Skip to main content
Open this photo in gallery:

With recessionary red flags waving, how should investors approach the rest of the year?Sébastien Thibault/Sébastien Thibault

The first two-thirds of the year had all the conditions for a stock-market bloodbath. But investors have barely been scraped.

Consider all that was thrown at investors so far in 2019. The breakdown of trade relations between the world’s two largest economic powers escalated into an all-out tariff war. Europe approached the brink of recession. Sovereign bond yields sank back toward historic lows, lifting the sum total of bonds trading at negative yields to nearly US$17-trillion globally. Key yield curves inverted for the first time since before the global financial crisis. Manufacturing activity contracted across the G7 countries. And the U.S. corporate sector swung toward a recession in profits, with third-quarter earnings expected to decline from last year.

But the stock market has been resilient. In fact, one of the best calendar years for equity returns since the global financial crisis is shaping up in the United States and Canada. The S&P 500 index is up by 16.7 per cent year to date, while the S&P/TSX Composite Index has risen by 14.8 per cent.

Rosenberg, Belski, Lascelles and four other market pros reveal their best advice for investing in the rest of 2019

Rob Carrick: If stock markets plunge this fall, these websites can help you cope with the carnage

To be fair, an ugly global sell-off that bottomed out on Christmas Eve, 2018, made for some easy early gains as stock markets recouped their losses. Still, major U.S. and Canadian indexes are just a few good days away from setting record highs, despite a chaotic geopolitical backdrop and mounting recessionary red flags.

The stock market’s strength suggests confidence that the growth outlook will improve in the fall, and beyond. The bond market is telling an entirely different story.

The latest bad omen to come out of the bond market was the sinking of 10-year yield below the two-year yield on U.S. Treasuries two weeks ago – an important predictor of economic strain.

And with that, “the countdown has begun,” Canaccord Genuity’s chief market strategist Tony Dwyer said in a research note. It’s only a matter of time before a U.S. recession and bear market in stocks, he said. And where the United States goes, in economic and financial matters at least, Canada is sure to follow.

Whether that happens soon, or two years from now, depends in large part on how the trade war unfolds, with more than US$700-billion in two-way trade already subjected to import charges.

The global toll of those competing tariffs is growing, with trade-sensitive economies like Germany struggling to tread water, while the global manufacturing slump already qualifies as an “industrial recession,” Mr. Dwyer said.

The U.S. economy itself is insulated somewhat from the direct effects of the trade dispute by its colossal domestic consumer sector, which is spending more than US$14-trillion annually, accounting for nearly 70 per cent of the country’s GDP.

But trade uncertainty also tends to have a dampening effect on individual businesses when deciding on levels of capital spending, investment and hiring. A recent Bloomberg Economics report forecast the indirect costs of the trade war at US$585-billion globally in 2021.

“If it escalates further, it's definitely going to reduce economic activity, it's going to increase difficulties for companies to have efficient supply chains, it's going to take prices up,” said David Sykes, head of TD Asset Management's fundamental equities team.

The stock market, meanwhile, is obviously attuned to the vagaries of the trade dispute, with the suggestion of new negotiations sparking a strong rally in stocks this week. But that goodwill could be quickly undone with a single tweet, as investors are well aware by now. U.S. President Donald Trump’s latest outburst about a week ago, when he “ordered” American companies “to immediately start looking for an alternative to China,” set off a volatile trading session that saw the Dow Jones Industrial Average decline by 623 points.

On one hand, a looming presidential election means Mr. Trump can little afford any significant economic setback or major market dislocation before next November, lest the average Trump supporter begin to doubt that America has been made great again.

On the other hand, Mr. Trump seems to be fighting a long war designed to exact more favourable trade terms and slow China’s economic rise, making a swift and tidy resolution unlikely.

In the absence of trade progress, the spreading fallout from tariffs runs the risk of provoking another growth scare in the stock market, putting another potential correction firmly on the table.

“Markets are just hypersensitive to the headlines around trade at the moment,” said Craig Fehr, a markets strategist at Edward Jones.

As a result, the remainder of the year could be a wild one for equity prices. “But I think the economic data will assuage some of those concerns in the market,” Mr. Fehr said.

The U.S. labour market is still booming, providing jobs for nearly every American that wants one, which is crucial in supporting consumer spending.

And lately, the broad deterioration in global economic readings has shown at least the hint of a reversal. Manufacturing indicators in Canada, Japan, and the euro zone ticked up in the latest month, for example.

“It remains to be seen whether this tentative revival represents an important inflection point emboldened by central bank stimulus, or is instead just the latest blip along the path of decelerating growth,” Eric Lascelles, chief economist at RBC Global Asset Management, said in a note.

“It is more likely the latter, but would be enormously consequential if it proves to be the former.”

It is often said that stock markets “climb a wall of worry,” using temporary impediments as stepping stones to greater heights. There is much to worry about in the months ahead.

