Knowledge Centre

The past quarter was another lesson in the benefits of long term investing as the markets were particularly volatile in the course of reflecting the January recessionary scare, to the grudging acceptance that returns might be limited by slower growth, to a flat out bull market surge at the end of the quarter. This turmoil has caused confusion but also created bargains and opportunities. Markets are caught in a tug of war between stubbornly slow growth and central bank stimulus.

The plunge in commodity prices, particularly in oil and gas, has caused a great deal of concern on Bay Street and as well as for Main Street. While the drop in oil prices is hurting a lot of businesses, improvements in non-energy based activities is more upbeat. The federal government is committed o further stimulating the economy, but welcome though it may be, it appears to becoming less necessary as improving employment and a stronger U.S. trading partner are starting to exert themselves.

The U.S. economy has been solid for the most part. While there has been strength in the labour and lending markets, a lack of business spending is slowing growth. Inflation rose in January from a year earlier, after 13 consecutive months with rises below 1%, owing to a slide in energy prices. U.S. households are benefiting from a tightening jobs market that is starting to push up ages. As is always the case, U.S. consumers will lead the way in supporting global growth.

At this point, international economies do not look that much different from most of 2015. Europe continues to be steady with the business climate showing surprising improvement. The European Central Bank unleashed another round of unprecedented stimulus, pushing interest rates below zero. Japan is not rushing toward more fiscal stimulus, but they too are laying the groundwork for additional easing if necessary after cutting its deposit rate to minus 0.1%,. The outlook for emerging markets is clouded by China’s diminishing growth and high debt, worsening demographics, as well as maturing emerging market economies are subduing any possible rapid expansion.

Central bankers have managed to steer the world economy clear of a recession but government bond yields are exceptionally low. With most advanced economies still experiencing anemic recoveries from the 2008 financial crisis, central banks have been forced to move from conventional monetary policy to a range of unconventional policies. Some have already implemented negative interest rates to try and force safety conscious investors to seek real returns.

The horrendous start for the equity markets in 2016 shows that investors are still very skittish. This pervasive pessimism and skepticism however were quickly overturned by the U.S. Federal Reserve’s dovish stance on interest rates; a dramatic softening of the U.S. dollar; and a sharp recovery in the commodity markets triggered a rebound in stocks. The Canadian stock market gained 4.5%, one of the best performing markets in the world. The U.S. stock market declined 5.4% (all returns in Canadian dollar terms), but all of this loss was due to the decline in the U.S. currency, which fell 6.7% in the quarter. International stocks dropped 9.6%, while Emerging Market stocks only declined 1.4% and were the best performing stock markets in their base currency terms. Canadian bonds continued to eke out positive returns, appreciating 1.4%.

The year began with the view that stable growth would be a very good thing given the nasty combination of events that could envelope the world. Investors were awash in angst, showing little faith the markets and instead worrying about hard landings, currency devaluation and risks around every corner. The first quarter is essentially a microcosm of what to expect to play out in markets over the next little while. These are not desperate times as slow and lackluster baby steps forward are expected to be the norm.

2015 After a disappointing year 2015 where the Canadian market fared as the worst among its peers, the TSX like other global markets started 2016 in the red amid concerns over China’s GDP growth, further deterioration in commodity prices and geopolitical tensions. On January 20th it hit a two and a half year low, dragged down by broad based losses in different sectors but notably in oil and commodities as prices in these sectors tested levels not seen in more than a decade. From an abysmal start, followed by intense volatility until mid quarter, the index managed to rebound more than 12% from its January low. It ended the quarter with a 4.5% gain on a total return basis, making it one of the best performing global markets year to date.

The economy surprised by expanding at an annual rate of 1.5% in January which was better than expected analysts’ expectations. But jobs unexpectedly went into reverse in January with 6,000 jobs losses and another 2,000 in February before blowing all forecasts with more than 40,000 jobs gain in March.

