Neil Watson, Vice-President of Leith Wheeler Investment Counsel Ltd.,
gives a professional investor’s view of the current crisis following the downgrading of US debt.
Given the significant declines we have seen in the markets recently, we thought that our clients would be interested in our views about the economic environment and, more specifically, the outlook for their portfolio including any action we are taking in response to market events.
July and August, which are usually a fairly quiet time for stocks, often produce a summer rally. Unfortunately, this is not the case this year as markets have retreated significantly, with the TSX declining another 4% yesterday while the S&P 500 has dropped 5.5%. As you will note in the news, yesterday’s weakness has been widely reported as being due to the downgrade on U.S. government long term debt from AAA to AA+ by S&P. Although this may have served as a catalyst for yesterday’s decline, the more significant concerns in the market are fears over debt levels in Europe which have spread to the larger economies of Italy and Spain as well as recent economic news which has been generally disappointing. Concern has increased that we may be entering another recession and interest rates may have to increase in the United States at a time when the government’s ability to respond to a slowdown is limited.
The downgrade by S&P was widely expected and we do not expect it to push up yields in any meaningful way which was, to some extent, confirmed by the lack of response from the bond market on Monday. On a positive note, it has put the fiscal situation of the U.S. under more of a spotlight and should, hopefully, push the politicians into a more credible long term plan to deal with their debt and deficits.
On the economic front, the last month has seen a significant revision in global growth prospects. These revisions have led to corrections in major equity markets globally and declines in interest rates for most developed bond markets. These concerns around growth expectations are somewhat a reaction to policy tightening in many regions of the world.
Emerging market countries have been leading the global economy higher since the end of the last recession. Unfortunately, price increases in these markets has led to persistent inflation with wage increases becoming routine. To battle this inflation, we have seen a tightening in monetary policy over the past year. In Brazil, overnight rates have increased from 8.5% to 12.5% while in China short term rates have been increased from 2% to 6%. Though these increases have had only a modest impact on economic performance to date, the market is concerned that a more significant slowdown is underway. Although we expect to see some slowing of growth, from lofty levels, in the emerging markets, we still expect these markets to be a key engine that keeps global GDP on an upward trend.
In Europe, the ECB has increased interest rates twice this year despite stresses within the periphery countries of Greece, Portugal, and Ireland. Last week’s market declines were precipitated by a lack of confidence in the Eurozone’s ability to manage larger debtor countries such as Italy and Spain. Recent economic data has shown only a modest softening in the industrial heartland within core Europe. However, the market has started to discount much slower growth throughout the Eurozone due to continued concerns around peripheral debt levels and the potential impact from weakening emerging economy exports.
In the U.S., most signs are pointing to an environment of continued slow economic growth, and the recent market volatility has increased the downside risk to these expectations. Our economy is closely linked to the U.S., as well as to the rest of the world, so our stock market has fallen in tandem.
The market is concerned that we will see a recession and with the recent economic weakness, the risks of a recession have increased. However, our base case scenario is for the U.S. economy and Europe not to enter a recession but rather to see a low level of growth in their economies despite their fiscal situation and debt levels.