Is Volatility The New Normal?


By Rob Edel, CFA

September lived up to its billing as, historically, the worst month of the year for equities with the S&P/TSX losing almost 9% and the S&P 500 and Dow 7.2% and 6.0% respectively.

What’s more, the volatility that plagued the markets in August continued, with the Dow moving up or down by more than 1% for 11 of last 13 trading days of September, with five of those days seeing moves of more than 2%.

The volatility of the market the past couple of months is extreme. Since the start of August, the market has moved an average of 1.69% a day versus 0.87% a day since 2000. According to Ned Davis Research, since 1900, the Dow has rarely moved more than 4% in a day. Last year, for example, the market never suffered such a swing, either up or down. This year, it has happened three times, all in the past couple of months, and regrettably, all to the downside.

Volatile markets traditionally take place when the market and economy are under stress. Case in point, there were 26 days of market moves exceeding 4% in 1931 and 22 in 2008. These make recent action seem rather boring. The fun might be just starting, however.

Historically, some of the market’s largest moves have taken place in October. The stock market crashes of 1929 and 1987 both took place in October and two of the largest declines in 2008 also happened in October. In fact, of the fifteen largest market crashes, eight have occurred in October. Scary stuff.

So why are investors so skittish?

Certainly there are concerns over the health of the U.S. and Canadian economies. However, as we discuss below, at the margin, North American economies actually looked a little stronger last month. The real concerns are overseas, particularly in Europe and China.

In the eurozone, Greece continues to dominate the headlines. It is becoming increasingly clear Greece’s ability to meet deficit targets and receive their next bailout cheque of €11-billion is in serious doubt. The most likely scenario would see a Greek default in the near future with bond holders taking up to a 50% haircut.

The recently approved €440-billion European Financial Stability Facility (levered up to over €1-trillion) would then be used to recapitalize European banks (who hold most of the Greek debt) and lend to other ailing European countries, namely, Portugal, Ireland and if needed, Italy and Spain. In other words, the can would be kicked as far down the road as the eurozone is politically able to kick it. The situation is very fluid and can change very quickly.

What still needs to be addressed is the future of the eurozone. Who goes and who stays? Clearly the experiment of monetary union without fiscal union has failed. The sooner this is addressed and uncertainty is removed, the better. Unfortunately, there are a lot of moving parts and a quick solution is unlikely. Europe remains the number one concern for the markets.

Perhaps the only good thing one can say about Europe is expectations are already pretty low. Its economy has basically been firing on one cylinder (Germany) for a while. China is different. Many had hopes that demand from China’s emerging middle class would become the engine of growth for the world economy, taking the burden over from the U.S. consumer.

Instead, investors have become increasingly concerned China is headed for a hard landing.

As evidence, Hong Kong’s Hang Seng index has been dropping all year, falling 23% year to date and 14% just last month. August retail sales in Hong Kong, while still up a robust 29% versus last year, were below expectations and up only 0.7% on a monthly basis versus 2.2% in July.

Even more telling, a recent wine auction conducted by Sotheby’s for Chateau Laffite Rothschild, a traditional Chinese favourite, failed to sell out for the first time in 17 auctions. Given the large role exports play in the Chinese economy and the state of the global economy, the concern is understandable.

Citigroup estimates current valuations are factoring in a 33% decline in earnings, which is about on par with previous Asian recessions. A slowing Chinese economy would have negative implications for commodity prices and countries that benefit from selling commodities, such as Canada.

On top of a hard landing, there is also growing concern that China may be heading for their own credit crisis with the red hot Chinese property market showing signs of topping out. Fuelling the fire, the internet is rife with pictures and stories of Chinese “ghost” cities that look to have been built on spec and are eerily void of people.

China is not the U.S., however. Mortgage debt totals only 15% of GDP with the average homeowner owing less than one year of household savings. Much of the slowdown being experienced is the result of tighter monetary policy implemented by the government to cool an overheating property market. If it slows too much, they can just as easily reverse course.

