We have been positioned very defensively throughout 2015 as we were concerned about the type of market fallout that we saw in August.  Looking back again at our market comments last month outlined the key reasons for this strategy:

“Our outlook remains cautious.  Central banks have ‘over-applied’ the medicine of zero/low interest rates with more success inflating the value of financial assets than stimulating global economic growth.  Companies are eschewing real expansion in favour of stock buybacks and mergers, in many cases borrowing funds at low rates to do so.  Average investors are being forced into riskier investments in order to receive a normal rate of return.  Meanwhile, the global economy is seeing few benefits from these low rates as consumers are still paying down excessive debt loads instead of spending; US growth remains in the 2% range as the negative impact of a stronger US dollar and low export growth; Europe growing at only 1.0-1.5% at best despite the Quantitative Easing, weak Euro and low oil prices.  Chinese growth is deteriorating as it over-expanded capital spending after the 2008 financial crisis and now needs to push consumer spending as an offset.  Despite weak growth, inflationary pressure could be starting to return due to rising wage growth and a lack of new spending which means that central banks are already ‘behind the curve’ and will need to raise rates.  Earnings growth is slowing down as profit margins are already at all-time highs and revenue growth is coming down.  Meanwhile, stock valuations are at levels which were higher only during the ‘tech bubble.’  While low interest rates could keep stocks rising in the short-term, we see similar warning signs to what we saw in 1999 and 2007.  Risk levels are elevated and the skeptics only need to look at the 50% collapse in oil prices last year or the 30% decline in Chinese stocks in the past four weeks to be reminded about how quickly ‘normalization’ can take place 

This outlook became reality last month as major markets crumbled and $5.7 trillion was wiped off the value of global equities.  The S&P500 Index sank 6.3%, the biggest monthly drop since May 2012, while Europe’s Stoxx600 plunged 8.5%, the worst month in four years.  Asia was the worst hit area though, with Japan losing 8.2%, Hong Kong down 12.0% and China dropping another 12.4%, putting the Shanghai Index almost 40% below its June high level.  Canadian stocks fell less than some of the major markets as the gold stocks generated gains but it still capped the worst month of trading in nearly a year.  The benchmark Canadian equities index fell 4.2 percent in August, with all ten sub-groups showing losses for the month.  Equities tumbled as concerns mount that China’s policy makers won’t be able to prop up its markets at the same time Federal Reserve officials signaled they’re preparing to raise interest rates.  Canadian stocks lost over 10% in a 19-day drop in August before jumping 6.2 percent in the last five trading days of the month.  While some investors pointed to the recovery as another signal to ‘buy the dip’ in stock prices, we saw it as little more than a bounce off the extreme selling seen on August 24th.  Technical indicators of volume, breadth and volatility hit an extreme that day.  After a selling climax like that, the market usually tries to recover.  Such recoveries tend to last from a few days to a few weeks.  Then the market retests its lows.  Our belief is that the selling is far from over and that we are heading into a period of elevated volatility and that stocks will break below those lows in the next wave of selling.

In terms of the ‘catalyst’ for the decline it is interesting to look for some specific event.  We can look back at the implosion of a mortgage fund managed by Bear Stearns back in 2007 as the ‘canary in the coal mine’ for the ultimate collapse in the US housing market and the ensuing global financial crisis, we believe that the actions of China in reducing the value of the Yuan and aggressively cutting interest rates may prove to have been the ‘catalytic event’ in the current downturn.  The move prompted a 12% slide in Chinese stocks, capping the worst two months since 2008.  What we are now seeing is the biggest decline in emerging-market currencies since the global financial crisis.  While these depreciations were supposed to lead to stronger export growth and economic recovery, they are quickly turning from a welcome event into something destructive.  The selloff has become so swift and so deep that officials are abandoning hands-off policies on concern the drop will fuel inflation, deter investment from foreigners and act as a drag on their economies at a time when global growth is already decelerating.  To counter the declines, policy makers from Mexico to South Africa and Turkey have either stepped up intervention, increased interest rates or signaled an end to monetary easing.  China was running down its foreign-exchange reserves to support its currency.  The government concluded that a currency regime change was needed to prevent the loss of further foreign-exchange reserves.  The authorities spent about $150 billion to support the currency, or smooth its decline.  It then cut interest rates to try to calm the market, and reduced the bank reserve-requirement ratio, allowing Chinese banks to be more generous in lending.  This has led to a global currency crisis that is under-mining the aggressive action of central banks and the ‘zero interest rate policies’ that were used to bring the global economy out of the financial crisis in 2008.  But countries cannot use their currencies to simultaneously ‘depreciate their way to prosperity.’  In prior balance-of-payment crises, such as Latin America in the early 1980s, Mexico in 1994, Asia in 1997, and Russia in 1998, the currencies involved typically declined by 40% to 70% before seeing any significant benefit to their economies.  If China were to depreciate to anywhere close to that it would drag the economies of their competitors into outright depressions due to losses of competitive advantage.

Meanwhile, the U.S. dollar has become viewed as the ‘safe haven’ for global investments, taking the role away from gold.  To put into perspective how bizarre this is we only have to look at the massive increase in debt in the U.S. over the past ten years as shown in the chart below.  Debt has risen from under $8 trillion in 2005 to over $18 trillion today; and yet the US dollar has been the strongest global currency over that period!  Seems like a classic example of the ‘best house in a really bad neighbourhood.’

 

Increase in debt in the U.S. over the past ten years

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