Uncertainty has always been the main source of angst for investors and there has been no shortage of that lately. The last few months have been a frenzy of dire predictions and hyperventilated commentary which has caused significant swings in the financial markets. However, at the end of the day, all the information available was absorbed and investors carried on. Perhaps global growth will take a short term hit but after some reflection and clarification, the anxiety will likely be subdued and the world will keep spinning.
Global demand continues to grow at a moderate rate despite many over hyped warnings. In reality, the most important issues of the day do not emanate from Europe: the potential fallout from China relying heavily on debt to fund infrastructure and economic expansion could lead to a financial crisis; weak business investment from companies spending less could slow earnings growth; and a slowdown in the U.S. economy that looks to be running out of steam and adding fewer new jobs, will have widespread repercussions.
The perceived worries following the U.K.’s vote to quit the European Union are fading and global growth is chugging along. Of course, the vote to quit the Eurozone roiled markets, torpedoed the pound and spurred a surge in demand for safe haven assets for a few days. But after the shock subsided, stock markets rebounded and in the U.S. they hit new all-time highs. Now we need to get down to the business of looking forward as the damage to global growth from Brexit should be limited.
Europe, on the other hand, needs to address many legitimate grievances and start to move in the right direction. It needs to manage a surge in refugees, Greece’s debt problems and the future of the shared currency. It cannot keep pretending that it is business as usual. It will be a long and tortuous journey but the risk of doing nothing is potentially even more dangerous. The good news is that growth is accelerating and has pushed the 19 country bloc to the level it was just before the recession of 2008. While unemployment is still 3% higher than 8 years ago, it is also on the right path.
Canada’s economy has reversed its trajectory from the two consecutive monthly declines earlier in the year, although the second quarter is still expected to be weak. The Alberta wildfires will likely sink the second quarter growth rate but a rebound is anticipated in the third quarter. The Bank of Canada will likely hold key its interest rate steady into 2017. The struggling manufacturing sector is surprisingly upbeat but the fallout from the U.K. uncertainty could lead to some surprises.
Despite the initial carnage after the Brexit vote, the second quarter was generally a good one for most investors. Canada was the second best performing market gaining 5.1% in the quarter and 9.8% year-to-date. Most of these gains were propelled by commodities as they surged 13% (all returns in C$ terms), spurred by a 25% gain in oil prices after a 6.2% rally in the first quarter. Canadian bonds increased 2.6%; U.S. stocks gained 2.8%; Asian stocks appreciated 1.1%, while emerging market stocks were flat. And while in the long run the Brexit turmoil will likely be just a blip, it did contribute to European stocks falling 3.9%.
Certainly more signs of economic weakness could unbalance investors but prolonged low rates and lackadaisical non-recession growth will continue to propel the markets upward. For now the real future of the markets and global economies are in the hands of the politicians. While the Brexit vote did not really produce financial carnage, it is an important reminder to expect the unexpected and prepare accordingly.
Stock market anxiety resurfaced after the Brexit vote which resulted in massive losses for global markets. The TSX in particular dropped more than 3% in the two days after the vote before bouncing back at quarter end. That bout of volatility and the adverse impact of the wildfire in Alberta would appear to have worked against the TSX. However the wildfire along with other geopolitical unrest triggered a decrease in daily oil production which ultimately propelled the price of oil to more than US$50 a barrel for the first time since mid 2015. Additionally the fresh nine month high in mining stocks helped the TSX break through the resistance level of 14,000 points. The result of all this activity was the TSX ending the quarter with a 5.1% gain, making it one of the best performing global markets in the world year to date.
A sector breakdown shows that Materials and Energy continued their impressive run that started in the middle of the first quarter. The Materials sector has been the natural beneficiary of negative interest rates, now common throughout some major economies in the world, including Japan and Germany. It led the pack on the TSX with a 26% gain followed by Energy with a gain of about 10%. Utilities were the third best performer during the quarter with a 6% gain, driven by asset value appreciation amid the subdued interest rate environment. On the flip side the index was dragged down by Health Care which posted a 7.5% loss as investors continue to be cautious due to the drug price scandal that began a few months ago. Information Technology also lagged the index with a 5.6% loss. Although the financial services sector was a modest detractor on the TSX with 0.2% loss, the sector is still striving to find some stabilization.
The Canadian economy, unlike its stock exchange, shows some fragility amid a see-saw growth pattern. The first quarter posted annualized GDP growth of 2.4% which is slower than the 2.9% pace economists expected. Though decent, there are few reasons to believe that such a pace will be maintained over the next few quarters as the February and March GDP readings were weak. The aftermath of the wildfire in Alberta will also likely cut a few percentage points from next quarter’s GDP.
The Canadian FTSE TMX Universe Bond Index gained 2.6% in the second quarter of 2016. Year to date the index is well into positive territory with a 4.0% 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 after having raised rates in December.
Canada’s central bank governor, Stephen Poloz, is finding it a challenge to determine the current state of the economy as data has been volatile. Following a speech to the Canadian Economic Association in June he noted that “Views in the market, about what policies might do, change virtually every week so our job is to continue to do our analysis to see our way through that volatility and focus on getting the trends right.” Senior Deputy Governor Carolyn Wilkins confirmed at a recent Monetary Policy Report press conference that the bank’s, “discussions focused on how we should look through the choppiness in recent data to see the underlying trends, and what these trends mean for the inflation outlook. Among other factors, the fires in Northern Alberta, which have been costly for many, represent a sharp, but temporary, hit to the economy. We expect to see GDP fall by 1% at annual rates in the second quarter, and then grow by 3.5% in the third quarter as oil production resumes, rebuilding around Fort McMurray begins and the new Canada Child Benefit lifts consumption.”
