Market Outlook – First Quarter 2015 – Retrospective and Prospective

Market Outlook – First Quarter 2015 – Will She or Won’t She

Janet Yellen Chair Federal Reserve

Janet Yellen, Chair of the Federal Reserve – will she or won’t she?

“Neither a borrower nor a lender be, For aft loses both itself and friend, And borrowing dulls the edge of husbandry” –  Polonius, Hamlet, Act I , Scene 3

“High debt levels, whether in the private or the public sector, have historically placed a drag on growth and raise the risk of financial crisis that spark deep economic recessions.” – The McKinsey Institute, Debt and (not much) Deleveraging

In the first quote above, Polonius is advising his son, Laertes, who is about to leave for Paris to complete his gentleman’s education, that lending money to friends is risky and can end up causing resentment and even the loss of the friendship.  Furthermore, Polonius points out that borrowing money can endanger husbandry or thrift.  The second quote, taken from a study by The McKinsey Institute, concludes that high levels of debt can lead to slower economic growth and even financial crisis.

It has been seven years since the last financial crisis.  In that seven-year period, the total global debt has increased by even more than it did in the seven years previous (2000-2007).  From the end of 2007 through to the end of the first half of last year, total global debt increased by 40%, or $US 57 TRILLION!  This massive increase in debt has been a consequence of easy money in a low interest rate environment aided and abetted by programs of quantitative easing (the provision of liquidity by central banks) in order to promote economic growth and investment.

The first quarter managed to record some positive results overall, despite severe declines in some sectors.

Canadian Dollar                        US Dollar
Q1    Q2    Q3    Q4    YTD       Q1    Q2    Q3    Q4    YTD

Toronto Stock Exchange    2.6%                           2.6%
S&P 500                          10.1%                         10.1%    1.0%                1.0%
MSCI EAFE*                    13.7%                         13.7%    4.2%                4.2%
91 Day T-Bill                     0.3%                           0.3%
DEX**                               4.2%                           4.2%
CDN/US dollar                                                                 -8.5%                -8.5%

* Europe, Asia and Far East Index
** Canadian Bond Universe Index

Investors’ concerns are now largely centred on the repercussions of these easy money policies and the massive build up of debt.  Debt has increased globally in 22 of the advanced economies and consumer debt has risen sharply in all of them with the notable exceptions of the US, UK, Spain and Ireland.

Within the emerging markets, US dollar denominated debt now exceeds $9 trillion, up from $2 trillion just 14 years ago. A large portion of this debt is corporate debt.

In China, debt levels have quadrupled in the last seven years.  Twenty-five percent of the corporate debt in China is denominated in US dollars.  Only 8.5% of corporate earnings in China are earned in US dollars.  Five percent of Chinese firms hold over 50% of that debt.

In conclusion, the combination of low interest rates and quantitative easing has flooded the world with liquidity and made borrowing all too tempting to resist.  Japan holds the record with debt now exceeding 250% of their GDP.

In Canada, debt levels have been highlighted by the Bank of Canada as an area of concern particularly consumer debt that has reached all time highs.  Consumer debt is reaching troubling levels in more than just mortgages.  Margin debt (money borrowed to make investments) is near record levels at over $19.2 billion.  Margin debt places those investors in a vulnerable position if their investments fall in price and they are forced to cover that debt.

So, will she or won’t she?  The she being Janet Yellen, the Chair of the Federal Reserve in the US.  The question is as to when she may deem it appropriate to raise interest rates.

While there has been a great deal of speculation as to when the first increase in rates may occur, it is not altogether clear that it will be in the immediate future.  There is no doubt that the Federal Reserve would like to raise rates given the strengthening of the US economy with the commensurate improvement in employment levels.  However, the strength of the US dollar that has appreciated 9% against the currencies of its major trading partners in the first-quarter, is already a concern as exports from the US are already facing a competitive disadvantage.  The US would not want to risk the economic chaos that night ensue globally as more fragile economies with large US denominated debt tilt back towards recession.

The decline in oil prices is beginning to reverberate throughout the world economies, particularly in Canada and the other large oil producing nations.  Over the last seven years, the US has become a large producer of oil and gas with the success of modern drilling technologies.  As we enter the next quarterly reporting period, we will be looking for the impact that this weakened environment will have on earnings.  In an environment where valuations are looking stretched, in our opinion, we could be entering a very volatile period in global equity markets.

As we concentrate on the valuations at which individual companies are trading, we will be looking for opportunities to compliment portfolio exposures in this environment.  We are well positioned in this regard.

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