Second Quarter Market Commentary

After six months of uninterrupted gains, the global stock markets declined during the last quarter.  The US stock market as measured by the S&P 500 lost 3.3%, which translates into a 1.3% decline in Canadian dollars. The resource heavy Canadian stock market was further impacted by declining energy and metal prices resulting in a decline of 6.4%.

The European debt crisis is dampening global economic growth.  The US Economy has slowed to 2% GDP growth during the last quarter.  Emerging market growth has also been negatively affected by the European debt crisis.  Global economic growth forecasts for 2012 have recently been lowered to 3.0% - 3.5% from a forecast of 4.0% six months ago.  For the moment, 2013 global economic growth is projected to reach 4%.

It is not surprising with all this negative news related to the European debt crisis and global growth, bonds returned 2.3% during the last quarter.  The yields for 10 year US government bonds declined to a generational low of 1.5%.  These historically low bond yields reinforce our belief that stocks will outperform bonds in the long term.

Conditions are ripe for the commencement of a long multiyear bull market in stocks.  Widespread negative investor sentiment, anxiety about the future and low valuations provide seeds for the next bull market. Potential catalysts to ignite investor enthusiasm include sustained global growth and evidence of firm plans to deal with European and American deficits. While we continue to favor stock over bonds, we recognize that growth and debt uncertainties are unlikely to disappear overnight.  The foundation for the next bull market remains in place, but fears related to these concerns will cap the near term upside, at least until we get clarity on the US presidential election.

European and American politicians understand the need for fiscal restraint and debt reduction. The European countries remain hampered by their inability to sell austerity measures to the voters.  US politicians are fighting a philosophical battle on the measures needed to reduce the deficit.  Both political parties understand the necessity of moving towards a more balanced budget, but differ on the timeframe and the mechanisms required (increased taxes vs. reduced spending) to achieve deficit reduction.

Typically when credit ratings decline, bond yields will increase as bond prices decline. In a world where sovereign debt ratings are under pressure, the continued decline in long term US government bond yields stands out as an anomaly.   On the surface this appears illogical but with the persisting European debt crisis, the US is currently perceived as the “best house in a bad neighborhood”.  The US government has continued to rack up record deficits resulting in increased risk of a credit rating downgrade. US cumulative debt as a percentage of GDP is approaching levels where bond prices decline due to the need for higher yields.  The US needs to get its fiscal house in order to prevent a fiscal crisis similar to that in Europe.

The US Government is collecting taxes at the relatively low rate of 15% of US GDP.  This compares to around 35% in Canada and Japan and 40-45% for most European countries.  This leaves some room to raise American taxes whereas the European economies have minimal flexibility in their ability to further raise taxes. 

Despite recent “doom and gloom” there are some positive signs.  There is no immediate recession call (except in select European countries). Stocks remain attractively valued.  Recent evidence  further supports our thesis that the US housing market is in a bottoming phase.  As we have previously discussed, any growth in housing activity would be positive for the economy and for employment.

We continue to recommend a balanced portfolio, weighted toward conservative stocks. Within our stocks we have taken a more defensive posture to compensate for the current lacklustre global growth environment.  Our preference is for high quality, dividend paying companies that have the ability to grow earnings in the current sluggish economic environment.