Despite volatile energy prices there are positive signs in other sectors. Thanks to the slow but steady growth in the U.S. economy and a lower Canadian dollar, exports outside of the energy sector have recovered to levels close to their pre-recession peak. Nevertheless exports are another example of volatile data. After two months of declines, Canada’s exports rose 1.5% in April while imports increased more slowly at 0.9%. Together they narrowed the country’s trade deficit to $2.9 billion from a $3.2 billion shortfall in March, which is a positive trend for Canada.
The Bank of Canada is projecting that inflation will average 2% in 2017 as the economy recovers. However, wage pressures have been subdued relative to historical experience so inflation may remain on the low side. A low inflation environment constrains the bank’s ability to raise rates and the current low interest rate environment is a concern to the bank as it is seen as a driver of high household debt levels and overly high home prices in the Vancouver and Toronto markets.
The Standard & Poor’s 500 index rose 2.5% in U.S. dollar terms over the second quarter of 2015 and in Canadian dollar terms the index was up 2.7%. For the year to date the benchmark is up 3.8% but fell 2.2% in Canadian dollars as our currency recovered some of the ground it had lost to the U.S. dollar in the first quarter. While weak in Canadian terms recently, the U.S. index continued to be positive as investors continued to ride one of the longest bull markets since the 1940s. The S&P 500 index has more than tripled since bottoming out in March 2009.
In February, when the S&P 500 index had fallen more than 10% since the beginning of the year, concerns were growing that the U.S. economy was slipping into a recession. Those fears have since subsided as consumer spending, which accounts for more than two thirds of U.S. economic activity, increased to $11,373 billion in the first quarter of 2016; an all-time high. Economists, impressed by the vitality of American consumers, expect the economy to grow at least twice as fast in the second quarter as the 1.1% pace we saw in the first quarter. The rough start to the year had prompted economists to initially lower their estimates for economic growth; however the average forecast now calls for better than 2% economic growth this year.
Economists were surprised by the strong employment increase in June as U.S. employers added 287,000 workers. The good jobs number is easing concerns that the labour market is in a slump. The unemployment rate did edge up from 4.7% to 4.9% but that was largely because more Americans resumed looking for work. The employment number stood in sharp contrast to May when only 38,000 people were hired, the smallest number in five years. At the time expectations were for 164,000 new hires.
While fear is increasingly evident it is actually a foundation for the bull market as stock prices perpetually climb a wall of worry. From a global perspective, the U.S. economy appears to be a relatively safe haven and there are signs of improvement. Recovering commodity prices confirm that the deflationary undertone dominating investor mindsets in the last couple of years seems to be finally easing and there are increasing reports that suggest earnings performance may begin to improve over the balance of the year. The second half of the year is also looking better due to renewed strength in housing and auto sales, and thanks to the most recent jobs report, consumer confidence is near a post-crisis high. After weakening earlier in the year, the outlook for the U.S. economy now appears to be reasonably good.
After the past quarter, the world appears very messy once again. However, the reaction out of the U.K. and Europe was entirely unpredictable and not all that bad, everything considered. The world did not stop spinning; sure the financial markets went through a period of volatility, which could lead to a slowdown in global growth, but let’s wait and see before charging into the next so-called “event-of-the-decade.”
The world has been focused for months on the debate about the U.K. remaining in the Eurozone. While the outcome was not as expected, it does come with a sense of relief. While it was long, hard and tedious to endure, the unfortunate part is that this is not the end of “Brexhaustion”. Negotiations that will lead to some kind of new relationship between the U.K. and Europe will begin.
The British financial markets had functioned smoothly despite the pound hitting a 30 year low and the absolute drubbing U.K. stocks initial experienced following the vote. But the markets rebounded somewhat and are content to take a wait and see attitude given the lack of hard evidence about the actual impact. However, the British exit out of the Eurozone is likely to act as a significant drag on the British economy and to a lesser extent on the Eurozone’s economy as well. European officials are in no hurry to implement any changes, as the process could take years to unwind and how it will end, nobody knows. The Eurozone’s economic growth continues to remain frustratingly low, with monetary policy becoming less and less capable of keeping the region afloat. It is probably time to pass on the baton to fiscal policy, but that is in the hands of the politicians and the private sector. Unfortunately, they are likely not in the mood to significantly increase spending at this juncture.
Japan’s recovery is apparently faltering again after the economy returned to growth in the first quarter. Industrial production is declining more than forecast as a drop in exports hit most of the country’s manufacturing sector. The Bank of Japan is flooding the economy with cash in the hope that doing so will prompt companies and households to start spending more. Still after sending interest rates into negative territory and unleashing a massive stimulus program, more will likely need to be done. Australia has also added its name to the list of troubled economies and is likely facing a prolonged period of political and economic instability.
After the U.K. exit vote’s initial panic selling spree that erased $3 trillion from global markets, the markets collectively began reversing their knee jerk reaction. Barring a severe global recession, large stock market declines generally undo themselves within three or four months. Even so, international stock markets on aggregate were barely down on the quarter, declining 1.2% (all returns in U.S. dollar terms). European stocks, as would be expected, were the biggest losers falling 4.2%. Asian stocks actually increased 0.8%, while emerging market stocks slipped marginally, declining 0.3%.
Looking past the initial disruption and current uncertainty, the true impact of the Brexit kafuffle will vary widely depending on proximity. The U.K. will suffer the most; Europe will likely stumble, but outside of that the rest of the world will carry on. Not many pundits are predicting a recurrence of 2008 all over again, so it is reasonable to expect that the financial markets will not seize up. Even as events in Europe unfold, the markets have settled down and the world will muddle through as always.