Q3 2015 | Market update
Sadiq S. Adatia
Chief Investment Officer
Opinions as of October 4, 2015
- China throws markets into confusion
- Global equity markets turn negative for the year
- Oil drops to US$44/barrel
- Canadian economy shows continued weakness
- North American bond yields remain low
China causes increased market volatility
People have finally come to the realization that China is slowing down. Growth is now expected to be closer to 5-6% over the coming years versus north of 10% not too long ago. The economy has moved from investment-driven growth to consumer-driven growth.
To add complication, China decided to devalue its currency. This seemed to be the blow that shocked markets the most as it was largely unexpected. Commodity-dependent countries like Canada saw their markets get hit hard given that China consumes over 50% of global commodities (see Chart 1).
China consumption % of world total
Source: Bloomberg. Data as at August 31, 2015.
Fundamentally, very little has changed in the world economies over the past few months, but markets dropped anyway – and most of this is due to noise around China.
As mentioned in our last commentary, we were expecting to see more volatility and potential headwinds in the markets and we have now seen that come to fruition. The U.S. Federal Reserve still has not raised interest rates, but Q4 looks to be when the central bank finally makes its move. Of course the decision depends on incoming data. We do think the pace of increases will be slower than others expect.
In some ways it pains us to say it, but our negative view toward the Canadian economy has for the most part been realized. The economy continued to weaken in Q2 following an already poor showing in Q1. A second dip in oil prices definitely added more worry and it remains to be seen how oil companies react to what most now believe is going to be a much longer time period of lower oil prices. The S&P/TSX Composite plummeted 7.9% in Q3, dragging the year-to-date return to -7.0%.
Though the situation in Greece has calmed somewhat, international developed markets could not overcome the China effect in Q3. The MSCI EAFE Index ended the period with a loss of 10.2% in US$ terms.
The MSCI Emerging Markets Index suffered one of the biggest losses, down 17.8% in US$ terms. In local currency terms, Chinese mainland shares dropped a whopping 27.8%.
Nervousness in markets, which we think is overdone, can sometimes create opportunities. We think this may be one of those scenarios.
As we head into the last quarter of 2015 we do not see the market jitters going away and we expect volatility to remain. We will take a conservative approach until the dust settles, but our expectation is that we’ll be looking to increase our equity exposure at that time.
Markets hit hard in Q3
Bloomberg. Data as of September 30, 2015.
Canadian bond yields head lower
In Q2 we were a bit surprised by the rise in domestic yields, so it was nice to see yields come back down again in Q3. This was a result of weak GDP numbers, the second interest rate cut by the Bank of Canada, and additional volatility caused by China.
With the Fed likely to raise rates next quarter, we should see U.S. bond yields rising. Canadian bond yields on the other hand may not appreciate as fast given we see no rate hike on the horizon and a rate cut remains a possibility, though this time we hope not. We expect negative bond returns in the U.S. and relatively flat returns for Canadian bonds for the rest of the year.
U.S. 10-year Treasury yields declined from 2.36% to 2.04% in the period, while Canada’s 10-year government bond yields declined from 1.68% to 1.43%.
No relief for Canadian equities
The economic impact of low oil prices continues to be a big burden in Canada. West Texas Intermediate crude couldn’t stay above US$60/barrel and headed significantly lower again to US$44/barrel, and with supply still high (though starting to ease), we could be around this level for some time. The energy sector followed up a negative Q2 with another negative period, but this time it had more company (see Chart 3).
It’s worth noting that though Canadian consumers continue to have high debt levels and the country has what we believe is an overvalued real estate market, we are less worried about those things in the short term now that the Bank of Canada has cut rates twice this year. This should help keep Canada from a more severe downturn. We remain bearish on the Canadian equity market but less so with respect to oil prices.
Resource sectors continue to be punished
Source: Bloomberg. Data as of September 30, 2015.
The U.S.: expectations getting too high?
Though the U.S. equity market also took it on the chin during the quarter, the country’s economy continues to look decent. Job growth continues (though the pace is slowing), consumers continue to look strong, and the Fed is being patient about pulling stimulus out of the economy – appropriately in our view. These are all signs of a healthy economy.
