While its true that there are significant worries around the globe, Greece and the Euro zone especially, the key driver for stock markets and interest rate policies is the fundamental health, or lack thereof, the global economy. Greece's debt woes wont affect China, India the US and Canada - but is the European headache a telling sign of the future of a global slowdown?
by Andrew Pyle, for Yahoo! Canada Finance
Depending on how heavily weighted you are in stocks, the experience of the past four weeks may have ranged from mild discomfort to panic. If you are in the latter camp, trust me when I tell you it might be time to have a heart-to-heart with yourself in the mirror and figure out if your risk tolerance really did return following the 2008-09 market crash. But, the blame for feeling a little out of control again doesn’t rest entirely with perhaps an overly high exposure to equities.
Anxiety over things like Greece’s mini debt crisis, Spain’s version of the S&L crisis and fear of an economic meltdown because countries are going to have to tighten their fiscal belts has resulted in not only the correction in stocks this past month, but an increase in market volatility. Indeed, my main observation of investor attitudes during 2008 was that it was not necessarily the extent of portfolio losses that caused unrest. It was that ugly feeling of not being in control and not knowing where things were heading and worse still, hearing that no one else seemed to have a working market Garmin either.
Real Risk Assessment
Some think that economists get paid to make correct forecasts. If so, they (including yours truly) would have been grossly underpaid since making accurate calls day in and day out could have been channeled instead into some wickedly profitable trading. No, economists pay for their groceries by assessing the current situation, examining all relevant risks, placing probabilities around those risks and being able to succinctly explain deviations between what actually happens and the outlook and risk assessment. By doing so, their clients are better prepared to establish more meaningful budgets and better calculate risk surrounding investment decisions.
The role of the financial adviser is similar, though I would be the first to argue that an adviser will best serve his or her client by not talking about the outlook. If economists, market strategists and equity analysts can’t make consistently accurate calls on the outlook, why should an adviser be expected to possess such wizardry. No, the adviser’s job is to listen to the information out there but make certain that the client is correctly allocated, in line with that client’s objectives, financial situation and risk tolerance. More importantly, the adviser needs to maintain that allocation strategy, unless the client’s situation changes and then establish a new strategy.
Let’s now put the two roles together. The economist will look at this current state of the union and, regardless of the base case assumptions, will have to acknowledge that there are some very real risks on the landscape. Europe may very well suffer a prolonged economic draught because of severe fiscal retrenchment, while there are some financial institutions that will suffer from continued stress in the eurozone bond market (government as well as corporate). There is also the risk that the recent market correction deepens (ie, the dreaded bear market) and causes collateral damage on economies outside of Europe. To dismiss these risks would be irresponsible; however, that doesn’t mean we necessarily have to assign huge probabilities to them.
What About the Positive Risks?
Yes, as surprising as it may seem, there are some silver linings to this May market cloud we’ve been in. Let’s start with the bond market. You may have noticed that your bond funds didn’t perform as well in the early part of this year as they did when the stock market was tumbling in 2008. There’s a good reason for that. When economies are imploding, central banks are cutting interest rates ferociously and people are pulling the rip cord on the way out of the equity plane in search of a softer landing, bonds excel. When economies start to grow again, stocks shoot higher and central banks begin to talk about tightening, bonds usually give back some of their previous winnings.
This was particularly true of Canada, where we saw significant increases in bond yields as Bank of Canada tightening was priced in. I still believe Mr. Carney will give us a hike next week, but there has been a substantial recovery in Canadian bonds as a result of this month’s equity slide. The 2-year federal government bond has dropped close to half a percent from the highs seen in April, while the 5-year yield has fallen 0.6%. For those of who you who thought they missed the boat in getting a good 5-year mortgage rate to lock in, fear not. Lower borrowing costs are also good for economic growth because they free up more money for consumers to spend. The same holds true for the US. In fact, most major economies have witnessed lower bond yields in the past several weeks. Even Greek bonds have knocked several percentages off from the worst of that country’s crisis.
Then there’s the cost of energy. I know that the oil bulls among us hated to see crude slide from over $85/barrel at the start of this month to lows touching $65 last week. However, if there was a concern that rising oil prices would threaten to choke off the global economic recovery, that concern has diminished. Gasoline futures have tumbled from about US$2.40/gallon to below US$2.00 in less than four weeks. Since we are now into the peak driving season for the US and Canada, the extra demand may limit the amount of pass-through of lower wholesale gasoline prices; but it is unlikely we’re going to see increases at the pump either. Less money at the pump means more money in the jeans and ultimately at the store next door.
Weighing the Risks Up
When I was asked late last year what chance there was for North America to experience a double-dip recession later in 2010 or in 2011, my answer was that it was still close to 50/50. That may have seemed high at the time but my central fear was that interest rates would rise excessively and cause the US housing sector to fall back on itself again. Considering that many US financial institutions (and states) were still in rough shape, this would be enough to cause the economy to contract, with negative repercussions for Canada. Yet, with interest rates under control and even declining, the day of reckoning for US housing has been pushed back. Ditto for Canada. Depending on how much refinancing activity we see with this temporary lull in rates (yes, I said temporary), the foundation of the housing sector could be strengthened enough to better endure the eventual climb in rates later on.
As for Canada, we have also seen some pressure on our currency as a result of the May madness. The drop from parity to almost 92 US cents shook a lot of people up, although this is basically where the equilibrium level for the Loonie’s exchange rate is. We should neither be spooked by this decline, nor be naïve enough to rule out a quick return to parity should global capital markets stabilize at the US dollar’s expense. Still, any weakening in the Loonie is a relief for manufacturers and exporters. In fact, I think this is a double positive for Canada. So far, there has been little slippage in the US economic recovery and we have actually seen consumer confidence in that country rise beyond expectations this month, despite the equity correction. Continued recovery in US economic demand plus a more relaxed Loonie tells me we’ll have decent export numbers.
So, the bottom line here is that things aren’t always as bad as they appear in the headlines. Sometimes we can discover offsets to the more talked about risks facing our own domestic economy and market. This is just one of those times. I’m not suggesting you drop everything and start loading up on stocks, but if your risk tolerance allows and you’re underweight equities versus your planned target, then perhaps this might a good time to rebuild positions. Again, it is important to first have this discussion with your financial adviser. Andrew Pyle
Saverio Manzo
www.saveriomanzo.com
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