Global markets roar back but investors still wary

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The markets' mercurial tendencies were on full exhibition this week in both directions, first dragging global stocks into a bear market before snapping back to end the week on a resurgence of risk assets.

In certain respects, all that sound and fury signified nothing. The Dow Jones industrial average ended the week near where it began, after a gut-wrenching round trip of roughly 600 points.

But other parts of the market made real gains, giving at least a temporary reprieve to the hasty descent that has dominated financial markets so far this year. Canadian stocks rallied by 7 per cent off a three-and-a-half-year low hit on Wednesday, the Canadian dollar gained 3 cents (U.S.) over that time to approach 71 cents, and crude oil soared by 22 per cent.

Few sensible investors, however, would trust this two-day revival.

"I wouldn't go so far as to say we've seen the bottom. I think there's more volatility to come," said Craig Fehr, an investment strategist at Edward Jones. "This is an emotion-driven market."

Just three weeks into the new year, a toxic blend of fears has seen investors worldwide renounce risk and retreat to safety, a rotation that obliterated $15-trillion in global equity value in just a dozen days of trading.

"What's characterized the markets so far in 2016 has been a laser focus on the risks, with almost no attention being paid to anything beyond oil and China," Mr. Fehr said.

Stock and bond markets assumed levels of panic that seemed to indicate dire financial conditions looming. And yet there does not seem to be evidence of any severe economic strains, at least in the United States.

"None of the data we've seen support the depths to which the market has gone," said Aaron Kohli, a fixed-income strategist at BMO Nesbitt Burns. Credit spreads, for example, have risen to levels historically associated with recessions.

The sell-off in U.S. high-yield securities has been under way for several months. The SPDR Barclays High Yield Bond ETF, which is considered one of the proxies for the performance of the high-yield market, has sunk to its lowest level since 2009, hitting a low on Wednesday at 20 per cent below its 52-week peak.

The credit sell-off has also consumed much of the investment-grade market, pushing spreads against comparable medium-term government bonds in both the U.S. and Canada to the high-100s in basis points, said Tom O'Gorman, director of fixed income at Franklin Bissett Investment Management.

"At 200, that's where you start pounding the table," he said.

The financial crisis of 2008-09 still casts a long shadow, and some investors have begun to consider whether markets are on the verge of something comparable.

But this is not 2008, Mr. O'Gorman said.

"In 2008-09, there was no financing for anyone, including the banks, when we started to question them as a going concern," he said.

"This isn't about the banks; this is about energy."

A puzzling element of the stark decline of investor sentiment has been the crash of energy prices as one apparent root cause. But cheap oil is historically positive for global growth, as it benefits oil-importing countries, energy-intensive industries and households.

Mr. Fehr said he suspects global markets are taking cues from oil for what it might say about the Chinese economy and, by extension, the global economy.

Crude prices have been suppressed not only by a persistent oversupply, but also by demand pressures, as expectations for global growth have been pared back.

"This is being seen as a harbinger of something worse to come on the demand side," Mr. Fehr said.

But even if crude oil at 13-year lows reflects, in part, grave concern for China's growth, economic readings show no sign of anything other than a slowdown.

"A collapse of growth in China would indeed be a world-changing event," Olivier Blanchard, former chief economist of the International Monetary Fund, recently wrote. "But there is just no evidence of such a collapse."

Meanwhile, on the equity side, strategists at both Morgan Stanley and Merrill Lynch said the market is pricing in about a 50-per-cent chance of a U.S. recession. The stock markets also seem to be far more pessimistic than the evidence would suggest is appropriate.

"Anything with risk, a cyclical label attached to it, or not correlated with the deflation theme had become more oversold than at any other time since the Great Recession ended in mid-2009," David Rosenberg, chief economist with Gluskin Sheff + Associates Inc., said in his daily newsletter on Friday.

"There may be extremely high levels of fragility across the planet from an economic, financial and political standpoint, but … the world has not changed even a fraction of what the markets seem to be pricing in during this year's head-spinning decline," Mr. Rosenberg said.

Correlations have suddenly become very high, meaning different markets and sectors are moving in tandem, even those that might be positively exposed to falling oil prices.

"Behaviour can be very lemming-like on the fear side," Mr. O'Gorman said.

In such an episode of volatility and risk-aversion, absent a comparably severe catalyst, a shift in sentiment back to the upside can be elusive and tenuous, Mr. Kohli said.

"We've seen two days of a bounce, but I'm not convinced that's suggestive of any real change in the tone of markets," he said. "When that comes, I think it will be much more gradual; it won't be a spectacular 5-per-cent-a-day move."