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The tranquil summer that investors were enjoying came to an abrupt end towards the latter part of the quarter as negative events triggered a brief wake up call and volatility crept back into the picture. While short term news may twist the market’s tail, it will be the major fundamental factors that truly change the course of the markets, namely corporate earnings and low interest rates. Fortunately, there has been some good news on both fronts.

Corporate earnings and cash flow are stabilizing and perhaps even rising as the earnings dip appears to be over. In the second quarter earnings were expected to decline however, excluding energy companies, year-over-year earnings were actually positive. The cash generated by corporations has allowed them to not only pay attractive dividends but also to buy back large quantities of their own shares which has strengthened the market. Interest rates have bottomed after falling since the beginning of the year. Even if there are some short term rate increases, the world’s central banks expect relatively low rates to prevail for years. And when interest rates are lower, earnings are worth more and share prices tend to rise.

The Canadian economy shriveled in the second quarter to its worst performance in seven years. This contraction compared with growth at an annual pace of 2.5% in the first quarter. The drop in the economy came as exports of goods and services fell dramatically. The jobless rate rose to 7.2% as the collapse in oil and gas prices caused significant job losses. While it was not pretty, growth is expected to pick up in the third quarter, due to the federal government’s new Canada child benefit program and a boost in infrastructure spending.

The U.S. and Canadian economies have parted ways of late, with the U.S. economy’s superior relative performance remaining quite strong despite operating below its long term historical patterns. Despite some wage pressures, inflation has been kept in check. It has often been said that expansions do not die of old age; they typically die of economic excess and aggressive monetary tightening. Accordingly, there are at least a couple of years of growth before trouble starts to brew.

The world’s economy remains fragile and uneven. Certainly politics and geopolitics are not helping, with the final stretch of a contentious U.S. presidential election dominating the headlines. In the U.K., the consequences of the Brexit vote have yet to be felt; Italy is facing its own defining referendum; and in Germany, the governing party suffered a humiliating local election defeat. Japan’s experiment with negative rates has been ineffective and possibly counterproductive. China is wrestling with widening economic imbalances and stresses in its financial system that could stall its growth.

The third quarter was very rewarding for investors with equity volatility and bond yields near historic lows. The question now is whether there is enough conviction to push markets even higher. The Canadian stock market gained 5.5% in the quarter and is up 15.8% for the year, the second best return across developed markets, rising on the back of earnings that are expected to surge 33% from a year ago. The U.S. stock market returned 4.7% (all returns in Canadian dollar terms) for the quarter; with international markets doing even better by climbing 8.4%. Emerging Markets led the way with a 10.3% gain. Canadian bonds produced the weakest returns eking out only a 1.2% gain for the quarter while climbing 5.3% for the year.

It is important to remember that is not about where markets are now, but what the markets are anticipating, that will expand and extend the current cycle. There will always be sudden air pockets in optimism but they are infrequent and have usually proved both temporary and quickly reversible.

The Canadian economy has been growing at its slowest pace in 60 years. In addition to the uncertainties in the global economy, many domestic factors have not gone in the country’s favour over the last few months; first the collapse of energy prices last year, then the wildfires which added to the disruption, and then there was an unprecedented decline in exports during the second quarter. Yet the Canadian stock market held its ground thanks to gold in particular which surged more than 75% year to date. Over the quarter the TSX posted a decent 5.5% total return. Although it lagged many other global peers in the quarter, it outperformed most other markets on a year to date basis with a 15.8% total return.

The TSX has been notably resilient as it stayed in positive territory for three consecutive months and corroborated the view that the Canadian market has been the place to be after years of underperformance vis-a-vis its global peers. One particular trend that has emerged within the Canadian stock universe is the return to positive gains for the small and mid cap segments of the market. Over the last five years, these segments, especially the small cap, have lagged their larger capitalized counterparts. This trend was reversed as small cap stocks have returned almost twice the performance relative to the TSX benchmark year to date.

