VOLATILITY Expected next several months. DESJARDINS Studies
posted on
Sep 08, 2014 07:38PM
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Investors have enjoyed a great run so far in 2014. The Canadian stock market distinguished itself with a return of over 15%. The S&P 500 also fared well with an increase of nearly 10%, breaking through the psychological barrier of 2000 points. Meanwhile, the bond market continued to trump Street expectations. The 10-year Canadian bond yield even dipped below 2% recently. The Canadian bond market posted a 6% gain, thanks to the drop in yields.
Since mid-year, the main asset classes have continued to move forward, whereas the financial environment has changed. In the first half of 2014, stock and bond market gains seemed to reflect, above all, the growing view that key rates over the medium term would level off at a much lower level than in the past. The considerable difficulties faced by the U.S. economy at the start of the year also fostered the view that the Federal Reserve (Fed) would wait a considerable period before beginning to tighten monetary policy, especially since inflation was quite low. These developments seemed very favourable to investors, leading to gains in all asset classes and low volatility in the markets. A low interest rate environment over an extended period of time enhances the attractiveness of assets generating a return. In theory, this could justify higher price/earnings multiples in the stock market.
However, things have changed in the last few weeks. Experts warning that certain financial markets may be starting to show signs of a bubble have seemingly limited demand for some risky assets since mid-July. Furthermore, paradoxically, solid U.S. growth figures seem to have triggered a wave of panic across markets, due to the heightened possibility of faster monetary tightening in that country. Particularly worrisome developments in Iraq and Ukraine subsequently accelerated investor flight to safe havens.
Victories by the Islamic State (IS) militant group against Kurdish forces as well as the capture of the strategically important Mosul dam in early August contributed to raising investors’ concerns. These events and other atrocities committed by the IS stirred the international community to action. U.S. air strikes and considerable support for Kurdish forces have forced the IS to retreat. The recent nomination of a less controversial prime minister in Iraq also raises hopes of easing the sectarian tensions that had helped the IS make gains. Still, we should expect the Middle East to remain a source of concern, given that tensions remain high in the region and the fact that American influence there has faded. The situation in Ukraine is even more of a concern, given Russia recently intensified its actions and given that it seems determined to support the separatists in eastern Ukraine.
Besides geopolitical pressures, it is the economic fundamentals and central bank action that will ultimately be the main drivers of the market. As a case in point, disappointing economic statistics in the euro zone recently contributed to financial market advances, and they led the European Central Bank to announce a financial asset purchase program.
Economic news is better in North America. Economic activity in Canada and the U.S. rebounded strongly in the second quarter, sending an encouraging signal for the future. With reduced fears that inflation would remain sustainably too low, it is not surprising that some Fed leaders are less comfortable with committing to leaving key rates unchanged for several more quarters. The Fed is not expected to raise the federal funds target rate for some time, but we do not believe that it would intervene at a slower pace than what was signaled during its meeting in June. This is nevertheless what the market is currently discounting, as futures contracts assume that the federal funds rate will be in the vicinity of 1.70% at the end of 2016, compared with a median forecast of 2.50% by the Fed leaders. Wrapping up its third quantitative easing program next fall could also fuel investor fears.
Given the above, there is reason to believe that the market volatility observed recently will continue over the next several months. Aside from the very unstable political climate, it is the intensifying debate on upcoming U.S. monetary policy that will likely take centre stage. We continue to forecast significantly higher bond yields in the next few quarters, as investor expectations should move closer in line with signals sent by the Fed. The stock market is expected to post better returns than the bond market with sustained economic growth and higher interest rates. However, the initial return to increasing interest rates could shake investor confidence and temporarily dampen the stock market. In view of this uncertain environment, it is paramount that investors have a well-diversified portfolio.