Ottawa Citizen ~ Global stock market gyrations reveal ’decoupling’ of economies a myth Keith Woolhouse, Citizen Special Published: Thursday, October 23, 2008

No question that these are chaotic days on global stock markets.

Not for nearly a quarter of a century have the markets experienced such turmoil. Some days we get the sizzle as equities deliver substantial gains, spurred by optimism that the approaching economic downturn may not be as severe as indicators suggest. Other days come the gut-wrenching declines.

All major benchmarks have suffered heavy losses and are firmly entrenched in bear market territory, recognized as a 20-per-cent decline off the high.

Canada’s benchmark S&P/TSX composite index opened trading today 38.7 per cent off its June 2007 high of 15,073 points.

The Dow Jones Industrial Average is down 39.8 per cent and the S&P 500 has given up 42.7 per cent.

Since Oct. 10 when it crumbled to a four-year low of 9,065 points, the benchmark S&P/TSX composite index has struggled to maintain momentum.

Prior to that, the Canadian market had crashed 29 per cent in 15 trading days, amid tumultuous selling that spread from New York to Tokyo and London.

The last time there was such a dramatic selloff was in 1987 when world markets crashed around 32 per cent in two weeks.

"The sizable decline in stocks ... reflects the growing awareness that the U.S. economy is going into a deeper and more protracted recession than expected," says BMO Capital Markets chief economist Sherry Cooper. "It is no longer seen as a housing recession, but a full-blown consumer recession. The consumer has represented as much as 72 per cent of the U.S. economy in recent years, so the deceleration in household spending has a profound impact on the overall economy."

Canada will not escape the unraveling of the American economy, she says, and that comes as no surprise. Canadians will also suffer from the wealth destruction arising from the plunge in the stock market and the slowdown in housing.

The U.S. economy is limping badly and there is an endless litany of grim news. "We have seen larger-than-expected declines in retail sales, industrial production, inflation, oil and gasoline prices and employment," says Ms. Cooper. "In the past three weeks, official as well as anecdotal evidence of a significant plunge in activity has mounted, including declines in shipping, homebuilding, auto sales, manufacturing, trucking, technology and restaurants ...

"Unemployment in the U.S. is headed to at least the seven to eight per cent range.

"While very dramatic actions have been taken by financial authorities worldwide, it will take some time before the free flow of credit emerges, and even more time until the economy recovers. It is painfully obvious that decoupling of other economies and financial markets was wishful thinking. The housing and credit bubbles have popped; and now the stock market shock is adding to consumer and business woes. The global credit crisis and economic slowdown has spread around the world."

In its "Strategic Edge -- Fall Outlook," Scotia Capital Markets reports investors are moving out of commodities in dramatic fashion for the safe havens of the defensive financial and consumer sectors. The severity of the recession, though, is up for debate. "Although we have little doubt that the world’s No. 1 economy will be hurting in coming months, we are yet to witness data pointing to a severe recession," Scotia Capital says. The firm does expect U.S. job losses to worsen and the extent of those will likely determine how deeply into the recession bites into the economy.

Richard Bernstein, Merrill Lynch chief investment strategist, says employment is the key to solving the credit crisis. U.S. and Canadian unemployment rates are at 6.1 per cent, but that percentage will likely rise as companies lay off workers to deal with the downturn.

"If one can watch only one economic indicator, it should be weekly initial jobless claims," Mr. Bernstein says. "Typically, people don’t default on their mortgages so long as they have a job. The fact that people have been defaulting on their mortgages before they lose their jobs has been a particularly disconcerting aspect to this cycle."

Falling inflation, materially slower growth and a rebounding U.S. dollar suggests that U.S. equities will lead the world for the next 12 months, predicts Scotia Capital. It is advising clients to overweight utilities and pipelines, consumer staples and discretionarys, financials and telecom sectors. It is underweighting energy and materials, and it expects that once U.S indictors bottom out, equity markets will experience a "massive rebound."

So, for now, give preference to equities over bonds with the assurance that patience over the next 12 months will bring its own reward. Barring, that is, another credit crisis or untoward economic catastrophe.

By this time next year, says Scotia Capital, the economy should have emerged out of the recession and the S&P/TSX composite index should be closing in on 12,800 points, given a forward price-to-earnings (P/E) ratio of 15.5. If Scotia’s analysts are correct, that will represent a 34 per cent increase from where the index sits today. The S&P 500 is forecast to surge around 43 per cent to 1,325 points with a 16 times forward P/E. That’s an encouraging outlook, but there will need to be further concerted action from world’s governments and central banks to overcome the considerable hurdles that lie ahead.

a© The Ottawa Citizen 2008