Market Volatility

With the equity markets showing signs of volatility, Credential’s Investment Strategy Group provides some insights on the current situation.

Written by Lindsey Eastman
August 25, 2015


Background

Over the past 12 months, equity markets had remained within relatively tight trading ranges—until last week when we saw markets begin to break down.

  • The TSX has been in a slower downward trend since April, but this was primarily driven by the Energy, Materials and Financial sectors that have been dragged down with commodity prices.
  • The S&P500 has moved into negative territory for the year and entered correction territory as of today’s market close (commonly defined as a 10% decrease from its high).

 

The Drivers

The increased level of volatility has mostly been driven by fears over China’s currency devaluation, weakness in commodities, uncertainty of the Federal Reserve, and technical factors.

1. China’s slowdown

  • On August 11, China’s central bank devalued its tightly controlled currency, causing fear of potential global currency wars and further evidence of a slowdown. Due to the unexpected nature of the devaluation and no clear direction of future plans, the magnitude of the impact was heightened.
  • China is the world’s second largest economy and has been a significant driver of global GDP growth for the past decade.
  • China’s growth has historically been focused on export-dependent manufacturing and internal infrastructure. However, as the economy has matured, efforts have been made to shift to a more balanced model of consumer-led growth. While this change in policy has impacted GDP growth expectations for the short term, it is more sustainable for the long term. However, the decreased growth expectations continue to cause concern of overall global growth.
  • China has cut their interest rate multiple times this year in an effort to stimulate growth. On Friday, August 21, a key indicator of China growth (Manufacturing PMI) dropped to 47.1%, falling below expectations of 47.7. It was the sixth straight month below the 50 point level (below 50 is an indication of contraction, while above is a sign of growth).
  • In addition to its economic situation, China’s stock market has been through a parabolic rise and subsequent crash over the last year

2. Potential increase in Fed Rate

  • The U.S. Federal Reserve has been at a near 0% interest rate policy since 2008 and stated that it would most likely begin raising rates in the fall.
  • This should be seen as positive as central banks do not raise rates unless they feel the economy is strong enough to be able to withstand the increase. Historically, there have been increased levels of volatility around the beginning of an interest rate increase cycle, but markets have moved higher afterwards.
  • A lack of clarity on the timing and speed at which rates will increase (we expect a very slow, incremental increase), have caused uncertainty in the markets, adding to the volatility in the short term.
  • Recently released Fed minutes mention the risk of China’s slowdown posing a risk to the U.S. economy, creating fear that the Fed believes the U.S. economy is fragile.
  • The expected increase in interest rates has contributed to the strengthening of the U.S. dollar.

 3. Commodity collapse

  • We have seen steep declines in oil from $110 to $40 in just over a year. Currently, prices have reached a low not seen since 2009.
  • Decreasing prices in oil and other commodities has created concern over growth as it signals slower growth and deflation.
  • Oil supply/demand imbalances have been the big impetus of the price drop. While global demand continues to increase, it is being outpaced by supply, which is fueled by technological advancements.
  • This has impacted the Energy-heavy economies (such as Canada) most significantly; however, we expect oil prices to recover from current levels over the longer term.

 4. Technical indicators

  • On Friday, August 21, the S&P500 broke through the 200-day moving average—a bearish indicator for technical analysis—causing increased short term selling pressure by computer programs.
  • Markets have been relatively complacent over the past 2 years. The VIX (Chicago Board of Options Volatility Index, which measures risk in the markets) remained at a low level for an extended period despite increased fears, leading to potential increased overreaction by markets in the short term.
  • Valuations over the past 6 years have moved higher and have been on the higher end of the fair value range relative to historical levels.

The Positives

1.  The United States, the world’s largest global economy, continues to show strength.

  • The U.S. Housing market continues to improve as July existing home sales and housing starts hit their highest levels since 2007. Home prices have also continued to rise.
  • Job creation remains strong with unemployment at very low levels (5.3%). There has been over 200,000 jobs per month created in five of the last seven months.
  • U.S. GDP has continued on a steady pace with a 2.3% increase in Q2, while Q1 was also recently revised from a -0.2% to 0.6% increase.
  • The U.S. is Canada’s top trading partner and we should continue to benefit from their growth and our low dollar.

2.  Most global central banks remain in easing mode and committed to stimulating growth.

  • We have seen a significant number of banks cutting rates this year, with the Bank of Canada having already cut rates twice this year.
  • Japan and Europe are continuing with their Quantitative Easing programs to stimulate growth, similarly to what the U.S. began in 2009.

3.  Commodities have dropped considerably over the past year, reducing the likelihood of further significant decrease.

4.  We believe this to be a correction and not a bear market.

  • Most bear markets are triggered by recession and key bear  market indicators—such as an inverted yield curve, increased unemployment, and reduced consumer spending—are not showing this as a likely scenario.

Outlook

1.  Market moves need to be kept in perspective given all of the current noise in the markets.

  • Corrections are a normal aspect of any healthy bull market. Historically, there has been a correction every 18 months on average. We have not seen a correction since 2011 on the S&P500, and the index has tripled since March 2009.
  • Corrections allow for a pause in the markets to ensure fundamentals remain intact and excessive valuations are removed, creating potential buying opportunities as stocks are being sold off indiscriminately.

2.  Increased clarity from China on stimulus and comfort from the Federal Reserve that they will take a cautious approach to rate hikes would help to stabilize the markets. We expect volatility to remain through the fall, albeit at lower levels.

3.  Corrections remind us to ensure that we maintain appropriate risk tolerances and diversified portfolios that focus on financial goals. Despite bonds having offered less attractive returns over the past five years, it’s times like these that we are reminded of the valuable role they play within portfolios. Dividend paying stocks can also help during times of increased volatility, as their cash flows to investors remain more consistent than stock prices.

Remember, fear is a much stronger emotion than greed and it tends to play out more intensely in the short term.

 

Mutual funds, financial planning and other securities are offered through Credential Securities Inc. The information contained in this report was obtained from sources believed to be reliable; however, we cannot guarantee that it is accurate or complete. This report is provided as a general source of information and should not be considered personal investment advice or solicitation to buy or sell any mutual funds and other securities. Credential®, Credential Securities® are registered marks owned by Credential Financial Inc. Credential Securities Inc. is a Member of the Canadian Investor Protection Fund.