Investment Watch

20 April 2015, written by iadmag

Recent gains may be creating an unrealistically rosy picture, given the current volatility of many markets. Are we all living in a fool’s paradise, with the price of most financial and real estate assets far higher than the worrisome backdrop justifies? As we approach tax time, let’s recall the performance of last year and look forward to the next 12 months.

Unless you have invested a lot of money in energy or gold, you should have been on a roll in recent times. In 2014, the S&P 500 Index advanced 11.4 per cent, while the S&P/TSX Composite Index rose 7.4 per cent, both after stellar performances in 2013. That’s spectacular performance now that inflation is minimal, and gives credence to French economist Thomas Piketty’s thesis that returns on capital in advanced economies are typically greater than the rate of growth. Last year, the U.S. S&P/Case-Shiller 20-City Composite Home Price Index gained 4.5 per cent, while the Canadian Real Estate Association’s MLS Home Price Index rose 5.4 per cent. Not bad at all.
But can these sorts of gains continue in light of the extraordinary volatility in many markets, particularly currency and commodity markets, and the plain fact that the U.S. economy is the only major economy that shows real strength? Astonishingly, the world has yet to recover fully from the devastating global recession of 2008-09. So what is going on?

I see three major themes at work that investors need to watch carefully.

First, there’s not the traditional worry about inflation, but a greater worry about deflation, a downward spiral of falling prices and weak demand, which can produce real interest rates of zero or even negative rates. Think of Japan since 1990 and consider how badly that advanced, innovative economy has done. It would actually be a good thing if the Federal Reserve finally raised rates because it would be proof that the world’s most important central bank feels that the world’s most important economy is on a healthy,
upward trajectory.

Deflation is particularly a worry in Europe. A key event missed by many North Americans was the landmark decision in late January by European Central Bank president Mario Draghi to belatedly follow the Federal Reserve Board’s example of “quantitative easing” by promising to buy 60 billion euros’ worth of bonds a month until at least September 2016. The goal is to stimulate growth in Europe and get largely dormant inflation back up to close to the 2 per cent target.

The decision is living proof that the multi-year European recession is far from over. As the Germans fear, it will take the pressure off countries to act with greater fiscal prudence. And once the stimulus ends, there could be a nasty reaction from the markets, given that officials will have played the very last card in the deck in an attempt to breathe life into a stumbling economy.

The second key theme is the 50 per cent plunge in the price of oil from its peak of US$110 a barrel in the middle of last year, yet another event that no one anticipated. The problem is a huge oversupply, so investors should not expect a return to much higher prices anytime soon. Energy expert Daniel Yergin, vice-chair of research firm IHS, says the price plunge “could mean a $1.5-to-$2-trillion US transfer from oil-exporting countries to oil-importing countries.” Thus the U.S., China, Japan and India gain while Canada loses overall, since energy stocks make up more than 20 per cent of the TSX.

The third major consideration is geopolitics, with Russian President Vladimir Putin and terrorism at the top of most experts’ list of fears. Both concerns are already being born out. Quite apart from the human cost, terrorism increases uncertainty and can paralyze decision-making. The aggression of Putin, who seemingly is trying to recreate an imperial Russia, is significant because Russia is critically important to Europe, both as an energy supplier and as a trading partner.

Finally, in such a vulnerable, volatile environment, there is a very real possibility that a rogue element will upset the entire apple cart. Greece, a speck on any economic map, is a good candidate. It might, for example, decide to leave the eurozone, perhaps prompting others to do the same. It is worth remembering that the 1997 Asian financial crisis was triggered by a crisis in economically tiny Thailand, where there were problems with the baht, a denomination most investors had never heard of.

In summary, while we are not all living in a fool’s paradise, there are worrisome economic, financial and geopolitical risks at play in the world today. In my view, prudent investors should keep their powder dry. Make sure your financial and real estate assets have a measured level of risk, and keep enough cash on hand for emergencies or for buying opportunities. It is not a climate in which to roll the dice.

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