September 2010
Double-dips are only for
ice cream cones
Investors have ridden roller-coaster capital markets in recent months. The sharp sell-off in May - June, and subsequent rebound in July, has undermined confidence. As a result, money market funds continue to attract inflows despite the negligible yields they offer. There is an old Wall Street saying that "A bull market climbs a wall of worry"; to investors today, the wall appears to be more of a mountain.
The Economy – Mixed data feeds fears of a doubledip recession
The second quarter has seen economic data come in generally above expectations. Global growth forecasts have been revised upwards, to 4.6% in 2010 and 4.5% for 2011, reflecting strength in North America and the Emerging Markets. Forecasts for Europe, of course, are falling.
The challenge of rebuilding after the 2008 credit crisis took centre stage as governments began the delicate process of weaning the global economy off the massive monetary and fiscal stimulus. This stimulus was instrumental in preventing the "Great Recession" from becoming something worse. While economic data was mixed, investors focused on the negative aspects – the risk of sovereign debt defaults in Europe, or that tighter credit could derail China's economy. As expected, global growth was led by the developing economies of Asia and Latin America. China's economy boomed with growth of 10.3%, while Korea, Singapore and Taiwan grew even faster. North America slowed during the second quarter from its rapid pace of the prior six months as inventory restocking ended. Still, the 2.4% growth enjoyed by the US economy and Canada's 3.0% growth rate were respectable, and consistent with our view that developed economies face an extended period of moderate growth. Results from Europe generally exceeded expectations; the UK economy expanded at a 4.5% annual rate in the quarter, and German unemployment fell to a two-year low as the weak euro bolstered export demand.
However, investor attention fixed on the tepid 1.6% growth in US consumer demand, rising mortgage foreclosures, and the fall-off in new home sales to 330,000 (annual rate) in June, despite record low mortgage rates. The poor housing environment and limited job growth subdued consumer confidence and resulted in a continued deleveraging by households, and the rise in the savings rate to 6.2%. Weak credit growth amongst consumers and businesses is a major source of concern for some pundits, but I view this as a positive step in building a more robust foundation for future growth.
The tightening of credit conditions by China, and the austerity budgets introduced by a number of European governments, are also seen to increase the risk of a "double-dip" recession. However, these initiatives must be taken in context. China is withdrawing some stimulus in order to avoid a property bubble, but money supply (M2) is still growing at a robust 18% rate. And the impact of fiscal tightening in Europe and the US is being offset by easy monetary policy; the yield of two-year US Treasury notes, an indicator of Fed policy, is at new lows. This is significant because the only recent example of a "double dip" recession in the US (1980/82) was triggered by aggressive Federal Reserve action to tame inflation. Other factors favouring a more constructive outlook include:
- strong corporate profits: earnings for the S&P 500 are forecast to be up almost 35% this year, with 15% growth forecast in 2011
- industrial commodity prices: the prices of key commodities remain substantially higher than June 2009 levels (oil +13%; copper +47%; nickel +38%)
European banks – Passing their stress tests triggers a rally
The MSCI World index jumped 8.0% (US$) in July; of course, this was after plunging 13.1% in May – June. The equity market recovery was launched by the results of the European bank stress tests, and was sustained by the stellar second quarter earnings reported by leading companies the world over. Corporations have emerged from this recession in better shape than from any previous one, and this is cause for optimism. However, that 84 of 91 European banks passed their stress tests, and that those who failed were already known, is little cause for celebration. The tests were not particularly onerous, and many banks must still rebuild their capital bases and refinance sizeable maturing debts over the next three years.
Where to now?
Market volatility returns – with a vengeance
May witnessed a return of equity market volatility, featuring gyrations that were unprecedented in amplitude and velocity. On May 6th, the US stock market hit an “air-pocket,” with the Dow Jones Industrials Index plunging 9.2% in the space of 20 minutes before order was restored and prices recovered. Trading volume on that day totalled 19 billion shares; to put this in context, the NYSE had its first 100 million share day in 1982. Ironically, the VIX index, a measure of market volatility based on S&P 500 options, hit its lowest level in two years on April 12 at 15.23; it had risen above 40 by the end of May, to its highest level since the bull market recovery began.
The spike in volatility suggests that leverage is again being employed aggressively by some investors, and that stock markets remain quite illiquid. Interestingly, these events have taken place just as the US Congress was developing a new legislative framework for regulation of financial markets. The spike in stock market volatility, and the record profits being reported by major banks that needed a bailout just 18 months ago, increases the chance that new, meaningful safeguards will be legislated.
Where to now?
Events of recent months affirm our view that investors face an extended
period of moderate economic growth. Equity markets will likely
remain range-bound along an upward trending path. Unfortunately,
the frequency and amplitude of market gyrations is likely to remain
unsettling until fears of the "double dip" recession scenario wane,
investors again embrace long-dated assets, and stock selection regains prominence over macro
considerations in driving investment returns. Indeed, investor experience after the last housingbust
related recession (1990-91), which saw the demise of the US Savings & Loan industry,
may provide some useful insights. The graph below highlights the halting nature of the equity
market recovery during that rebuilding phase.
A low interest rate, moderate growth environment should benefit the shares of quality businesses that pay dividends, like those favoured by the Maxxum team. Quality companies with competitive advantages that yield superior revenue and earnings growth, the focus of our Ivy and Universal teams, should also be favoured. Price inflation is likely to remain in check, but interest rates are likely to respond to supply pressures; thus shorter term government bonds and quality corporate bonds should be favoured in fixed income portfolios. The risk of future inflation due to excessive monetary stimulus keeps real return bonds appealing. The Sentinel team is well positioned in all income categories. The risk of future inflation will also foster demand for real assets, including bullion and commodities – our Universal family has a range of strong offerings in this segment. Finally, Canadian investors will likely be well served by foreign diversification given the superior growth from emerging economies, and the values presented by restructuring businesses in developed nations – Cundill provides you a window on both.