This article is a guest contribution by David Andrews, CFA, Director, Investment Management & Research, Richardson GMP
The euphoria around better than expected first quarter Earnings Season appears to have waned and become a distant memory in the minds of many investors. In fact, it has become more difficult to find positive news when the headlines have been dominated by Eurozone debt problems, Chinese monetary policy, oil spills, and financial reform regulation. The collective and pervasive overhang of each of these issues proved too much for equity and commodity markets last week and most equity indexes reached correction territory (a drop of 10% from a recent high).
Foreign currency markets have dominated headlines for the past couple of weeks as speculators have continued to test the will and the skill of European policy makers in holding the political union and its single currency together. Currency traders doubt the $1 trillion dollar support package announced May 9th will be enough to offset the potentially contagious problems plaguing Europe. Concerns have turned toward fear with the news Germany was going to impose a ban on naked short selling on European bonds and ten key European financial institutions. Rather than calm markets as the Germans intended, the move only intensified concerns about the solvency of European banks that hold vast sums of European debt on their books. The Euro reached a six year low against the U.S. dollar trading as low as $1 .2143 before rumours of central bank intervention surfaced last Thursday. The volatility in stock markets has intensified with the fear gauge (VIX) spiking from 30 last Monday to 48.2 on Thursday. Equity investors are concerned the austerity measures for Greece, Spain, and Portugal will effectively cut government spending and raise taxes, therefore impeding regional and ultimately global GDP growth. Adding in the fact the Chinese want to cool their heated economy and some disappointing economic data for the U.S. last week, you can see how the perfect storm for equity markets has formed.
Our view on equities has been that stocks would likely find the going a bit tougher as we got into the second half of 2010. Recent headline news out of both Europe and China has accelerated that difficulty and the equity markets have struggled for the past few weeks as a result. One of the big questions we have been getting is could stock market difficulty accelerate from here? If risk aversion levels were to return to 2008 levels, it would likely provide for more impediment ahead but, at this point, we think investors need to be reminded of the fundamentals of inflation, interest rates, and profits which are now at more equity friendly levels than in 2008. We encourage all investors to revisit their asset allocation with their advisors regularly. Times of market stress may be an opportunity to objectively rebalance portfolios as asset price levels readjust.
Canadian inflation data for April showed core prices (ex food and energy) increasing at 1.9% which is slightly below the Bank of Canada’s 2% target. Data did come in a touch higher than consensus expectations and with the Canadian dollar on a weaker footing due to the economic woes in Europe, the debate about the central bank raising rates at its next policy setting on June 1st has resurfaced. A hike ahead of July is likely dependent on the ever evolving European debt situation and the impact it may have on Canadian growth. We expect the Bank of Canada to begin hiking rates this summer and we will likely see a series of modest incremental of 25 basis point (0.25%) hikes over the next number of quarters. Despite better housing data in the U.S. last week, it appears the Federal Reserve is likely to remain on hold with rate increases given the recent surge of the U.S. dollar against the Euro and the British Pound. Our expectation is that rates will increase sometime in 2011. The Japanese Yen is the only major currency to outperform the U.S. dollar over the past couple of weeks and we see this as a clear sign of investors’ desire to unwind risk.
Earnings focus this week returns to Canada as the second quarter earnings season for the major Canadian banks kicks off with Bank of Montreal on Wednesday. We anticipate earnings to be up 7% year over year and flat quarter over quarter. Amidst the gloom in equity markets these days we believe the Canadian banks may prove to be a positive catalyst for markets. Clearly there is a defensive element to the dividend yield of the Canadian banks which should benefit if investors continue to take risk off the table and look to exit Materials and Energy stocks. Also, as international capital looks to escape the uncertainty playing out in Europe, Canadian bank stocks offer sufficient liquidity for larger global institutional investors.
Commodities continue to trade in a volatile fashion with crude oil trading in a wide range as low as US$64.24 and as high as US$ 71.29 last week. We begin this week with the July crude futures trading around $70 a barrel. The U.S. Department of Energy has been reporting that oil inventories (not including that which is floating in the Gulf of Mexico) have been increasing for the past month. When you add in concerns about future demand in both Europe and China, you get the significant price volatility we have been experiencing.
Copyright (c) 2010 Richardson GMP
