Sunny with a chance of volatility

In this newsletter we will explore the exciting thought that the US economy may once again be a bright economic light with respect to global growth.

A key sign of an improving American economy is a decline in food stamp usage. After the 2008 recession, rates of food stamp usage in the US soared. As of December 2012, a record 47.8 million Americans were on food stamps, or the Supplemental Nutrition Assistance Program (SNAP) as it is more formally called. SNAP allows users to buy basics, but not tobacco, pet food or alcohol. Since Dec 2012, the number of people on SNAP has declined by 1.6 million leaving 14.8% of the US population on SNAP. Prior to the 2008 recession, the share of the population on SNAP ranged from 8% to 11%. While the number of people on SNAP is declining it remains high relative to historical levels. Nonetheless, this decline in usage is a positive sign for the US economy. It suggests more Americans are employed, thus they no longer need or are eligible for assistance due to personal income growth.

The Institute for Supply Management (ISM) is predicting accelerating US manufacturing growth for the second half of the fiscal year. The ISM's Manufacturing Purchasing Managers Index was above 56 for each of the last 3 months, its highest sustained readings in over 3 years. A reading above 50 is considered positive as it indicates the manufacturing sector of the economy is expanding.

The Fed's quantitative easing program is almost complete. Although the Fed has re-committed to keeping interest rates low for the foreseeable future they are also hinting that the Fed Funds rate will begin to rise sometime next year. This has translated into a rise in US interest rates, which in turn has made US dollar investments more attractive for foreign capital.

Major US trading partners are not expected to raise interest rates in the near term as they are not seeing the same economic uplift that is currently taking place in the US. The net result is a significant rise in the US dollar versus most major currencies. For example, the US dollar has gained 5.0% versus the Canadian dollar over the recently completed quarter.

During the third quarter, the US stock market (as defined by the S&P 500) rose 0.6%. This translated into a 5.6% gain for the S&P 500 in Canadian dollars. The Canadian stock market declined by 1.2%, in part related to a less robust Canadian economic forecast. The decline in oil prices affected the 25% of the Canadian stock market index that is energy related. The Canadian bond market gained +1.1% as there was no material movements in Canadian interest rates.

So where does that leave us for the rest of the year and beyond? We have a US economy that continues to gain strength in a sluggish global economy. The Canadian economy's tepid performance will continue, with the Bank of Canada forecasting sub 2% growth for the next few years. The European economy is slowing and there are concerns about it slipping back into recession. Unemployment remains high in Europe. Unrest in Ukraine and slow growth are pushing the European Central Bank to consider additional stimulus. Recent tax changes led to the Japanese economy contracting over 7% in the second quarter. Japan continues to hope that its easy monetary policy will have a positive impact on economic growth.

Chinese economic growth has also slowed. Sluggish or non-existent GDP growth in their trading partner's economies is slowing Chinese exports. Their real estate sector is also undergoing a serious correction. Property prices have fallen 3.1% since April and housing sales have also declined 10.9% from the prior year. Unlike previous real estate sector corrections which were
triggered by government policy decisions, this downturn appears to be primarily related to a buyers “strike”. There is no quick and easy government policy to be reversed that would lead to a rebound in the real estate market.

GDP growth in China is forecasted to be at multi-year low, at 7% for 2014. With a number of structural issues, economic reform and an anti-corruption campaign it is possible that Chinese growth will not return to growth levels of greater than 8% any time soon. As the Chinese population ages and personal incomes rise, the Chinese economy may be approaching a point where historical heady growth numbers are no longer sustainable for prolonged periods of time.

What we are left with is a global economy where the US may once again become the prime economic growth engine. A bigger question is whether a rising US tide (US economy) will lift all boats (other global economies) or just benefit the US economy? We believe it is likely to be the latter, where the US stock market continues to rise, but not all companies benefit to the same proportion. It will be trickier for investors to keep pace with the stock market averages as there will be wider dispersion from individual stock returns. We have already begun to see an increase in stock volatility levels over the past quarter.

Current stock valuations are reasonable, but definitely not as cheap as they were a few years ago. Stocks will need earnings growth to sustain upward movements in stock prices. With variable economic conditions around the globe, we should expect more volatility in both individual stocks and the markets in general. Differences in economic fundamentals from one country to another have yet to register in stocks indices where monthly returns from one market to the next have remained similar. Global sector indexes show a similar trend. Within the S&P 500, dispersion between individual stock returns on a monthly basis is close to multi decade lows. Low stock volatility created an environment where fundamentals across markets, sectors and stocks are not correctly priced. Driving this tendency is a low interest rate and an easy money environment. Investors who would typically invest in high quality bonds have put a higher than normal proportion of their money into stocks. Not all investors are focused on the differences in individual stocks and markets. We anticipate a gradual increase in volatility, which was largely absent over the last year.

While markets may see increased volatility, we still believe that stocks remain the preferred investment vehicle relative to other asset classes. Stock markets (especially the US market) offers return potential that is in line with the historical averages (7 - 8%) and above the expected returns for bonds. We have been fairly consistent that stocks are a more attractive place to invest money, and we see nothing to change this outlook. We recognize that after a huge run for stocks from the bottom in 2009, bigger and more frequent corrections will probably be the norm. A diversified portfolio of stocks which is appropriately allocated should generate above market returns, while minimizing volatility relative to the market. Feel free to contact us so we can explain how best to achieve this.