Knowledge Centre

Global growth in the first quarter 2015 was essentially the same as it was at the end of last year. With a cursory glance at the headlines from around the world one could conclude that the global marketplace is on the precipice of calamity; however nothing is further from the truth. The list of potential headwinds seeming to gang up on future prosperity is long: deflation; falling oil prices; freakish weather conditions; the strong U.S. dollar; Europe’s problems; Greece’s issues; China’s slowdown; the Middle East; the Ukraine conflict; increasing U.S. interest rates and lastly terrorism. In reality these issues are already priced into the market. In fact growth is expected to rebound later this year as lowered oil prices should lead to higher corporate spending in Canada.

Canadian economic activity slowed across most industries last quarter, with oil & gas activity slumping to record lows. This broad based decline was felt across most manufacturing industries. The severe weather patterns experienced further reduced economic activity and sapped the positive momentum provided by the service sector. Even so the country should be able to eke out a marginal level of expansion. While the worldwide drop in oil prices will be a boom to other nations, it will have a decidedly negative impact across Canada. On a positive note, corporate profit margins hit a 27 year high as a result of soft labour costs and a 25% depreciation in the dollar.

The U.S. economy continues to chug along nicely despite disruptions from the heavy snowfall in the northeast. The bigger picture remains positive as declining unemployment and low inflation boost incomes, which will lead to increased consumer spending. Manufacturing growth is slowing but the service sectors are faring well as consumers appear to be spending their oil windfall. The Federal Reserve is expected to tighten monetary policy later this year which could lead to a stronger dollar. This is not necessarily a reason to worry about stock market prices because stocks typically continue to rise for a considerable time after interest rates start to increase.

Europe is not going to be the driving force of the world’s economy anytime soon, but it is moving the right direction. Unemployment has fallen to a three year low, deflation looks to be less of a worry and a weak currency is an added bonus. Throw in the European Central Bank’s heightened stimulus package and a growth spurt should occur. Japan’s limited recovery at the end of last year has already fizzled and the economy is stagnated. China, the world’s second largest economy, has slowed sharply which could lead to new stimulus measures to prevent growth from slowing even more. Austerity is a thing of the past and the oil price decline is the equivalent of a big tax cut for consumers.

On some metrics, stock valuations appear relatively stretched which is triggering a shift from North American into European and Japanese equities. However a rebound in profits will likely temper this perception and allow North American stock markets to continue to appreciate. Global equities dominated performance results for one simple reason, depreciation of the Canadian dollar, which lost 9.1% in the quarter. U.S. equities were up 10.1% (all figures in Canadian dollar terms); European equities climbed 12.0%; Asian equities soared 16.1%; and Emerging Market stocks rose 11.1%. Compared to the enhanced foreign market returns, Canadian equity stock gains of 2.6% and bond returns of 4.2% look anemic.

Overall, while global activity remained weak it is expected to pick up towards the latter part of the year. The economic boost from the collapse in oil prices has yet to be fully integrated into the economy and the recovery in Europe is going to be unambiguously positive for the rest of the world. While there are still many risks remaining which cannot be brushed off as mere inconveniences or distractions, the long overdue recovery story is firmly in place.

The Canadian equity market did not find any clear direction in the first quarter of 2015. In January the S&P TSX index performed modestly, followed by a strong February and then fell in March. This lack of direction was largely due to the significant oil price decline of more than 50%, as well as a decline in commodity prices. As a result economic forecasts for Canada have been significantly revised to the downside. A notable event was the unexpected decision by the Bank of Canada to cut its key rate by one quarter of a percentage point to 0.75% in January, the first rate cut in almost six years. While that decision was explained by the Bank as insurance against the negative effects of oil’s price plunge, it appeared aggressive to investors who preferred to take a wait and see approach.

The S&P TSX index managed to post a gain of more than 2.5% on a total return basis for the quarter as Materials enjoyed a comfortable rally and Energy recouped some losses. This performance appeared unimpressive vis-à-vis other developed markets such as Europe which enjoyed double digit returns. A review of index sector performance confirms that none of the larger sectors led the pack. Health Care was by far the best performing sector with a 28% gain which was largely attributed to the consolidation activities of Catamaran and Concordia. Information Technology managed to return almost 8% despite weakness in Blackberry. The Consumer Discretionary sector came in third with a 5.5% gain. On the downside, Telecoms underperformed by more than 4.0%, Financials fell 3.0% and Energy dropped 1.6%.