Canada’s growth outlook for the months ahead has received warnings signs from many analysts and institutions such as the Bank of Canada and the International Monetary Fund (IMF). A few months ago the IMF revised its GDP growth expectations for 2016 to under 2% and trimmed 2017 GDP growth from 2.4% to 2.1%. Many positive developments in the economy have occurred since then, notably the revival of manufacturing and exports. In January manufacturing sales rose 2.3% to more than 53 billion dollars, an all time high, while exports also hit a record high in January. The depreciation of the Lonnie was the main reason for the increased competitiveness and there has been a shift of the economy away from energy and commodities and towards manufacturing and exports. Likewise the Bank of Canada acknowledged in a recent report that the economy is improving, although it is still facing downside risks. It is a well known that the TSX’s performance is highly correlated with oil prices. That correlation is at a long term high even though energy’s weight in the index has decreased. The index’s earnings excluding energy is very strong and once oil prices revert to normal levels, the index will likely reclaim it’s spot among the leaders in global markets.

In the first quarter of 2016 the Canadian FTSE TMX Universe Bond Index gained 1.4% and the Bank of Canada’s target for the overnight rate remained unchanged at 1/2 of one percent. Over the course of 2015 Canada’s central bank lowered its target for the overnight rate by 1/4 of one percentage point on two occasions; first in January and again in July. In the U.S., the Federal Reserve maintained its benchmark interest rate target range of 1/4 to 1/2 of one percent after having raised rates in December for the first time in seven years.

As 2016 began, global financial markets were in the midst of a steep correction, commodity prices were plunging and concerns were being raised about growing risks of a world recession. Since then the Bank of Canada believes that some of the pressure facing the country’s economy has eased and the central bank is taking a wait and see approach to the federal government’s multibillion dollar fiscal stimulus. The market has steadily lowered the odds of a further rate cut as the combination of firmer oil prices, much-improved nonresource exports and the growing expectation that the U.S. central bank will most likely raise rates this year have all contributed to a change in sentiment. The possibility of a rate cut in Canada remains though as GDP growth is still well below potential, unemployment had been moving higher at the end of 2015 and the currency’s recovery has been removed as an obstacle for a rate cut.

The central bank’s recent Monetary Policy Report noted three important changes to the bank’s outlook. Expectations for global economic growth for 2016 and 2017 have been reduced, the energy sector has reduced its investment intentions despite the significant rebound in oil prices and the Canadian dollar has rallied from its lows. A further recent change was the introduction of the recent federal budget. The report noted that “We can’t be entirely certain about the full effects of the budget on the economy, as some will depend on how households react over time. But Governing Council judged that the budget actions will more than offset the negatives from the other three changes. The net effect is that our projected growth profile is generally higher than it was in January.” The report concluded that “In sum, recent economic data have been encouraging on balance, but also quite variable. The global economy retains the capacity to disappoint further, the complex adjustment to lower terms of trade will restrain Canada’s growth over much of our forecast horizon, and households’ reactions to the government’s fiscal measures will bear close monitoring. We have not yet seen concrete evidence of higher investment and strong firm creation.”

The Standard & Poor’s 500 index climbed 1.3% in U.S. dollar terms over the first quarter of 2016 but in Canadian dollar terms the index lost 4.9% as the Loonie recovered in the early months of the year. While the U.S. market was little changed over the quarter in U.S. dollar terms, the near flat return belied a volatile period as stocks fell dramatically over the half of the quarter and more than recouped those losses by the end of the quarter. In March the bull market in the U.S. celebrated its seventh birthday and while it has been a long run, the longest post war bull market lasted for nearly 10 years, until March 2000,

Modest economic growth continues to be seen in the U.S. but the economy is sending mixed signals according to the recent Beige Book report from the Federal Reserve. The Beige Book, more formally called the Summary of Commentary on Current Economic Conditions, is a report published in advance of meetings of the central bank’s Federal Open Market Committee and includes anecdotal information of current economic conditions. The April 2016 Beige Book noted that, “Reports from the twelve Federal Reserve Districts suggest that national economic activity continued to expand in late February and March, though the pace of growth varied across Districts. Most Districts said that economic growth was in the modest to moderate range and that contacts expected growth would remain in that range going forward.” Overall the anecdotal evidence suggested that consumer spending is weakening but wage growth is picking up and business spending is increasing in most districts.

