Economic & Market Review - October 2013

by Gavin Graham, Chief Strategy Officer October 30, 2013
Notice: This newsletter is intended as a general financial market outlook, and should not be relied on as investment advice.
The controversy in October over the raising of the US federal government debt limit from its already amazing amount of U$ 17 trillion (that’s not a misprint) and the temporary shutdown of parts the federal government due to the failure of the Obama administration and the Republican-controlled House of Representatives to agree on a budget, gave investors a chance to assess the longer term outlook for the world’s largest economy. While the US continues to grow, with second quarter annualized GDP expanding at 2.5%, five years after the worst post-war recession, the US economy is still some way off its pre-recession peak, and growth over this period has only averaged 2.2% p.a., the slowest such recovery for the last century. The participation rate for the labour force is at a 35 year low, and although unemployment has fallen to a six year low of 7.3%, real wages after inflation are still below where they were in 2007. It’s unsurprising that political debate is so partisan and rancorous; it’s much easier to be moderate and forgiving if the economy is motoring along at a 3-4% p.a. rate as it was during the last major government shutdown in 1995-96.

Despite this lacklustre performance, US stock markets have been on a tear. The venerable Dow Jones Industrials is up 21.6% year-to-date, the broader S&P 500 is up 25.6% and the technology weighted Nasdaq is up a remarkable 31.5%, despite the fact that its heaviest weighted stock, Apple, is actually down almost 10% over the last year. The Dow and the S&P 500 both hit new all time highs this month, while the Nasdaq is now almost back to 4,000, a level last seen in 2000. In Europe, the German DAX and the UK FTSE100 are both up 18.6% year-to-date in local currency terms, while Japan’s Nikkei 225 is up an astonishing 40% in yen terms, although the sharp decline in the yen has reduced that to 17% in U$ terms. By comparison, the Canadian S&P/TSX Composite has been a relative laggard, only up 11% year-to-date, while the Shanghai Composite is actually down -2.7% over the same period.

This strong performance of the major indices has less to do with economic growth than the fact that all of the world’s central banks are still engaged in Quantitative Easing (QE), which is most easily thought of as the creation of new supplies of money through expansion of their balance sheets, otherwise known as money printing. The US Federal Reserve, as we noted last month, backed away from its suggested reduction (“tapering”) of the U$85 billion a month of Treasury bonds and mortgage-backed securities it has been purchasing for the last year in September, while the Bank of Japan, the Bank of England and the European Central Bank have all reiterated their intention of maintaining their purchasing of government bonds and keeping interest rates low for the foreseeable future.

While loose monetary conditions can help stock markets to new highs, and are keeping the housing and auto markets in relative good health in the US and the UK, the two countries which eased earliest and most aggressively, they do not do much to address the longer-term issues that still trouble the US. The share of company profits in the GDP has risen to its highest level since the 1920s, and the income inequality (i.e. the difference between the share of national income enjoyed by the wealthiest 10% and the poorest 10%) has also widened to its highest level in decades. i This is contributing, without a doubt, to the partisan bickering that characterizes political debate in the US these days, although ironically, many of the wealthiest entrepreneurs and executives, especially those in the technology and media industries, which have been amongst the best performing sectors of the economy, are Democratic supporters rather than Republicans, as would have traditionally been the case.

The conclusion that investors should draw from the present elevated levels of stock markets in the US combined with the patchy and slow recovery is that liquidity will always be more important than the underlying fundamentals in the short term. With interest rates still at 60 year lows, and likely to remain there until the new Chairperson of the Federal Reserve, widely expected to be well known dove Janet Yellen, is well established in her new job by mid-year 2014, investors looking for a real return above inflation, running at 1.5-2% p.a., have been driven to invest in higher yielding corporate and high yield bonds, and equities, whether domestic or international.

This situation can continue for the next few months, but, as the 1% increase from 1.8% to 2.8% in the benchmark 10 year US Treasury bond yield between May and September this year showed, any hint of reduced stimulus, let alone interest rates actually increasing, will see investors moving their cash into what they regard as safe havens. There was also a dramatic outflow of funds from emerging markets such as Brazil, India and Turkey during this period, where investors who had been borrowing in low cost US dollars to gain higher interest rates in these emerging markets bond markets abruptly demanded the return of their money, leading to sharp falls in these countries’ currencies and rises in their bond yields.

Probably the least vulnerable markets at present are those such as Canada, which have under-performed due to their high weighting in energy and materials stocks, which have been laggards due to the slowdown in the Chinese economy, which also accounts for the poor performance of the Shanghai Composite Index. With China’s GDP growth accelerating back to 7.8% annualized in the third quarter, both the S&P/TSX Composite and the Shanghai index have recovered in the few months, with Toronto up more than 5% in October alone. Investors should consider locking in some their profits from the strong performance of the US and Europe, and reallocate towards those markets which have lagged over the last year, specifically the emerging markets and Canada.

Source: Bloomberg October 30th, 2013