Market Insights: Fourth Quarter wrap-up

It has been a tumultuous year in the markets, with a large equity market correction in the summer and again at present.  Canada was in a technical recession the first half of the year and its stock market is in a stealth bear market, while the U.S. Large Cap Equity Index is in solid correction territory and its Small Cap Equity Index is also in a bear market.  In addition, 19 of the 51 global stock indices are currently in a bear market and 44 in correction mode, erasing more than two years of equity market gains and $14 trillion of paper wealth.  It has been the worst year for global equities since the bull market began nearly seven years ago. 

Corporate fixed income markets have also struggled, particularly high yield bonds which were down about 5% last year in North America.   Canadian Government bonds had a reasonably good year; however, having capital in long-dated bonds with historically low yields is not a comfortable place to invest with a long-term mindset, as the amount of inherent interest risk could now be considered significant.

 

Neither of the other two major asset classes, commodities and real estate, provided any shelter in 2015.  The S&P/TSX Capped REIT Index was down 4.7% while the FTSE Global REIT Index was down 0.4%.  We know all too well the rout that commodities are in.  Nothing can portray this better than looking at the Thomson Reuters Core CRB Index Excess Return Index which is at a level first hit all the way back in 1973.  On the equity side, the S&P/TSX Capped Energy Price Index is down approximately 60% from its most recent high in June 2014, and even more shockingly, down about 70% from its all-time high hit in May 2008. 

 

In currencies, the story continues to be the Greenback, with the U.S. dollar index (basket of six currencies) rising over 23% in the last two calendar years.  The other, and perhaps more important, story to present itself recently is the devaluation of the Renminbi (Chinese Yuan).  This may be a very significant root cause behind the current turbulence in global markets.  Since 2005, China’s currency had appreciated 33% against the U.S. dollar, until the first devaluation by the People’s Bank of China on August 11th, 2015.  The move knocked over 3% off of its value, its largest single drop in 20 years.  It has since fallen another 3%.  Some believe this to be China’s attempt to boost exports in support of an economy growing at its slowest rate in a quarter century, while others say it is all part of their reforms, aimed at moving towards a more market-oriented economy.  Regardless of the export boost, the move is consistent with their commitment to let the market play a greater role in determining economic outcomes, and allowing the yuan to depreciate does seem to be in line with market fundamentals.  The market has evidently taken this as evidence of a slowing global economy, as it would be difficult to ignore the fact that, shortly after the devaluation in August, the S&P500 fell 11% in the span of just four days. 

With all the volatility and short-term drawdowns we have seen in equity and high yield bond markets, our portfolios have held up nicely.  What is now important is how best to navigate through the current environment.  How will 2016 stack up against 2015?  At present, the markets have sold off further and we are seeing sentiment and technical indicators at historically low (i.e. bearish) levels.  One of the two major sentiment indicators' bullish percentages has actually dropped below its 2009 Great Recession level.  In addition, the amount of index components in the S&P 500 that are below their 10 and 50-day moving averages have moved into the sub-5 and 10% areas which is an extremely oversold condition.  The Volatility Index (VIX) has risen above 30 and has been above 20 for ten consecutive days (a rare occurrence).  Lastly, there is currently an incredible amount of negative media/press and large institutions making uncharacteristically bearish announcements.  With the U.S. currently not in a recession, this level of pessimism, from a contrarian point of view could be an opportunity.  At the very least, it likely indicates that we are not too far off from a short to intermediate-term low. 

Nowhere is this pessimism greater than here in Canada.  Although we are in difficult times, the following two charts could be looked at through a contrarian (and positive) lens.  Both are at all-time highs:

It is still our current view that the U.S. economy is relatively healthy and will not enter a recession this year, and therefore, as long-term investors, we have made only minor adjustments to our asset allocations.  We continue to watch our long-term equity indicators closely for forward guidance and will make adjustments accordingly.

What are the major risks we are watching now that could alter our current cautiously optimistic stance?  If the current strength of the U.S. service sector and labor markets falters, recessionary risk could rise.  The Fed may raise short-term interest rates faster than the markets anticipate, and there is some precedence to this.  The hard/soft landing debate in China is unresolved and difficult to assign probabilities to.  There are currently many geopolitical tensions abroad, such as Russia/Ukraine, Iran and North Korea.  Lastly, the rise of the U.S. dollar could prove to be uncontrollable, and the implications of this for capital flight from emerging markets would be considerable.  

Here is our Milestone Market Report on economic data, capital markets, commodities and currencies through December 31st: