since 2009.

MSCI EAFE/MSCI North America

Chart

Source: MSCI, Macrobond, Forstrong Global Asset Management. As of October 31, 2017.1 3 Month moving average. 2 Rebased: December 31, 2008 = 100.

What are the challenges?

The current global equity bull market is one of the longest on record, and numerous indices are hitting record highs on a weekly basis. At times like these, we must be especially vigilant, keeping a close eye on risk indicators and challenging our existing views. What are some of the things that keep us up at night? Extremely tight high-yield spreads, low equity and interest rate volatility, frothy valuations and highly optimistic market sentiment, to name a few. A flattening U.S. yield curve since the presidential election last year is inconsistent with an accelerating growth environment. Does the bond market know something that the stock market does not?

Additionally, the U.S. Federal Reserve has at long last shifted from quantitative easing (QE) to quantitative tightening (QT). The Fed’s holdings of treasuries and mortgage-backed securities will be reduced as it seeks to taper its balance sheet. We must acknowledge that QT is unprecedented, and could have unforeseen consequences for financial markets. However, we do not believe that QT will have the equal and opposite effect of QE. Gradually removing stimulus when markets are functioning well is likely to have far less impact than QE had when markets were in turmoil.

How are you positioning the funds?

When evaluating the global investment landscape, Forstrong’s primary focus is always risk management. Regardless of the degree of conviction we have in our views, broad global diversification remains the first line of defense at all times.

The funds remain modestly overweight equities and underweight fixed income. From a regional perspective, we have a preference for developed market equities in Europe and Asia, as well as emerging market fixed income. We are overweight financial sector stocks in the U.S. and Europe, and continue to favour exposures with above-average dividend yields. Our cautious outlook on interest rates has warranted higher cash levels and reduced bond duration.

Why is this the right approach for 2018?

With global growth likely to persist into 2018, the above positioning attempts to capitalize on a constructive environment for corporate earnings. Overweighting equities, particularly in markets with high operational leverage to global supply chains, is our preferred approach. The U.S. economy appears to be transitioning into a late cycle phase, while years of outperformance versus global peers has left the stock market with lofty relative valuations. This reinforces our preference for Europe and Asia, which are earlier in their respective business cycles.

While inflation has been stubbornly low since the Global Financial Crisis, a continuation of economic momentum should ultimately be reflationary in nature. This, coupled with a gradual transition towards monetary tightening from major central banks, will likely put upward pressure on bond yields. Although interest rate movements can be difficult to forecast in the short term, we foresee an asymmetric risk profile over the medium term, and believe that a shortened-duration profile is justified. Emerging market bonds offer attractive yields, while an improving economic backdrop should help support spreads, even as the Fed continues to raise interest rates.

icon  2018 market outlook - Tyler Mordy

Where are the opportunities?

Finding investment opportunities over the next year will have more to do with security selection and sector allocation and less to do with just being invested. A bottom-up, fundamentals-driven approach will be critical to finding the right securities. Flexibility to shift portfolio allocations will also be key to adapting to broad macroeconomic movements.

Things have changed over the past year. We have seen synchronized global economic growth for the first time in almost a decade. This is clear from a number of indicators, particularly robust consumer spending and healthy levels of global liquidity. It is also evident when we compare current Purchasing Managers’ Index (PMI) data to figures from a year ago (see graph below).

PMIs indicate synchronized global growth

Chart

Note: Measured through August 2017. Source: Bloomberg; RBC CM Canadian Equity Strategy.

This cycle appears to have staying power and will favour equities over government bonds for the foreseeable future. Investors looking for a balanced approach may want to consider a fixed-income allocation that favours credit, including higher-yielding bonds, and focuses less on interest rate sensitive government securities. The current environment, which is characterized by monetary policy normalization, should be more supportive of value investing than growth investing. It should also be supportive of stable-to-higher oil prices and higher interest rates.

Our call over the past two years that the Canadian dollar would appreciate relative to the U.S. dollar has been out of consensus, but accurate. We expect the Canadian dollar to appreciate for a third year as 2018 progresses. Against this backdrop, we expect global economic growth to exceed expectations for a second straight year. This bodes well for U.S. and European equities, but Canadian equities are likely to have better returns than both.

What are the challenges?

Can this environment be so good that it’s actually bad? Not from a fundamental perspective. However, we should be concerned about central banks around the world reducing their balance sheets. While central banks begin to taper, equity markets have enjoyed one of their longest stretches in recent history without a material correction. We expect a correction in equity values during the first half of 2018, which will likely sow the seeds for attractive returns in the year following.

How are you positioning the funds?

Our philosophy is based on investing in businesses, rather than market multiples. We search for companies that have sustainable business prospects, as well as safety in their cash flows and dividends. We wrap this bottom-up, fundamental approach with a macroeconomic overview to help mitigate potential risks and identify possible opportunities.

With positive economic momentum, rising interest rates and stable-to-increasing inflation, our funds are currently positioned with an even split between what we consider defensive and cyclical holdings. As interest rates are biased upward, we are finding better risk-adjusted yield opportunities in equities than fixed income. Our equity exposure also generally has a higher dividend yield than the market. Our fixed-income exposure is concentrated in lower interest rate sensitive high-yield corporate bonds, as we believe the economy will remain strong while rates are increasing. We are also positioned for near-term market volatility with a higher-than-normal cash position. Volatility generally creates attractive buy opportunities; with a higher cash allocation, we are able to take advantage of individual opportunities as they present themselves.

Why is this the right approach for 2018?

We view the risk of recession to be minimal, but there is potential for an earnings growth pause, which may cause a short-term market correction. We believe a correction in the context of a secular bull market would be welcome news for well-positioned investors to take advantage. In a normalizing environment, we should expect security selection to be an important driver of investment returns. Minimizing exposure to sectors with excess interest rate risk will be an important tool for minimizing downside potential.

icon  2018 market outlook - Dan Bastasic

Where are the opportunities?

As we enter 2018, the global macroeconomic backdrop remains positive, with moderate GDP growth, strong corporate earnings and low inflation. These conditions support U.S. Federal Reserve monetary policy normalization through continued interest rate increases and, potentially, balance sheet reduction. We are positive on the prospects for investment grade and non-investment grade credit in 2018. However, we are in the latter stages of the economic and credit cycle. This suggests that, while there may be further room for appreciation, there is likely less room than at earlier points in the cycle. By many metrics, current valuations are elevated for both equity and fixed-income markets. Credit spreads continue to be very tight as default rates remain low. Our outlook for credit is positive in the current environment, as fundamentals are supportive, but we remain conservative in our portfolio positioning with a focus, as always, on minimizing surprise risk.

Global demand for yield remains strong in the current low interest rate environment. Yield curves have flattened in the latter half of 2017 as the Fed and Bank of Canada have increased their overnight rates. Bond yields at longer parts of the curve remain anchored by expectations of low inflation and bids from European and Japanese fixed-income buyers. If yield curves remain flat, we expect demand from retail loan mutual funds and ETFs to be modest, which was the trend in the latter part of 2017. Earlier in 2017, when the yield curve steepened due to expectations of higher inflation from President Trump’s policies, we witnessed increased investor demand for loans. This led to a surge in refinancing activity and, as a result, spread compression and lower coupons. Some of the compression has been offset by an increasing LIBOR, the floating leg of a loan’s coupon. The 3-month LIBOR rate has increased roughly 48% year-to-date and currently sits at 1.48%. LIBOR should continue to march higher next year in tandem with expected increases in the U.S. overnight rate. Consistent with prior years, we expect a coupon-like return for loans in 2018, which we believe will be attractive to investors given the alternatives in fixed income.

What are the challenges?

We expect to end 2017 with a relatively flat yield curve, as expressed by the spread between yields on 10-year and 2-year government bonds (2/10 spread) in Canada and the U.S.

Canada and U.S. 2/10 spreads

Chart

Bloomberg, as at November 30, 2017.

We also expect interest rate increases from both the Fed and the Bank of Canada. The flat yield curve provides investors with minimal incremental compensation for taking on interest rate risk. Investors looking to increase yield have to incur meaningfully more interest rate risk to achieve their targets. Low yields also reduce the margin of safety to absorb the negative consequences of even small increases in rates.

A flat yield curve, combined with a more aggressive stance on interest rate increases from the Fed, may be a positive for investors in floating rate loans. Increases in the overnight rate typically lead to increases in 3-month LIBOR, thereby increasing loan coupons. Historically, increased fund flows into loans occur when there is a steepening of the yield curve. If the yield curve remains flat, inflows into loans should remain muted, thereby decreasing spread compression from refinancing activity.

How are you positioning the funds?

In general, we continue to position all the funds we manage quite conservatively in order to limit price volatility and surprise risk. Our non-investment grade positions are focused on larger companies with higher credit ratings. As usual, we avoid companies with cash flows linked to commodity prices, which are inherently volatile.

Within our loan portfolios, we started purchasing European loans in 2017 and plan to continue building this position in 2018. We initiated this position for diversification and to counteract some of the spread compression from the elevated refinancing activity in the U.S. loan market. The European loan market is smaller and almost the exclusive domain of institutional investors. As a result, it is less affected than the U.S. market by large swings in retail mutual fund and ETF flows. In addition, we are currently earning a return from hedging EUR to CAD due to differences in the overnight rates set by the Bank of Canada and the European Central Bank.

Within our investment grade mandates, we continue to be low duration. One particular area of the market where we see value is investment grade collateralized loan obligations (CLOs), specifically AA and AAA-rated CLOs, which offer an enhanced yield and lower duration over traditional securities like corporate and government bonds with the same rating.

Why is this the right approach for 2018?

Our philosophy has always centered on the belief that investors want low volatility and minimal surprise risk from their fixed-income portfolios. Accordingly, our strategy is to construct portfolios with a focus on capital preservation rather than generating outsized returns by reaching for yield or actively trading. The value-add we deliver through active management is the ability to avoid areas of the market where the potential downside is greater than any potential upside. We believe this is the right approach to fixed income in any market environment.

icon  2018 market outlook - Jeff Sujitno

Where are the opportunities?

We continue to prefer equities over fixed income and expect the continuation of the synchronized global recovery to be conducive to corporate earnings growth, which in turn should drive markets higher despite current valuation levels. Global growth remains on a strong footing – despite a slowing China – and is in its early stages for many parts of the world.

We continue to see positive earnings growth in North American markets. Current consensus expectations for EPS growth is 10% for the U.S. and 9.3% for Canada, which is fairly robust. If tax reform is successful in the U.S., earnings growth could increase significantly from current estimates. Finally, as we stated last year, inflation should grind higher, and on that basis, we could see interest rates continue to increase. This, in turn, could lead to a rotation of funds from traditional fixed income into equities, which should help sustain multiples for a period of time.

U.S. inflation expectations rising

Chart

Source: Federal Reserve Bank of St. Louis, as at November 29, 2017.

What are the challenges?

The risk/reward environment has become less favourable after market appreciation in many asset classes over the last couple of years. Key to continued market appreciation is positive earnings growth, as the multiple expansion story has pretty much played out. With this backdrop, we need to see earnings meet or beat expectations. Further, macro momentum is expected to slow while inflation should trend modestly higher in 2018. In 2017, inflation was muted due to a combination of cyclical and structural factors. However, with unemployment running at decade-low levels, despite a generational demographic shift, we could see inflation come back faster than expected, which could accelerate U.S. Federal Reserve interest rate increases and potentially cause some pressures (such as a decrease in U.S. bond prices and a potentially short-term drag on U.S. equity markets). The removal of liquidity by central banks across the globe also puts us in uncharted territory, but we expect it to unfold in the most investor friendly way possible. Another potential issue is geopolitical risk. Areas of concern include the North American Free Trade Agreement (NAFTA), Brexit, North Korea, Russia, Organization of the Petroleum Exporting Countries (OPEC) and the Middle East. Taken together, the range of challenges we face as we transition into 2018 suggest higher volatility in the year ahead.

From a longer-term perspective, we believe that we are on the cusp of a multi-decade inflection point with respect to many disruptive technologies, including electric vehicles (and supporting infrastructure), artificial intelligence, blockchain, cryptocurrencies, automation, the internet of things, the sharing economy and the Amazon effect. There will be many opportunities here, as well as many risks. Moreover, there is significant potential for “old world” industries to suffer irreparable setbacks, both in terms of investor sentiment and valuations.

How are you positioning the funds?

We are likely in latter stages of the economic cycle. Historically, this means some of the best returns of the cycle, which can more than offset any short-term losses that come during inevitable periods of economic softness. We are ardent believers in value creation through compounding over the long term. With all three of our mandates, we are always focused on net-of-fee risk-adjusted returns. At this point in the cycle, we see prudence in being extremely selective in light of increasing leverage and valuations across many sectors and companies. To do this, we place particular emphasis on companies that have balance sheet strength and economically resilient business models. This allows them to generate sustainable free cash flow and increase dividends in all environments.

