In recent weeks, global equity markets have become extremely volatile with market swings reminiscent of the credit crisis of 2007 - 2009. For the third quarter ending Sept. 30, the S&P/TSX Composite Index was down more than 12.6% and has fallen for the past five months in a row.
While the magnitude of the loss is disturbing so too is the level of day-to-day volatility that investors have experienced recently. Out of the 63 trading days in the third quarter, there were 11 which had moves of more than 2%. In other words, nearly one in five trading days was up or down more than 2%.
Globally, it is a very similar story with the S&P 500 dropping more than 14.3% in U.S. dollar terms and the MSCI EAFE Index was down 19.6%. While the equity markets sank, fixed income investments, particularly the traditional safe haven government bonds rallied, with the DEX Universe Bond Index moving higher by 5.1%.
Understandably, many investors are growing increasingly worried about this continued volatility and are uncertain regarding the future. First, let's take a look at the issues that are driving the volatility and uncertainty. There are three main issues overhanging the global economy at the moment. They are:
The European Sovereign Debt Crisis - Perhaps the most pressing issue at the moment is the European debt crisis. With Greece on the verge of default and other Eurozone nations such as Portugal, Ireland and Spain set to join them, the global economy is on tenterhooks. Over the past two years, there have been a number of austerity measures and bailout packages proposed, however, the progress towards a proper resolution has been slow. Pessimism is ruling investor sentiment and markets are swinging wildly on the daily news flow out of the region.
What is certain is that the situation will have to be resolved. What that resolution will look like is up for debate. Many experts are expecting a restructuring of Greek debt, which will prevent a full scale default. A default could have serious repercussions, particularly to the global banking system as many banks around the world hold Greek bonds which could be worthless overnight. While default may be an option, many parties are working to ensure that doesn't happen with some calling for the International Monetary Fund (IMF) to step in and play a role making the whole process as orderly as possible. But until this situation is fully resolved, markets will continue to be extremely volatile, selling off sharply on the hint of bad news and rallying higher on good news. European financial stocks appear to be the most vulnerable in the near term, although should a satisfactory resolution be found, they are also likely to experience a significant jump in value.
Fear of a Recession in the Developed Markets - While the Eurozone debt issues dominate the headlines, the threat of a recession in the developed world is weighing on investors' minds. In the U.S., the risk of a recession continues to rise as the housing market stagnates and job growth, while positive, is not strong enough to spur hope for a speedy economic recovery. The Federal Reserve has stated that there are "...significant downside risks to the economic outlook", further adding to investors' fears.
The Fed had previously utilized a tool known as Quantitative Easing (or QE2) which was the purchase of $600 billion of U.S. government bonds as a means to injecting liquidity into the monetary system with the goal of stimulating economic growth. The program ended in June of this year and thus far the Fed has been reluctant to introduce another round of quantitative easing for fear of spurring inflation within the economy. Instead, the Fed has brought out another tool from their stimulus toolbox known as Operation Twist which is essentially the selling of short term bonds and the simultaneous purchase of longer term bonds. If successful, this will result in the lowering of longer term interest rates in the economy which is expected to help spur economic activity.
While the Fed may want to twist again, markets didn't really want to dance and sold off sharply after the announcement. Further, Goldman Sachs recently downgraded their growth assumptions for the global economy to 3.5% for 2012, down from their previous estimate of 4.2%, while predicting that there was about a 40% chance of a U.S. recession. Until the housing and job markets improve, the overall pace of economic growth is expected to lag. Canada, while in a much stronger position than the U.S. will likely escape a recession, but it is very likely that the pace of growth will slow.
A Slowdown in the Emerging Markets - Unlike the previous two issues, the slowdown in the emerging market is more of a deliberate, man made issue. Many of the countries in the developing world, particularly China, have been growing at a pace which is unsustainable over the long term. The Chinese government has been actively trying to slow the pace of economic activity to a more sustainable level. Recent data suggests that they have been successful, as a pronounced slowdown in manufacturing and housing has occurred. While the short term impact of a slowdown, namely a cooling in commodity prices, may negatively impact Canada, the more sustainable growth rates will allow for China and the emerging markets to continue to be drivers of global growth into the future. While there are issues dragging the global economy, there are a number of positives for the markets. Perhaps the biggest positive is that many corporate balance sheets remain strong. Companies are generating decent earnings, and many are sitting on significant piles of cash, which will help them withstand any short term setbacks. Further, according to Gerry Coleman, manager of the CI Harbour Fund, we are witnessing "...brisk merger and acquisition activity with takeovers at large premiums to market values and record levels of insider buying." Additionally, while many economists have cut their growth forecasts for the coming year, it is important to note that even when reduced, the level of economic activity anticipated is still positive.
Bottom Line
So what does all of this mean to investors? Simply put, more of the same, at least for the remainder of the year and the first part of 2012. We fully expect that markets will continue to be extremely volatile for the near to medium term. For investors, it's "gut check" time - time to revisit their portfolios and make sure that they are comfortable with the level of volatility of their investments.
Within portfolios, investors should emphasize quality, both in fixed income and equity holdings. While the longer term outlook for fixed income is bleak, near term, with interest rates likely on hold until mid 2012 or later, high quality fixed income will provide a good buffer against the volatility of the equity markets. Investors should focus on Canadian government and high quality corporate bonds. (Examples in the fixed income space include high quality bond funds like PH&N Bond or TD Canadian Bond, both of which contain high exposure to high quality corporate bonds.
Within the equity portion of their investments, investors should again focus on quality investments - funds which invest in quality companies with strong balance sheets that have high dividend yields. Examples in the Canadian equity space include CI Harbour, IA Clarington Canadian Conservative Equity and Fidelity Canadian Large Cap. In the U.S. equity space, examples include Dynamic American Value and CI American Value. In the Global Equity space, examples of high quality funds which should hold up well in volatile environments include Ivy Foreign Equity and Renaissance Global Markets.
By focusing on quality, investors can help to manage some of the short term volatility while still providing an opportunity to generate some capital growth.
