Knowledge Centre

Investors who slept through the first half of 2015 did not miss much with regard to the global financial markets. The world continues to be swept up in the Greek crisis with every twist and turn played out in the press and the financial markets. The global economy barely achieved a passing grade as first quarter growth crawled along at its slowest pace since the financial crisis in 2008. Throw in some unlucky bounces and the first six months of 2015 were basically a write off, although the next six months are starting to look better, as the hit from the oil shock and a soft U.S. economy will likely be nothing more than fading memories.

2015 is shaping up to be an exceptionally disappointing year for Canada’s economy, the slowest growth in a non-recession year since the early 1980s. The economy slumped into negative territory in the first quarter as it was hampered by the plunge in oil prices and an unusually harsh winter, which kept unemployment levels at bay. In fact, the first four months of 2015 saw a contraction which has not happened since the end of the 08/09 recession. The hope for a turnaround in the manufacturing sector failed to materialize. Business spending remains weak as firms are unwilling to dig into their pockets. The hangover from plummeting oil prices lingers in the labour market to such an extent that another cut in interest rates by the Bank of Canada could be in the cards.

The U.S. economy declined in first the quarter, paving the way for its worst first half performance in four years. Even before this dismal quarter, economic growth was well off the levels of past recoveries. Employment gains have been healthy with signs emerging that wages are being pushed up after being stagnant for six years. This should eventually accelerate consumer spending and economic growth. Auto sales jumped to an almost ten year high and home sales are running at an eight year high. Many leading indicators have turned up sharply, supporting the view that the economy will improve in the remaining half of the year.

Sluggish capital investment, meager productivity gains, fiscal uncertainties and hesitant consumers are combining to dampen global growth. The global economy eked out 1.1% growth in the first quarter of 2015, its weakest expansion since 1998. Uncertainty over Greece is weighing on the Eurozone as the clock is ticking on the country’s efforts to avoid bankruptcy and a possible exit from the Euro. A sustained decline in unemployment has helped buoy consumers, as has the fall in oil prices. Monetary easing and currency depreciation in China and Japan are the weapons of choice to lift growth and increase trade but it is taking time.

Globally, developed markets had a strong first half, gaining 13.3%, while emerging markets gained 9.1% (all figures in Canadian dollar terms). Asian markets enjoyed a stellar first half of 2015 gaining 17.1%. European markets climbed 10.5% over the six month span. Canadian equities finished the first half of 2015 in positive territory, up 0.9%. It was helped by Health Care stocks which gained 58% but hampered by the Energy sector which declined 5%. The U.S. equity market gained 8.8% over the same period. In the second quarter Canadian stocks declined 1.6%, while U.S. stocks lost 1.2%. U.S. equities have tripled since the March 2009 low, propelled by a doubling of earnings over the period. Canadian bonds had a weak second quarter, declining 1.7%, but were up 2.4% for the first six months of 2015.

While growth has been hard to achieve, investors are beginning to realize that the magnitude of the risks facing the financial world are overblown. The biggest guessing game for investors is when will the U.S. Federal Reserve start increasing interest rates for the first time since 2006 and to what degree? It is a tricky decision if the consensus view is not correct and both the global economy and corporate profits do not strengthen in the second half of the year. Financial markets could be vulnerable. While optimism amongst investors is wavering, conditions for further sustained upward movement in global markets are emerging.

The second quarter of 2015 ended with recessionary concerns as Canadian GDP fell for four consecutive months as of April amid the protracted collapse of the energy sector. Although the fallout in the first quarter was not a surprise to many analysts, there was some level of optimism about a turnaround in the economy for the remainder of the year. Even a statement from the Bank of Canada qualified the Q1 fallout as “front-loaded” and predicted a rebound. The disappointing GDP reading of -0.1% in April opened the possibility of another weak quarter and even a technical recession. As expected, the weak economy translated into mixed jobs numbers, with 20,000 job losses in April, 59,000 new jobs in May and 6,000 job losses in June. Paradoxically, the unemployment rate remained at 6.8%, as fewer people looked for work. Notwithstanding the weak domestic economy, the TSX has also been affected by the Greek debt crisis. On June 29 amid intense negotiations on the so called Grexit issue, the TSX dropped more than 300 points, enough to erase previous year to date gains. The index posted a 1.6% loss for the quarter and closed the first half of the year with a 0.9% gain (both including dividends) – the worst six month start in two years.

