July 2010
“ Brother, can you spare a euro?”
(with apologies to the late Bing Crosby)
There was a lot of positive news in May (for example, the performance of Les Canadiens in the playoffs), but there was little to smile about for investors. Indeed, “Sell in May and go away” is a saying that may attain the status of investment gospel after the experience of May 2010. Investors were subjected to violent week-to-week capital market swings triggered by a range of events. When the dust settled, the Canadian market was off 3.5% and the S&P 500 had lost 8.2%, its worst performance in over 60 years. Contrary to our expectations at the start of the year that “stock picking” would be the key performance driver this year, the month of May saw “macro” items return to the forefront.
The Economy – Two out of three ain’t bad
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.
As expected, the major emerging markets have continued to lead the global economic recovery, benefiting from strong consumer demand and heavy investment in infrastructure. China’s economy accelerated in the first quarter, growing at an 11.9% annual rate. India’s economy, with 8.6% growth, and Brazil’s with growth of 8.4% followed close behind. Investors reacted apprehensively to these stellar results with all three equity markets suffering losses through the end of May: India off 3.9% (C$), Brazil down 14.0% (C$), and China dropping 21.6% (C$). These declines reflect concern that the growth will not be sustainable as the associated rise of inflation, now 5.3% in Brazil, and risks of a real estate bubble in China, force authorities to raise interest rates and tighten credit.
Canada enjoyed an impressive 6.1% growth rate for the first quarter, while the US economy expanded at a 3.0% rate. The consumer was a major contributor to growth as confidence continued to recover thanks to low interest rates and strong gains in employment. The housing market, strong in Canada and stable in the US, also buoyed spirits and spending. Growth forecasts for 2010 also improved to 3.1%. This moderate growth environment proved more comforting to investors as North American equity markets outperformed those in Asia and Europe by a significant margin.
European economic growth has been more subdued, at 0.8% for the first quarter. The unsettling impact of the Greek sovereign debt crisis on capital markets mushroomed during April and May. The initial agreement between the European Union and the International Monetary Fund (IMF) to provide 110 billion euros of financial support to Greece over three years, failed to calm fears of a Greek default. Yields on 2 year Greek government bonds hit 20% in the first week of May as investors anticipated a debt restructuring with a write-off of 20%-50%.
This forced the European governments to take more aggressive action, and they agreed to a 750 billion euro ($1 trillion) capital market stabilization program to support the debt of all member countries. This aggressive response was necessary because of fears of “contagion” – that weakness in Greece would undermine the ability of other southern European states to raise capital. The heavy exposure of European banks to weak sovereign credits also necessitated a strong response. Ironically, while the yield on 2 year Greek bonds fell back to 8%, and capital markets stabilized, the infighting that preceded the accord raised concerns about the long-term viability of the Euro.
The euro – headed for par?
Greece’s immediate financial challenges have been addressed, in part through the introduction of fiscal austerity programs featuring tax increases and cuts to pensions and other social programs. This pattern has been repeated throughout the Europe, with new austerity budgets introduced in France, Italy, Spain and the UK. These measures will likely extend the period of moderate economic growth in the region. However, the bigger question that investors are wrestling with is whether the political will exists to impose these hardships on voters when, without the means of bolstering growth, all these measures will accomplish is to stabilize debt at current levels. Leaders in Europe face a daunting task – reinvigorating their economies while under fiscal duress and facing weak domestic demand because of consumer deleveraging. Hence, speculation persists that Greece will eventually default because it lacks the means to grow out of its debt problem.
However, as discussed in our last issue, we see currency devaluation as the new G8 policy. The euro has been falling steadily as the sovereign credit crisis has gained vigour, and is now at a four-year low versus the US dollar. Allowing the euro to depreciate further will help all of Europe’s indebted states. Indeed, one of the biggest beneficiaries would be Greece, as 56% of its exports go outside the European Union; Germany, with 40% of its exports to non-EU members, would be another winner. Of course, recent instability has caused the euro to lose its standing as heir-apparent to the US dollar as a reserve currency, and foreign central banks are thus cooling their demand for the currency, further accelerating its descent to parity. 
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?
Investors have traversed a macro gauntlet over the last couple of months. The question is – how should recent events shape investment strategy going forward? We believe that “moderate growth” remains the most likely scenario – this should benefit dividend-paying stocks, whose total return is less cyclical in nature. Investors are also expected to apply a premium valuation to quality companies with competitive advantages that can translate into superior revenue and earnings growth.Price inflation is expected to remain in check due to excess capacity, but interest rates are likely to remain sensitive to supply pressures; thus we believe shorter-term government bonds and quality corporate bonds should be favoured in the short term; the risk of higher inflation in the future due to excessive monetary stimulus makes real return bonds appealing. The risk of future inflation will also foster demand for real assets, including bullion and commodities.
Overall, we continue to expect that equity markets will remain range-bound along a generally upward trending path, but still subject to periodic corrections triggered by economic surprises or disappointing earnings news.