For income generation through dividends in our large-cap mandate, the IA Clarington Canadian Conservative Equity Fund, we continue to favor a balanced approach between the more defensive interest rate sensitive sectors (e.g. consumer staples and telecommunications companies) and the procyclicals (e.g. Energy, consumer discretionary and industrials), which should benefit from global growth in 2018. We are not giving up on the bond proxy sectors (such as pipelines, utilities, telecommunications companies and REITs), as we still see pockets of value and the ability to safely receive dividends from select securities. We also believe these sectors can provide stability during expected periods of volatility in 2018.

The equity portion of our multi-asset class alternative income mandate, the IA Clarington Growth & Income Fund, and our conservative growth mandate, the IA Clarington North American Opportunities Fund, are positioned similarly. For our North American allocation, we intend to position the portfolios more in large- and mid-cap names with global exposure, as we expect these to outperform smaller-cap names in the U.S., given the stage of the cycle, valuations and leverage levels. However, success for U.S. tax reform would be the upside risk here for a period. In Canada, which disappointed in 2017, we continue to expect headwinds for domestically related stocks, given the indebted consumer. However, given solid global growth, we are positioning the portfolios in Canadian sectors and companies with U.S. and global exposure that can prosper from the global reflation trade. These are the types of companies that tend to benefit from rising economic growth and inflation, such as cyclical equities, for example. When we look for Canadian companies with U.S. exposure, we strive to make sure they have the U.S. capacity and labour to satisfy U.S. demand in this new protectionist era.

Why is this the right approach for 2018?

We see no reason to stray from our time-tested approach of investing in reasonably priced, quality stocks. We’re looking for companies that can grow earnings and cash flow, and have the ability to increase dividends on pace with increases in the 10-year U.S. government bond yield. Dividend growth strategies tend to perform well in most environments, but especially in environments like the current one. On the valuation spectrum, we also see GARP (Growth At a Reasonable Price) stocks outperforming both growth and value stocks at this stage of the cycle.

icon  2018 market outlook - Terry Thib

Where are the opportunities?

With the current bull market moving into its ninth year, valuations have become very expensive, which means we should lower our return expectations for 2018. Following what will go down as one of the least volatile years in recorded history, in 2018 markets will likely see a return to a healthy level of volatility.

We continue to see opportunities in equities, but favour the EAFE and Canadian markets, which trade at attractive discounts relative to the U.S. A more volatile market favours active investors, and we plan to take advantage of opportunities the markets present us in 2018.

Long-term bonds also seem well anchored at current levels and could offer investors some downside protection in case of a stock market pullback. One “asset class” that has remained volatile is the Canadian dollar, and we continue to dynamically manage our exposure to foreign currencies.

What are the challenges?

Uncertainty surrounding the fate of the North American Free Trade Agreement (NAFTA), as well as the increasingly protectionist tone from the U.S., could be a drag on growth in the years to come. Keep in mind that since China joined the World Trade Organization (WTO) in 2001, exports (and, incidentally, Wall Street earnings) have grown at a much faster rate than global economic activity.

In Europe, political uncertainty in Germany could make investors ponder whether the good times can last. While the European Central Bank is getting closer to ending its quantitative easing program, there is some risk that the eventual removal of liquidity could lead to a rapid, mass exodus from certain asset classes, especially European high-yield bonds, which currently offer similar rates to U.S. Treasuries.

The ongoing process of monetary policy normalization should continue to push short-term rates higher, leading to a further tightening of the yield curve. This could cause a shift in investor sentiment and pave the way for the return of healthy volatility.

Valuations favour EAFE and Canada over the U.S.

Chart

Chart

 

Source: Bloomberg as at December 1, 2017. * Based on 12-month forward earnings for price earnings ratio (P/E) and 12 months forward book value for price to book ratio (P/B). Canadian equities represented by S&P TSX Composite Index, U.S. equities represented by S&P 500 Index and EAFE equities represented by MSCI EAFE Index.

How are you positioning the funds?

Given pricey equity valuations, particularly in the U.S., we are leaning towards a more neutral weight on equities, but with a tilt towards the Canadian and EAFE markets. We continue to hold some put options on the major indices, as low volatility is keeping the cost of protection at historically low levels. We also hold some preferred shares, through an ETF, as well as some long-term U.S. Treasuries to add further downside protection to the portfolios amid growing geopolitical risks.

Why is this the right approach for 2018?

The combination of a potentially slowing global economy, rising protectionism, hefty valuations and a flatter yield curve could mean more volatility in the markets next year. Downside protection will be crucial, and investors should avoid overreaching for returns. We will carefully monitor and manage risks and rely on our active approach to add value for clients as opportunities arise.

icon  2018 market outlook - Clément Gignac

Where are the opportunities?

Value stocks underperformed growth stocks in 2017 by a wide margin, but we believe they could catch up in 2018. The S&P 500 index is trading at 18× forward earnings, compared to 14× for the IA Clarington U.S. Dividend Growth Fund. The market in 2017 has been dominated by technology stocks, particularly the FANGs (Facebook, Amazon, Netflix and Google), leaving other names below the radar. Amazon-related fears have created opportunities in many consumer and industrials stocks. We are also seeing opportunities in financials, technology, health care and energy.

What are the challenges?

President Trump’s protectionist bent is an issue, and any significant move in this direction would not be welcomed by investors. There is a mix of complacency and head scratching about the low inflation numbers in the U.S., and protectionism could create additional concerns on that front. Unexpected inflation, which could change the U.S. Federal Reserve’s dovish tone, is something we need to watch for.

The U.S. President’s tax plan could change the earnings growth outlook for the S&P 500 Index. Uncertainty surrounding the final outcome can cause more volatility in many sectors of the stock market.

How are you positioning the funds?

The funds have a focus on large-cap dividend growth stocks. We are positive on financials stocks in particular because of their attractive valuations compared to the S&P 500 Index and the protection they offer against rising interest rates. At least two other factors make these stocks attractive. The first is the Trump administration’s plan to significantly reduce the regulatory burden imposed upon the financials sector by the previous administration. This reversal will likely become a tailwind not only for share prices, but also for dividend growth, which has been negative in recent years (see chart below). The second factor is the Trump administration’s pro-growth tax reform plan, which we also expect to be positive for the sector’s share prices and dividend growth.

Financials vs. S&P 500 Index: historical and estimated dividend per share growth

Chart

Source: BMO Capital Markets Investment Strategy Group, Bloomberg, as at November 17, 2017.

In the healthcare sector, consolidation between pharmaceutical and biotech firms may increase potential development of ‘blockbuster’ pharmaceuticals. Some technology names are still attractive even after a strong 2017. Energy names have underperformed commodities by a wide margin and are so out of favour that they need to be considered for an overall re-rating in 2018. The funds remain underweight in the bond proxy sectors such as utilities and real estate.

Why is this the right approach for 2018?

We believe that dividend growers in the U.S. could do well in 2018. Both dividend growers and value stocks tend to outperform in a rising Treasury bond environment. When selecting dividend growers, we emphasize value criteria and are always looking for stocks with a combination of 25% upside potential over the next 12 – 18 months and limited downside risk. More volatility and less expected return in the stock market could lead us to use our covered call strategy in 2018 much more than we did in 2017. Active currency hedging also remains also an important part of our strategy to protect returns.

icon  2018 market outlook - Pierre Trottier

Where are the opportunities?

The economic environment continues to improve, with growth becoming more synchronized globally. We expect the expansion to continue in the absence of a geopolitical shock. While the Trump administration has had difficulties implementing much of its proposed pro-growth agenda, we do believe there is a strong possibility that some items, such as deregulation and tax reform, could come to fruition. If successfully implemented, we expect these policies to be supportive of GDP growth and equity markets, particularly in the financials and industrials sectors.

Outside the U.S., Europe should continue to perform strongly with significant excess capacity, and most emerging market economies are still early in their recoveries. Against this backdrop, we expect continued profit growth (and low interest rates) to support equity valuations. Specifically in equities, we believe there are many opportunities in the technology sector as the pace of change accelerates. Innovation is also creating disruptions (and opportunities) in other industries, particularly retail, consumer goods, media and healthcare.

In global fixed income, we expect government bond yields to rise, but not substantially. Developed markets could see higher yields, albeit at a low trajectory, given our inflation and monetary policy expectations. An inflation surprise could spur less positive outcomes for bonds, but we think medium- to long-term yields will move moderately higher over the next 12 months. We also expect the U.S. dollar to be range bound relative to global peers. Emerging market aggregate economic growth has been outpacing the U.S. and attracting equity inflows. Strong earnings expectations outside the U.S. could lead to further U.S. dollar outflows.

What are the challenges?

Global markets could become more volatile in 2018, driven by changing central bank policies and geopolitical events. As mentioned above, the Trump administration’s ability to implement its pro-growth agenda is still uncertain, and failing to achieve growth-supportive policies could prompt a negative response from investors. An increasingly bellicose North Korea continues to make headlines; thus far markets have had a fairly muted response, but are likely to react if there is further escalation. In Europe, economic data continues to show signs of improvement; however, various populist forces are still at play. Brexit proceedings appear to be moving slowly at best, offering limited visibility and creating an uncertain investment environment. There are also rising tensions in the Middle East, with Saudi Arabia and Iran fighting proxy wars across the region.

How are you positioning the funds?

From an allocation perspective, the fund continues to have a majority equity allocation, reflecting our view that valuations are more attractive in equities than fixed income.

In equities, portfolio positioning continues to be driven by individual security selection. We focus on stocks that possess three alpha drivers: quality, the ability to grow intrinsic value over time and attractive valuations. At the sector level, we have significant exposure to the information technology, financials and industrials sectors. We have no exposure to utilities or telecom.

Within information technology, we hold leaders in platform businesses with strong network effects and consulting companies with robust technology capabilities that help companies adapt to a rapidly changing environment. In financials, we hold a mix of balance sheet-sensitive names and fee-based businesses, as well as companies that are supported by secular trends. In industrials, we hold high-barrier-to-entry companies and businesses with replacement, consumable or subscription-based products, offering steady cash flow growth and visibility. Lastly, in consumer discretionary we hold travel-oriented companies with internal growth levers and e-commerce companies.

In fixed income, we are positioned for increasingly synchronized global growth and a benign inflationary environment, with exposure to credit supported by strong fundamentals or compelling value. We expect a modest rise in yields on U.S. Federal Reserve interest rate hikes and balance sheet reduction plans; we hold short-duration developed market bonds and longer-duration bonds of select emerging markets. We also believe we are past the peak of the default cycle and a recession is unlikely until 2020 (at the earliest). Therefore, we are maintaining exposure to preferred high-yield issuers. Given expensive developed government bond markets and below-average credit spreads at the broad market level, we are also maintaining above-average liquid reserves in government bonds that could be deployed in any higher-yielding opportunities that arise in 2018. Interest rates remain negative after inflation in most developed economies, posing a challenge for investment grade fixed income investors.

Chart

Source: Trading Economics, as at November 23, 2017.

Why is this the right approach for 2018?

We believe asset allocation shaped by our best global alpha opportunities can generate attractive long-term risk-adjusted returns. We allocate capital by leveraging our core competency in fundamental research, which we believe is a more effective method to allocate capital than trying to correctly predict macroeconomic variables (which may be backward looking and not correlated with returns). We anticipate new opportunities to allocate capital on an individual security basis across both equity and credit in the coming year, as we expect volatility to increase due to changing global monetary policies and political uncertainty.

icon  2018 market outlook – Loomis, Sayles & Company

Where are the opportunities?

Global synchronized growth appears to have sufficient drive to carry over to 2018. This theme is garnering increased attention among investors and central banks, specifically around stronger growth in emerging markets (EM). We share this optimism, and believe that average growth among EM economies could rise to 4.8% in 2018, from 4.4% in 2017, on the back of an improved global trade outlook, higher commodity prices and domestic-led growth.

This should eventually lead the growth differential between EM and developed markets (DM) to widen to levels not seen for more than five years. This would be a reversal of a convergence trend that has been broadly in place since 2009 and could signal significant returns in EM.

Emerging markets offer a vast debt universe in both U.S. dollars and local currencies. We advocate for dynamic allocation between the three dominant asset classes: sovereign hard currency debt, sovereign local currency debt (unhedged), and corporate debt. Over a 12-month investment horizon, we have a preference for local currency debt, based on expectations of upside from currency appreciation. While these trends never occur in a straight line, the more conservative investor will want to maintain an allocation to U.S. dollar debt, which tends to reduce return volatility.

