Global Market Turmoil: Canadian Investors Brace for Economic Storm

A general view looking down Bay Street in the heart of Toronto's financial district, in a file photo. (The Canadian Press/Chris Young)

Commentary

Following sharp declines on Wall Street and amid uncertainty surrounding the global economy, Asian markets crashed on Aug. 5. The Japanese stock index, the Nikkei 225, dropped an astonishing 13.5 percent in one session. As markets in Europe and North America opened, they were also hit with large price drops, albeit nowhere near the extent of Asia.

It is clear that something is going on and we are in a volatile period. The question investors and everyone else are asking themselves is: 1) Have we entered a significant bear market in stocks? 2) Are we entering the much-anticipated global recession? 3) How bad could this get?

These questions must be particularly concerning to Canadians as the TSX has lagged the U.S. indices for years. The Canadian economy has flatlined in terms of official numbers while the standard of living of ordinary Canadians has plummeted, with stagnant income and necessities like food and housing soaring in price. If we are going into a bear market and recession globally, Canada will not have experienced a typical boom-bust but a slump/bust.

The U.S. yield curve as defined by the spread between ten- and two-year Treasury bonds had been inverted for about two years. This metric has been a reliable recession indicator; however, it takes time. I’m not surprised at the long delay because after years of artificially low rates since 2008, long-term borrowers like U.S. homeowners and corporations locked in low rates and had long average terms to maturity of their debt. It takes time for cheap debt to mature and be replaced by expensive debt. Many government officials, pundits, and self-serving stock promoters of various types assured us that “this time it’s different.” However, recessions usually begin when the ten- and two-year spread goes back to positive. That seems to be the case now as the spread is barely inverted and the trend is going positive. This indicator is flashing red for both a recession and a bear market.

Adding to the anxiety of a potential bear market is that two prescient stock valuations indicators, the Buffett Indicator and the Shiller P/E ratio, are at century highs, apart from the dot-com bubble which saw a 78 percent fall in the index. Interestingly, Warren Buffett has been selling stock and raising cash proving that he looks at his own indicator. Go figure. Markets are even more expensive than they were in October 1929, and we know how that worked out. The only thing we seem to have learned from history is that this time we are starting the civil insurrections and wars earlier in the cycle.

S&P index volatility as defined by the volatility index (VIX) is also of concern. It has soared from a low of just over 12 in mid-July to over 28. In the context of a falling market, this is usually a harbinger of bad times ahead in the stock market. High valuations compound the risk to investors. Canadians will not be immune. Most are internationally diversified, and large international money managers may favour selling their Canadian stocks first given that the policy environment has not been favourable to investments in recent years.

As well, given current yields and inflation outlooks in Canada and the United States, in my view the loonie is overpriced. Foreign portfolio managers should be thinking the same thing, and Canadian investors may want to increase their exposure to U.S. Treasuries.

Another economic indicator that has proven reliable over generations has been the price of copper. This is because copper goes into so many manufactured goods. Copper is largely ignored by younger market participants. Here again, we see storm clouds forming. After peaking at over $5 in May, copper has declined to about $4, a drop of 20 percent.

Some indicators are not as bearish. Although corporate bond spreads have widened, they have not exploded on the upside. A sudden and brutal drop in corporate bond prices usually coincides with a severe bear market and a recession. Also, U.S. Treasury yields on longer maturity issues have not dropped in a “flight to quality” trade that usually accompanies a sell-off. Are bond market players correct or are they and asset allocators asleep? It’s very strange.

The Federal Reserve is almost certain to cut interest rates at its next meeting, likely by 0.50 percent instead of the usual 0.25 percent. Looking at the data dispassionately, there is a high probability that we are heading towards a bear market. Historically, when the Buffet Indicator and Shiller P/E ratios signalled this high level of being overbought, markets have gone into periods of multiple years of negative real returns. The data is pointing to economic hard times ahead globally, as if Canadians haven’t suffered enough in the last few years, starting even before the lockdowns.

Canadian investors should stick with safe investments and concentrate on preservation of capital. U.S. Treasuries are always a good place to hide, especially given risks to the Canadian dollar. One should resist trying to predict a bottom and buying “on cheapness.” Given the current environment, this would be like trying to catch a falling knife.

Hoard cash, and sit tight. The storm will eventually end and those with cash will be able to truly buy cheap.

Views expressed in this article are opinions of the author and do not necessarily reflect the views of The Epoch Times.