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The bull markets – in housing prices, equities, bonds, all of it – are going to end, and the aftermath will be financially painful for Canadian investors. The question is: when?

Thanks in part to unprecedented global monetary stimulus by central banks, investors have enjoyed the longest equity bull market in history. The S&P/TSX Composite Index is higher by 185 per cent from March 9, 2009 and the S&P 500 has appreciated 424 per cent in U.S. dollar terms. Ultra-low Canadian interest rates have helped push national housing prices higher by 84 per cent during the same time frame.

Brokers I worked with in the past were fond of reminding clients that previous strong growth can’t be extrapolated into the future forever.

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It’s also true, however, that market tops are much more difficult to pinpoint than market bottoms.

What follows is a guide comprising 10 things to help you assess how close we may be to the inevitable end to the major bull markets we find ourselves in today.

**

Retail sales vs. housing prices

Canada retail sales year-over-year

percentage change

Teranet-National Bank House Price Index

Composite 11, year-over-year

percentage change

20%

15

10

5

0

-5

-10

2010

2012

2014

2016

2018

THE GLOBE AND MAIL, SOURCE: BLOOMBERG

Retail sales vs. housing prices

Canada retail sales year-over-year percentage change

Teranet-National Bank House Price Index Composite 11,

year-over-year percentage change

20%

15

10

5

0

-5

-10

‘09

‘10

‘11

‘12

‘13

‘14

‘15

‘16

‘17

‘18

THE GLOBE AND MAIL, SOURCE: BLOOMBERG

Retail sales vs. housing prices

Canada retail sales year-over-year percentage change

Teranet-National Bank House Price Index Composite 11,

year-over-year percentage change

20%

15

10

5

0

-5

-10

‘09

‘10

‘11

‘12

‘13

‘14

‘15

‘16

‘17

‘18

THE GLOBE AND MAIL, SOURCE: BLOOMBERG

1. The interaction between retail spending and housing prices, shown in the first chart, is what I think is the most important economic indicator for Canadians. A sharp decline in spending growth would form a warning that high household debt levels have started biting Canadians’ financial health, and threaten the outlook for the domestic economy.

Because mortgage payments are not optional, and a percentage of consumer spending is, an increase in the number of Canadians struggling with high debt levels will first become evident in weaker-than-expected consumption data.

The retail spending data gained even more significance after Goldman Sachs economist Jan Hatzius noted that Canada, along with Britain, has fallen into a spending deficit whereby total income has fallen below spending levels. For Mr. Hatzius, this ratio is a better indicator of economic crisis than the trade deficit.

The data show retail spending levels that are mediocre relative to recent history, but not at negative levels that might warn of a housing correction. The expansion in retail estate prices has clearly slowed significantly.

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**

Industrial metals vs.

manufacturing growth

S&P GSCI Industrial Metals Index

year-over-year percentage change

JPMorgan Global Manufacturing PMI

year-over-year percentage change (right scale)

50%

8%

40

6

30

4

20

2

10

0

0

-10

-2

-20

-4

-30

-40

-6

2014

2015

2016

2017

2018

THE GLOBE AND MAIL, SOURCE: BLOOMBERG

Industrial metals vs. manufacturing growth

S&P GSCI Industrial Metals Index year-over-year

percentage change

JPMorgan Global Manufacturing PMI year-over-year

percentage change (right scale)

50%

8%

40

6

30

4

20

2

10

0

0

-10

-2

-20

-4

-30

-40

-6

2014

2015

2016

2017

2018

THE GLOBE AND MAIL, SOURCE: BLOOMBERG

Industrial metals vs. manufacturing growth

S&P GSCI Industrial Metals Index year-over-year percentage change

JPMorgan Global Manufacturing PMI year-over-year percentage change (right scale)

50%

8%

40

6

30

4

20

2

10

0

0

-10

-2

-20

-4

-30

-40

-6

2014

2015

2016

2017

2018

THE GLOBE AND MAIL, SOURCE: BLOOMBERG

2. The recent weakness in industrial metals prices and mining stocks is entirely justified by slowing growth in global manufacturing activity. The evidence is to be found in Chart 2, illustrating the close relationship between the year-over-year change in the S&P GSCI Industrial Metals index and the annual change in the JPMorgan Global Manufacturing PMI (a survey of major manufacturing executives across the world).

The rate of change in global manufacturing activity, while still healthy, has been deteriorating since March of 2017. At that point, the JPMorgan index of worldwide manufacturing levels was higher by 6 per cent relative to 12 months earlier, but the most recent results for July saw no annual change in growth.