The EM/DM growth differential is widening, with EM inflation at historical lows

Chart

Source: IMF, World Economic Outlook Update as at October 2017.

The shrinking EM/DM growth differential accelerated between 2013 and 2015. This, combined with a broadly stronger U.S. dollar, drove EM currencies down. However, weaker exchange rates have allowed EM economies to recuperate and gave some of the more vulnerable countries time to get their current account imbalances back into shape. If growth dynamics reverse, this could be the missing piece of the puzzle to orchestrate a stronger, fundamentally driven revival in EM currencies against the U.S. dollar.

What are the challenges?

The main challenge to our optimism on EM currencies is that emerging markets are not isolated from what is going on in the rest of the world. External factors, such as the Fed’s interest rate policy and uncertainty surrounding U.S. President Trump’s policies (including the current tax plan proposal and continued concerns about international trade), could have a significant impact on the U.S. dollar and dollar-denominated EM bonds – both positive and negative. This would call for actively managing investment positions and making timely decisions on when to have exposure to the U.S. dollar and when to diversify away from it. The U.S. dollar has a tendency to react very strongly to unexpected signals or actions from the Fed, and may overreact to headlines from time to time. But since the market is now on board with the prospect of the Fed raising interest rates three times in 2018, we believe the surprise effect could be for the Fed to do less, particularly if U.S. inflation persistently undershoots the Fed’s target level.

In broadening the EM investment universe from U.S. dollar bonds to local market exposure, the investment team will have to be even more diligent in understanding the economic and political dynamics of those countries. Political risks are always a factor in countries such as Mexico, Turkey and Brazil, but we also view the higher risk premium associated with these countries as having been discounted by the financial markets, and higher yields compensate for that risk over time.

How are you positioning the fund?

We are using global macro-based scenario analysis and dynamic asset allocation to invest in emerging markets in an optimal fashion. Taking into account our expectations for synchronized, albeit moderate global growth, our strategic allocation has maximum exposure to local currency debt.

The technical picture remains robust for all EM debt markets, but EM corporate debt, in particular, is facing a diminishing net supply pipeline in 2018. This, together with ongoing inflows into the broad asset class, will further support corporate bond prices in a firming growth environment. Adding to the attraction, EM corporate debt is less sensitive to rising Fed interest rates and offers stability during periods of increased volatility.

From a country perspective, we like the disinflation stories in Brazil and Russia combined with improving central bank credibility in both countries. Similarly, there is great potential for declining inflation and stronger reforms in Argentina and Egypt, which could spark investor appetite. Investment grade countries such as Chile and Peru should benefit from higher commodity prices.

Why is this the right approach for 2018?

Investors have often looked at emerging markets for exciting growth stories. However, they have been starved of such stories since the financial crisis. This may be turning, as we expect EM growth to outpace DM growth in the coming years, opening new avenues for EM to outperform.

The strength EM currencies experienced in 2017 has highlighted the need for yield-hungry investors to be involved in these markets again. EM fundamentals have improved since the taper tantrum of 2013, but even with the stronger growth outlook, EM currencies are unlikely to move up in a straight line. This, along with the increase in political uncertainty in many EM countries, means active management will be critical.

Dynamic asset allocation between U.S. dollar EM debt and higher-yielding EM local currency debt offers access to the benefits of currency differentiation and the potential to participate in an upward trend in EM currencies as the rising EM growth trajectory becomes more entrenched and anchored by domestic demand.

icon  2018 market outlook – PineBridge Investments - Steve Cook & Anders Faegermann

PM
Michael J. Kelly MBA, CFA

Steven Oh MBA, CFA

PineBridge Investments LLC

IA Clarington Global Bond Fund

Where are the opportunities?

We expect that, overall, opportunities across global fixed income will be more limited in 2018. Anticipated changes to central bank policy are setting the stage for shifting and more volatile interest rate yield curves and a normalization of inflation. However, we also believe asset class outcomes are likely to become more dispersed, which should provide additional alpha opportunities – both across and within asset classes – for investors who can identify relatively undervalued assets.

While global central bank balance sheets will continue to expand in 2018, we anticipate a transition from expansion to contraction, as the European Central Bank (ECB) is poised to follow the U.S. Federal Reserve in exiting its asset purchase program. In the U.S., this means inflation should shift from persistently falling below target levels to meeting them. In many other developed economies, it means inflation should stabilize.

Central bank balance sheets will start to contract collectively in 2019

Global central bank balance sheet growth as a percentage of GDP

Chart

Source: Thomson Reuters Datastream, Bloomberg, PineBridge Investments, as at October 23, 2017.

We expect this shift to result in conditions that should lead to lower overall returns for global fixed income portfolios. Therefore, it becomes more critical to identify the select opportunities that can deliver the best relative returns while safeguarding portfolios.

Given improving global growth and increased interest rate risk, we see the best opportunities in higher-quality credit within non-traditional areas of fixed income – areas where portfolios tend to be underinvested. These include elements of emerging market debt, tranches of collateralized loan obligations (CLOs) and adjacent senior secured loans, and bank capital securities. Unlike most developed markets, where monetary policy normalization will be a headwind to fixed income, the fundamental outlook for many areas of emerging market fixed income is more supportive, due to a combination of stable growth and declining inflation.

What are the challenges?

The improving global outlook is allowing monetary policies to shift towards synchronized normalization, which will facilitate the exit of central banks from extraordinary measures. This will finally result in the removal of excess liquidity that provided persistent tailwinds for global fixed income in recent years.

Valuations across many asset classes have compressed substantially, leaving little room for downside risk. At current valuation levels, most fixed-income asset return outcomes have become more asymmetric, whereby reasonable upside scenarios result in coupon returns that are at or near historical lows. And just as there are key monetary policy risks, increasing levels of fiscal and political policy risks could have a negative impact on fixed-income portfolios.

How are you positioning the funds?

In this environment of limited upside potential but increasing downside risk, we are advocating a more defensive portfolio bias overall, particularly with respect to interest rate risk. While conditions are supportive of corporate credit risk, generally tight valuations call for an incrementally more defensive approach toward credit risk as well.

We currently favour secured floating-rate credit assets such as bank loans and higher-rated CLO tranches. Our overall duration profile is short, at less than two years, to mitigate interest rate risk. Given the favourable outlook for, but tight spreads on emerging market debt, we have some highly targeted positions in local currency and hard currency debt. Within developed markets, we favor U.S. assets relative to Europe and Japan. We are also in certain safer assets, such as high-quality asset-backed securities (ABS), which provide flexibility to reallocate should attractive opportunities arise from increased volatility or market shocks.

Why is this the right approach for 2018?

We believe it is prudent to have a broadly defensive approach to fixed-income portfolios with targeted risks that offer better relative-value yield opportunities. This is not the environment to chase yield by extending duration or increasing credit risk. Our base case expectation is for a favourable macroeconomic backdrop, where many asset classes tighten further as investors reach for returns and inflation remains subdued. But we believe most fixed-income assets are currently valued for a near-Goldilocks scenario. Therefore, any deviation from it poses more downside risk, as there is limited cushion to absorb a change in investor outlook. In this environment, we believe that focusing on safety and flexibility with selective yield enhancement opportunities is the appropriate course.

icon  2018 market outlook – PineBridge Investments - Michael J. Kelly & Steven Oh

Where are the opportunities?

Broadly speaking, it is increasingly difficult to find value today, but we continue to identify opportunities on a company-by-company basis across asset classes, sectors and geographies. Share price weakness, resulting from what we believe to be short-term headwinds, has allowed us to enter new investments and increase several long-held positions.

Market volatility has been very subdued over the last year, although risk factors are not in short supply: uncertainty around trade negotiations may cause capital expansion plans to be delayed; rising interest rates will impact governments and households that have built up record levels of debt; and heightened geopolitical risks threaten to undermine investor and consumer confidence.

While uncertainty in financial markets can be uncomfortable to bear, it often leads to increased volatility, and therefore opportunity, for value investors. We own businesses that can navigate economic shocks and political surprises. While we don’t try to implement short-term trading strategies based on anticipated outcomes, we will take action if volatility allows us to own wonderful businesses at attractive prices. Given changing global dynamics, we should be prepared for volatility to increase in the coming year.

What are the challenges?

Equity valuations remain elevated, particularly for the high-quality, stable businesses we tend to focus on. Given the lower yields of other options, valuations may continue to climb higher still. The chart below shows that the most expensive 20% of the S&P 500 Index (average P/E of 26.2) generated the lowest average 10-year annualized returns; the cheapest 20% (average P/E of 8.7) generated the highest average 10-year annualized returns.

Average 10-Year S&P 500 Annualized Real Total Return Based on Price/Average 10-Year Earnings

Chart

*Earnings estimate used for latest completed quarter. Concept coutesy of Plexus Asset Management Data Source: Robert Shiller, Irrational Exuberance, Standard & Poor’s. Bureau of Labor Statistics. © Copyright 2017 Ned Davis Research Inc.

The willingness of yield-hungry investors to accept balance sheet and valuation risk is unusually high, but we remain selective and patient, ensuring we do not sacrifice quality for value, and vice versa.

Above-average valuations have reduced our long-term return expectations as a whole. Instead of reaching for higher returns by increasing risk, we remain disciplined in our risk management process. Admittedly, this is not easy to do. During a bull market, risk management can often mean leaving sizeable returns on the table. However, at the risk of short-term underperformance, our philosophy for long-term success prioritizes capital preservation on the downside. We can’t accurately predict when the current bull market will come to an end. It may take substantial time for interest rates and stock valuations to normalize. Although market transitions are uncomfortable, they provide an opportunity to invest in quality businesses as they go on sale.

How are you positioning the funds?

Elevated valuations in both stock and bond markets continue to offer a lower margin of safety, supporting a conservative asset mix in the balanced fund. The portfolios are well diversified and contain companies that are generating attractive levels of profitability while carrying below-average levels of debt. This provides a solid foundation for reinvestment, returning capital to shareholders and navigating economic turbulence. Our focus continues to be on reasonably priced businesses that are able to increase their competitiveness, expand margins and maintain growth characteristics through economic and political cycles. The Canadian funds also have much less industry concentration than their benchmarks, which are heavily weighted to resources and financials. In fixed income, we are positioned with low duration in high-quality bonds. The portfolios offer a number of attractive characteristics compared to the broader markets, providing further support in more challenging periods.

Why is this the right approach for 2018?

At a time when it is difficult to generate yield above inflation, investors are being compensated very little to take on risk. QV’s investment approach focuses on trying to manage downside risk. We take the view that it is more important to protect capital in challenging times than to try to maximize returns. We invest in enduring businesses run by capable and aligned leadership. We believe our focus on monitoring and managing the growth, value and balance sheet risks within the portfolios will continue to pay dividends over time.

icon  2018 market outlook – QV Investors

Where are the opportunities?

In 2017, growth outperformed value by a wide margin. Despite this headwind to our investment style, we continued to stick with our long-term value approach of searching the globe for good companies trading at bargain prices. In the past year, our new investments have come mainly from outside of the U.S. and across many sectors (industrials, financials, health care, real estate and telecommunications).

What are the challenges?

Looking into 2018, we believe the biggest risks to global markets are geopolitical events (North Korea, Brexit, U.S. policy) and the impact of rising interest rates globally.

Mindful of current global equity market valuations, we remain cautious of downside risks should global growth not meet market expectations.

How are you positioning the funds?

China/Hong Kong remains one of the biggest country weightings in the IA Clarington Global Opportunities Fund (23%). Over the past few years, our investments in the region have been some of the strongest contributors to the fund’s returns. While some of our positions have reached full value and, accordingly, have been removed from the portfolio, we believe the remaining positions continue to offer an attractive risk/reward dynamic. These are companies with strong industry positions and solid balance sheets, and they are trading at some of the cheapest valuations in the portfolio. Our weighting in the region has increased over the past year, as we have uncovered new investment opportunities.

Over the past year, we have also reduced our weighting in the financials sector. Since early 2016, our large-cap bank and broker stocks (Bank of America, Citigroup and Morgan Stanley) have staged a strong rally on the back of improving fundamentals and expectations for a more favourable operating environment under the Trump administration. With the strong move, these stocks are approaching our estimates of intrinsic value and we have prudently taken some money off the table.

Why is this the right approach for 2018?

With our global long-term value approach to investing, we are constantly looking for the best investment opportunities around the world across all sectors and market caps. We are constantly replacing expensive stocks with cheap ones, which allows us to avoid areas of the market (country/ sector/market cap) that may be overvalued. As a result, our funds are currently trading at a discount to the market on an earnings basis. In addition, we focus on companies with strong balance sheets or asset value support to help protect on the downside from company-specific or macro events.