Out of control local government borrowing is a problem, however, and the central government will probably be on the hook for at least some of it. Total local and central government debt, however, only adds up to about 60 to 80% of GDP. This is still far lower than the U.S. at well over 90% or Japan with debt-to-GDP well in excess of 200%.

Don’t get us wrong, the Chinese economy will slow if the U.S. (and the rest of the world) goes into recession. We just don’t think a European-style credit crisis is a near-term concern.

Like everyone else, China needs the U.S. economy to recover.

In order for this to happen, deleveraging needs to run its course. Federal Reserve Chairman Ben Bernanke has described this process as a “formidable headwind that is blowing against the economy’s natural momentum and fiscal and monetary policies aimed at propelling it”.

So, to paraphrase a kid on a long car ride: “Are we there yet”?

Corporations certainly are. In fact, most are flush with cash. While consumers have made some progress and are saving more, debt levels remain well above historical norms. With wage growth flat and job growth subpar, it’s hard to see this changing anytime soon. Most of the decline in mortgage debt, for example, is due to borrowers defaulting.

As for the government sector, they haven’t even started to deleverage yet. Translation: the recovery is going to take a while.

The impact of the recession and the lack of a recovery are starting to take a toll on the middle and lower classes. The poverty rate, at 15.1%, recently hit its highest level since 1993. U.S. household income in 2010 fell for the third year in a row and on an inflation adjusted basis, is back to where it was in 1996.

The gains of the booming 2000’s have vanished. For a typical male (rather than a household) working full time, year round, you can throw away the 80’s and 90’s as well – income adjusted for inflation is lower than in 1978.

It’s worse for younger workers, with the poverty rate for those under 18 spiking to 22%. 5.9 million, or 14.2% of Americans between the ages of 25 and 34 years of age, live at home versus 4.7 million or 11.8% before the recession.

The rich, on the other hand have fared somewhat better. The wealthiest 1% of Americans earns nearly 25% of total income and controls 40% of total wealth versus 12% of income and 33% of wealth 20 years ago.

According to the Gini index, which measures the deviation from a perfectly equal distribution, wealth distribution in the U.S. is more unequal than in any other country in the 17-member OECD. If a country has a Gini index of zero, everyone has the same income. A Gini index of 1 indicates one person has all the income. In 2008, the U.S. has a Gini 0.38, meaning 38% of income in the U.S. would need to be redistributed in order to achieve perfect equality.

A recent study by two university professors discovered Americans have no idea how unfairly income is distributed in America and over 90% identified an income distribution closer to that of Sweden as the ideal model.

Of course we are much more liberal and fair in Canada, right? Well maybe on an absolute basis, but the trend is working against us. While the wealth gap maybe wider in the U.S., it is growing at a faster rate in Canada. For example, the 100 best paid Canadian CEO’s made 155 times the average worker in 2009 versus “only” 104 times in in 1998.

Why is this significant? Well, the recent “Occupy Wall Street” demonstrations indicate people are starting to take notice. Most of the demonstrators are young, unemployed and losing hope. While it’s not clear what the demonstrators want, it is clear that they are frustrated and feel the system is not working, at least not for them.

They characterize themselves as “The 99%,” demonstrating against the 1% (who make all the money and have all the wealth). Given what happened in the Middle East/East Africa with the so called “Arab Spring,” politicians should take heed. We are not suggesting crowds bearing torches and pitchforks are going to round up the rich send them to the guillotine (at least not yet), but the movement definitely has the potential to help shape political platforms.

We would suggest the Republicans position against any kind of tax increase ­– even for the very rich – might become negotiable.

 

The U.S. Economy

Despite the sell-off in the equity markets, the U.S. economy actually looked a little stronger in September. Q2 GDP growth was revised back to 1.3% from 1% and ISM manufacturing and non-manufacturing (services) purchasing manager indexes rose in September.

