Overreaction or reality check?

We will not sugar coat today’s market situation as performance since April, and the last couple of weeks in July in particular, has been terrible. Not only have many market indices, such as the TSX Index and the S&P 500, corrected so too have many commodity prices which does not bode well for the Canadian stock market in general.

The purpose of this article is to review how we got to this situation so that you have a better understanding of where the market currently stands and where it might be going.

How Did We Get Here?

We would like to offer our thoughts on the following issues which are weighing heavily on sentiment and thus dragging down stock markets globally:

• A slowing U.S. economy
• The U.S. budgetary problems and the downgrade by Standard &Poor’s (S&P) of U.S. sovereign debt
• Debt and economic uncertainty in Europe

A Slowing U.S. Economy

Most investors would have few complaints about how the TSX performed in the first three months of the year, but performance since then has struggled as we’ve seen continued signs that the U.S. economic recovery has weakened. We will cut straight to the chase by noting we believe this about face in the U.S. economy was caused partly by supply chain effects from the Japanese earthquake/tsunami, but mainly by escalating energy and food costs witnessed earlier this year. Higher prices at the pump and grocery store influenced consumer behaviour and moderated the U.S. economy’s ascent. Simply put, the more money Americans had to use to pay the bills, less money was available for discretionary spending.

The fallout from these price spikes resulted in very disappointing economic data releases which have included a weakening ISM Manufacturing and Non-Manufacturing Index, underwhelming retail sales, and a couple of disastrous employment reports (although we admit last week’s employment report beat expectations). Nevertheless the data is still weak and the U.S. economy has a long way to go to get back on its feet.

However, with that said, the picture is not entirely bad as economic data still shows that the U.S. economy is expanding for the time being and jobs are being created even if they’re not being created as quickly as we’d like. The U.S. recovery was always going to be a struggle considering the collapse of the financial system in 2008, so it comes as no surprise that we are seeing some signs of the struggle today.

The U.S. Budgetary Problems and the Downgrade byS&P of U.S. Sovereign Debt

Many of you are aware the government of the United States recently attempted to create a new road map for its budgetary future as a condition to raise the U.S. debt ceiling. The end result was a “debt deal” that nobody liked including the politicians who created it. However, the most important takeaway from this deal was that the debt ceiling was raised and will continue to be raised if necessary through the 2012 elections. This is important as it guarantees that the U.S. will not default on its financial commitments. However, the rest of the deal was underwhelming compared to what politicians wanted to achieve and illustrated why the U.S. has a very inefficient system of government when it comes to producing meaningful and effective legislation.

There are some Americans that would argue that their system is the best in the world and that slow change is required to make sure the Government does not make changes hastily; however, we disagree. Time will tell if the bipartisan “super committee”, established under the new debt deal, can agree on and implement effective tax and spending policies to address the U.S. deficit effectively.

Going into the latter part of negotiations, S&P told the U.S. government that it needed to come up with $4 trillion worth of cuts over the next 10 years to avoid a downgrade. Considering that politicians produced a deal that only accomplished half that amount resulted in S&P downgrading the U.S. from AAA to AA+ credit rating on Friday night. This event should have had more impact on fixed income markets than equity markets, but the symbolic nature of the world’s largest economy being downgraded for the first time ever has scared away investors in general.

This is more of a knee jerk reaction in our view than a decision made on fundamentals. While the fallout from the downgrade will likely continue in the equity markets for the next few days, we do not believe this event alone is a reason to sell equities. We would also like to remind investors that while S&P downgraded the U.S., other rating agencies such as Fitch and Moody’s have not. That’s not to say that they won’t, but remember that S&P is only one of many rating agencies and quite frankly had no choice but to carry through with the downgrade.

The anger in the markets today probably has more to do with the timing of the downgrade than the downgrade itself as some investors thought S&P would wait to see what the new “super committee” would come up with in terms of cost savings later this year. Considering the nature of U.S. politics and that the next election is just over a year away, it is unlikely much progress will be made on balancing the books until the 2012 campaign is over.

Debt and Economic Uncertainty in Europe

While some market observers digest the U.S. downgrade, we believe Europe is a much more important issue for equity investors. You already know about Greece, Ireland and Portugal and recent weeks have brought the larger economies of Spain and Italy into the equation. The “Greek debt deal” of a few weeks ago was not a solution to Europe’s debt woes and might even prove not to be the final solution for Greece itself. In fact the measures, including the new European Emergency Fund, still need to be passed by all 17 Euro governments before the European Central Bank can put that facility to work.