Funds offer compelling valuations

Chart

Source: Bloomberg, Capital IQ and Radin Capital Partners, as at November 23, 2017. *Refers to underlying securities.

icon  2018 market outlook – Brad Radin

Where are the opportunities?

From a bottom-up, value-oriented perspective, we are finding that attractive investment opportunities are few and far between. While there are many great companies, most have been bid up to prices that a rational business owner would not consider for purchase. We insist on paying a price that gives our clients a significant margin of safety. There are some “cheap stocks” in the market today, but too often they are companies that have serious fundamental problems. This leads us to question whether they are, in fact, truly bargains or whether the numerically cheap statistics we see in their financial statements accurately reflect the underlying conditions of the business. Digging a little deeper into most of these so-called bargains leads us to reject them as buy opportunities.

Our strategy is to continue to hunt for what we have always sought after – great businesses at cheap prices. If we can’t find them, we will behave as rational business owners and wait – often with a great deal of cash – until we find companies that meet the requirements of our stringent investment discipline.

What are the challenges?

Our greatest challenge is to remain patient and not risk clients’ capital in a potentially dangerous fashion. As Warren Buffett says, “The most important quality for an investor is temperament, not intellect.” We know that historically it has been prudent to sit in cash when bargains are not available. We also know that it is difficult to sit in cash – sometimes for periods lasting years – while the market hits higher highs every day. We believe we have outperformed over the long run both because we avoid long-term losses and because we are willing to do what most investors aren’t: forego short-term gains. We point to the Shiller P/E ratio, which is an average of the last 10 years’ earnings compared to current prices (adjusted for inflation). Today, the Shiller P/E ratio is almost at the same level it was at in 1929, just before the Great Crash. The only other time it has been higher is the year 2000.

Historical Shiller P/E ratio

Chart

Source: www.multpl.com/shiller-pe, as at November 29, 2017.

How are you positioning the funds?

The IA Clarington Sarbit U.S. Equity Fund is more than 50% cash. The remainder of the portfolio is invested in eight stocks. We are great believers in concentration – putting large amounts of capital into a few extraordinary companies at great prices. As mentioned above, companies that meet our strict criteria are very difficult to find today. When we do find such companies, we want to maximize their weighting, which we believe will have a meaningfully positive impact on the long-term performance of the fund.

Why is this the right approach for 2018?

We believe that after a strong bull market over the last eight years, markets are expensive and investors should be prepared for a potential fall. We caution that we do not know the timing or severity of this potential fall. But, we aren’t new to this business and we’ve lived through both bull and bear markets. Benjamin Graham, the father of value investing, said: “The essence of investment management is the management of risks, not the management of returns.” Investing in a fund that is less susceptible to decline in a crisis – thanks to excess cash reserves and investments in great, economically defensive businesses – will allow our clients to have a much greater chance of satisfying the first rule of investing: don’t lose money.

icon  2018 market outlook – Larry Sarbit

Where are the opportunities?

At this time last year, we predicted a strong Canadian economy, opportunity in equities and a rebounding resource sector. Much of what we predicted has materialized. The U.S. and global economies have also continued to improve. In fact, we’re now seeing synchronized growth across all 35 Organisation for Economic Co-operation and Development (OECD) countries for the first time since 2007. After a weak first half of 2017, commodities have shown signs of life and are up significantly from their lows. Underlying Canadian stock fundamentals continue to improve and Canada’s GDP growth leads the G7 economies. Corporate profits have rebounded and the loonie strengthened against the U.S. dollar. And yet, despite an improving resource landscape and strong economy, Canada’s equity market was one of the worst performers in 2017.

We may have been early, but our thesis on Canadian equities still holds. In fact, the case for Canada is now even stronger. Negative sentiment towards Canada is overdone and has pushed Canadian equities to excessive lows. The valuation gap between Canadian and U.S. equities is at a level not seen since 2008. Last year, growth stocks outperformed value by the widest margin since the dotcom bubble as investors chased performance. But at some point, valuation, earnings and fundamentals have to matter.

Déjà vu?: Value and Canadian equities dominated after dotcom bubble

Chart

Source: Bloomberg, June 1999 – December 2005.

Keep in mind that the current expansion is still young. Indeed, while this is one of the longest economic cycles on record, there’s still a long way to go. We’ve been saying this for a while, but the typical signs that we are nearing the end of the cycle – high inflation, high interest rates, wage growth and rising unemployment – are just not there. Leading indicators suggest this expansion could last another five or six years. Expansion is an important phase for equities vis-à-vis bonds and for Canada in particular, with its largely cyclical-based equity market. In the expansion phase we can expect global manufacturing capacity to tighten, which in turn will drive up the value of many products produced here in Canada and sold globally. With capacity at its maximum and a stronger global economy, companies will have the confidence to start reinvesting in their businesses. Canada’s resource market supplies much of the materials to support that growth.

What are the challenges?

Canada’s underperformance relative to the U.S. in 2017 was likely due, in part, to trade concerns and our southern neighbour’s more investor-friendly policies. As the U.S. moved to reduce taxes and relax regulation, Canada moved in the opposite direction. With NAFTA still up in the air, Canada’s trade relationship with the U.S. is a major concern. Our government appears to be making little progress on a NAFTA deal as U.S. threats to scrap the agreement loom. Ending NAFTA could throw a wrench into Canada’s thriving economy and put pressure on our dollar. Experts argue about how severe the damage to Canada’s GDP could be, but some sectors (auto manufacturing) and regions (Ontario) are more vulnerable. That said, Canada is the largest consumer of U.S. products in the world and a key supplier of materials and parts. Canada–U.S. trade accounts for about 5% of U.S. employment and almost 7% of U.S. GDP. Given that President Trump is pro-business and pro-jobs, it would make little sense for him to eliminate any trade deals with Canada. Too many states are dependent on Canada for imports and exports. Also, companies we have consulted with generally agree that eliminating trade deals would have far-reaching ramifications that the Trump administration couldn’t ignore – job losses, plant closures, and a lack of U.S.-based alternative suppliers or manufacturing infrastructure.

How are you positioning the funds?

The Focused Funds are almost fully invested to position for continued growth in the U.S. and an improving global economy. We continue to overweight Canadian equities, with a focus on highly cyclical sectors and interest rate sensitive businesses that are best positioned to benefit from the expansion (which, as mentioned, could last another five or six years). In the expansion phase, you want exposure – not protection. We have good exposure to high-quality cyclical U.S. names leveraged to the economy and rising rates. We are maintaining the Funds’ exposure to resource-based equities just above market weight. In the energy sector, we are focused on producers. Staying true to our contrarian roots, we continue to add new positions and increase existing positions at points of maximum pessimism. Last year we were rewarded for adding to key positions such as Encana Corp., when the stock hit 52-week lows on weak commodity prices. We were also rewarded for taking advantage of short-term market overreaction to negative news surrounding MDC Partners and Home Capital Group. We have been prudent in our security selection, focusing on quality companies that can endure periods of market turbulence. Our portfolios are concentrated, with about 27 positions, so we can be opportunistic. And we have the flexibility to shift the portfolios’ sector and geographic exposures if we believe conditions are changing.

Why is this the right approach for 2018?

While value investing outperforms growth over the long term, there will always be periods that favour growth. The past few years have been difficult for value investors. Value stocks tend to be mid-to-late cycle performers. The Canadian investment landscape is largely value-based, dominated by companies with cycle-sensitive earnings. Synchronized global growth bodes well for value investors and Canadian equities in particular. We are also buoyed by the prospect of rising interest rates, which tend to favour value stocks over growth. Historically, Canada’s equity market, and its energy sector in particular, has outperformed following rate hikes.

Our bullish stance on Canada doesn’t mean we’ve given up on the U.S. We believe the U.S. economy, and in turn, U.S. equities, still have legs. The U.S. equity market continues to advance and mark new all-time highs, despite a volatile political environment and recent natural disasters. Investors abandoned Canada last year, but at some point fundamentals take over and investors go where they see the most upside. Taken together, a solid domestic economy, strong earnings, attractive valuations and our position in the cycle make a very strong case for Canada.

icon  2018 market outlook – David Taylor

Where are the opportunities?

A supportive macroeconomic backdrop remains for 2018: there continues to be a broad-based, synchronized recovery in global GDP; forecasts for global earnings-per-share growth in the high single digits look achievable; low unemployment has not yet translated into significant wage inflation; and the usual signals of recession are not present.

Given that we are still in the latter stages of the economic cycle, we are focused on opportunities that meet our environmental, social and governance (ESG) criteria within “late cycle” sectors showing earnings growth leadership, such as financials and industrials. We also believe areas of secular growth, such as established technology companies, will maintain attractive profit margins, benefit from corporate capital expenditures and continue to add value.

Financials, insurance companies and banks have historically increased profitability when short-term interest rates rise.

Industrials tend to benefit from inventory replenishment and improving capital spending. Companies in this sector are in good financial shape: margins have soared, balance sheets are strong, net debt has decreased and earnings growth has stabilized.

Another beneficiary of corporate investment is the technology sector, as companies invest in technology to improve productivity. In addition, the consumer side of technology continues to be supported by a robust economy, low unemployment and buoyed consumer sentiment.

We believe that established, high-quality firms with a proven history of profitability will be the key supporters of equity market returns in 2018. Both capital appreciation and dividend income will be equally important components of return expectations.

What are the challenges?

It is too early to call a recession, but after coming through the historically low volatility and modest drawdowns of 2017, we expect the ride for markets to get a bit bumpier in 2018.

Annual S&P 500 Index returns and maximum drawdowns

Chart

Source: Bloomberg as of October 31, 2017. In U.S. dollars.

Valuations have increased but may be range bound in 2018, with expectations for higher interest rates and rising inflation capping multiple expansion. Earnings growth will have to drive the next leg of the economic expansion.

Stock selection remains a critical part of our investment process as companies reporting earnings shortfalls will likely see their share prices under pressure.

How are you positioning the funds?

Our collaborative, socially responsible investment approach integrates ESG analysis with traditional financial analysis. We only invest in companies that meet both our ESG and financial criteria. This strategy results in portfolios of sustainable businesses that have earnings growth rates and return on shareholder equity that are better than market levels.

From a global developed market perspective, we think Europe still has room to catch up to U.S. equity markets. The overhangs of Brexit, European Central Bank stimulus tapering and political uncertainty have hampered economic growth. We will continue to look for opportunities in the region.

Why is this the right approach for 2018?

ESG factors not only help make a portfolio socially responsible, they also add a layer of risk management that conventional portfolios may lack. This enhanced risk mitigation may help stabilize investors' portfolios as volatility picks up in 2018. Maintaining discipline by ensuring that portfolios are regularly rebalanced to their long-term target asset mix is one of the best ways of taking advantage of increasing volatility without taking undue risk. We expect that 2018 should still offer opportunities for long-term investors with diversified portfolios.

icon  2018 market outlook – Andrew Simpson


Forstrong Global Strategist Income Fund
Forstrong Global Strategist Balanced Fund
Forstrong Global Strategist Growth Fund
IA Clarington Global Yield Opportunities Fund

Where are the opportunities?

Despite numerous recent geopolitical hurdles (Brexit negotiations, tensions with North Korea, Catalan secession efforts and a turbulent U.S. political backdrop, among others), global growth finally appears to have gained a solid footing. For the first time in a decade, all 35 Organization for Economic Co-operation and Development (OECD) member countries are growing their economies simultaneously. This has led to a resurgence in trade activity, as evidenced by emerging market exports exhibiting the fastest growth rate since 2011. Low commodity prices continue to provide a boost to consumption and feed into tepid inflation, permitting many central banks to maintain stimulative monetary policies.

Recoveries in Europe and Asia are still in their infancy relative to the U.S., which should allow for an extended period of catch-up growth. Pro-Euro political victories in the Netherlands and France have helped ebb EU dissolution fears. With the European Central Bank still highly accommodative, unemployment has been sharply decreasing and loan growth is finally starting to perk up. In Japan, return on equity has been quietly trending upwards and corporate profits just hit a record high relative to GDP. Japanese companies also happen to be sitting atop US$4 trillion in cash. That means capital expenditures can be radically increased without borrowing.

Given this backdrop, developed market equities outside of North America look attractive. As shown in the chart below, EAFE equities offer compelling valuations relative to their North American peers, and appear to be forming a bottom after underperforming since 2009.

MSCI EAFE/MSCI North America

Chart

Source: MSCI, Macrobond, Forstrong Global Asset Management. As of October 31, 2017. 1 3 Month moving average. 2 Rebased: December 31, 2008 = 100.