However, what cannot be ignored is that the U.S. dollar has been quite strong against most major currencies, exports are slowing down, and it appears market anxiety is higher than it was a few quarters ago. The economy continues to add jobs, but at a slower pace.
What does that mean? It means that despite good numbers, the U.S. equity market may not live up to the high expectations. Every number will be closely watched and volatility is likely to be high. Hence there is a greater likelihood of overreaction on the downside. We have already seen some of that in Q3. We continue to expect a positive year for the U.S. equity market but as mentioned in our previous commentary we think record highs are likely behind us for now and risks are increasing.
Eurozone fundamentals improving
The eurozone economy continues to improve. We saw better job numbers as well as decent growth in Q3. Greece has been quiet, but don’t be surprised to hear more noise before too long.
We feel patience is required when investing in the eurozone, as the region contains multiple economies and not all will be working efficiently at every point in time. So lots of headline noise will be out there but from a broader perspective we like where things are heading.
We feel it would help keep the economy growing if the euro were to go lower. A weak euro reduces the cost of goods to those outside the eurozone, which helps to improve exports. This in turn would likely create jobs, improve confidence and boost spending.
With Halloween just around the corner, China decided to spook markets with a currency devaluation. Though the yuan only declined about 3%, the surprise factor is what caused alarm. This raised the question of whether growth was actually slower than what’s been reported by China’s government.
Most currencies in emerging markets had already taken a major hit this year and China’s move didn’t help. Though valuations look attractive, we think this is not the time to jump in to emerging markets as more downside risks may remain in the short term.
Outlook: lower volatility likely
We do expect to see volatility continue in Q4 but probably not to the levels we witnessed in Q3. Greece seems to be resolved for the time being and China shock factor may now be behind uns as well. However, nervousness has not gone away and that’s the reason we feel volatility will persist.
We still feel good about the U.S. economy and we see the recent pullback as increasing the equity market’s risk/reward attributes somewhat, which is opposite to what we thought heading into Q3. We have grown more cautious however since the market drop. We believe policies in the eurozone are slowly doing the right things and keeping the region headed in the right direction. As long as quantitative easing continues and the euro remains low, we expect positive results out of the markets. Political noise has not gone away however and could continue to disrupt markets over the next few quarters.
On the home front there is good news. It’s not that we feel the pain is gone and the economy is recovering, and our long-term view does indeed remain bearish. It’s that for the first time in three years we have raised our short-term view.
We think the central bank’s cut in interest rates has pushed the problems of debt and real estate out a few years, which should help the economy this year and into 2016. However, until oil prices move significantly higher, the economy will have issues. While we do expect oil prices to stay lower in the short term, we’re monitoring the market closely for opportunities to position ourselves for long-term gains.
The Canadian dollar ended the quarter at just around US$0.75. We expect marginal pressure going forward as much of the Fed’s expected rate hike is priced in. However, a third rate cut by the Bank of Canada could potentially push the dollar lower, though we don’t expect that to happen this year.
We expect bond yields to continue their upward trajectory once the Fed starts raising rates, causing negative returns for bonds – more so for global bonds than Canadian bonds.
Overall, we feel that volatility is here to stay and further upside in most equity and bond markets may be limited. However, the recent pullback has created opportunities that we feel may be worth pursuing… with patience.
This commentary contains information in summary form, for your convenience, published by Sun Life Global Investments (Canada) Inc. Although this commentary has been prepared from sources believed to be reliable, Sun Life Global Investments (Canada) Inc. cannot guarantee its accuracy or completeness and is intended to provide you with general information and should not be construed as providing specific individual financial, investment, tax, or legal advice. The views expressed are those of the author and not necessarily the opinions of Sun Life Global Investments (Canada) Inc. Please note, any future or forward looking statements contained in this commentary are speculative in nature and cannot be relied upon. There is no guarantee that these events will occur or in the manner speculated. Please speak with your professional advisors before acting on any information contained in this commentary.
© Sun Life Global Investments (Canada) Inc., 2015. Sun Life Global Investments (Canada) Inc. is a member of the Sun Life Financial group of companies.