That’s not to say growth is robust. Far from it. The ISM’s index for new orders was slightly below 50, indicating future activity may slow and the NY and Philadelphia indices are both indicating manufacturing is contracting in those regions.

Also indicating potential trouble ahead was the Economic Cycle Research Institute’s weekly leading index, preferred by many analysts as a good predictor of economic recessions. The ECRI has, in fact, correctly called 6 of the past 7 recessions since the 1960’s, recently turned negative and is now predicting a recession in the U.S. Don’t worry too much, however; the ERCI has also turned negative 17 times without a resulting recession.

A Wall Street Journal poll conducted in early September also returned a gloomy result, with one-third of forecasters now believing the U.S. will fall back into recession over the next year. The good news is forecasters have apparently been notoriously poor at predicting recessions.

Presumably, the best signal of a recession is if a majority of forecasters agree that one is on the way. According to the Philadelphia Federal Reserve, however, since the 1970’s 50% of forecasters have never agreed that a recession was forthcoming. Actually, the only time over 50% of forecasters agreed a recession was forthcoming, was when a recession was already under way.

The bad news, unfortunately, is that in reality it only takes about 30% of forecasters to call for a recession, and when one-third of forecasters believe a recession is coming (as they do now), they’ve only been wrong once (in 1988).

 
Are there any signs of relief?
We could talk about President Obama’s $447-billion spending initiative that is estimated to add 2% to GDP growth and create 1.9 million jobs, but there is little chance the bill will make it through Washington’s gridlocked congress.

Can’t blame him for trying though. Obama’s chances of getting re-elected with unemployment rates above 9% are slim. The only thing he has going for him is the team the Republicans are putting forward.

Not a bad month for job creation in September with 103,000 new jobs and August’s total revised from basically zero to an increase of over 50,000 new jobs. Also back up were hours worked and wage inflation, all good news.

Not so good news was the fact that nearly half the increase in jobs was the result of 45,000 striking Verizon telecommunication workers returning to work. Jobless claims remain high and the Challenger Job-cut Report is indicating more lay-offs are in the cards.

While the unemployment rate remained at 9.1%, the marginally attached and involuntarily part-time rate increased to 16.5%. Also, 44.6%, or 6.3 million Americans, have been out of work for more than six weeks. That’s a scary number. The employment picture in the U.S. remains a work in progress.

Inflation was again on the rise in August with headline year-over-year CPI increasing at its quickest pace since September 2008. While we would normally be more concerned, the recent pull-back in energy and commodity prices give us some hope inflation may have peaked.

The DJ-UBS commodity index of 19 widely consumed commodities ended the third quarter down 11.3% with copper down a startling 26% while oil prices have retreated over 30% from their highs. Soybeans were also down 9.7%, leading to hopes that food prices may have also peaked. But then, who eats soybeans anyways? Yuck.

A potential economic slowdown in China is the main reason cited for the sharp pull-back in commodity prices.

Consumer confidence picked up a bit in September. While the trend is positive, consumer confidence remains at depressed levels. Not surprising, given events taking place in Europe and volatility in the equity markets.

Retail sales were predictably depressed in August but picked up steam in September, partially driven by discounts to clear back-to-school inventory. Luxury and discount merchants continue to do well, while department stores and apparel retailers lag.

All eyes are now focused on the all-important holiday shopping season, which on average represent 20% of annual sales. The fear is retailers, who must order inventory well in advance, may have been too optimistic earlier in the year when the economy was stronger and may now be left with too much inventory for today’s frugal shopper.

ShopperTrak is forecasting sales will increase only 3% this season versus last year’s 4.1%. A survey of by AlixPartners LLP found 41% of shoppers expect to spend less this Christmas versus only 31% last year.

Consumer product companies are a resilient bunch, however, and are doing everything they can to separate you from your hard earned money. Coke is taking a page out of their Mexican play book and introducing a greater variety of bottle sizes. Coming soon to a U.S. grocery store near you are 12.5oz, 89-cent bottles.