What are the challenges?

The current global equity bull market is one of the longest on record, and numerous indices are hitting record highs on a weekly basis. At times like these, we must be especially vigilant, keeping a close eye on risk indicators and challenging our existing views. What are some of the things that keep us up at night? Extremely tight high-yield spreads, low equity and interest rate volatility, frothy valuations and highly optimistic market sentiment, to name a few. A flattening U.S. yield curve since the presidential election last year is inconsistent with an accelerating growth environment. Does the bond market know something that the stock market does not?

Additionally, the U.S. Federal Reserve has at long last shifted from quantitative easing (QE) to quantitative tightening (QT). The Fed’s holdings of treasuries and mortgage-backed securities will be reduced as it seeks to taper its balance sheet. We must acknowledge that QT is unprecedented, and could have unforeseen consequences for financial markets. However, we do not believe that QT will have the equal and opposite effect of QE. Gradually removing stimulus when markets are functioning well is likely to have far less impact than QE had when markets were in turmoil.

How are you positioning the funds?

When evaluating the global investment landscape, Forstrong’s primary focus is always risk management. Regardless of the degree of conviction we have in our views, broad global diversification remains the first line of defense at all times.

The funds remain modestly overweight equities and underweight fixed income. From a regional perspective, we have a preference for developed market equities in Europe and Asia, as well as emerging market fixed income. We are overweight financial sector stocks in the U.S. and Europe, and continue to favour exposures with above-average dividend yields. Our cautious outlook on interest rates has warranted higher cash levels and reduced bond duration.

Why is this the right approach for 2018?

With global growth likely to persist into 2018, the above positioning attempts to capitalize on a constructive environment for corporate earnings. Overweighting equities, particularly in markets with high operational leverage to global supply chains, is our preferred approach. The U.S. economy appears to be transitioning into a late cycle phase, while years of outperformance versus global peers has left the stock market with lofty relative valuations. This reinforces our preference for Europe and Asia, which are earlier in their respective business cycles.

While inflation has been stubbornly low since the Global Financial Crisis, a continuation of economic momentum should ultimately be reflationary in nature. This, coupled with a gradual transition towards monetary tightening from major central banks, will likely put upward pressure on bond yields. Although interest rate movements can be difficult to forecast in the short term, we foresee an asymmetric risk profile over the medium term, and believe that a shortened-duration profile is justified. Emerging market bonds offer attractive yields, while an improving economic backdrop should help support spreads, even as the Fed continues to raise interest rates.

icon  2018 market outlook - Tyler Mordy

IA Clarington Strategic Corporate Bond Fund
IA Clarington Strategic Equity Income Fund/Class
IA Clarington Strategic Income Fund
IA Clarington Strategic U.S. Growth & Income Fund
IA Clarington Tactical Income Fund

Where are the opportunities?

Finding investment opportunities over the next year will have more to do with security selection and sector allocation and less to do with just being invested. A bottom-up, fundamentals-driven approach will be critical to finding the right securities. Flexibility to shift portfolio allocations will also be key to adapting to broad macroeconomic movements.

Things have changed over the past year. We have seen synchronized global economic growth for the first time in almost a decade. This is clear from a number of indicators, particularly robust consumer spending and healthy levels of global liquidity. It is also evident when we compare current Purchasing Managers’ Index (PMI) data to figures from a year ago (see graph below).

PMIs indicate synchronized global growth

Chart

Note: Measured through August 2017. Source: Bloomberg; RBC CM Canadian Equity Strategy.

This cycle appears to have staying power and will favour equities over government bonds for the foreseeable future. Investors looking for a balanced approach may want to consider a fixed-income allocation that favours credit, including higher-yielding bonds, and focuses less on interest rate sensitive government securities. The current environment, which is characterized by monetary policy normalization, should be more supportive of value investing than growth investing. It should also be supportive of stable-to-higher oil prices and higher interest rates.

Our call over the past two years that the Canadian dollar would appreciate relative to the U.S. dollar has been out of consensus, but accurate. We expect the Canadian dollar to appreciate for a third year as 2018 progresses. Against this backdrop, we expect global economic growth to exceed expectations for a second straight year. This bodes well for U.S. and European equities, but Canadian equities are likely to have better returns than both.

What are the challenges?

Can this environment be so good that it’s actually bad? Not from a fundamental perspective. However, we should be concerned about central banks around the world reducing their balance sheets. While central banks begin to taper, equity markets have enjoyed one of their longest stretches in recent history without a material correction. We expect a correction in equity values during the first half of 2018, which will likely sow the seeds for attractive returns in the year following.

How are you positioning the funds?

Our philosophy is based on investing in businesses, rather than market multiples. We search for companies that have sustainable business prospects, as well as safety in their cash flows and dividends. We wrap this bottom-up, fundamental approach with a macroeconomic overview to help mitigate potential risks and identify possible opportunities.

With positive economic momentum, rising interest rates and stable-to-increasing inflation, our funds are currently positioned with an even split between what we consider defensive and cyclical holdings. As interest rates are biased upward, we are finding better risk-adjusted yield opportunities in equities than fixed income. Our equity exposure also generally has a higher dividend yield than the market. Our fixed-income exposure is concentrated in lower interest rate sensitive high-yield corporate bonds, as we believe the economy will remain strong while rates are increasing. We are also positioned for near-term market volatility with a higher-than-normal cash position. Volatility generally creates attractive buy opportunities; with a higher cash allocation, we are able to take advantage of individual opportunities as they present themselves.

Why is this the right approach for 2018?

We view the risk of recession to be minimal, but there is potential for an earnings growth pause, which may cause a short-term market correction. We believe a correction in the context of a secular bull market would be welcome news for well-positioned investors to take advantage. In a normalizing environment, we should expect security selection to be an important driver of investment returns. Minimizing exposure to sectors with excess interest rate risk will be an important tool for minimizing downside potential.

icon  2018 market outlook - Dan Bastasic

IA Clarington Floating Rate Income Fund
IA Clarington U.S. Dollar Floating Rate Income Fund
IA Clarington Core Plus Bond Fund
IA Clarington Tactical Bond Fund

Where are the opportunities?

As we enter 2018, the global macroeconomic backdrop remains positive, with moderate GDP growth, strong corporate earnings and low inflation. These conditions support U.S. Federal Reserve monetary policy normalization through continued interest rate increases and, potentially, balance sheet reduction. We are positive on the prospects for investment grade and non-investment grade credit in 2018. However, we are in the latter stages of the economic and credit cycle. This suggests that, while there may be further room for appreciation, there is likely less room than at earlier points in the cycle. By many metrics, current valuations are elevated for both equity and fixed-income markets. Credit spreads continue to be very tight as default rates remain low. Our outlook for credit is positive in the current environment, as fundamentals are supportive, but we remain conservative in our portfolio positioning with a focus, as always, on minimizing surprise risk.

Global demand for yield remains strong in the current low interest rate environment. Yield curves have flattened in the latter half of 2017 as the Fed and Bank of Canada have increased their overnight rates. Bond yields at longer parts of the curve remain anchored by expectations of low inflation and bids from European and Japanese fixed-income buyers. If yield curves remain flat, we expect demand from retail loan mutual funds and ETFs to be modest, which was the trend in the latter part of 2017. Earlier in 2017, when the yield curve steepened due to expectations of higher inflation from President Trump’s policies, we witnessed increased investor demand for loans. This led to a surge in refinancing activity and, as a result, spread compression and lower coupons. Some of the compression has been offset by an increasing LIBOR, the floating leg of a loan’s coupon. The 3-month LIBOR rate has increased roughly 48% year-to-date and currently sits at 1.48%. LIBOR should continue to march higher next year in tandem with expected increases in the U.S. overnight rate. Consistent with prior years, we expect a coupon-like return for loans in 2018, which we believe will be attractive to investors given the alternatives in fixed income.

What are the challenges?

We expect to end 2017 with a relatively flat yield curve, as expressed by the spread between yields on 10-year and 2-year government bonds (2/10 spread) in Canada and the U.S.

Canada and U.S. 2/10 spreads

Chart

Bloomberg, as at November 30, 2017.

We also expect interest rate increases from both the Fed and the Bank of Canada. The flat yield curve provides investors with minimal incremental compensation for taking on interest rate risk. Investors looking to increase yield have to incur meaningfully more interest rate risk to achieve their targets. Low yields also reduce the margin of safety to absorb the negative consequences of even small increases in rates.

A flat yield curve, combined with a more aggressive stance on interest rate increases from the Fed, may be a positive for investors in floating rate loans. Increases in the overnight rate typically lead to increases in 3-month LIBOR, thereby increasing loan coupons. Historically, increased fund flows into loans occur when there is a steepening of the yield curve. If the yield curve remains flat, inflows into loans should remain muted, thereby decreasing spread compression from refinancing activity.

How are you positioning the funds?

In general, we continue to position all the funds we manage quite conservatively in order to limit price volatility and surprise risk. Our non-investment grade positions are focused on larger companies with higher credit ratings. As usual, we avoid companies with cash flows linked to commodity prices, which are inherently volatile.

Within our loan portfolios, we started purchasing European loans in 2017 and plan to continue building this position in 2018. We initiated this position for diversification and to counteract some of the spread compression from the elevated refinancing activity in the U.S. loan market. The European loan market is smaller and almost the exclusive domain of institutional investors. As a result, it is less affected than the U.S. market by large swings in retail mutual fund and ETF flows. In addition, we are currently earning a return from hedging EUR to CAD due to differences in the overnight rates set by the Bank of Canada and the European Central Bank.

Within our investment grade mandates, we continue to be low duration. One particular area of the market where we see value is investment grade collateralized loan obligations (CLOs), specifically AA and AAA-rated CLOs, which offer an enhanced yield and lower duration over traditional securities like corporate and government bonds with the same rating.

Why is this the right approach for 2018?

Our philosophy has always centered on the belief that investors want low volatility and minimal surprise risk from their fixed-income portfolios. Accordingly, our strategy is to construct portfolios with a focus on capital preservation rather than generating outsized returns by reaching for yield or actively trading. The value-add we deliver through active management is the ability to avoid areas of the market where the potential downside is greater than any potential upside. We believe this is the right approach to fixed income in any market environment.

icon  2018 market outlook - Jeff Sujitno

IA Clarington North American Opportunities Class
IA Clarington Growth & Income Fund
IA Clarington Canadian Conservative Equity Fund/Class

Where are the opportunities?

We continue to prefer equities over fixed income and expect the continuation of the synchronized global recovery to be conducive to corporate earnings growth, which in turn should drive markets higher despite current valuation levels. Global growth remains on a strong footing – despite a slowing China – and is in its early stages for many parts of the world.

We continue to see positive earnings growth in North American markets. Current consensus expectations for EPS growth is 10% for the U.S. and 9.3% for Canada, which is fairly robust. If tax reform is successful in the U.S., earnings growth could increase significantly from current estimates. Finally, as we stated last year, inflation should grind higher, and on that basis, we could see interest rates continue to increase. This, in turn, could lead to a rotation of funds from traditional fixed income into equities, which should help sustain multiples for a period of time.

U.S. inflation expectations rising

Chart

Source: Federal Reserve Bank of St. Louis, as at November 29, 2017.

What are the challenges?

The risk/reward environment has become less favourable after market appreciation in many asset classes over the last couple of years. Key to continued market appreciation is positive earnings growth, as the multiple expansion story has pretty much played out. With this backdrop, we need to see earnings meet or beat expectations. Further, macro momentum is expected to slow while inflation should trend modestly higher in 2018. In 2017, inflation was muted due to a combination of cyclical and structural factors. However, with unemployment running at decade-low levels, despite a generational demographic shift, we could see inflation come back faster than expected, which could accelerate U.S. Federal Reserve interest rate increases and potentially cause some pressures (such as a decrease in U.S. bond prices and a potentially short-term drag on U.S. equity markets). The removal of liquidity by central banks across the globe also puts us in uncharted territory, but we expect it to unfold in the most investor friendly way possible. Another potential issue is geopolitical risk. Areas of concern include the North American Free Trade Agreement (NAFTA), Brexit, North Korea, Russia, Organization of the Petroleum Exporting Countries (OPEC) and the Middle East. Taken together, the range of challenges we face as we transition into 2018 suggest higher volatility in the year ahead.

From a longer-term perspective, we believe that we are on the cusp of a multi-decade inflection point with respect to many disruptive technologies, including electric vehicles (and supporting infrastructure), artificial intelligence, blockchain, cryptocurrencies, automation, the internet of things, the sharing economy and the Amazon effect. There will be many opportunities here, as well as many risks. Moreover, there is significant potential for “old world” industries to suffer irreparable setbacks, both in terms of investor sentiment and valuations.

