Autumn is upon us and memories of the fateful fall of 2008 resurface - the equity market collapse that signaled the beginning of the Great Recession and shook investor confidence to the core. Only in recent months did the TSX Composite Index break the 15,000 mark that was first reached in May and June of 2008.
In the last six years steady progress has been made in deleveraging the world’s economies. This process of debt reduction has been a slow process and is still going on. One way to calculate the potential duration of deleveraging and thus slow growth is to look back to the Great Depression which lasted for ten years. The lessons learned in the Great Depression shaped government reactions in 2008 and in the years following. Rather than cut costs and add to the slowdown, governments moved to preserve the financial system. This avoided the domino effect of failing financial companies bringing down other companies that marked the 1930s. Another major difference in this period of economic stress is the state of the corporate sector. With the exception of the financial sector and auto sector in the U.S. and Europe (not including Canada for financials) corporations in general have been able to survive and even increase earnings and dividends. Corporate balance sheets have never been stronger which has helped corporations avoid the massive layoffs that occurred during the Great Depression.
In the U.S. the collapse of the housing market and the resulting wave of foreclosures left the personal financial affairs of many Americans in shambles. In the intervening years U.S. personal debt has been paid down to reasonable levels helped by rising house prices and improved employment. The U.S. debt burden because of stimulation programs has shifted to governments both state and federal. The U.S. Federal Government either directly, or through the Federal Reserve, has pumped billions of dollars into the U.S. economy. The Financial Sector, the first to be rescued, has already repaid most of the loans and more recently has been in the process of paying billions in fines for their pre-crash indiscretions. Government debt in the U.S. has continued to grow but at a slower rate as expenditures have been cut and tax revenues have increased. Low coupon rates on government borrowing has also been beneficial. With the exception of such events as Detroit’s default we have not seen the wave of state and municipal defaults that were a feature of the Great Depression. However this mountain of government debt remains and will present a drag on future growth for years to come.
In Canada our financial system weathered the crash of 2008 very well and our housing sector remained untouched. Despite slow economic growth since 2008 Canadian employment has already exceeded 2008 levels. There is cause for concern as Canadian personal debt levels have continued to rise. This is largely due to rising house prices that result in new home buyers taking on significant debt. Housing remains affordable despite high prices due to historically low interest rates. This leaves many new home buyers vulnerable to any sharp increase in interest rates. Government concern has led to a tightening of lending rules as to who can qualify for CMHC mortgage insurance.
Canadian government finances are mixed, with the Canadian Federal Government expected to soon have a surplus, while the provinces present a less buoyant picture. The western provinces, with Alberta leading the way, are in good fiscal shape. The Maritime Provinces are doing OK, but Quebec and Ontario have significant budget deficits that are likely only solvable by tax increases - so be prepared!
With the foregoing background, where do we go from here? First let’s look at interest rates. With inflation low and economic growth sluggish, there is little pressure on central banks to raise rates. Added to this is the recent economic weakness in Europe which led to a cut in interest rates. It would appear that until growth rates increase, interest rates will remain low. Returning to our comparisons to the Great Depression, this could mean four more years of low interest rates.
At the time of this writing Canadian and U.S. equity markets are in the midst of a correction. As pointed out in our previous issue of the Artisan, equity markets were well overdue for such a decline. So far the pull back is in the 5% range, which may be enough to reduce margin borrowing to more reasonable levels and also reduce speculation. A further 5% decline would be a more convincing correction bringing equity values to more attractive levels and thus setting the stage for a good rebound. Regardless of the depth, any pull back in markets is a healthy event that brings reality back into over excited markets. We by no means think this correction, or even a period of a sideways market, spells the end of the bull market in equities. While we see a further four year period of constrained economic growth we still expect to have growth during that period. Corporations are in good financial shape and corporate profits will continue to see growth. We believe virtually all large cap dividend payers will maintain their dividends and some will even declare dividend increases.
In the months ahead the U.S. will continue its steady but modest growth which is good news for Canada. Europe will continue to struggle but will finally provide some economic stimulus that will help avoid a return to recession. Currency movements are an increasing factor in the economic environment. The strong U.S. dollar and thus a weak Canadian dollar is a positive for Canada despite the pain it causes snowbirds and some exporters. Given the lacklustre growth potential for Europe, Japan, and perhaps China, the U.S. will continue to attract investors and the U.S. dollar will continue to be strong.
International events still have the potential to threaten markets. Russia will continue to be a risk to any neighbour with significant Russian speaking minorities. Iraq and its struggle with ISIS will continue to be a threat to world oil prices. Unrest in Hong Kong and questions as to growth potential in China could also be a future negative for equity markets. These sorts of external risks are a normal part of equity investment and should not discourage participation in equities.
At Northland Wealth Management we continue to emphasize that a diversified portfolio of investments that contain a mixture of dividend-paying equities, income producing real estate and select hedge funds, create the optimal balance of risk and return in this low interest rate environment.