Federal Reserve Chair Janet Yellen indicated that the Fed still envisions only a gradual pace of interest rate increases in light of global pressures that could affect the U.S. economy. She said risks to the U.S. appear limited but cautioned that that assessment is subject to “considerable uncertainty.” The U.S. central bank is monitoring a global economic slump which has hurt some U.S. companies and key sectors such as manufacturing. In particular she is concerned about China, noting widespread uncertainty over how well Beijing will manage a delicate slowdown in the coming years. She said that because foreign economic growth seems to have weakened this year, the Fed will “proceed cautiously” in raising rates. Yellen noted that the U.S. job market and housing recovery have lifted the economy close to full health despite the risks that remain. She also noted that the economy has also benefited from low long-term interest rates. Those rates have been held down by money flowing into U.S. bonds from investors who have now scaled back their expectations for the number of Fed rate hikes this year. Longer term, U.S. worker productivity will need to begin increasing in order to boost the outlook for the U.S. economy.

The first quarter of 2016 was a roller coaster ride for international stocks. The first few weeks of the year were littered with large swathes of losses as negative sentiment smothered global stock markets. Then just as suddenly in mid-February, stocks made an epic about face, rebounding at a rate not seen in ninety years. This was not a reckless rally; it has been a very cautious comeback. While skepticism has not disappeared, the number of positive and negative economic surprises is slowly shifting in favour of further upward momentum.

Europe needs to make their economies and labour markets more competitive, rein in profligate spending and fix their banks. Reform efforts need to be stepped up, particularly to encourage banks to lend out money instead of hoarding it. Unemployment has somewhat improved but is still too high. The inflation rate is minus 0.2%, nowhere near the 2% target rate. The European Central Bank has enacted a series of stimulus measures, such as cutting interest rates to minus 0.4% and pumping newly printed money into the markets in an attempt to expand credit to companies. However, the ECB cannot do it alone so consumer spending will likely be key if the
Eurozone’s growth is to regain momentum.

In England the outlook for financial markets has deteriorated due to the risks surrounding the possible termination of membership in the European Union. The upcoming referendum is the most significant risk to financial stability and economic growth currently facing the U.K. The possible negative spill over effect on Europe is immense and once again highlights the overwhelming impact politics plays on economics.

Japan’s economy is at risk of falling into recession once again as volatile financial markets and sluggish emerging market growth threatened to derail a fragile recovery. Its manufacturing activity contracted at the fastest pace in more than three years as exports shrank. Household spending has slumped due to lower average income. The Japanese central bank has for years tried to bring the economy to life but none of the measures seem to work. Even larger stimulus could be in store to jolt the country out of its malaise.

Bull markets reigned from Brazil to Russia as the U.S. central bank indicated that it was going to slow down the speed of interest rate increases, fueling optimism that capital inflows would improve. At the same time a bounce in oil prices and a shift in sentiment on commodities in China lifted all markets but a rough ride for emerging markets is still ahead.

Global shares rebounded from the January plunge and embarked upon a bullish tear. Despite the international stock market’s 12% recovery since the February 11th low, most markets produced losses over the full quarter. Across all international developed market the declines were fairly uniform. European stocks dropped 3.2% (all returns in U.S. dollar terms); Asian stock fell 2.9% for an average loss around the globe of 2.9%. Emerging markets were the only respite from the pain, as they gained 5.4%. Most of the weakness stems from poor corporate earnings as most global company profits remain 15% below the record highs reached in 2007.

There is ample opportunity for investor’s sentiment to improve. In a lot of instances sentiment turns unjustifiably negative, followed by surprising surges in stock markets. Of course the embedded skepticism about this glacial recovery is well founded. The emphasis going forward is on investors, companies and consumers who need to put their money to use, to expand or buy things and ultimately stimulate growth.