Only last year, Coke came out with 16oz bottles to complement their standard 20oz offering. Always the savvy marketer, while the smaller portion carries a lower sticker price, they actually cost more per ounce. Robin Hood they are not.

Consumers are battling back by buying more generic or “store” brands. The middle class have become particularly frugal and continue to maintain shopping habits learned during the recession. The main reason for this is the middle class was hit particularly hard during the recession and have not seen their incomes recover.

The U.S. Census Bureau estimates the Gini index in the U.S., (which as described above measures the income inequality of a country) increased 20% over the past 40 years and is now on par with Mexico and the Philippines. The result is what Citigroup calls the “Consumer Hourglass Theory” where investors are urged to invest in companies catering to the very affluent or the more disadvantaged, but not the middle class.

Companies like Proctor and Gamble are developing more products that target the “value” segment, like Gain dish soap, while also rolling out expensive high end skin care products, such as Olay Pro-X. It also explains why stores like Nordstrom’s are doing better than JC Penny.

While the declining U.S. birth rate can explain part of the decline, Huggies brand VP Eric Seidel concedes there has been a decline in the number of diapers used per baby. Understandable, given it costs about $1,500 per year to diaper a baby six times a day.

Even more telling, Northwestern Memorial Physician Group pediatrician Anjali Rao reports seeing a 5-10% increase in cases of diaper rash while market research firm SymphonyIRI claims sales of diaper rash ointment has spiked 8% over the past year.

Things are tough all over, literally.

Existing home sales showed some strength, especially compared to last year’s depressed levels, and the S&P/Case Shiller price indexes indicate prices may have bottomed. Pending home sales, however, suggest sales could slow over the next few months and new home sales and prices may continue to decline.

Given the recent weakness in the U.S. economy, forecasters are becoming less optimistic that a recovery in the housing market will transpire any time soon. A recent survey of 100 economists by MacroMarkets LLC indicated prices are expected to drop 2.5% in 2011 before rebounding a mere 1.1% a year through 2015.

This would provide scant relief for homeowners who have seen more than $7-trillion in value disappear since 2005 and homeowners’ equity fall to 38.6% from 59.7%. Little wonder the rate of home ownership fell in the past decade by the largest amount since the great depression.

Depressingly, it could fall even further as home ownership rates are still at their second highest level on record. 20% of homeowners with mortgages owe more than their homes are worth and four million mortgages are in some stage of foreclosure or “seriously delinquent.”

The recent decline in mortgage rates will help, with 30-year mortgage rates recently dipping below 4%. Credit Suisse estimates more than 60% of borrowers with 30-year fixed rate mortgages would be able to shave 1% off their rates by refinancing versus only 42% in early August. The problem is fewer borrowers qualify given underwriting standards are tighter and home equity is, in some cases, non-existent.

In most cases, lower rates are not helping those that need it most. Also, new borrowers are hesitant to step into a market that is still falling. It’s not the level of interest rates that is the problem, rates are plenty low enough.

Why do we care? Buying a house is typically the largest purchase and biggest investment the average consumer makes in their lifetime. If prices decline, net worth declines with it and consumers become more conservative with their spending habits.

In addition to its indirect impact on consumer spending, the housing sector has a direct impact on GDP growth, especially when the economy is recovering from a recession. The Federal Reserve Bank of St. Louis estimates housing contributed only 0.03% to GDP growth over the past 35 years, but in the two years after a recession, housing historically adds 0.5%. During the recent recovery, housing has had actually had a negative impact on GDP growth.

According to Capital IQ, the housing and housing-related sector represented 16.8% of GDP in 2005 but fell to 13% in the second quarter of this year, the lowest share since 1982. As Steve Blitz from ITG Investment Research says, “The whole U.S. economy in this last decade was built on housing and the services that come with it: mortgages, moving, and furniture.” It’s going to take time to work through the excess built during the last bubble.

