Mr. Market is depressed. This does not mean Mr. Market is correct.
The recent tumble in world stock markets reflects escalating gloom about the global economy, just as record highs for the S&P 500 in mid-September demonstrated boundless enthusiasm about the outlook for the U.S. economy. There is a strong possibility that both will turn out to be emotional overreactions.
For all the reasons to worry about what lies ahead, there are corresponding arguments for optimism. In recent weeks, investors have fixated on one side of the argument – and for good reason, given the Brexit shambles and mounting U.S.-China tensions – but they should keep the other side of the debate in mind. Reasonable valuations, robust consumers (outside Canada, anyway) and supportive central banks suggest this is no time for panic.
“My personal view is that we’re taking out summertime froth in credit and earlier stock market gains but talk on the wires of recession, crisis economics and the 1930s seems absurd at this point,” Bank of Nova Scotia’s Derek Holt wrote in a note on Tuesday.
Mr. Holt points out that stocks in many major markets are reasonably priced – if not downright cheap. In Britain, for instance, shares are trading for less than 12 times their expected earnings over the next 12 months. In the United States, the equivalent figure for the S&P 500 is only 15 times. These are bargain valuations by the standards of recent history, and the same holds true in other major markets, from Toronto (less than 13 times forward earnings) to Shanghai (less than 10 times).
Income investors can find a lot to like. Many international indexes, including those in Canada, Australia, Britain, Germany and Hong Kong, now boast dividend yields in excess of 3 per cent, Mr. Holt notes. To be sure, a true international crisis – say, a no-holds-barred showdown between the United States and China over trade or a euro zone crisis sparked by Italy’s increasingly risky bonds – could endanger these lush payouts, but, for now anyway, many markets are well-supported by generous yields.
A second reason to remain calm is that household budgets in most countries look robust. In the United States, Britain, Japan and continental Europe, families are typically having to devote less of their cash flow to paying debt than they did before the financial crisis, according to Capital Economics.
“Debt and debt-service costs in advanced economies are below their precrisis peaks, and household wealth has been rising steadily in recent years,” said Franziska Palmas of the economics forecaster. “Consequently, in aggregate, we think that consumption will slow only very gradually next year, even as monetary conditions tighten and the world economy loses steam.”
To be sure, not all countries are equal in regard to household borrowing. Canada is one of five advanced economies – the others are the Netherlands, Sweden, Norway and Australia – where the cost of servicing debt eats up more than 10 per cent of families' income. A strong rise in interest rates could pressure households in these countries.
But that brings up a third reason for optimism: Central banks in Canada and elsewhere are unlikely to push their economies into recession deliberately.
Recent trends in bond and futures markets suggest further rate hikes are likely to be tame, gradual affairs. For instance, the yield on benchmark 10-year U.S. government bonds has declined from 3.24 per cent earlier this month to about 3.05 per cent on Tuesday – not the reaction you would expect if markets were bracing themselves for substantially higher rates in 2019.
If central banks hold their fire, the current anxiety in global stock markets may well dissipate. But what could go wrong?
The most obvious candidate is a geopolitical disaster. U.S.-China trade talks, euro zone negotiations over Italy’s free-spending ways and the risk of a no-deal Brexit provide lots of potential flash points. If you want to avoid possible turbulence, by all means take shelter from those potential catastrophes.
But nobody can predict such events. Patient investors, who can ride out the current storm, may instead want to take advantage of today’s reasonable valuations and generous dividend yields to hunt for potential buys among companies that are insulated from the turmoil. Canadian utilities and energy stocks have both suffered over the past 12 months and are among the sectors you should examine.