As we entered September, investors were focused on the September meeting of the U.S. Federal Reserve’s Open Market Committee. The consensus was that this meeting would be when the Fed chair Ben Bernanke finally announced that they would begin to slow the pace of their massive bond buying program, signaling the beginning of the end for low interest rates. Traders were widely expecting a cut of between $10 billion and $20 billion per month.
Then, Mr. Bernanke did the unthinkable and did not announce any tapering. The results were almost immediate, pushing equity markets higher, and bond yields lower. This should provide some idea of what is really driving markets these days – liquidity. It is certainly not economic fundamentals, because if it were, then we likely would have seen a selloff when no tapering announcement was made.
The Fed having to taper their bond purchases is an indication that the economy is on the right track. Instead, by not tapering, they are effectively saying that the economic recovery is not strong enough to sustain itself without the aid of monetary stimulus. Others point out that Mr. Bernanke may have not pulled the taper trigger this time around for fear of the economic fallout of the government shutdown and debt ceiling negotiations.
Regardless, markets rejoiced. Global markets were all sharply higher. The S&P 500 gained more than 3% in U.S. dollar terms, while the MSCI EAFEW Index shot up by more than 7%. Europe and Asia were also strong with the MSCI Europe Index gaining 7.2% and the MSCI Pacific Index up nearly 8% in U.S. dollar terms. Unfortunately for Canadian investors, the loonie gained against the U.S. greenback, muting returns in Canadian dollar terms.
Gold was pummeled, with the S&P/TSX Global Gold Index losing 11.5%. This was no doubt a contributor to the lackluster returns of the Canadian markets, with the S&P/TSX Composite Index gaining 1.4% in the month.
As I write this, the U.S. government remains mired in a shutdown and traders remain optimistic that a deal can be reached before October 17th that would avert the U.S. defaulting on its debt obligations, something that has been weighing heavily on the minds of traders and investors around the world. If the U.S. defaults, some are predicting a major global financial crisis. Perhaps I’m being naïve, but I remain optimistic that a deal will be reached. I believe that U.S. lawmakers will realize that the potential implications are far too important to let it happen. Let’s hope cooler heads prevail.
Even with the current crisis, my investment outlook remains consistent from last month. Mid to long term, I favour equities over bonds because with a longer term bias towards higher interest rates, the return expectations for fixed income remain under pressure. Still, there remains the potential for a continued short term rally in bonds. Within fixed income, I continue to favour shorter durations over long, corporate bonds over governments, and where possible, high quality global bond exposure. These strategies should help to minimize the impact of rising rates.
Within equities, I continue to favour the U.S., but am starting to warm up to global, large cap names in Europe, although valuations may be getting ahead of fundamentals at the moment. Canadian equities should remain volatile, and may be prone to a drop if we see a sustained pullback in gold or oil. There are also some concerns about the earnings outlook for banks, particularly if we see any sort of pullback in the Canadian housing market.
In this environment, I favour actively managed funds over those that look like the index. This is true of both equity and fixed income funds. I firmly believe that if you stick with high quality funds, managed by strong managers with disciplined processes in place, you should be able to withstand the volatility better than with a more passive strategy.