Economic & Market Review - May 2014

by Gavin Graham, Chief Strategy Officer May 25, 2014
Notice: This newsletter is intended as a general financial market outlook, and should not be relied on as investment advice.
One third of the way through 2014, stock markets have already experienced enough volatility for an entire year. With a sharp fall in January, the S&P 500 Index was off 3.5%, and the MSCI EAFE Index of non-North American developed countries down 5.2%. The market enjoyed a strong rebound in February, with the S&P500 up 4.4% and the MSCI EAFE up 6.1%. Since then, despite the turmoil in Ukraine and the Russian takeover of Crimea, world markets have generally moved sideways, although the Japanese stock market fell more than others in January (-6.7%) and only rebounded 2.5% in February, before falling away again. This has left it down 8.6% year-to-date against increases of 2.2% for both the S&P500 and the MSCI EAFE over the same period and 4.9% for European shares.

The S&P/TSX Composite, which many observers expected to lag behind the US again, has turned in the best performance amongst developed countries up 8.5% so far in Canadian dollars, although the weakness of the loonie has reduced that return by 2.5% against the US dollar. The strength of gold and energy stocks has certainly been a major factor in boosting the Canadian index’s returns, with the S&P/TSX Global Gold Index up 15.2% and the S&P/TSX Capped Energy index up 16.6% so far this year.

North American government bonds, which had been enjoying a thirty year bull market until 2012, saw their yields rise by 0.8-0.9% over the last year, leaving the benchmark US 10 year Treasury yielding 2.6% and the Bloomberg US Treasury Bond Index with a negative return of 1.2% over the last year, despite rallying over the last four months from a 3% yield. Other government bonds have also produced negative returns, with the exception of Euro-zone countries such as Germany, France and Italy, where very low inflation and the continued recession meant bonds did better.

Pension funds have traditionally been comprised of a mixture of investment grade (primarily government) bonds and developed market equities. While we experienced a sixty year low in yields in 2012, when 10 year US Treasury bonds, Canadian government bonds, German bunds and UK gilts all neared 1.5%, investors owning traditional (non-inflation protected) government bonds will almost certainly lose money in real terms over the next decade, eroding the real value of their pensions. Investors need to add additional fixed income categories to their asset mix, including investment grade (3% yield on the Bloomberg Corporate Bond Index), high yield (6% on the Bloomberg High Yield Index) corporate bonds, US dollar denominated emerging market sovereign (4.8% yield on the Bloomberg Emerging market Sovereign Bond Index) and corporate (5.2% on the Bloomberg Emerging Market Corporate Bond Index) debt.

Investors will not only increase the yield they receive, but diversify away from slow growth developed economies with high debt levels and unattractive demographics. The same is true for equity markets. Most developed markets indexes are within 5% of their all-time highs in 2000 and 2007, despite the lacklustre GDP growth most countries have displayed. The rise in the markets has been driven more by the expansion of Price/Earnings (P/E) multiples for company earnings than by rapid growth in the earnings themselves. This has left the US, Japan and Europe selling at PE multiples in the mid to high teens at around 14-18 times 2014 earnings, which are levels from which stock markets have struggled to perform well.

The rapid fluctuations in equity markets and the rise in long term government bond yields suggest that developed markets will not perform as strongly as they did last year, when, as we have noted in previous commentaries, almost all stock market rose between 15% and 30%, with the exception of Canada, which only rose 8%. Canada’s weakness was partially due to its large resource weighting, with energy and materials comprising almost one third of the S&P/TSX Composite. The weak performance of the major emerging markets, especially China, which account for much of the demand for commodities, led to the decline in prices for base metals and bulk commodities, as well as gold.With the MSCI Emerging Market Index down 5% over the last twelve months, and almost 20% over the last three years, the slowdown in GDP growth for such major developing economies as China, India and Brazil is well reflected in share prices. PE multiples are reasonable and towards the bottom of their long term range in the low teens (12-14 times 2014’s earnings). Investor sentiment is negative towards emerging markets funds, which have experienced substantial outflows in recent months. The crisis in Ukraine has reinforced concerns over political uncertainty, not helped by general elections in India, Indonesia and South Africa.

Canada’s strong performance this year, given its links with emerging market growth through commodity prices, may be an indicator that the relative performance of developed and emerging markets may be about to change. At the very least, investors should ensure that their pension fund has a meaningful exposure to the faster growing and cheaper emerging countries. In the meantime, the best way to take advantage of the sharp changes in direction in stock markets is to dollar cost average through fixed regular contributions to a pension plan. The increase in volatility in recent years due to the growth of High Frequency Trading, as discussed by author Michael Lewis in his most recent book, means that attempting to time investments has become more difficult than ever.

Sources: as of May 7th, 2014