Canada’s economy began the year with a disappointing 0.1% decline in GDP for the month of January after posting surprisingly strong GDP growth of 2.4% in the fourth quarter of 2014. Though the decline might appear to be solely due to the energy sector, it was pervasive across numerous economic sectors including wholesale, retail, manufacturing and construction. Fears of an “atrocious quarter”, as qualified by the Bank of Canada due to the decline in GDP, did not materialize in the job numbers as January posted a comfortable 35,000 jobs gain. February did see a loss of about 1,000 jobs but these numbers were far below the predictions of 5,000 to 20,000 in losses. More recently March saw an unexpected gain of about 29,000 jobs which left the unemployment rate at 6.8%. In the months ahead, the likelihood of a protracted bear market in energy should keep inflation on the downside which would support a low interest rate policy. This ongoing low interest rate environment is a positive factor for the economy.

The Canadian FTSE TMX Universe Bond Index rang up another healthy 4.1% gain in the first quarter of 2015 and for the 12 month period ending March 31st the index rose a remarkable 10.3%. The Bank of Canada surprised the market in January when it announced that it was lowering its target for the overnight rate by 1/4 of one percentage point to 3/4%. The Bank cited the sharp drop in oil prices as the reason for the surprise rate cut.

Bank of Canada Governor Stephen Poloz suggested that the Bank is not in any hurry to cut rates further. The Bank’s forecast for first quarter GDP growth had stood at 1.5% annualized, however that now seems unlikely. At the end of March Statistics Canada confirmed that the economy contracted 0.1% in January which was attributed to the dampening effects of bad weather and the oil shock. The central bank now seems prepared to wait and monitor how well the economy is managing the oil price shock before announcing any further policy change.

In a widely expected move, the U.S. Federal Reserve (Fed) removed its commitment to be “patient” in its March monetary policy report. The language change signals that the central bank is preparing to raise short term interest rates, perhaps as soon as the middle of the year, but at the same time the Fed also seemed to suggest that it might wait until inflation is running at a 2% annual rate before making changes. 2015 may finally be the year that interest rates begin to rise but keep in mind that a bet on higher interest rates was likely the call most investors got wrong in 2014.

Many fixed income investors are concerned that the eventual rise of U.S. interest rates could portend a crash in the bond market. This is a possibility if rates rise quickly or inflation soars but the onset of previous tightening cycles has not usually been associated with a slowdown in global growth. Bond market crashes have actually been rare and mild. Going back to 1857 in the U.S., the biggest one year drop in 30 year corporate bonds was 12.5% for the 12 month period ending in February 1980 after Paul Volcker took the helm of the Federal Reserve and killed off inflation by hiking interest rates so high that he created a major recession. Compare that bond market loss to the U.S. stock market where one year losses have exceeded 12.5% on 23 occasions since 1900.

The global recovery should be able to withstand the next Fed tightening cycle for several reasons. U.S. monetary policy is likely to remain very loose, the global employment picture is rapidly improving, and both corporate and household debt has undergone a significant reduction. Against this backdrop the U.S. economy should expand rapidly despite lower than previously expected GDP growth in the first quarter due to temporary factors. The U.S. is now well placed for growth which would be a welcome driver of the Canadian and global economies.

The Standard & Poor’s 500 index rose a mere 1.0% in U.S. dollar terms over the first quarter of 2015 but in Canadian dollar terms the index was up 10.3% for the period as the Canadian dollar continued to weaken. While weak in U.S. terms the index continued to be positive as investors rode one of the longest bull markets since the 1940s. The S&P 500 index has more than tripled since bottoming out in March 2009.

The latest reports on the U.S. economy have not all been good. Growth seems to have stalled in the first quarter of the year as evidenced by the disappointing jobs report released on Good Friday. Payrolls rose by just 126,000 in March, far undershooting a consensus estimate of 243,000. The weak report builds a case for the U.S. central bank to further delay an interest rate hike. Such hesitation would normally be interpreted as a positive for stocks but there are also concerns that companies are facing a slowdown in profits. During the first three months of 2015 as the most populous part of the country was hit by very cold and very snowy weather, the U.S. dollar strengthened significantly which hurt those big companies that compete globally, and oil prices collapsed leading to a huge decline in investment in the oil patch as oil companies are turning off the drills and shutting down production in fields where it is too expensive to extract oil.