The U.S. trade deficit narrowed nicely in July as lower oil prices helped lower energy imports while exports were driven by higher capital goods and automotive sales.

While the trade deficit with China was unchanged in July, trade with China remains a one-way street, thus providing an easy target for campaigning politicians. While the Yuan remains on a slow, but gradual path higher versus the U.S. dollar and has increased 30% against the dollar since 2005, most believe it is still undervalued and accuse the Chinese of manipulating their currency in order to gain an unfair trading advantage.

A recent study by three economists concludes they might have a point. While it is generally accepted that free trade benefits all nations in the long term and cheap Chinese imports have helped keep inflation in the U.S. low, the speed in which China has increased exports has overwhelmed the normal adaptation process.

As Paul Samuelson argued in a 2004 article, trade may benefit some Americans, but it is also decimating the wages of blue-collar factory workers. In fact, up to two-thirds of the benefits from free trade maybe may be off-set by increased costs, such as higher unemployment insurance, food stamps and disability payments.

That said, nothing lasts forever, and China’s trade advantage is slowly eroding. Higher costs in China, particularly wages, and increased union flexibility in the U.S., is shifting the balance in favour of U.S. manufacturers and jobs that were seemingly lost forever are starting to trickle back to the U.S.

The Boston Consulting Group has identified seven industry groups susceptible to relocating manufacturing back to the U.S. over the next four years that could result in 800,000 new manufacturing jobs and up to 3 million jobs in total if service support jobs are included. This would be good news indeed.

The Canadian Economy

Canada’s GDP continued to recover in July with a 0.3% increase month-to-month and a 2.3% increase versus last year. Manufacturing managed to increase for the first time in four months, rising 1.4%. RBC Purchasing Managers index and the Ivey Purchasing Managers index point towards further strength in the coming months.

The job market had us worried last monthwhen it contracted for the first time in 7 months. No fears, however, as September saw it rebound nicely with a monster 60,900 increase and a decline in the unemployment rate to its lowest level since December 2008.

To put the job gains in perspective, the Canadian economy is roughly a tenth the size of the U.S. economy. An increase of 61,000 jobs in Canada is the equivalent of 610,000 new jobs in the U.S. If the U.S. were able to deliver job growth like this, there would be dancing in the streets, and President Obama would be at the head on the conga line.

It’s not all good news, however. Over half the increase was due to the seasonal increase in education jobs (+38,000) and the private sector actually lost 15,000 jobs. Youth and low-skilled job creation are also lagging. Still pretty good though. Party on, Mr. Harper.

Inflation in Canada again moved higher with core CPI getting dangerously close to the Bank of Canada’s mid-range target of 2%. Don’t look for any increases in short-term interest rates, however. While Bank of Canada Governor Mark Carney would love to increase rates, there is little chance he will, given the state of the global economy. As in the U.S., oil and food prices should moderate over the coming months and CPI should move lower.

Consumer confidence increased slightly after falling for four months in a row. Retail sales were lower than expected in July due to soft auto sales. Lower retail sales may be a good thing as household debt continues to march higher and hit a record 148.7% of disposable income in the second quarter.

Existing home sales were a little weaker in August and prices slipped slightly, but the market has been so hot lately this is only as minor setback. TD Bank is forecasting prices will continue to pull back and eventually drop 10% from current levels.

They expect prices to trough sometime in 2013. Given the carnage the housing market has suffered around the World, if TD is right and this is the extent of the correction in Canada, we’ll take it.

Canada’s trade deficit narrowed in July with broad based increases in exports. Increased auto exports indicate supply disruptions from the Japanese tsunami have largely dissipated.

Overall, the Canadian economy, like the U.S. economy, looks to be moderately stronger than last month. Certainly a lot stronger than the equity markets would indicate. Of course, what is happening in Europe, the U.S. and China is going to have a large say in what happens to the Canadian economy.