Market Drops - Can we Connect the Dots on Why?

February 10, 2018

 

The markets have been the hottest in over 8 years since we've gotten through the 2008-2009 recession.

 

The view on world growth remains strong while at same time searching for things to go wrong.

 

SO WHY NOW?

The overall market situation seems to indicate that despite the ongoing world growth there must be something out there to disrupt this trend.

 

Yet nothing exciting raised it head to trigger the events except in the last few days for a Wage growth statistic in the US.

 

The latest 'one month's' tracking showed U.S. wage growth at 2.9%.

 

Fundamentally this sounds great for Workers. But there's a couple of things we need to look at:

 

1) is this wage growth percentage sustainable OR

2) was this a one month anomaly.  

 

There will be close eyes on next month's report looking for consistency as one month's data in not a trend. 

 

THE RIPPLE EFFECT    

The ripple effect of higher wages means higher costs for companies and lower profits.

 

Coupled with that is Wage growth at a rate higher than inflation (year over year). 

 

This sends caution throughout the markets.  

 

The primary Focus of Central banks (Bank of Canada, US Federal Reserve, etc.) is to control inflation. To the extent inflation gets higher than 2% they are positioned to take action by raising interest rates.

 

Stock Markets are meant to be forward looking and they look at current events and extrapolate what the financial impact might be on stocks in six months time or more.

 

DO HIGHER WAGES = INFLATION ?

  • Higher wage growth sends a message that inflation will immediately cause interest rates to rise. 

  • Higher interest rates negatively impacts on existing bond Portfolios. 

  • In addition, interest rates on borrowed money by companies will also decrease profits.  

 

PROFITS - Winners and Losers 

With higher wages and higher interest rates the assumption is corporate profits will drop and stocks values should reduce accordingly.  

 

Also interesting, is higher interest rates have a positive impact on Bank stocks. This is because their interest rate spread increases when rates go up. With a third of the Canadian market in financials this should be a steadying influence in Canada. 

 

SO HERE WE ARE.  

Companies profess to be doing well. Current profits and growth are expected to remain steady. 

 

The Central banks have yet to do anything and yet the markets dropped.

 

In the past 10 years we have seen three significant market corrections:

1) the recession in 2008/09 dropped Canadian Equity markets by 35%,

2) in 2011 the TSX dropped by 11% and

3) in 2015 the TSX again dropped by 11%.      

 

Through all of these former events the markets have rebounded and I see nothing to suggest this won't be the case again this time.

 

MACRO ECONOMIC INDICATORS

The chart below shows us that every major economic indicator has no red flags.  

 

 

All indications are the world is in strong growth mode. This is almost universal in every corner.  

 

What we have then is an immediate reaction to one situation which has rippled it's way through the markets. 

 

You may recall in 2008/2009 we had Mortgage Backed Securities (MBS) and this situation was compounded by stocks being sold because of the use of Computerized Selling Software. To  some, yet lesser extent we have something similar in the Hedge Fund world using a Risk Parity Model, which automatically does essentially the same thing. It's a more sophisticated model but the outcome is similar to computerized selling. 

 

In our opinion these two situations have created the current market turmoil. It doesn't take away from the fact the Markets have fallen but it gives us reassurance about how sensitive the markets can be to influences.

 

The Wage issue is a MACRO Economic influence whereas the Risk Model selling process is more micro in nature as it relies on a set of specific circumstances to exist and then moves to the auto sell mode.

  

With Corporate growth and profits on the rise world wide and with no Macro economic factor pointing negatively other than this one monthly wage statistic it is our opinion the markets had become to complacent with profits and this one factor had been the trigger.   

 

CONCLUSION

We will want to see two things going forward before we'll have any real concern: 

1) will this wage increase indicator be consistently repeated each month to solidify itself as being real and

2) will we hear anything different from the corporations worldwide, about a change in profit and growth trends.   

 

The GIC Investors will snub their noses once again but fail to acknowledge in the last six years the Canadian market was up over 33% and the US market was up over 83%. In that context is a 5% drop that significant.   

 

As in the past our philosophy has been to ensure our clients have a well diversified portfolio.

 

Diversified Portfolios are broad based with a multi-faceted approach. We continue to believe a well balanced portfolio will benefit all our investors over the longer term.

 

Remember, investing is a marathon, not a sprint.     

 

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