Consumers have received a windfall as fuel prices have plunged but so far they have chosen to save rather than spend it. Price adjusted incomes have risen at a 7.7% annual rate over the past three months but spending has only grown half as fast. In January the household savings rate rose to 5.5%, a two year high. Consumers, who fuel about two thirds of the economy, now have more money to spend thanks to the ongoing decline in fuel prices which began in June of 2014 and accelerated in the fall. Consumer confidence is now higher than it has been in years. Households are in good shape to spend more money because more people are working and incomes are rising. Consumers have also paid down their debts and are now spending just 9.9% of their income on debt servicing which is the lowest on record.

Since the end of the Second World War there have been twelve bull markets which lasted an average of 58 months. The current streak of 72 months is now the fourth longest on record. While this run has been a long one, it is nowhere near that of the longest streak which began in 1990 and lasted 113 months before culminating with the tech “bubble” of 2000. The current U.S. bull market has continued despite political gridlock, economic woes in Europe and increasing tensions in the Middle East. Market observers remain confident as we haven’t yet seen the telling signs of investor speculation that often accompany a market peak.

The global economy which many feared was floundering from Asia to Europe now appears poised for a rebound on the back of cheap oil and falling interest rates. A sustained expansion of the global economy will depend on whether consumer spending can regain momentum. This optimistic outlook marks a shift from last fall when the war in Ukraine, a hesitation by the European Central Bank (ECB) to implement stimulus efforts and the rise of the Islamic State terror group led investors to take a dispiriting view of the markets outside of North America.

A sustained economic recovery is occurring in Europe. Numerous indicators point to growing confidence of both businesses and consumers due to inexpensive oil and central bank stimulus policies. The ECB cut its benchmark interest rate to near zero and launched large scale purchases of bonds with newly printed money to lower longer term borrowing costs. As a result household spending has picked up to almost a ten year high and unemployment is at its lowest level in nearly three years. The Euro has seen one devaluation after another as it dropped 25% against major currencies and hit a 12 year low against the U.S. dollar. Smaller economies like Portugal and Ireland are just emerging from bailout programs, while Italy, Spain and France are still focused on reducing debt. Last year Britain’s economy grew faster than previously thought and is one of the fastest growing amongst developed nations.

After crawling out of recession, Japan’s economy looks unlikely to accelerate at a brisk pace despite the government’s herculean effort to end two decades of malaise and rebuild Japan’s competitiveness. Its frailty since the financial crisis has done little to help the global recovery. While the ultra loose monetary policy is designed to spark household and businesses spending, most seem hesitant to step into the fold. The central bank has been pumping trillions of yen into the economy which has resulted in rising corporate profits with a 51% surge in stock prices since 2013. Unfortunately the government’s massive debt, now standing at 250% of GDP, leads the world in indebtedness.

China’s growth is decelerating and is at its slowest pace in a quarter century. This is prompting concerns that the government’s desire to transform the country from export based to self sustaining domestic consumption is starting to veer off target. To forestall this and avoid a politically dangerous spike in unemployment the government cut interest rates on two occasions and may need further stimulus measures. With inflation falling, the country should be alert to the possibility of deflation. Export and import growth has also nose-dived. The outlook for growth in other Emerging Markets is less optimistic but could still attract bargain hunters as Emerging Markets have favourable valuations compared to their developed counterparts. Even resource rich Australia sees the need to jolt its stagnant economy from the falling commodity price quagmire.

International equity markets followed up the Q4 2014 positive performance with even better results in the first three months of 2015. It seems investors are starting to see beaten down stock markets around the world as good buying opportunities. As a whole, international markets gained 5.0% (all figures in U.S. dollar terms) propelled by Asian stocks which appreciated 6.9% and European stocks which expanded by 2.9%. Emerging Market stocks got into positive territory for the first time in two years with a 1.9% gain.

Using the last five or six years as a roadmap, we can certainly confirm that the path of the unfolding recovery will not go smoothly. Europe and Japan have been in intensive care for a while now, Emerging Markets are a shadow of their former selves and even the powerhouse giants are suffering. With structural reforms and business friendly practices starting to take hold, the healing will continue and give breathing room for a sustained recovery in the coming year.