The trade war crisis

The developed world is currently mired in its third global industrial slowdown of the economic expansion that started a decade ago, Mr. Dwyer said.

The first coincided with the European sovereign debt crisis in 2011-12, while the second was brought on by plummeting commodity prices and faltering emerging market economies in 2015-16. “Now we have the Trade War Crisis in 2018-19,” Mr. Dwyer said.

The composite leading indicator of the Organization for Economic Co-operation and Development, considered a strong predictor of turning points in the global economy, has fallen every month over the past year.

In its latest world economic outlook, the International Monetary Fund partly blamed trade tensions for weakening industrial activity.

“Business sentiment and surveys of purchasing managers, for example, point to a weak outlook for manufacturing and trade, with particularly pessimistic views on new orders,” the IMF said.

It’s possible for a manufacturing recession to precede a general economic recession, and there’s a strong historical precedent for just that.

But the U.S. economy isn’t dominated by factory output, as it once was, with manufacturing accounting for around 12 per cent of GDP.

“The real U.S. economy – the companies, households, local governments – we don't see excesses there that might be precursors to a recession,” said Kent Shepherd, a portfolio manager at Franklin Templeton.

Each of the two prior industrial slowdowns were also accompanied by bear markets in equities, which is conventionally defined as a 20-per-cent decline in broad market indexes.

It could be argued that investors have already endured a bear market this time around. Last fall, the S&P 500 index declined by 19.8 per cent. “Close enough in our book,” Mr. Dwyer said.

If the requisite stock market pain of the manufacturing slide has already been felt, and if early signs of stabilization in the global economy mount in the coming months, then it is likely to be an ascendant autumn for equities.

There is (still) no alternative

Over the past decade, investors have had little choice but to invest in stocks. Rock-bottom interest rates have made investing in bonds an unrewarding exercise for income-seeking investors.

Nearly US$17-trillion worth of sovereign bonds is now trading at negative yields, meaning investors receive less at maturity than what they initially put in.

The stock market has become a haven for income investors orphaned by the bond market, with 30-year Treasury yields dipping below the dividend yield on the S&P 500 index last week for the first time in a decade.

The dividend-heavy TSX, meanwhile, has long been more generous than the safest long-term bonds. The S&P/TSX Composite Index has a 3.1-per-cent dividend yield, which is more than double the yield on 30-year Government of Canada bonds.

“As long as bond yields stay reasonably low, stocks will continue to climb the proverbial wall of worry,” Peter Berezin, chief global strategist at Montreal-based BCA Research, wrote in a recent report.

One key worry equity investors will need to climb past is the earnings outlook.

Slowing economy activity has increasingly weighed on corporate profitability over the last year. Last October, the forecast for third-quarter 2019 profit growth for the S&P 500 was 12.1 per cent, according to Refinitiv data. That estimate has since declined to minus 1.9 per cent. “The earnings recession has arrived,” David Rosenberg, chief economist at Gluskin Sheff + Associates Inc., wrote in a newsletter.

Canadian earnings have also weakened, with third-quarter S&P/TSX profits forecast to shrink by 2.8 per cent over the prior year.

The outlook for U.S. earnings depends in large measure on how the trade war plays out in the coming months. Renewed tensions would make it difficult for the corporate sector to rebound.

“But if we have seen the worst of the trade dispute, then I'm confident in earnings growing 4 or 5 per cent,” Mr. Sykes said.

Meanwhile, in Canada

It will be a busy fall on the home front.

The federal election, taking place on Oct. 21, will be an important one for the oil patch, which remains stuck in a sector-wide depression.

Investors both foreign and domestic have largely abandoned the Canadian energy sector. Exploration and production stocks are trading close to record lows, down 75 per cent from their 2011 peak, as a group.

It’s no secret there is widespread discontent with the federal Liberal government in the oil patch and a Conservative Party victory would likely be received well by energy investors.

Outside of the oil patch, however, the domestic economy seems to be emerging from its soft patch relatively intact. Second-quarter GDP growth of 3.7 per cent was the highest in two years, with the improvement fuelled by strength in exports and residential investment.

“While some overseas economies are teetering on the edge of recession, Canada just posted a growth rate miles above potential,” Royce Mendes, senior economist at Canadian Imperial Bank of Commerce, said in a note.

That growth may prove to be strongest of the G7, which could, in turn, delay the next Bank of Canada rate cut. The market is currently expecting a cut by October.

“Unless the trade conflict between the United States and China escalates further, there is no need for monetary stimulus in Canada,” wrote Matthieu Arseneau, deputy chief economist for National Bank Financial.

Canadian equities have largely kept pace with the global updraft that kicked off the year, as well as the holding pattern that has kept markets flat for roughly the last five months.

The fate of Canadian equities in months ahead, like markets everywhere, hinges in large part on the course of the trade relationship between two particular superpowers.

Follow related authors and topics

Authors and topics you follow will be added to your personal news feed in Following.

Interact with The Globe