On the economic front, the third quarter started weakly. During the first half of the year, Gross Domestic Product (GDP) saw its worst drop since 2009 as it was hit by oil production disruptions in Alberta as well as setbacks in exports. The weak employment numbers at the beginning of the quarter raised concerns for many analysts as the nation lost over 31,000 jobs in July versus the 10,000 in gains that they had predicted. But reports over the entire quarter showed that GDP bounced back solidly as it gained 0.5% in July and exports reignited nicely to narrow the previous months’ deficit.

For the remainder of the year the economic momentum is expected to continue, given that the Federal government has rolled out an enhanced child benefit plan that should increase consumption. Nonetheless the sustainability of a full turnaround in the longer term could be in doubt due to the many economic challenges that may prevail. In the face of lower potential GDP growth over the upcoming quarters, the Bank of Canada has few alternatives other than to adopt a dovish tone until the economy is back at full capacity.

The Canadian FTSE TMX Universe Bond Index gained 1.2% in the third quarter of 2016. Year to date the index is well into positive territory with a 5.3% gain. The Bank of Canada continues to maintain its target for the overnight rate 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.

The Canadian economy looks to have recovered during the third quarter following a second quarter drop of 1.6% in Gross Domestic Product (GDP) due to weak exports and the impact of May’s wildfires in Alberta. More recently, GDP grew by 0.5% for the month of July, largely due to the oil sands sector which gushed 19% as production returned to normal after the wildfires. Canada’s trade deficit in August shrank to its lowest level in eight months on stronger non-Energy exports. Exports rose a healthy 3.4% in July and another 0.6% in August. Canada’s central bank has long projected that exports would rise on the back of the weak Canadian dollar and a recovery of the U.S. economy. U.S. economic growth is now picking up after a first half lull and job gains have remained healthy.

The prospect for an eventual rise in interest rates is heavily dependent on the U.S. With the improving employment numbers, the Federal Reserve now only needs to see inflation approach its 2% target in order to implement a higher rate policy. It has been a slow grind but inflation has been creeping upward, driven by higher food and energy costs. The prospect for an eventual rise in U.S. rates is supporting the American dollar relative to a weak Canadian dollar.

There had been expectations that the Bank of Canada might lower rates to maintain the trade advantage of a weak Loonie but that is now looking less likely as the Canadian currency remains relatively weak. Looking forward Canada could be one of the next countries to raise rates in the next few years which would be well ahead of Europe or Japan where rates aren’t expect to rise until at least 2020.

In this low rate environment, yield hungry investors have been ditching the safety of bonds in a search for returns in risker real estate investment trusts and high dividend yielding stocks. This can be a dangerous game as these investments don’t have the defensive characteristics of high quality bonds. Investors should note that while the bull market in bonds may be over, it does not mean that a bear market in bonds is beginning.

The Standard & Poor’s 500 index rose 3.9% in U.S. dollar terms over the third quarter of 2016 and in Canadian dollar terms the index was up 4.7%. For the year to date the benchmark is up 7.8% but in Canadian dollars was only ahead 2.6% as our currency recovered some of the ground it had lost to the U.S. dollar in the first quarter. Investors in the U.S. market continue to ride one of the longest bull markets since the 1940s as the S&P 500 index has more than tripled since bottoming out in March 2009.

U.S. Gross Domestic Product (GDP) expanded at a 1.4% annual rate according to the Commerce Department in its third estimate of second quarter GDP as exports outpaced imports and businesses increased their investments. That was up from the earlier estimate of 1.1% and higher than analysts’ expectations. The revised data showed businesses sank more money into research and development and suggests that the worst of the Energy-led slowdown in business investment might be over. As well, the rebound in exports relative to that of imports was enough to boost GDP by the most since the third quarter of 2014. Nevertheless, the economy has struggled to regain momentum since output started slowing in the last six months of 2015 and the overall growth rate for GDP in the second quarter was below historically normal rates. On the plus side, consumer spending, which makes up more than two-thirds of U.S. economic activity, was robust in the second quarter, rising at a 4.3% annual rate.