How are you positioning the funds?

We are likely in latter stages of the economic cycle. Historically, this means some of the best returns of the cycle, which can more than offset any short-term losses that come during inevitable periods of economic softness. We are ardent believers in value creation through compounding over the long term. With all three of our mandates, we are always focused on net-of-fee risk-adjusted returns. At this point in the cycle, we see prudence in being extremely selective in light of increasing leverage and valuations across many sectors and companies. To do this, we place particular emphasis on companies that have balance sheet strength and economically resilient business models. This allows them to generate sustainable free cash flow and increase dividends in all environments.

For income generation through dividends in our large-cap mandate, the IA Clarington Canadian Conservative Equity Fund, we continue to favor a balanced approach between the more defensive interest rate sensitive sectors (e.g. consumer staples and telecommunications companies) and the procyclicals (e.g. Energy, consumer discretionary and industrials), which should benefit from global growth in 2018. We are not giving up on the bond proxy sectors (such as pipelines, utilities, telecommunications companies and REITs), as we still see pockets of value and the ability to safely receive dividends from select securities. We also believe these sectors can provide stability during expected periods of volatility in 2018.

The equity portion of our multi-asset class alternative income mandate, the IA Clarington Growth & Income Fund, and our conservative growth mandate, the IA Clarington North American Opportunities Fund, are positioned similarly. For our North American allocation, we intend to position the portfolios more in large- and mid-cap names with global exposure, as we expect these to outperform smaller-cap names in the U.S., given the stage of the cycle, valuations and leverage levels. However, success for U.S. tax reform would be the upside risk here for a period. In Canada, which disappointed in 2017, we continue to expect headwinds for domestically related stocks, given the indebted consumer. However, given solid global growth, we are positioning the portfolios in Canadian sectors and companies with U.S. and global exposure that can prosper from the global reflation trade. These are the types of companies that tend to benefit from rising economic growth and inflation, such as cyclical equities, for example. When we look for Canadian companies with U.S. exposure, we strive to make sure they have the U.S. capacity and labour to satisfy U.S. demand in this new protectionist era.

Why is this the right approach for 2018?

We see no reason to stray from our time-tested approach of investing in reasonably priced, quality stocks. We’re looking for companies that can grow earnings and cash flow, and have the ability to increase dividends on pace with increases in the 10-year U.S. government bond yield. Dividend growth strategies tend to perform well in most environments, but especially in environments like the current one. On the valuation spectrum, we also see GARP (Growth At a Reasonable Price) stocks outperforming both growth and value stocks at this stage of the cycle.

icon  2018 market outlook - Terry Thib

IA Clarington Monthly Income Balanced Fund
IA Clarington Yield Opportunities Fund
IA Clarington Managed Portfolios
IA Clarington Global Yield Opportunities Fund

Where are the opportunities?

With the current bull market moving into its ninth year, valuations have become very expensive, which means we should lower our return expectations for 2018. Following what will go down as one of the least volatile years in recorded history, in 2018 markets will likely see a return to a healthy level of volatility.

We continue to see opportunities in equities, but favour the EAFE and Canadian markets, which trade at attractive discounts relative to the U.S. A more volatile market favours active investors, and we plan to take advantage of opportunities the markets present us in 2018.

Long-term bonds also seem well anchored at current levels and could offer investors some downside protection in case of a stock market pullback. One “asset class” that has remained volatile is the Canadian dollar, and we continue to dynamically manage our exposure to foreign currencies.

What are the challenges?

Uncertainty surrounding the fate of the North American Free Trade Agreement (NAFTA), as well as the increasingly protectionist tone from the U.S., could be a drag on growth in the years to come. Keep in mind that since China joined the World Trade Organization (WTO) in 2001, exports (and, incidentally, Wall Street earnings) have grown at a much faster rate than global economic activity.

In Europe, political uncertainty in Germany could make investors ponder whether the good times can last. While the European Central Bank is getting closer to ending its quantitative easing program, there is some risk that the eventual removal of liquidity could lead to a rapid, mass exodus from certain asset classes, especially European high-yield bonds, which currently offer similar rates to U.S. Treasuries.

The ongoing process of monetary policy normalization should continue to push short-term rates higher, leading to a further tightening of the yield curve. This could cause a shift in investor sentiment and pave the way for the return of healthy volatility.

Valuations favour EAFE and Canada over the U.S.

Chart

Chart

Source: Bloomberg as at December 1, 2017. * Based on 12-month forward earnings for price earnings ratio (P/E) and 12 months forward book value for price to book ratio (P/B). Canadian equities represented by S&P TSX Composite Index, U.S. equities represented by S&P 500 Index and EAFE equities represented by MSCI EAFE Index.

How are you positioning the funds?

Given pricey equity valuations, particularly in the U.S., we are leaning towards a more neutral weight on equities, but with a tilt towards the Canadian and EAFE markets. We continue to hold some put options on the major indices, as low volatility is keeping the cost of protection at historically low levels. We also hold some preferred shares, through an ETF, as well as some long-term U.S. Treasuries to add further downside protection to the portfolios amid growing geopolitical risks.

Why is this the right approach for 2018?

The combination of a potentially slowing global economy, rising protectionism, hefty valuations and a flatter yield curve could mean more volatility in the markets next year. Downside protection will be crucial, and investors should avoid overreaching for returns. We will carefully monitor and manage risks and rely on our active approach to add value for clients as opportunities arise.

icon  2018 market outlook - Clément Gignac

IA Clarington Global Value Fund
IA Clarington U.S. Dividend Growth Fund
IA Clarington U.S. Dividend Growth Registered Fund

Where are the opportunities?

Value stocks underperformed growth stocks in 2017 by a wide margin, but we believe they could catch up in 2018. The S&P 500 index is trading at 18× forward earnings, compared to 14× for the IA Clarington U.S. Dividend Growth Fund. The market in 2017 has been dominated by technology stocks, particularly the FANGs (Facebook, Amazon, Netflix and Google), leaving other names below the radar. Amazon-related fears have created opportunities in many consumer and industrials stocks. We are also seeing opportunities in financials, technology, health care and energy.

What are the challenges?

President Trump’s protectionist bent is an issue, and any significant move in this direction would not be welcomed by investors. There is a mix of complacency and head scratching about the low inflation numbers in the U.S., and protectionism could create additional concerns on that front. Unexpected inflation, which could change the U.S. Federal Reserve’s dovish tone, is something we need to watch for.

The U.S. President’s tax plan could change the earnings growth outlook for the S&P 500 Index. Uncertainty surrounding the final outcome can cause more volatility in many sectors of the stock market.

How are you positioning the funds?

The funds have a focus on large-cap dividend growth stocks. We are positive on financials stocks in particular because of their attractive valuations compared to the S&P 500 Index and the protection they offer against rising interest rates. At least two other factors make these stocks attractive. The first is the Trump administration’s plan to significantly reduce the regulatory burden imposed upon the financials sector by the previous administration. This reversal will likely become a tailwind not only for share prices, but also for dividend growth, which has been negative in recent years (see chart below). The second factor is the Trump administration’s pro-growth tax reform plan, which we also expect to be positive for the sector’s share prices and dividend growth.

Financials vs. S&P 500 Index: historical and estimated dividend per share growth

Chart

Source: BMO Capital Markets Investment Strategy Group, Bloomberg, as at November 17, 2017.

In the healthcare sector, consolidation between pharmaceutical and biotech firms may increase potential development of ‘blockbuster’ pharmaceuticals. Some technology names are still attractive even after a strong 2017. Energy names have underperformed commodities by a wide margin and are so out of favour that they need to be considered for an overall re-rating in 2018. The funds remain underweight in the bond proxy sectors such as utilities and real estate.

Why is this the right approach for 2018?

We believe that dividend growers in the U.S. could do well in 2018. Both dividend growers and value stocks tend to outperform in a rising Treasury bond environment. When selecting dividend growers, we emphasize value criteria and are always looking for stocks with a combination of 25% upside potential over the next 12 – 18 months and limited downside risk. More volatility and less expected return in the stock market could lead us to use our covered call strategy in 2018 much more than we did in 2017. Active currency hedging also remains also an important part of our strategy to protect returns.

icon  2018 market outlook - Pierre Trottier

IA Clarington Global Tactical Income Fund

Where are the opportunities?

The economic environment continues to improve, with growth becoming more synchronized globally. We expect the expansion to continue in the absence of a geopolitical shock. While the Trump administration has had difficulties implementing much of its proposed pro-growth agenda, we do believe there is a strong possibility that some items, such as deregulation and tax reform, could come to fruition. If successfully implemented, we expect these policies to be supportive of GDP growth and equity markets, particularly in the financials and industrials sectors.

Outside the U.S., Europe should continue to perform strongly with significant excess capacity, and most emerging market economies are still early in their recoveries. Against this backdrop, we expect continued profit growth (and low interest rates) to support equity valuations. Specifically in equities, we believe there are many opportunities in the technology sector as the pace of change accelerates. Innovation is also creating disruptions (and opportunities) in other industries, particularly retail, consumer goods, media and healthcare.

In global fixed income, we expect government bond yields to rise, but not substantially. Developed markets could see higher yields, albeit at a low trajectory, given our inflation and monetary policy expectations. An inflation surprise could spur less positive outcomes for bonds, but we think medium- to long-term yields will move moderately higher over the next 12 months. We also expect the U.S. dollar to be range bound relative to global peers. Emerging market aggregate economic growth has been outpacing the U.S. and attracting equity inflows. Strong earnings expectations outside the U.S. could lead to further U.S. dollar outflows.

What are the challenges?

Global markets could become more volatile in 2018, driven by changing central bank policies and geopolitical events. As mentioned above, the Trump administration’s ability to implement its pro-growth agenda is still uncertain, and failing to achieve growth-supportive policies could prompt a negative response from investors. An increasingly bellicose North Korea continues to make headlines; thus far markets have had a fairly muted response, but are likely to react if there is further escalation. In Europe, economic data continues to show signs of improvement; however, various populist forces are still at play. Brexit proceedings appear to be moving slowly at best, offering limited visibility and creating an uncertain investment environment. There are also rising tensions in the Middle East, with Saudi Arabia and Iran fighting proxy wars across the region.

How are you positioning the funds?

From an allocation perspective, the fund continues to have a majority equity allocation, reflecting our view that valuations are more attractive in equities than fixed income.

In equities, portfolio positioning continues to be driven by individual security selection. We focus on stocks that possess three alpha drivers: quality, the ability to grow intrinsic value over time and attractive valuations. At the sector level, we have significant exposure to the information technology, financials and industrials sectors. We have no exposure to utilities or telecom.

Within information technology, we hold leaders in platform businesses with strong network effects and consulting companies with robust technology capabilities that help companies adapt to a rapidly changing environment. In financials, we hold a mix of balance sheet-sensitive names and fee-based businesses, as well as companies that are supported by secular trends. In industrials, we hold high-barrier-to-entry companies and businesses with replacement, consumable or subscription-based products, offering steady cash flow growth and visibility. Lastly, in consumer discretionary we hold travel-oriented companies with internal growth levers and e-commerce companies.

In fixed income, we are positioned for increasingly synchronized global growth and a benign inflationary environment, with exposure to credit supported by strong fundamentals or compelling value. We expect a modest rise in yields on U.S. Federal Reserve interest rate hikes and balance sheet reduction plans; we hold short-duration developed market bonds and longer-duration bonds of select emerging markets. We also believe we are past the peak of the default cycle and a recession is unlikely until 2020 (at the earliest). Therefore, we are maintaining exposure to preferred high-yield issuers. Given expensive developed government bond markets and below-average credit spreads at the broad market level, we are also maintaining above-average liquid reserves in government bonds that could be deployed in any higher-yielding opportunities that arise in 2018. Interest rates remain negative after inflation in most developed economies, posing a challenge for investment grade fixed income investors.

Chart

Source: Trading Economics, as at November 23, 2017.

Why is this the right approach for 2018?

We believe asset allocation shaped by our best global alpha opportunities can generate attractive long-term risk-adjusted returns. We allocate capital by leveraging our core competency in fundamental research, which we believe is a more effective method to allocate capital than trying to correctly predict macroeconomic variables (which may be backward looking and not correlated with returns). We anticipate new opportunities to allocate capital on an individual security basis across both equity and credit in the coming year, as we expect volatility to increase due to changing global monetary policies and political uncertainty.

icon  2018 market outlook – Loomis, Sayles & Company

IA Clarington Emerging Markets Bond Fund

Where are the opportunities?

