Stock markets around the world have been tumbling almost in unison. The customary instruction from financial planners — stay invested and wait for the inevitable recovery — is tough to accept when, every day seemingly without let up, stock averages lose several per cent.
The heartache will stop and the tumble from grace will end in time. After all, the world recovered from the Great Depression of 1929 to 1939, the Great Recession of 2008 to 2009, the dot com collapse in 2000, the tragedy of Sept. 11, 2001 and numerous Canadian corporate collapses such as the Bre-X fraud and the implosion of Nortel Networks. But this time is different. Recovery will take a change in major forces tearing down years of growth of the biggest corporations in Canada, the U.S. and Europe.
Here is a list of what ails capital markets:
- Slowdown in global growth to little more than one per cent of global GDP compared to the 2010 to 2013 rate of growth of 2.5 to 3.0 per cent with concurrent rise in market volatility.
- Slowdown of China’s economy to a growth rate of six per cent of GDP per year, down from eight per cent two years ago with shutdown of infrastructure construction.
- Collapsing commodity prices from reduced construction in China, reduced demand for Canadian chemical fertilizers, collapsed demand for Canadian metallurgical coal.
- Downward spiral of energy prices, a good thing for energy importers but a bad thing for energy exporters like Canada.
How serious and widespread the global slowdown is can be seen in major world stock market averages. Between Dec. 31, 2014, and Jan. 31, 2016, the world’s major global stock averages have tumbled as follows in U.S. dollar terms: 8.3 per cent for the Dow Jones Industrial Average, 20.3 per cent for the Chinese SSEA, 16.8 per cent for the British FTSE 100, and 28.0 per cent for Canada’s S&P/TSX. Some emerging markets fared worse than Canada. South Africa’s JSE average was down 30.4 per cent, Brazil’s Bovespa was down 46.6 per cent and Egypt’s Case 30 index was down 37.9 per cent.
Look at those numbers: what they say is that Canada’s stocks are now trading like those of emerging markets. Indeed, the correlation of share prices in the widely used Morgan Stanley Capital International Emerging Markets Index and the S&P/TSX index since 2010 is almost perfect.
What these numbers do not reveal is where money is going. After all, with so much stock being sold around the world, there has to be a pile of cash somewhere. Well, not exactly. Money that has left stocks has found its way to the bond market where buying of the most liquid asset in the world, the 10-year U.S. Treasury bond —and its almost-as-liquid counterparts for one, two, five and 30 years — has had dramatic results for yields. Bond yields move opposite to bond prices (as you pay more for the bond, your percentage return declines). Yields reveal what people are getting for their money. The table shows how low returns have fallen.
These incredibly low returns means that a large investor, say a pension fund, can buy and hold a U.S. 10-year Treasury bond and get 1.75 per cent a year. Inflation is higher than these returns in all markets, guaranteeing a loss of purchasing power even before tax. Worse, some yields are negative. If you want to buy a Swiss franc denominated bond from the Swiss National Bank, you will be charged three-tenths of one per cent per year for your trouble. However, appreciation of the yen and the Swiss franc and other currencies with low and negative yields have made up for the nominal losses these bonds offer.
Bank stocks and bonds
The flip side of the hot performance of national bonds is what is happening to bank stocks and bank bonds. Among the worst hit are major banks in Europe and the U.S. Germany’s biggest bank, Deutsche Bank AG, has seen its shares flop 50 per cent in the last year. It is the most visible casualty, but for Europe as a whole, bank shares are bleeding badly. Europe’s Stoxx 600 Bank Index has lost 28 per cent since the start of 2016. Why? Because of bad loans. Specialist traders in bank stocks reporting on Feb. 1, 2016 said that 16.7 per cent of Italian bank loans are non-performing (the borrowers are not paying on time). For Europe as a whole, almost six per cent of bank loans by value are in the red.
Banks in Canada, the U.S. and the rest of the world are taking it on the chin. The reasons are not only loan losses, still trivial in most of Canada except Alberta, but, as well, the traditional business of commercial lending. Banks borrow short through savings accounts held in the branches and via the term deposits they sell and lend long for mortgages, big commercial loans and term loans for cars and industrial equipment, business leases and so on. With central banks pushing down interest rates, the difference between borrowing short and lending long gets smaller. The banks make less money on loans. At the same time, big banks’ investment banking business shrinks. Who wants to buy new shares on businesses in a crummy economy, after all?
The new fashion in investing is risk aversion. Investors buy negative yield or low yield government bonds, preferring to take a small loss or make virtually nothing rather than take a big loss on stocks. Banks own bonds, especially the bottom of the barrel risky bonds called Contingent Convertibles or Canada’s long winded name, Non-Viable Contingent Capital, that convert to stock at the worse possible moment when banks run out of money to lend or cannot pay depositors, are collapsing in price as holders sell before their issuers run into trouble.
What to do? Friends, the sky is not falling. Shares of Canadian chartered banks have tumbled. Royal Bank is off 18 per cent from its 2015 highs. CIBC is down about 15 per cent from its 12-month high. They pay dividends and did not cut them in 2008. Excellent Canadian utilities like Fortis Inc. pay four per cent and change. BCE Inc. is pretty steady. Its shares are off just five per cent and pay 4.5 per cent as a dividend. All these companies have paid steadily and raised their dividends for many years.
It is a question of taking reasonable risks. Stock dividends are not guaranteed. Bond holders get first crack at the kitty and can put a company into bankruptcy if they are not paid. But bank bonds are being clobbered in the rush for safety and when times get better and interest rates rise, bank bonds with today’s low rates will fall further.
Best bet: buy solid dividend stocks and take advantage of market fear. Dividends on the so-called “dividend aristocrats” are likely to rise as business conditions improve. And they will. Dividends pay you to wait. Moreover, research shows that dividends constitute 70 per cent of total stock returns.
Eventually, China will expand to use up its vastly overbuilt infrastructure like entire new cities with no one to live in them, international airports with no traffic, highways to nowhere, etc. Commodities move in long cycles. The global oil glut will disappear. After all, when the price of gas tumbles, people remember the slogan of the radical sixties, “burn, baby, burn!”
You can be despondent about your portfolio or an opportunist. Consult your financial advisor, move slowly — it’s dangerous trying to catch a falling knife, after all. But don’t think the world is ending. We’ve been through much worse than this. Perspective is precious; keep it.