Knowledge Centre

In the span of three months the global equity markets have gone from contentment to dread. Even the formerly invincible U.S. stock market started to show cracks. There has been no specific reason for the selling but a collection of interconnected concerns: the slowing Chinese economy, the continuing commodities collapse, the prospect of the first U.S. interest rate hike since the financial crisis and the evaporation of growth and inflation around the world. The correction and spike in volatility were long overdue and will pave the way for financial markets to find a new equilibrium.

The Canadian economic slump in the first half of the year was one of the shortest, mildest and strangest recessions ever as consumer spending and employment are both surprisingly up. Despite the weak start to the year, there is good reason to believe that the worst is over with the stage now set for a recovery in the second half of the year. There is optimism that Canada will benefit from the acceleration of the U.S. economy and the low interest rate environment. Despite the deep and ongoing collapse of oil prices, much of the panic over the energy sector has subsided; helping the Canadian economy beat recent expectations.

U.S. economic fundamentals look resilient with consumers in robust shape and growing healthier, while the housing market continues to push ahead. The job market is strengthening with only minor signs of wage pressure which is keeping inflation tame. Falling oil prices were expected to save drivers lots of money at the gas pump which could then be spent elsewhere to propel the expansion forward. Instead, they have chosen to pay off debt. Unfortunately this frugality has been the biggest driver of weaker corporate earnings and ultimately falling stock prices.

The European recovery appears to be gaining momentum as worries of a Greek exit have eased and led to an improved business environment. It still faces debt problems and is going to need more growth if unemployment is to come down significantly from the current rate of 11%. The European Central Bank has kept its interest rates at record lows and is ready to provide more stimulus if needed.

China has been at the epicenter of many of the recent global market moving events as it attempts to rebalance its economy toward services and consumption while maintaining high growth. It is walking a tightrope in introducing reforms as evidenced by the currency devaluation and stock market swoon confirming that the slowdown may be worse than expected. These concerns have posed a challenge to emerging market countries as the dual pressure of plunging commodity prices and the risk of a rise in U.S. interest rates have taken their toll.

The third quarter can lay claim to being the worst quarter in four years as a wave of selling hammered equities. A pause is natural and in this case long overdue so there is no need for panic. Sell offs do not end bull markets. They quite often restore value to securities which allow markets to revert back to their upward trend. The Canadian stock market now has valuations that are below their long term average after falling 7.9% in the quarter. The U.S. market, which is set to trump the Canadian market for the fifth straight year, gained 1.0% (all figures in C$ terms) after a decline in the Canadian dollar of 7.4% is taken into consideration. International stocks lost 2.8%, paced lower by an 8.8% drop in Asian stocks. Emerging markets were the hardest hit, plunging 11.1%.

The reappearance of volatility has stirred memories of the financial crisis and pushed sentiment to extreme pessimism. China is now big enough to pose a threat to financial markets but the possibility that it will stop growing is remote, though future growth may be at a diminished rate. Both the U.S. and Europe will contribute to growth and corporate profits, helping global growth to continue to be very much viable.

The S&P/TSX index, which struggled to recoup some lost ground in the first half of the quarter, skidded lower in September. The total return version of the Canadian index, which includes dividends, closed the quarter at 14,461, a drop of about 3,500 points or 7.9% lower than where it traded at the end of June.

About 80% of the stocks in the TSX index are trading below their 200 day moving average. The losses were somewhat foreseeable due to the collapse of the Energy and Materials sectors that started last year. The decline was further aggravated by volatility which suddenly resurfaced in mid quarter. Materials lead the pack downward with a 26% loss, followed by Energy which turned in a 19% loss even with dividends. A noticeable change in the market’s dynamics was the abrupt reversal in what had been the leading sector as the Heath Care sector posted a 16% loss, largely due to Valeant and Concordia HealthCare. Valeant and Concordia HealthCare have been under severe pressure from proposed U.S. legislation that would curb some of these drug companies’ aggressive pricing models.

