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opinion

Eric Lascelles is chief economist at RBC Global Asset Management.

Stock market swoons are always frightening affairs. They arrive abruptly, and it's no easy task to distinguish between garden-variety corrections and the onset of a secular bear market. A natural "recency bias" – the inclination to assume that the latest trend will persist – prods many investors toward the latter conclusion, even though the former is usually correct.

The financial market rout of the past week is primarily the result of worries over China's four-headed hydra: an equity bubble, a newly floating exchange rate, a massive debt overhang and economic weakness. The prospect of Fed tightening later this year is arguably a secondary concern.

These are legitimate worries and conceivably capable of driving markets lower. But there is nevertheless reason to think any weakness will ultimately prove temporary.

It is worth reflecting on just how aggressive a 10-per-cent stock market repricing is. It is the equivalent of concluding that one 10th of every company's future earnings stream has suddenly and forevermore vanished. Even a full-bore recession doesn't usually have an effect that corrosive.

To the contrary, global leading indicators continue to point to mediocre economic growth. The Chinese slowdown – while certainly consequential for the world – is unlikely to induce a recessionary nadir at the global level. Meanwhile, the latest bout of low interest rates and low commodity prices are both accretive to global growth.

Second, Chinese concerns warrant a more careful parsing. Recent stock market problems in the Middle Kingdom hardly matter to the rest of the world – the market is small relative to its host economy. China's stock indexes remain higher than they were in mid-2014 and mainland shares are largely domestically held. The currency story is also no great shakes given that the currency has stabilized at just 3 per cent lower against the U.S. dollar.

China's debt problems are a legitimate concern and the main reason for China's economic deceleration. Recent news of shadow-finance entities requesting government bailouts merely adds to the list of supplicants. Fortunately, the national government remains both inclined and equipped to rescue beleaguered parties. To be sure, China's economy will continue slowing, but a "soft landing" is still more likely than a crash.

Third, it is surprisingly normal for stock markets to swoon by 10 per cent or more. This happens every few years, and markets normally then reclaim the lost ground in short order. When framed in the context of the U.S. presidential cycle – a classic technical indicator – the bellwether S&P 500 usually experiences a decline very similar to this one somewhere in the year before an election, before surging back to new highs later that year.

Fourth, stock market valuations were fine before the correction took place. There is always a searing debate on this subject, given the wide range of metrics that exist, but classic measures such as the price-earnings ratio and more advanced ones such as the risk premium between stocks and bonds argue that equities are a reasonable buy.

Fifth, policy-makers generally do what they can to restore tranquility to financial markets. Chinese policy-makers almost certainly have more up their sleeves. The European Central Bank may yet do more in light of the euro's revival. Possibly most important, the Fed is now unlikely to tighten rates in September – eliminating one of the original catalysts for the stock market correction.

In the end, identifying financial market bottoms is highly imprecise, and some markets – including Canada's – may experience an especially sluggish revival due to persistently undershooting commodity prices. But with these caveats firmly in place, this looks more like a temporary correction than a permanent new trend.