The decline in the pace of manufacturing growth has reduced demand for base metals. This trend goes a long way in explaining why the copper price has fallen 17 per cent since June 7, 2018.

**

Loonie vs. bond yield spread

CADUSD

Two-year spread: two-year Government

of Canada bond yield minus two-year U.S.

Treasury yield (right scale)

$1.10

1.5

1.05

1.00

1.0

0.95

0.90

0.5

0.85

0.80

0

0.75

0.70

-0.5

0.65

0.60

-1.0

‘10

‘12

‘14

‘16

‘18

THE GLOBE AND MAIL, SOURCE: BLOOMBERG

Loonie vs. bond yield spread

CADUSD

Two-year spread: two-year Government of Canada bond

yield minus two-year U.S. Treasury yield (right scale)

$1.10

1.5

1.05

1.00

1.0

0.95

0.90

0.5

0.85

0.80

0

0.75

0.70

-0.5

0.65

0.60

-1.0

‘09

‘10

‘11

‘12

‘13

‘14

‘15

‘16

‘17

‘18

THE GLOBE AND MAIL, SOURCE: BLOOMBERG

Loonie vs. bond yield spread

CADUSD

Two-year spread: two-year Government of Canada bond

yield minus two-year U.S. Treasury yield (right scale)

$1.10

1.5

1.05

1.00

1.0

0.95

0.90

0.5

0.85

0.80

0

0.75

0.70

-0.5

0.65

0.60

-1.0

‘09

‘10

‘11

‘12

‘13

‘14

‘15

‘16

‘17

‘18

THE GLOBE AND MAIL, SOURCE: BLOOMBERG

3. For the most part, the value of the Canadian dollar will be determined by the U.S. Federal Reserve. Relative bond yields – specifically the Government of Canada two-year bond yield minus the two-year U.S. Treasury bond yield – have been driving the loonie price for the past number of years, more so than the oil price.

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The Fed and the Bank of Canada are in the midst of a tightening cycle – steadily raising interest rates – and this is pushing two-year bond yields higher on both sides of the border. Bank of Canada Governor Stephen Poloz has sounded a more cautious tone on rate hikes in recent weeks, so if the Fed continues with a faster pace of rate increases, this is likely to push the loonie lower.

**

Central banks vs. global equity prices

Total central bank asset purchases

(US$, billions)

Estimated central bank asset purchases

(US$, billions)

MSCI World Index three-month percentage

change (right scale)

$300

60%

250

40

200

20

150

0

100

-20

50

-40

0

-50

-60

2010

2012

2014

2016

2018

2020

THE GLOBE AND MAIL, SOURCE: CITIGROUP

Central banks vs. global equity prices

Total central bank asset purchases (US$, billions)

Estimated central bank asset purchases (US$, billions)

MSCI World Index three-month

percentage change (right scale)

$300

60%

250

40

200

20

150

0

100

-20

50

-40

0

-50

-60

‘09

’10

‘11

‘12

‘13

‘14

‘15

‘16

‘17

‘18

‘19

‘20

THE GLOBE AND MAIL, SOURCE: CITIGROUP

Central banks vs. global equity prices

Total central bank asset purchases (US$, billions)

Estimated central bank asset purchases (US$, billions)

MSCI World Index three-month percentage change (right scale)

$300

60%

250

40

200

20

150

0

100

-20

50

-40

0

-50

-60

‘09

’10

‘11

‘12

‘13

‘14

‘15

‘16

‘17

‘18

‘19

‘20

THE GLOBE AND MAIL, SOURCE: CITIGROUP

4. Global equity markets, including the S&P/TSX Composite, have benefited tremendously from central bank policies of low rates and monetary stimulus. The world’s major central banks are now moving in the opposite direction – tightening monetary conditions and raising rates – and there’s a distinct risk that some of the market gains of the post-crisis rally will be retraced.

Citigroup Inc. credit strategist Matt King was among the first analysts to recognize the correlation between central bank stimulus and global equity prices. In the fourth chart, Mr. King shows that the performance of the MSCI World Index has closely tracked the level of open market purchases by central banks. If this pattern holds, it doesn’t bode well for equity returns in the coming years.

