The Pause That Refreshes

With second quarter US economic data validating our thesis that first quarter weakness was largely transitory, it appears increasingly likely that the Fed will raise interest rates sometime in 2015. While the resumption of economic growth is positive for stocks, it will not necessarily bode well for the bond market. The Canadian bond market returned over 4% in the first quarter as investors questioned the sustainability and pace of economic growth. With more recent data demonstrating economic growth, rising interest rates resulted in the bond market giving back almost half of the first quarter's gains resulting in a -1.7% return for the bond market.

For a change of pace, most of the action was in the bond market during the second quarter as government yields increased sharply. Ten year German Bund Yields rose from a low of 0.1% to over 1.0% before settling in around 0.76%. The sharp movement in German bonds was related to unsettling remarks from the chair of the European Central Bank, Mario Draghi in combination with bond yields being unusually low due to deflationary concerns. With Europe leaning more to an economic recovery, deflationary fears eventually dissipated resulting in a rise in interest rates. This rise in German bond yields was the primary catalyst for an upswing in global government bond yields.

The Greek debt crisis pushed stock markets into the red at the end of the second quarter, despite trading flat for the majority of the quarter. Notwithstanding fears of a Greek default and exit from the European Economic Union, the quarter was relatively quiet with most stocks trading within a narrow band. The S&P 500 (US $) was flattish (-0.2%) while declining 1.9% in CDN dollars. The Canadian markets (as measured by the S&P / TSX composite) declined by 2.3%.

The end of the brutally cold winter season contributed to a more positive GDP in Q2. Retail sales accelerated and consumer spending growth is tracking to increase 2.3% in Q2 (final numbers have not yet reported). We are also seeing rising auto sales and the continued growth in housing starts. Consumer balance sheets are also in great shape. Household liabilities / assets are at fifteen year lows of around 21% which compares to greater than 30% in 2007. Recent employment data is also coming in strong with employment growth of 2.2% and year over year payroll income growth of 4.3%. This has resulted in the savings rate increasing by 1% over the last eight months. Also contributing to the higher savings rate is lower oil prices putting more money in consumers' wallets.

Investors have taken more of a wait and see attitude with respect to putting cash to work in the stock markets. To use a poker analogy, they are "checking" for more information before making large bets on the stock market. There are a number of wild cards and investors are searching for clues as to how they settle out. A number of geo-political situations (Russia and the Ukraine, ISIS) are periodically diverting investor's attention away from corporate earnings, which is the primary long term driver of stock prices. Greece's perennial debt restructuring drama remains a concern, with fears of a Greek debt default and its impact on the Euro. Company valuations are also a little higher than historical averages, reducing the margin of safety. Global growth remains tepid. The strong US dollar is also acting as a headwind for US company revenue and earnings growth. We continue to believe that these issues are unlikely to derail the economic expansion or the bull market for stocks.

The US stock market has had some big gains over the last few years, and it would be prudent to expect some sort of pause before resuming its upward trajectory. Absent an imminent recession (which we do not envision), we don't foresee a large market correction. For the stock market to begin its next upward swing, there will need to be growth in corporate revenue and earnings. Although earnings continue to grow, they do so at a slower pace than we originally forecasted six months ago. Stocks moving sideways coupled with a little more earnings growth will result in valuations trending down to something that is closer to the long term average. We feel that we are currently experiencing nothing more than a pause in a bull market. Longer term we continue to prefer stocks over bonds. With a stronger US economy, and the Fed poised to increase interest rates, the recent rise in US interest rates is unlikely to reverse. We expect US interest rates to continue to creep up resulting in low single digit bond returns. Canadian rates are likely to stay flat, as the Canadian economy is not as robust as the US economy.

Contact us to ensure that you are properly positioned to navigate these potentially murky markets.