Many investors are concerned that the valuation of the U.S. stock market is at or above historical extremes while at the same time the U.S. economy is historically weak. The concerns are that a bear market is imminent because markets are expensive. While expensive valuations may precede a bear market, they are not in themselves the cause. Market declines are generally caused by larger economic effects. The data confirms that considerable slack remains in the U.S. economy. Single family residential building permits are significantly below their long term potential, durable goods orders are scraping along the bottom, and while consumers remain the bedrock of the U.S. economy, consumption as a percentage of income is weak. What the data does suggest is that a recession is not likely for at least another 18 to 24 months. While we are more than seven years into this economic expansion, the U.S. economy is by no means at risk of overheating. The economic landscape today is one of low inflation and considerable slack in housing, autos, and investment

There is also a compelling story for U.S. equities when viewed from a global context. Despite the underwhelming rate of economic growth domestically, the economy is still growing relatively well when compared to most other parts of the developed world. U.S. GDP is expected to grow at or above the 2% range next year, while the Eurozone economy is projected to advance at around 1% and Japan’s GDP is forecast to rise by even less than that. For global investors a bet on the U.S. economy is seen as a good way to invest.

While international stock markets have done very well lately and seem to be pushing to the forefront of investors’ consciousness, the high hurdle of sustainable economic growth has not been cleared. Political and event risks have intensified and may spread while the macroeconomic environment could also be deteriorating.

The market’s recovery since the 2008 financial crisis has been moving at a snail’s pace. Still, there are quite a few trends that have dominated the landscape and will eventually allow the global economy to scale new heights: interest rates are not going up any time soon; borrowing for both government and consumers continues to grow at a faster pace than the economy; cheap energy means the world’s economy will continue to enjoy the benefits; technology’s impact and velocity for change is accelerating; demographic trends are reshaping the world around us; and Emerging Market growth will eventually overwhelm the poor demographic trends in Western countries. Ultimately concerted and meaningful growth should ensue.

Growing caution seems to be the buzz phrase currently; as the economic outlook and political uncertainty in Europe weigh on investors; as the U.K. gears up to start exit proceedings from the European Union; and as Germany and France are facing elections. Europe’s business activity in September expanded at its weakest rate since the beginning of 2015. While strong export sales saved the Eurozone from stagnation in the second quarter, investments slowed and consumers reduced domestic spending. And with the key driver of growth, declining oil prices, starting to fade, the potential for ramped up support from the European Central Bank could be on the horizon. However, the Bank may have little left in the tank to boost growth after unleashing unprecedented monetary stimulus in recent years.

Japan has been the most daring country in using monetary stimulus to confront deflationary pressures and stagnation, but it now appears to be shifting from the “whatever-it-takes” approach of the past three years. It is taking a more long-term view of re-inflating Japan’s economy and is focusing on controlling interest rates more effectively across the entire yield curve. How successful this approach will be given the fact that the government already owns more than a third of outstanding government bonds is anyone’s guess, especially since little else has worked to stimulate the economy.

China has been supporting its economy since 2008 through record investment spending. As such, its debt levels have skyrocketed. But government support can only go so far as many industries are facing overcapacity issues. At the same time, consumers’ spending power is falling, resulting in a surge of bad loans which is raising concerns of bloated debt levels and housing bubbles. Even so, industrial output and retail sales have handily beat expectations which means third quarter growth is holding up better than expected and will likely remain on target.

International stock markets were the best place to invest during the third quarter. On a whole, international stocks were up 6.5% (all figures in U.S. dollar terms), with Emerging Markets being the pace setter increasing 8.3%. Asian stocks were the next best performing region with gains of 6.7%. European markets were the laggards with a return of 5.0%. This quarter was only the fifth time international stocks have outperformed both the Canadian and U.S. stock market simultaneously in the past 5 years.

Global economic growth should recover somewhat but no miracles can be expected with weakening employment growth and geopolitical issues dominating the headlines. Global trade is also likely to be lackluster in the later portion of the year. It’s important to remember that these sluggish conditions are quite often the best times for stock markets as investors look past the current doldrums and envision much better times ahead.