The Canadian economy apparently fell into a technical recession in the first half of the year as GDP growth dropped in the first two quarters. Initial estimates of GDP are subject to a number of revisions as the initial numbers are often well off the mark. Many analysts recognize that there is weakness in the economy but the flurry of recession talk appears misplaced as data from across the country does not provide sufficient evidence of a serious economic downturn which would be typical of a recession. Positive job creation, with about 14,000 new jobs year to date as of September, provides a compelling argument to hold off on confirming that Canada is indeed in a recession pending the issuance of revised GDP numbers. A full economic rebound might not occur for a number of quarters as weak commodity and energy prices will likely remain a headwind for the economy for many months to come. On the plus side the economy has a strong competitive advantage with the loonie at its lowest point in many years. The ongoing drop in interest rates was further aided by the Bank of Canada as it dropped its benchmark rate to 0.5% in July. The low interest rate policy is a positive stimulant which should eventually help propel the economy forward, momentum that is expected to continue into the future.

The Canadian FTSE TMX Universe Bond Index gained a nominal 0.1% in the third quarter of 2015 and year to date the index is well into positive territory with a 2.8% gain. 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. More recently the central bank cut its trend setting rate by the same amount in July. The overnight rate now stands at 1/2 of one per cent. No change was made to the rate at the most recent meeting on September 9th.

The central bank cited the sharp drop in oil prices as the reason for the first surprise rate cut. The rate had been unchanged since September 2010, the longest period of rate stability since the early 1950s. The reasoning for the second rate cut appears to be to weaken the loonie in order to boost trade. An improved trade outlook is vital to the country as there are indications that the Canadian economy went into recession in the first half of the year. Following the most recent rate cut the Canadian dollar dropped to a post Great Recession low which has the adverse impact of raising the cost of living as Canadians are heavily reliant on imports. A consequence of the dependence on imports is that Canada is currently enduring its second worst trade deficit on record.

The U.S. Federal Reserve is keeping U.S. interest rates at record lows in the face of threats from a weak global economy, persistently low inflation and unstable financial markets. Following the Federal Open Market Committee’s highly anticipated meeting on September 16 and 17, Fed officials confirmed that while the U.S. job market is doing well, global pressures may “restrain economic activity” and further drag down already low inflation.

The market turmoil that swept across the globe in September also hurt Canadian bond issuers as corporate borrowing costs spiked to their highest level in three years. Following the slowest August in a decade for debt issuance, corporations are facing higher borrowing costs despite the central bank’s two interest rate cuts this year. The extra yield that bondholders demand to own Canadian corporate borrowings relative to government bonds expanded dramatically in August as corporate bond yields saw their biggest monthly jump since May 2012 and the fattest spread between government and corporate issues since September of 2012. In the first half of the year Canadian companies issued bonds at the fastest rate in at least a decade. That pace is now slowing though and seems unlikely to break the 2013 record of $106 billion. Corporate yields are still near record lows but the widening yield gap over federal debt shows it is getting more costly to entice investors to take on the added risk of lending to companies. Changes in regulatory requirements are also compounding the difficulty of buying and selling corporate bonds in Canada. Capital requirements in the U.S. and globally have led some financial institutions to reduce their traditional role as bond market middlemen which is making it harder and costlier for investors to trade bonds.

The Standard & Poor’s 500 index fell 6.4% in U.S. dollar terms over the third quarter of 2015 but in Canadian dollar terms the index gained 1.9% for the period. The U.S. dollar was one of the few upward trending financial instruments as equities worldwide fell dramatically in September.

After a harsh winter, the U.S. economy posted a solid rebound in the second quarter, led by a surge in consumer spending and a recovery in residential construction. In late September the U.S. Bureau of Economic Analysis revised upward its estimate for U.S. GDP. New data showed the U.S. economy expanded at an annual rate of 3.9% which was well up from the 0.6% first quarter increase. The revision to second quarter growth was led by a boost in consumer spending, which expanded at a 3.6% rate, up from the previous estimate of 3.1%. Business investment spending was revised higher, reflecting increased spending on structures and equipment.

Residential construction grew at a steady pace as single family housing starts are up 15% from a year ago and multifamily starts are up 20%. Economists are looking for growth to strengthen more in the second half of the year as consumer spending is bolstered by employment gains. The unemployment rate in August dropped to a seven year low of 5.1% and remained at that level for the month of September as full time employment surged by one million in recent months. U.S. employment has been strong resulting in a few signs of wage pressures. In this case inflation would be a strong positive as the alternative, deflation, can be a difficult situation for an economy to extract itself from. So far however, inflation is well below the U.S. central bank’s 2% target.