Global synchronized growth appears to have sufficient drive to carry over to 2018. This theme is garnering increased attention among investors and central banks, specifically around stronger growth in emerging markets (EM). We share this optimism, and believe that average growth among EM economies could rise to 4.8% in 2018, from 4.4% in 2017, on the back of an improved global trade outlook, higher commodity prices and domestic-led growth.

This should eventually lead the growth differential between EM and developed markets (DM) to widen to levels not seen for more than five years. This would be a reversal of a convergence trend that has been broadly in place since 2009 and could signal significant returns in EM.

Emerging markets offer a vast debt universe in both U.S. dollars and local currencies. We advocate for dynamic allocation between the three dominant asset classes: sovereign hard currency debt, sovereign local currency debt (unhedged), and corporate debt. Over a 12-month investment horizon, we have a preference for local currency debt, based on expectations of upside from currency appreciation. While these trends never occur in a straight line, the more conservative investor will want to maintain an allocation to U.S. dollar debt, which tends to reduce return volatility.

The EM/DM growth differential is widening, with EM inflation at historical lows

Chart

Source: IMF, World Economic Outlook Update as at October 2017.

The shrinking EM/DM growth differential accelerated between 2013 and 2015. This, combined with a broadly stronger U.S. dollar, drove EM currencies down. However, weaker exchange rates have allowed EM economies to recuperate and gave some of the more vulnerable countries time to get their current account imbalances back into shape. If growth dynamics reverse, this could be the missing piece of the puzzle to orchestrate a stronger, fundamentally driven revival in EM currencies against the U.S. dollar.

What are the challenges?

The main challenge to our optimism on EM currencies is that emerging markets are not isolated from what is going on in the rest of the world. External factors, such as the Fed’s interest rate policy and uncertainty surrounding U.S. President Trump’s policies (including the current tax plan proposal and continued concerns about international trade), could have a significant impact on the U.S. dollar and dollar-denominated EM bonds – both positive and negative. This would call for actively managing investment positions and making timely decisions on when to have exposure to the U.S. dollar and when to diversify away from it. The U.S. dollar has a tendency to react very strongly to unexpected signals or actions from the Fed, and may overreact to headlines from time to time. But since the market is now on board with the prospect of the Fed raising interest rates three times in 2018, we believe the surprise effect could be for the Fed to do less, particularly if U.S. inflation persistently undershoots the Fed’s target level.

In broadening the EM investment universe from U.S. dollar bonds to local market exposure, the investment team will have to be even more diligent in understanding the economic and political dynamics of those countries. Political risks are always a factor in countries such as Mexico, Turkey and Brazil, but we also view the higher risk premium associated with these countries as having been discounted by the financial markets, and higher yields compensate for that risk over time.

How are you positioning the funds?

We are using global macro-based scenario analysis and dynamic asset allocation to invest in emerging markets in an optimal fashion. Taking into account our expectations for synchronized, albeit moderate global growth, our strategic allocation has maximum exposure to local currency debt.

The technical picture remains robust for all EM debt markets, but EM corporate debt, in particular, is facing a diminishing net supply pipeline in 2018. This, together with ongoing inflows into the broad asset class, will further support corporate bond prices in a firming growth environment. Adding to the attraction, EM corporate debt is less sensitive to rising Fed interest rates and offers stability during periods of increased volatility.

From a country perspective, we like the disinflation stories in Brazil and Russia combined with improving central bank credibility in both countries. Similarly, there is great potential for declining inflation and stronger reforms in Argentina and Egypt, which could spark investor appetite. Investment grade countries such as Chile and Peru should benefit from higher commodity prices.

Why is this the right approach for 2018?

Investors have often looked at emerging markets for exciting growth stories. However, they have been starved of such stories since the financial crisis. This may be turning, as we expect EM growth to outpace DM growth in the coming years, opening new avenues for EM to outperform.

The strength EM currencies experienced in 2017 has highlighted the need for yield-hungry investors to be involved in these markets again. EM fundamentals have improved since the taper tantrum of 2013, but even with the stronger growth outlook, EM currencies are unlikely to move up in a straight line. This, along with the increase in political uncertainty in many EM countries, means active management will be critical.

Dynamic asset allocation between U.S. dollar EM debt and higher-yielding EM local currency debt offers access to the benefits of currency differentiation and the potential to participate in an upward trend in EM currencies as the rising EM growth trajectory becomes more entrenched and anchored by domestic demand.

icon  2018 market outlook - PineBridge Investments - Steve Cook & Anders Faegermann

IA Clarington Global Bond Fund

Where are the opportunities?

We expect that, overall, opportunities across global fixed income will be more limited in 2018. Anticipated changes to central bank policy are setting the stage for shifting and more volatile interest rate yield curves and a normalization of inflation. However, we also believe asset class outcomes are likely to become more dispersed, which should provide additional alpha opportunities – both across and within asset classes – for investors who can identify relatively undervalued assets.

While global central bank balance sheets will continue to expand in 2018, we anticipate a transition from expansion to contraction, as the European Central Bank (ECB) is poised to follow the U.S. Federal Reserve in exiting its asset purchase program. In the U.S., this means inflation should shift from persistently falling below target levels to meeting them. In many other developed economies, it means inflation should stabilize.

Central bank balance sheets will start to contract collectively in 2019

Global central bank balance sheet growth as a percentage of GDP

Chart

Source: Thomson Reuters Datastream, Bloomberg, PineBridge Investments, as at October 23, 2017.

We expect this shift to result in conditions that should lead to lower overall returns for global fixed income portfolios. Therefore, it becomes more critical to identify the select opportunities that can deliver the best relative returns while safeguarding portfolios.

Given improving global growth and increased interest rate risk, we see the best opportunities in higher-quality credit within non-traditional areas of fixed income – areas where portfolios tend to be underinvested. These include elements of emerging market debt, tranches of collateralized loan obligations (CLOs) and adjacent senior secured loans, and bank capital securities. Unlike most developed markets, where monetary policy normalization will be a headwind to fixed income, the fundamental outlook for many areas of emerging market fixed income is more supportive, due to a combination of stable growth and declining inflation.

What are the challenges?

The improving global outlook is allowing monetary policies to shift towards synchronized normalization, which will facilitate the exit of central banks from extraordinary measures. This will finally result in the removal of excess liquidity that provided persistent tailwinds for global fixed income in recent years.

Valuations across many asset classes have compressed substantially, leaving little room for downside risk. At current valuation levels, most fixed-income asset return outcomes have become more asymmetric, whereby reasonable upside scenarios result in coupon returns that are at or near historical lows. And just as there are key monetary policy risks, increasing levels of fiscal and political policy risks could have a negative impact on fixed-income portfolios.

How are you positioning the funds?

In this environment of limited upside potential but increasing downside risk, we are advocating a more defensive portfolio bias overall, particularly with respect to interest rate risk. While conditions are supportive of corporate credit risk, generally tight valuations call for an incrementally more defensive approach toward credit risk as well.

We currently favour secured floating-rate credit assets such as bank loans and higher-rated CLO tranches. Our overall duration profile is short, at less than two years, to mitigate interest rate risk. Given the favourable outlook for, but tight spreads on emerging market debt, we have some highly targeted positions in local currency and hard currency debt. Within developed markets, we favor U.S. assets relative to Europe and Japan. We are also in certain safer assets, such as high-quality asset-backed securities (ABS), which provide flexibility to reallocate should attractive opportunities arise from increased volatility or market shocks.

Why is this the right approach for 2018?

We believe it is prudent to have a broadly defensive approach to fixed-income portfolios with targeted risks that offer better relative-value yield opportunities. This is not the environment to chase yield by extending duration or increasing credit risk. Our base case expectation is for a favourable macroeconomic backdrop, where many asset classes tighten further as investors reach for returns and inflation remains subdued. But we believe most fixed-income assets are currently valued for a near-Goldilocks scenario. Therefore, any deviation from it poses more downside risk, as there is limited cushion to absorb a change in investor outlook. In this environment, we believe that focusing on safety and flexibility with selective yield enhancement opportunities is the appropriate course.

icon  2018 market outlook - PineBridge Investments - Michael J. Kelly & Steven Oh

IA Clarington Canadian Balanced Fund/Class
IA Clarington Canadian Small Cap Fund/Class
IA Clarington Global Equity Fund

Where are the opportunities?

Broadly speaking, it is increasingly difficult to find value today, but we continue to identify opportunities on a company-by-company basis across asset classes, sectors and geographies. Share price weakness, resulting from what we believe to be short-term headwinds, has allowed us to enter new investments and increase several long-held positions.

Market volatility has been very subdued over the last year, although risk factors are not in short supply: uncertainty around trade negotiations may cause capital expansion plans to be delayed; rising interest rates will impact governments and households that have built up record levels of debt; and heightened geopolitical risks threaten to undermine investor and consumer confidence.

While uncertainty in financial markets can be uncomfortable to bear, it often leads to increased volatility, and therefore opportunity, for value investors. We own businesses that can navigate economic shocks and political surprises. While we don’t try to implement short-term trading strategies based on anticipated outcomes, we will take action if volatility allows us to own wonderful businesses at attractive prices. Given changing global dynamics, we should be prepared for volatility to increase in the coming year.

What are the challenges?

Equity valuations remain elevated, particularly for the high-quality, stable businesses we tend to focus on. Given the lower yields of other options, valuations may continue to climb higher still. The chart below shows that the most expensive 20% of the S&P 500 Index (average P/E of 26.2) generated the lowest average 10-year annualized returns; the cheapest 20% (average P/E of 8.7) generated the highest average 10-year annualized returns.

Average 10-Year S&P 500 Annualized Real Total Return Based on Price/Average 10-Year Earnings

Chart

*Earnings estimate used for latest completed quarter. Concept coutesy of Plexus Asset Management Data Source: Robert Shiller, Irrational Exuberance, Standard & Poor’s. Bureau of Labor Statistics. © Copyright 2017 Ned Davis Research Inc.

The willingness of yield-hungry investors to accept balance sheet and valuation risk is unusually high, but we remain selective and patient, ensuring we do not sacrifice quality for value, and vice versa.

Above-average valuations have reduced our long-term return expectations as a whole. Instead of reaching for higher returns by increasing risk, we remain disciplined in our risk management process. Admittedly, this is not easy to do. During a bull market, risk management can often mean leaving sizeable returns on the table. However, at the risk of short-term underperformance, our philosophy for long-term success prioritizes capital preservation on the downside. We can’t accurately predict when the current bull market will come to an end. It may take substantial time for interest rates and stock valuations to normalize. Although market transitions are uncomfortable, they provide an opportunity to invest in quality businesses as they go on sale.

How are you positioning the funds?

Elevated valuations in both stock and bond markets continue to offer a lower margin of safety, supporting a conservative asset mix in the balanced fund. The portfolios are well diversified and contain companies that are generating attractive levels of profitability while carrying below-average levels of debt. This provides a solid foundation for reinvestment, returning capital to shareholders and navigating economic turbulence. Our focus continues to be on reasonably priced businesses that are able to increase their competitiveness, expand margins and maintain growth characteristics through economic and political cycles. The Canadian funds also have much less industry concentration than their benchmarks, which are heavily weighted to resources and financials. In fixed income, we are positioned with low duration in high-quality bonds. The portfolios offer a number of attractive characteristics compared to the broader markets, providing further support in more challenging periods.

Why is this the right approach for 2018?

At a time when it is difficult to generate yield above inflation, investors are being compensated very little to take on risk. QV’s investment approach focuses on trying to manage downside risk. We take the view that it is more important to protect capital in challenging times than to try to maximize returns. We invest in enduring businesses run by capable and aligned leadership. We believe our focus on monitoring and managing the growth, value and balance sheet risks within the portfolios will continue to pay dividends over time.

icon  2018 market outlook – Joe Jugovic, Wendy Booker Urban, Darren Dansereau & Ian Cooke

IA Clarington Global Opportunities Fund/Class
IA Clarington Global Growth & Income Fund

Where are the opportunities?

In 2017, growth outperformed value by a wide margin. Despite this headwind to our investment style, we continued to stick with our long-term value approach of searching the globe for good companies trading at bargain prices. In the past year, our new investments have come mainly from outside of the U.S. and across many sectors (industrials, financials, health care, real estate and telecommunications).

What are the challenges?

Looking into 2018, we believe the biggest risks to global markets are geopolitical events (North Korea, Brexit, U.S. policy) and the impact of rising interest rates globally.

Mindful of current global equity market valuations, we remain cautious of downside risks should global growth not meet market expectations.

How are you positioning the funds?