For the upcoming quarters, unless a dramatic rebound in energy prices occurs, the economy will likely show mixed signals with a greater prevalence of downside risks. Global institutions such as the IMF (International Monetary Fund) have already trimmed their Canadian GDP forecast from 2.2% to 1.5% for 2015. Many analysts believe that the Bank of Canada will revise its second quarter GDP forecast down a few percentage points from its original 1.8% forecast. On the positive side, inflation is still muted and any change to the key interest rate by the Bank of Canada will likely be “dovish”, which should support the economy. Noteworthy is a call by some investors to short Canada and especially the banks due to the elevated household debt and the fallout of the Energy sector – a trend known as “the Great White Short.” Digging deeper into the data, that view appears inconsistent with the broader market expectations about Canada as recent numbers clearly show that foreign investors are in fact bullish on Canada. In the first four months of the year they have injected more than $50 billion into the Canadian market. This is nearly triple the amount compared to the same period in 2014. Therefore it seems that the Canadian market and overall economy have pockets of resilience. Once commodity prices stabilize the Canadian market should be better equipped to keep pace with other major economies.

The Canadian FTSE TMX Universe Bond Index lost 1.7% in the second quarter of 2015 but year to date the index is up 2.4%. The Bank of Canada surprised the market in January when it lowered 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.

Canada’s economic growth, as measured by real gross domestic product (GDP), decreased by 0.6% in the first quarter of 2015. The Canadian economy was sideswiped by the global collapse in oil prices which threatened to pull energy-dependent Alberta into recession and perhaps Saskatchewan along with it. It did not help that the U.S. economy got off to a slow start in 2015. Another concern is the high level of consumer debt as Canadian households just don’t need any more incentive to leverage their finances. Low rates are already providing stimulus and may lead to a debt problem that will need to be addressed in the future.

The January rate cut did provide some stimulus to the Canadian economy, however the impact was marginal. With interest rates already low, much of the drop in yields in the early months of 2015 reflected a rally in global fixed income markets. The biggest stimulus to the economy was a further weakening of the Canadian dollar but it may have only lowered the exchange rate marginally. A weaker trading range for the Canadian dollar will help the export sector rebuild. Ongoing weakness may cause the central bank to cut rates further but the economy is largely being dragged down by events in the global economy which the central bank cannot control.

Federal Reserve Chair Janet Yellen said she expects to raise interest rates this year if the economy meets her forecasts and that any further rate increases will be very gradual. The Fed has two criteria that need to be met before they will raise rates from the near zero level they have been at since December 2008. They are ongoing improvements in labour market conditions and an outlook for inflation to move closer to 2% over the medium term. While the labour market is nearing full strength, she recently confirmed that “we are not there yet”. Consumer prices were flat in May compared to a year earlier and have been below the Fed’s goal since April 2012. Another measure of price pressure showed that the cost of living excluding food and energy rose 1.7% in May from a year earlier.

Looking forward, consumers, businesses and investors are facing an era of higher borrowing costs as some of the lowest global interest rates in modern history begin to rise. The message from many economists is a reassuring one as they do not expect rates to rise fast or high enough to inflict much damage on the global economic recovery. Borrowers and investors may feel some short term pain but should be able to manage the change over the long run.

The Standard & Poor’s 500 index rose a nominal 0.3% in U.S. dollar terms over the second quarter of 2015 and in Canadian dollar terms the index lost 1.4% for the period. Year to date the U.S. equity benchmark is up 1.2% but gained 8.8% in Canadian dollars as the Canadian loonie weakened significantly in the first quarter of 2015.

The U.S. Bureau of Economic Analysis confirmed in late June that the U.S. real gross domestic product (GDP) decreased at an annual rate of 0.2% in the first quarter of 2015. The weakness has been attributed to a stronger dollar that has hurt U.S. exporters and cheaper gasoline prices, which are great for consumers, but have hit the previously rapidly growing energy industry hard. Drillers have shed thousands of jobs and shelved expansion plans. Both consumers and companies aren’t spending as much as had been hoped at this stage of the economic recovery. As a result, the economy is on track to grow less than 1% in the second quarter according to a new tracking tool created by the Atlanta Federal Reserve and the New York Federal Reserve has cut its growth forecast for 2015 to 1.9% from a year earlier estimate of 3.5%.