The Federal Reserve’s policies of targeting employment and inflation have kept them from raising interest rates from ultra-low levels and they may have missed the opportunity to end the zero interest rate policy this year due to the collapse in inflation expectations. Some economists say that the Fed is paying particular attention to three key gauges in deciding when to raise rates. They need to see a stable U.S. dollar, steady energy prices and a still stronger jobs market. The U.S. dollar has risen about 15% against a basket of currencies in the past year and has hurt U.S. manufacturers as their goods have been priced out of overseas markets. A strong dollar also reduces inflationary pressures because foreign made goods become cheaper. On the energy front, the price oil is less than half of what it was a year ago, leading to suppressed inflation. Fed officials may be reluctant to act until they believe that oil prices have bottomed. Finally, while employers have added almost 3 million jobs over the past year, the hiring has yet to spur faster wage growth. Trends in these three factors will have to improve for inflation to reach the Fed’s objective.

The global economy is in the middle of a significant transition as developed nations try to normalize policy, while China and other emerging countries try to reconfigure their economies. This means rich countries are left as the sole engine of growth, although Europe’s recovery remains fragile. Unfortunately with interest rates at rock bottom levels there is little wiggle room to stimulate economies. As such, the relentless deceleration of global growth has meant a slow down this year with only a minor pick up in pace anticipated in 2016.

Fundamental concerns are being raised about China, the world’s 2nd largest economy, which accounts for 15% of global GDP and approximately 50% of global growth. Weakening growth and a devalued currency have combined to put pressure on the government’s efforts to smoothly evolve from a command economy to a market economy. Declining exports and a gyrating housing market means China faces a period of strong headwinds. And yet the doomsayers have generally gone too far. China is not in crisis. Its economy continues to grow at a steady 7% per year and while the growth rate is losing steam, China still has plenty of room to stimulate growth by cutting interest rates further or stepping up spending.

A genuine revival in the Eurozone earlier this year appeared to be taking hold, as equity markets were jubilant and consumers were confident. Unfortunately this optimism was short lived as a new round of unspectacular growth emerged. Worries have cropped up despite the stimulus of slumping oil prices, quantitative easing and record low interest rates. Tepid growth has left inflation as a spent force, for now. The shadow of the Greek demon has passed, so the Eurozone’s recovery now comes down to fundamental factors which are currently lagging.

The Japanese economy actually contracted in the second quarter, forcing the government to step up its monetary easing efforts. The world’s 3rd largest economy has been trying for two decades to pull itself out of the doldrums by enticing foreign investment to combat deflation. Japan’s largest trade partner, China, has caused extensive turmoil with its slowdown and market churning policies. Japan’s expected recovery in the second half of the year is now in danger of disappearing.

Emerging market stocks and currencies tumbled again as the formerly powerful cocktail of strong Chinese growth, low interest rates and buoyant commodity prices evaporated leaving them to face the ensuing hangover. Emerging market growth has slowed for the fifth consecutive year and this year’s declines have been the sharpest since the 2008 financial crisis. Once again heightened fears over China have fed worries that emerging markets could suffer a repeat of the Asian financial crisis of 1997-98. Fortunately these fears are not grounded in reality.

There was no shelter from the global storm in the third quarter as stock prices experienced one of its most volatile three months since 2011. International equities as a whole dropped 10.2% (all in returns in U.S. dollars), which was essentially matched by European stocks which fell 10.1%. Emerging market equities continued their five years of underperformance versus developed markets, declining by a whopping 18.5%, and Asian shares slid 16.2% due to the impact of plunging Chinese stocks and collapsing commodity prices.

Global economies and financial markets do not move in sync. Some countries zig and others zag; the only question is whether the majority are expanding in unison. Developed economies have regained some of their poise, but fears remain although in many ways these worries are misplaced. Uncertainty about China’s growth is now one of the main swing factors in markets. As a result global stock markets could continue to be volatile over the next while as these things sort themselves out.