China/Hong Kong remains one of the biggest country weightings in the IA Clarington Global Opportunities Fund (23%). Over the past few years, our investments in the region have been some of the strongest contributors to the fund’s returns. While some of our positions have reached full value and, accordingly, have been removed from the portfolio, we believe the remaining positions continue to offer an attractive risk/reward dynamic. These are companies with strong industry positions and solid balance sheets, and they are trading at some of the cheapest valuations in the portfolio. Our weighting in the region has increased over the past year, as we have uncovered new investment opportunities.

Over the past year, we have also reduced our weighting in the financials sector. Since early 2016, our large-cap bank and broker stocks (Bank of America, Citigroup and Morgan Stanley) have staged a strong rally on the back of improving fundamentals and expectations for a more favourable operating environment under the Trump administration. With the strong move, these stocks are approaching our estimates of intrinsic value and we have prudently taken some money off the table.

Why is this the right approach for 2018?

With our global long-term value approach to investing, we are constantly looking for the best investment opportunities around the world across all sectors and market caps. We are constantly replacing expensive stocks with cheap ones, which allows us to avoid areas of the market (country/ sector/market cap) that may be overvalued. As a result, our funds are currently trading at a discount to the market on an earnings basis. In addition, we focus on companies with strong balance sheets or asset value support to help protect on the downside from company-specific or macro events.

Funds offer compelling valuations

Chart

Source: Bloomberg, Capital IQ and Radin Capital Partners, as at November 23, 2017. *Refers to underlying securities.

icon  2018 market outlook – Brad Radin

IA Clarington Sarbit U.S. Equity Fund
IA Clarington Sarbit U.S. Equity Class (Unhedged)
IA Clarington Sarbit Activist Opportunities Class

Where are the opportunities?

From a bottom-up, value-oriented perspective, we are finding that attractive investment opportunities are few and far between. While there are many great companies, most have been bid up to prices that a rational business owner would not consider for purchase. We insist on paying a price that gives our clients a significant margin of safety. There are some “cheap stocks” in the market today, but too often they are companies that have serious fundamental problems. This leads us to question whether they are, in fact, truly bargains or whether the numerically cheap statistics we see in their financial statements accurately reflect the underlying conditions of the business. Digging a little deeper into most of these so-called bargains leads us to reject them as buy opportunities.

Our strategy is to continue to hunt for what we have always sought after – great businesses at cheap prices. If we can’t find them, we will behave as rational business owners and wait – often with a great deal of cash – until we find companies that meet the requirements of our stringent investment discipline.

What are the challenges?

Our greatest challenge is to remain patient and not risk clients’ capital in a potentially dangerous fashion. As Warren Buffett says, “The most important quality for an investor is temperament, not intellect.” We know that historically it has been prudent to sit in cash when bargains are not available. We also know that it is difficult to sit in cash – sometimes for periods lasting years – while the market hits higher highs every day. We believe we have outperformed over the long run both because we avoid long-term losses and because we are willing to do what most investors aren’t: forego short-term gains. We point to the Shiller P/E ratio, which is an average of the last 10 years’ earnings compared to current prices (adjusted for inflation). Today, the Shiller P/E ratio is almost at the same level it was at in 1929, just before the Great Crash. The only other time it has been higher is the year 2000.

Historical Shiller P/E ratio

Chart

Source: www.multpl.com/shiller-pe, as at November 29, 2017.

How are you positioning the funds?

The IA Clarington Sarbit U.S. Equity Fund is more than 50% cash. The remainder of the portfolio is invested in eight stocks. We are great believers in concentration – putting large amounts of capital into a few extraordinary companies at great prices. As mentioned above, companies that meet our strict criteria are very difficult to find today. When we do find such companies, we want to maximize their weighting, which we believe will have a meaningfully positive impact on the long-term performance of the fund.

Why is this the right approach for 2018?

We believe that after a strong bull market over the last eight years, markets are expensive and investors should be prepared for a potential fall. We caution that we do not know the timing or severity of this potential fall. But, we aren’t new to this business and we’ve lived through both bull and bear markets. Benjamin Graham, the father of value investing, said: “The essence of investment management is the management of risks, not the management of returns.” Investing in a fund that is less susceptible to decline in a crisis – thanks to excess cash reserves and investments in great, economically defensive businesses – will allow our clients to have a much greater chance of satisfying the first rule of investing: don’t lose money.

icon  2018 market outlook – Larry Sarbit

IA Clarington Focused Balanced Fund
IA Clarington Focused Canadian Equity Class
IA Clarington Focused U.S. Equity Class

Where are the opportunities?

At this time last year, we predicted a strong Canadian economy, opportunity in equities and a rebounding resource sector. Much of what we predicted has materialized. The U.S. and global economies have also continued to improve. In fact, we’re now seeing synchronized growth across all 35 Organisation for Economic Co-operation and Development (OECD) countries for the first time since 2007. After a weak first half of 2017, commodities have shown signs of life and are up significantly from their lows. Underlying Canadian stock fundamentals continue to improve and Canada’s GDP growth leads the G7 economies. Corporate profits have rebounded and the loonie strengthened against the U.S. dollar. And yet, despite an improving resource landscape and strong economy, Canada’s equity market was one of the worst performers in 2017.

We may have been early, but our thesis on Canadian equities still holds. In fact, the case for Canada is now even stronger. Negative sentiment towards Canada is overdone and has pushed Canadian equities to excessive lows. The valuation gap between Canadian and U.S. equities is at a level not seen since 2008. Last year, growth stocks outperformed value by the widest margin since the dotcom bubble as investors chased performance. But at some point, valuation, earnings and fundamentals have to matter.

Déjà vu?: Value and Canadian equities dominated after dotcom bubble

Chart

Source: Bloomberg, June 1999 – December 2005.

Keep in mind that the current expansion is still young. Indeed, while this is one of the longest economic cycles on record, there’s still a long way to go. We’ve been saying this for a while, but the typical signs that we are nearing the end of the cycle – high inflation, high interest rates, wage growth and rising unemployment – are just not there. Leading indicators suggest this expansion could last another five or six years. Expansion is an important phase for equities vis-à-vis bonds and for Canada in particular, with its largely cyclical-based equity market. In the expansion phase we can expect global manufacturing capacity to tighten, which in turn will drive up the value of many products produced here in Canada and sold globally. With capacity at its maximum and a stronger global economy, companies will have the confidence to start reinvesting in their businesses. Canada’s resource market supplies much of the materials to support that growth.

What are the challenges?

Canada’s underperformance relative to the U.S. in 2017 was likely due, in part, to trade concerns and our southern neighbour’s more investor-friendly policies. As the U.S. moved to reduce taxes and relax regulation, Canada moved in the opposite direction. With NAFTA still up in the air, Canada’s trade relationship with the U.S. is a major concern. Our government appears to be making little progress on a NAFTA deal as U.S. threats to scrap the agreement loom. Ending NAFTA could throw a wrench into Canada’s thriving economy and put pressure on our dollar. Experts argue about how severe the damage to Canada’s GDP could be, but some sectors (auto manufacturing) and regions (Ontario) are more vulnerable. That said, Canada is the largest consumer of U.S. products in the world and a key supplier of materials and parts. Canada–U.S. trade accounts for about 5% of U.S. employment and almost 7% of U.S. GDP. Given that President Trump is pro-business and pro-jobs, it would make little sense for him to eliminate any trade deals with Canada. Too many states are dependent on Canada for imports and exports. Also, companies we have consulted with generally agree that eliminating trade deals would have far-reaching ramifications that the Trump administration couldn’t ignore – job losses, plant closures, and a lack of U.S.-based alternative suppliers or manufacturing infrastructure.

How are you positioning the funds?

The Focused Funds are almost fully invested to position for continued growth in the U.S. and an improving global economy. We continue to overweight Canadian equities, with a focus on highly cyclical sectors and interest rate sensitive businesses that are best positioned to benefit from the expansion (which, as mentioned, could last another five or six years). In the expansion phase, you want exposure – not protection. We have good exposure to high-quality cyclical U.S. names leveraged to the economy and rising rates. We are maintaining the Funds’ exposure to resource-based equities just above market weight. In the energy sector, we are focused on producers. Staying true to our contrarian roots, we continue to add new positions and increase existing positions at points of maximum pessimism. Last year we were rewarded for adding to key positions such as Encana Corp., when the stock hit 52-week lows on weak commodity prices. We were also rewarded for taking advantage of short-term market overreaction to negative news surrounding MDC Partners and Home Capital Group. We have been prudent in our security selection, focusing on quality companies that can endure periods of market turbulence. Our portfolios are concentrated, with about 27 positions, so we can be opportunistic. And we have the flexibility to shift the portfolios’ sector and geographic exposures if we believe conditions are changing.

Why is this the right approach for 2018?

While value investing outperforms growth over the long term, there will always be periods that favour growth. The past few years have been difficult for value investors. Value stocks tend to be mid-to-late cycle performers. The Canadian investment landscape is largely value-based, dominated by companies with cycle-sensitive earnings. Synchronized global growth bodes well for value investors and Canadian equities in particular. We are also buoyed by the prospect of rising interest rates, which tend to favour value stocks over growth. Historically, Canada’s equity market, and its energy sector in particular, has outperformed following rate hikes.

Our bullish stance on Canada doesn’t mean we’ve given up on the U.S. We believe the U.S. economy, and in turn, U.S. equities, still have legs. The U.S. equity market continues to advance and mark new all-time highs, despite a volatile political environment and recent natural disasters. Investors abandoned Canada last year, but at some point fundamentals take over and investors go where they see the most upside. Taken together, a solid domestic economy, strong earnings, attractive valuations and our position in the cycle make a very strong case for Canada.

icon  2018 market outlook – David Taylor

IA Clarington Inhance Balanced SRI Portfolio
IA Clarington Inhance Bond SRI Fund
IA Clarington Inhance Canadian Equity SRI Class
IA Clarington Inhance Conservative SRI Portfolio
IA Clarington Inhance Global Equity SRI Class
IA Clarington Inhance Growth SRI Portfolio
IA Clarington Inhance Monthly Income SRI Fund

Where are the opportunities?

A supportive macroeconomic backdrop remains for 2018: there continues to be a broad-based, synchronized recovery in global GDP; forecasts for global earnings-per-share growth in the high single digits look achievable; low unemployment has not yet translated into significant wage inflation; and the usual signals of recession are not present.

Given that we are still in the latter stages of the economic cycle, we are focused on opportunities that meet our environmental, social and governance (ESG) criteria within “late cycle” sectors showing earnings growth leadership, such as financials and industrials. We also believe areas of secular growth, such as established technology companies, will maintain attractive profit margins, benefit from corporate capital expenditures and continue to add value.

Financials, insurance companies and banks have historically increased profitability when short-term interest rates rise.

Industrials tend to benefit from inventory replenishment and improving capital spending. Companies in this sector are in good financial shape: margins have soared, balance sheets are strong, net debt has decreased and earnings growth has stabilized.

Another beneficiary of corporate investment is the technology sector, as companies invest in technology to improve productivity. In addition, the consumer side of technology continues to be supported by a robust economy, low unemployment and buoyed consumer sentiment.

We believe that established, high-quality firms with a proven history of profitability will be the key supporters of equity market returns in 2018. Both capital appreciation and dividend income will be equally important components of return expectations.

What are the challenges?

It is too early to call a recession, but after coming through the historically low volatility and modest drawdowns of 2017, we expect the ride for markets to get a bit bumpier in 2018.

Annual S&P 500 Index returns and maximum drawdowns

Chart

Source: Bloomberg as of October 31, 2017. In U.S. dollars.

Valuations have increased but may be range bound in 2018, with expectations for higher interest rates and rising inflation capping multiple expansion. Earnings growth will have to drive the next leg of the economic expansion.

Stock selection remains a critical part of our investment process as companies reporting earnings shortfalls will likely see their share prices under pressure.

How are you positioning the funds?

Our collaborative, socially responsible investment approach integrates ESG analysis with traditional financial analysis. We only invest in companies that meet both our ESG and financial criteria. This strategy results in portfolios of sustainable businesses that have earnings growth rates and return on shareholder equity that are better than market levels.

From a global developed market perspective, we think Europe still has room to catch up to U.S. equity markets. The overhangs of Brexit, European Central Bank stimulus tapering and political uncertainty have hampered economic growth. We will continue to look for opportunities in the region.

Why is this the right approach for 2018?

ESG factors not only help make a portfolio socially responsible, they also add a layer of risk management that conventional portfolios may lack. This enhanced risk mitigation may help stabilize investors' portfolios as volatility picks up in 2018. Maintaining discipline by ensuring that portfolios are regularly rebalanced to their long-term target asset mix is one of the best ways of taking advantage of increasing volatility without taking undue risk. We expect that 2018 should still offer opportunities for long-term investors with diversified portfolios.

icon  2018 market outlook – Andrew Simpson