But Europe is our main concern because the debt situation and the austerity that it requires has and will put countries back into recession. Admittedly, as long as Germany and France continue to expand, the effects of recessions in other countries will be minimized. However, if the effects of the European crisis bring the entire region into recession, then concerns about U.S. economic growth increase. While we expect a global effort to keep European debt concerns at bay, any default of any nation could potentially start a domino effect within the region, financial institutions will be affected and once again we could face a global liquidity crisis. Again, we believe the world’s central banks should be able to avert this situation, but it is one that stock markets are pricing in as a worst case scenario. Let us be clear: a solution in Europe will not take weeks or months to implement, but years. Naturally, with such a long time frame to be considered, markets are unhappy with the uncertainty that comes along with it.

Is it All Bad?

We’ll be blunt when we say it’s easy to have a negative outlook on the markets as you’ve been bombarded with worrisome headlines for the past couple of weeks. However, we think it’s important to remind you of some positive takeaways in the market at this moment. First and foremost, while governments are having a hard time keeping their books in order, corporations are not as some balance sheets remain quite strong and corporate earnings have been resilient during the economic recovery. Furthermore, many defensive equities in Canada still offer a very nice dividend yield for income oriented investors. Moving away from Canada, we would also like to remind investors that even after tightening interest rates since last fall, China has managed to post reasonable GDP growth numbers while trying to fight inflation at the same time. While there is no guarantee the growth will persist, we believe China is managing its economy in a controlled fashion and should avoid any material declines in GDP growth. In other words, we believe China is dealing with its growth in a way that should produce a soft landing as opposed to a crash and of course that is good for the Canadian market and global markets as a whole. Then again, we do recognize that if Europe and the U.S. continue to struggle, it will be hard for the Chinese economy to grow at current levels.

What to Expect in the Coming Days

As we continue through these difficult markets, we would highlight the following events in the near future which will continue to influence market performance:

• Federal Reserve meeting on Tuesday. Considering the market declines of the past couple of weeks and increased volatility, some investors are expecting the Federal Reserve to take action tomorrow in a global coordinated effort to calm the markets. Can we expect the announcement of Quantitative Easing (QE3) on Tuesday? While there is no guarantee, the odds of a monetary stimulus announcement have certainly increased. While we don’t know what a QE3 package would entail, we believe a repetition of QE2 could cause more harm long term than good for a couple of reasons: (1) money supply is not the problem, it’s money velocity that is not helping U.S. growth. The U.S. system has sufficient money, it’s just that the banks, as middlemen, aren’t putting that cash in the hands of consumers and small business owners, (2), QE weakens the U.S. dollar and pushes asset prices higher including commodities, but weren’t higher commodity prices a problem earlier this year? Any QE answer will have to try and keep commodity prices under control while getting money directly into the hands of people who will need it and use it.
• Continued margin selling will persist. With any decline like what we’ve had recently, losses are always accentuated by margin selling. Naturally, due to liquidity, this hurts smaller cap names more than larger cap stocks, but larger cap equities are still victims of selling regardless.
• Chinese economic data will be released this week (likely Tuesday) including industrial production, inflation and retail sales. Considering the importance of China to the world’s economy, this data will influence the markets even though headlines from Europe and the U.S. will be at the forefront.

Portfolio Positioning

In terms of portfolio positioning in this environment, while market values have changed, our recommendations have not. We still believe balanced investors should continue focusing on high quality, blue chip, dividend yielding equities as this market uncertainty persists. For those investors who insist on looking at cyclical stocks right now, we would advise them to look at larger cap names in this environment as smaller cap equities will likely remain very volatile. We also believe that investors with a balanced portfolio should maintain some exposure to precious metals at this time. We recommend a position in gold itself or in larger cap gold related equities. With respect to bonds, we would reiterate the views of our bond desk which are a preference towards corporate and provincials over federal bonds and below benchmark duration.

Overall Thoughts

Simply put markets are in a difficult position, not because of what we know, but because of what we don’t know. We don’t know with certainty what the outcome will be for the U.S. and European economies and we can’t say with certainty that the world’s central banks and governments will be able to avoid defaults in Europe. However, we are certain that these bodies will use everything at their disposal to avoid a repetition of the financial crisis. We strongly believe that the situation in Europe will be the guidepost for where equity markets move in the near future. While we recognize the significance of the S&P downgrade of the U.S. from a historical perspective and that the economic recovery there has not gone according to plan, we still feel that the U.S. is in a better position than its European counterpart to stimulate growth. Investors should expect recent volatility to persist until effective monetary and fiscal policies are put into place as efficiently as possible. This is a global problem and will require a global response to calm markets and strengthen economic fundamentals going forward.

Gareth Watson is the Vice President, Investment Management & Research at Richardson GMP in Toronto. This team of research experts is responsible for monitoring and interpreting economic, geo-political situations, current market environments and trends. @Gareth_RGMP