The June jobs report reflected the uneven nature of the recovery. The unemployment rate fell to 5.3% from 5.5% and is now at its lowest level since the April 2008 level of 5%. The downside is that the drop was attributed to 432,000 people having left the labour force, most of whom are young and just graduated from school. The percentage of Americans in the labour force has now fallen to its lowest level in 38 years. The report confirmed that wages of U.S. workers has been disappointingly flat, rising just 2% over the past 12 months. The May and April employment numbers were also revised downward and the evidence is that the U.S. is not expanding as fast as it was in the middle of 2014.

Many investors are concerned that the U.S. equity market has run too far, too fast. The S&P 500 index is trading at 17 times estimated 12 month forward annual earnings which is about 1 standard deviation above the ten year moving average. That is lower than the October 2007 peak and much lower than the average 19.6 price/earnings ratio of U.S. market tops since 1929. A big driver of the market has been the low interest rate monetary policy and there are concerns that the eventual rise in rates will cause the market to fall. High valuations and a rise in rates however may not be enough on their own to trigger a market drop as two hallmarks of past bubbles have yet to fully appear. These are the return of individual retail investors to the market and a significant uptick in merger and acquisition activity. U.S. retail investors have largely been watching the rally from the sidelines as more than $80 billion has flowed out of equity mutual funds since 2009. Mergers and acquisitions have begun to pick up and is only now at its highest pace since before the Great Recession.

The world’s economies have been helped by the drop in oil prices and the decline in the value of the Euro relative to the U.S. dollar. At the start of 2015 investors were almost paralyzed with fear that Europe would tumble into a deflationary spiral that would cripple business and consumer spending. The tides have changed and we now seem to have a degree of normalcy in the financial markets. If this new-found level of comfort could be spread around the world a little more, then we might experience a global calming in the financial markets.

Europe is still in a precarious situation with its biggest headache being Greece. The uncertainty surrounding a disorderly default and exit from the European Union has been ongoing. A so called Grexit would cause a massive depression in Greece as the country reverts back to an old, weaker currency, the Drachma. Despite the Greek drama and a disappointing slowdown in Germany, the European economy is picking up speed and growing at its fastest pace since the second quarter of 2013. Italy is enjoying its first expansion in two years and perhaps the most notable increase was in Spain, which saw robust growth for a change. The U.K. unexpectedly slowed, posting its weakest performance in more than two years as demand from Europe sizzled, but it is still one of the fastest growing countries among developed nations.

Japan’s economy grew at a faster pace than expected in the first quarter of 2015 on stronger corporate spending. Consumer spending, which accounts for nearly two thirds of Japan’s economy, rose only marginally and signals a continued reluctance among consumers to splurge. Exports and public spending continue to be a drag on growth. The government has pointed to the stronger growth as a sign the recovery is gaining strength and the considerable efforts to re-inflate the economy after 20 years of stagnation are finally yielding benefits.

China’s growth engine is not running on all cylinders, but might be headed to the garage for a minor tune up, as opposed to a major refit. It is not keeping pace with the expansion that the world had been counting on to support the global economies. China is having a negative impact on other Asian countries due to its size and deep trade and financial linkages. China’s vaunted consumers are showing signs of spending fatigue and the service sector is also cooling. The government has rolled out a flurry of initiatives, including interest rate cuts and more infrastructure spending to energize an economy which looks set for its worst performance in 25 years.

For the most part the second quarter was rather indifferent to international stocks as few markets eked out better than 1.0% performance. However, combined with the first quarter’s strong results the year-to-date returns were much more impressive. Overall the developed markets increased 5.9% (all figures are in U.S. dollar terms) in the first six months of the year, led by Asian gains of 9.6%. European stocks lagged with only a 3.1% gain, while emerging markets appreciated a weak 1.7%. The remarkable market was China where stocks have rallied more than 110% since November, easily making it the best performing stock market in the world. More recently, Chinese stocks have collapsed rapidly since June 12, losing more than 30% in jaw dropping volatility.

The global financial markets continue the tug of war led by the competing forces of improving activity in Europe on one side versus the unfolding Greek tragedy and slowing China on the other. Hopefully, improving global demand for manufacturing goods will be the tonic needed to create a virtuous cycle of growth where increased demand will ultimately put more money in people’s pockets so they can spend more. While there have been worries over the last several months that the level of the markets may be as good as they will get for a while, the prospect of better days ahead are improving.