Over thousands of years of evolution, we have built up the tendency to over associate events with a skew towards the negative, and for good reason. Mistake a shadow in the grass for a lion and flee to safety – you’ll live to see another day. Mistake a lion for a shadow in the grass, and your chances aren’t so good. This fear has helped keep us alive, but in situations that aren’t life and death, it can drive people to associate insignificant events with irrationally negative outcomes.
The market is no exception, it reads like a cardiograph of the global heart rate. Since 2008 jittery investors have been looking to spot lions everywhere and it has caused a lot of big swings in market prices of securities and commodities. This most recent quarter is only a reminder that the investor of 2015 is still a wary one.
In this update, we review the major reasons for the decline in Q3 and highlight the market fundamentals that should help us shine a rational light on market expectations going forward.
Negative Sentiment in Several Key Markets
Several negative headlines in Q3 combined to give us the worst performing quarter in four years; the U.S. S&P 500 index and the Canadian S&P/TSX Composite index were both down 7% and 9% respectively. Canadian stocks were driven down by continued downside pressure on oil prices and a scathing New York Times article on Valeant Pharmaceuticals. Fixed Income securities in Canada fared quite well as the flight out of equities in the quarter drove down yields, increasing the value of the bonds.
In Europe, Volkswagen’s emissions scandal has left the German auto manufacturer with billions to pay in remissions and billions more to worry about with its lending and banking arm. Given the instability of the rest of the European market, including separatist talks in Catalonia, Spain and continued political turmoil in Greece, this black mark on the crown jewel of German manufacturing is not a welcome issue for Europe’s largest economy.
Looking east to China, the slowing economic activity kept commodity prices suppressed while the Shanghai market (pictured below) corrected and fell nearly a third in Q3, effectively clawing back any of the gains made in the first half of the year. While this has had a significant effect on global markets, we feel the correction brings the overall picture in China much more in line with its general fundamentals.
(Source: Yahoo Finance)
U.S. Interest Rate Uncertainty
Through all the turmoil over Q3, analysts' held their breath in the days leading up to the U.S. Federal Reserve ("Fed") decision on whether or not to raise interest rates over fear that the global economy might be too fragile to handle an interest rate hike. Markets momentarily breathed a sigh of relief as the Fed kept interest rates at current levels, but dropped soon after as Fed Chair Janet Yellen promised to raise rates before year end.
Why is the Fed looking to hike rates at this point? Well, let’s take a look at the state of the U.S. economy. Money supply has accelerated over the quarter; this means there is more money in the hands of consumers, businesses are increasing production, and there is a higher demand for labour. U.S. core inflation is at 1.8% and the Gross Domestic Product (a measure typically used to determine the size of the economy) has recently been revised up to 3.9%, both strong numbers. Corporate profits are also up 3.5% and cash flows are up 7.5% from a year ago. All of this fundamental data signals that the U.S. engine, which powers 23% of global GDP, is revving up. A rate hike is timely and it tells us things are moving in the right direction.
What to Look for Going Forward
Expect an interest rate hike from the Fed before year end. Remember, it’s a positive thing, as the economy is growing and all signs point to it staying that way for the time being. Europe will likely remain on shaky ground until some doors are closed on the ongoing political uncertainty. Until supply is reduced, we expect commodity prices to hover around the current levels.
In Canada, the impending election may cause added volatility in the markets. However, we expect the U.S. economy to be the main driver of market sentiment in the short term as corporate balance sheets remain flush with cash and consumer spending continues to remain strong.
In China, the irrational growth in the first half of the year is now behind us, and the market is back to where it began the year. An inclusion of the Yuan in the IMF reserve basket should bode well for a renewed confidence in the Chinese market. Also, let’s not forget that the Chinese government, which has significant foreign currency reserves, has many policy options to support the economy and revive growth. Any such policy announcement could quickly reverse sentiment in the markets.
Surely there will be more negative headlines to suppress growth in the major economic markets, but it is important that we not mistake the forest for the trees and keep the broader global fundamentals at the forefront of our minds. When it comes to the markets, those who can keep a cool head when others are reacting to the latest scare will do the best in the long run. Stay focused, stick to your plan, and don’t panic! Holding a well-diversified portfolio, making regular contributions to your savings plan and reducing costs of investing – all well within your control – are the definitive ways to succeed in the long term.
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