Stocks continued to grind higher after going through a ‘mini-correction’ of under 5% through the end of July and early August.  The S&P/TSX Composite Index gained another 2.07% in August, pushing to a record high, but almost two years after most major stock markets hit their record highs.  The gains were broadly based with smaller stocks participating to a larger degree.  The Consumer Discretionary sector was the big winner in August, gaining over 6% on the announced merger between Tim Hortons and Burger King.  Energy stocks also bounced back despite weaker oil prices.  Financials lagged the overall market, gaining only 0.1% as investors were unimpressed with record earnings from the big six banks.  Basic Materials also lagged the overall market on a 5.2% drop in the mining index, which is somewhat of a negative since the cyclical and resource sectors should be exhibiting stronger leadership at this point in the economic cycle.

U.S. stocks lead global indices higher, with the S&P500 Index gaining over 3.8%.  The Nasdaq Index was even stronger, gaining 4.8% on strength in old line technology and biotech stocks.  Outside of North America, the German stock market gained 0.7% in August, but that was after dropping over 5% early in the month, below the critical 9000 level on the DAX Index, but then recovering in the last 2 weeks.  Japan lost 1.2% in August on weaker economic data while Brazil was the standout winner, gaining over 10% following the successful World Cup in July.  What is interesting about the strength of the Brazilian market is that it came during a period when economic output, GDP, fell by 0.6% in the three months to June, worse than analysts had predicted, and revised figures for the first quarter of the year also showed a fall of 0.2%.  That means Brazil was officially in a recession during the first half of 2014, since a recession is usually defined as two consecutive quarters of contraction.

The gains in stock markets with slow growth clearly shows what seems to be the key factor driving many stock prices back up; that weaker economic data will force central banks to cut lending rates even more aggressively, just as the U.S. Federal Reserve did with its Quantitative Easing (QE) program.  That same logic was behind the August rally in European stocks, where expectations have grown that ECB Head Mario Draghi will have to initiate further ease in the Eurozone with a QE program of their own.  The bottom line is that markets are once again in the ‘bad news is good news’ mode, believing that weaker economic data will lead to more stimulus, which is viewed as good news for stocks.

Ditto for China where Investors are returning at the fastest pace in almost two years on signs a government stimulus program will support growth in the world’s second-largest economy.  The iShares China Large-Cap ETF attracted over $500 million in August, putting it on track for the biggest monthly inflow since $1.34 billion was added in December 2012.  Investors are speculating that Chinese equities will extend gains as the government has promoted railway spending, cut some banks’ reserve requirements and reduced taxes to protect an annual growth goal of about 7.5% that’s been under threat from a weakening real estate market.  The Hang Seng China Enterprises Index has risen 1.4% this year after slumping 5.4% in 2013.  That is the paradox of global stock markets over the past few years.  Earnings are still important, but the bigger driver of market gains is the notion that central banks will continue to keep interest rates at record low levels to stimulate growth later on.  At some point this will translate into a fear about inflation, but that seems to be a distant risk right now.

The CRB Commodity Index fell again in August as oil prices dropped by over 2% despite the tensions in the Gaza and Ukraine, while copper prices also drifted down by 2%, presumably on the weaker economic data that came out of Europe.  This also is an anomaly; with the geo-political crises occurring and global growth supposedly on the mend, it seems counter-intuitive that we would be seeing weakness in key, economically-sensitive commodities such as oil and copper.  Either growth is slowing down or the strong U.S. dollar is driving investment demand out of the commodity group again.  Only Uranium prices bucked the downward trend, gaining over 10% as the commodity bounced off multi-year lows on renewed buying interest by utilities.

The Canadian Bond Index returned over 1% in July as long-term bond yields continued to drop.  Corporate bonds lagged the return of the government sector as the record low spreads widened out a bit.  But the bond rally was also not as simple as it appeared as it was driven less by economic weakness and more by relative value, as German 10-year bond yields dropped below 1%, making U.S. yields (at 2.34%) and Canadian bond yields (at 2.1%) look very attractive by comparison.

Despite continued political risks from the Ukraine/Russian showdown and more unrest in the Gaza, stock investors shifted their focus to strong second quarter earnings reports and more chatter from the central banks that interest rates will not be going higher for a long time.  Economic data has been weaker over the past two months as the U.S. has been losing some momentum while the European data has been significantly below past quarters, particularly in Germany.  But investors continue to see this as the ‘Goldilocks’ scenario; economic growth that is ‘neither too hot nor too cold’, strong enough to keep positive growth in earnings but not fast enough to start bringing back any of the inflationary worries that would have central bankers such as U.S. Fed’s Janet Yellen or ECB Head Mario Draghi having to reverse any of their very easy money policies.  The impact on stocks is shown in the chart below which measures the difference between the earnings yield on stocks and the 10-year bond yield.  The higher the value, the cheaper stocks are compared to bonds.  This reached a peak of almost 8 percentage points in early 2012, but has fallen in half since then as stocks have rallied.  Any rise in interest rates would narrow this difference even further, knocking out another leg in the support for stocks.  That is the reason why any strong economic news is a risk for stocks; while it would support higher earnings estimates, it would also increase the risk of higher interest rates.

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