**

Eye on high-yield bond spreads

S&P 500

Merrill Lynch U.S. High Yield Master II

Option-Adjusted Spread (right scale)

3,500

25%

3,000

20

2,500

15

2,000

1,500

10

1,000

5

500

0

0

1998

2002

2006

2010

2014

2018

THE GLOBE AND MAIL, SOURCE: BLOOMBERG

Eye on high-yield bond spreads

S&P 500

Merrill Lynch U.S. High Yield Master II

Option-Adjusted Spread (right scale)

3,500

25%

3,000

20

2,500

15

2,000

1,500

10

1,000

5

500

0

0

‘98

‘00

‘02

‘04

‘06

‘08

‘10

‘12

‘14

‘16

‘18

THE GLOBE AND MAIL, SOURCE: BLOOMBERG

Eye on high-yield bond spreads

S&P 500

Merrill Lynch U.S. High Yield Master II Option-Adjusted Spread (right scale)

3,500

25%

3,000

20

2,500

15

2,000

1,500

10

1,000

5

500

0

0

‘98

‘00

‘02

‘04

‘06

‘08

‘10

‘12

‘14

‘16

‘18

THE GLOBE AND MAIL, SOURCE: BLOOMBERG

5. High-yield bond spreads – the difference between junk bond yields and U.S. Treasury bond yields – will be the key signal that the market rally is over and a bear market is set to begin.

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In a research report published in May, highly respected Credit Suisse Group market strategist Andrew Garthwaite pointed out that credit spreads widened ahead of a peak in equities on eight out of past nine occasions, with an average lead of about seven months.

Chart 5 shows the long-term history of the high-yield bond spread and the S&P 500. Currently, there is little to worry about because spreads are stable. The circled areas in the chart, however, show that rising junk-bond spreads signalled U.S. equity market peaks before the tech bubble collapsed in 2000, and also before the financial crisis.

**

Five more things important to ponder

6. We might, and I emphasize might, get a “blow-off top” – a big aggressive rally to end the cycle, such as what we saw in 1998-99 – before this bull market is done. Central banks are tightening monetary conditions, but a decade of easy money has left a lot of investment assets chasing returns. In the late 1990s, investor assets became concentrated in a few technology and telecom stocks, which drove the Nasdaq higher by 86 per cent in 1999 alone before the painful end of the dot-com rally in early 2000.

The same seeds have been sown in markets now. If the CBOE Volatility Index starts rising along with equities, as it did in the late 1990s, this scenario becomes more likely.

**

7. Even if the housing market rally is close to its conclusion, domestic bank stocks may do just fine. A Moody’s report published earlier in August concluded that major Canadian bank balance sheets could withstand an apocalyptic 35-per-cent decline in housing prices and a jump in mortgage defaults to 11 per cent. This doesn’t mean that bank stock prices will continue their inexorable rise, but fears of a serious domestic financial crisis appear far-fetched.

**

8. I think it would be healthy if technology investment shifted from consumer and entertainment applications and back to enterprise-driven spending. Online shopping is great, but social media and gaming have been generally detrimental to the kind of economic productivity growth that increases broad living standards.

Cloud computing and some elements of artificial intelligence are examples of technology subsectors that can increase productivity levels. But there will be pain along with fundamental productivity gains: If investment rotates from consumer-oriented to enterprise tech, this will likely result in S&P 500 weakness. The benchmark’s recent returns have been dominated by mega-cap FAANG stocks, which would be supplanted as the sector’s performance leaders.

**

9. I think the biggest risk to global equity portfolios is the possibility of a financial meltdown in China, and that Canadian investors underappreciated this threat. It’s true that pundits have been predicting debt-related economic struggles for China for years and been wrong – local officials have managed to stick-handle their way through brief bouts of volatility. There are no signs of imminent crisis in the Chinese economy or I would have ranked this risk much higher in the list.

The sheer scale of credit growth in China in the past decade, however, combined with inefficient infrastructure investment and poor financial regulation, increases the potential for a major economic catastrophe. A Chinese economic crisis is not assured by any stretch, but it would be devastating for many Canadian portfolios. The country’s rapid development has helped global GDP growth immensely – assisting the many cyclical companies in the S&P/TSX Composite that are highly sensitive to global growth – and China remains responsible for close to half of the world’s demand for many major commodities.

10. Finally, even if the final stage of the rallies is likely to look like the late 1990s, there are two other historical market precedents that could repeat themselves in some form.

The first alternative is the “Japan scenario,” where all signs of accelerating economic growth fade quickly and are replaced by conditions characterized by low interest rates and mediocre GDP expansion, as hit Japan beginning in the early 1990s. Demographic forces are the strongest force in this direction.

The second alternative scenario is the most optimistic option. A synchronized global economic expansion could occur, providing broad-based earnings growth across industry sectors. In this event, value investors will finally have their patience rewarded, as the lowest priced equities will perform best.

Scott Barlow, Globe Investor’s in-house market strategist, writes exclusively for our subscribers at Inside the Market.

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