Double threat: Why stock markets could go to hell in a handcart

Briefing highlights

• Stock markets face threats
• A B.C. scene I’d love to see
• Stocks, loonie, oil at a glance
• Brexit developments sink pound
• U.S. factory sector contracts
• Crescent Point sells assets
• Air Canada challenges WestJet deal

Two issues threaten to send stock markets to hell in a handcart as summer vacations end and investors look toward the rest of the year.

The first is what the bond market suggests as yield curves invert. The second is the U.S.-China trade war, truce or no truce.

This comes after several days of turmoil as markets reeled and then recovered with the twists and turns in the Washington-Beijing tariff spat.

Investors rejoiced Friday, the last trading day of August and almost the end of summer for most of us, as China signalled a ceasefire.

"With no major updates on the trade war, investors will wait and see if September will see any de-escalations with tariffs as we start to see the economic pain be passed onto the U.S. consumer," said Oanda senior market analyst Edward Moya.

"Time is running out on President Trump to secure a trade deal and possibly delay a U.S. recession further into 2021."

Here's a look at the two threats:

The bond market

"Yield curves have inverted in most advanced economies over the past couple of weeks, including in the U.S., Germany and the U.K., sparking fears of an imminent global recession," said markets economist Simona Gambarini of Capital Economics in London.

"While most advanced economies will just avoid falling in a recession in our view, the recent inversions don’t bode well for stock markets in the U.S. and elsewhere."

Ms. Gambarini was referring in a report last week to a fear that has sparked a lot of buzz of late, that yield curve inversions can signal recessions.

A yield curve inverts when longer-term rates fall below those of shorter terms. And, as Ms. Gambarini noted, economic slumps have oft followed such inversions in the U.S.

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“Indeed, staff at the [Federal Reserve] have developed a model to estimate the probability of the U.S. economy being in a recession in 12 months’ time based on the prevailing slope of the 10-year/three-month Treasury curve,” Ms. Gambarini said.

"The model has correctly 'predicted' all of the eight U.S. recessions since 1959, with only one false positive in 1966," she added.

"It is currently assigning a probability of about 37 per cent that the U.S. will be in a recession in 12 months’ time – the highest since the global financial crisis."

The same has not held true for inversions in Germany and Britain, though their stock indexes, the DAX and FTSE, respectively, have fared poorly after such events in the U.S., Ms. Gambarini said.

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"This partly reflects the high degree of integration between those financial markets," she added.

"But also the fact that companies in the DAX 30 and FTSE 100 generate a large share of their revenues abroad, including in the U.S."

So get ready because she and her colleagues "expect the S&P 500, the DAX 30 and the FTSE 100 to end 2019 much lower than they are now," Ms. Gambarini said.

"Our end-year forecasts for those indices are 2,500, 11,250 and 6,800, which equate to drops of 5 per cent to 15 per cent from current levels," she added.

"This is partly tied to our view that the U.S. economy will slow further and that growth in the rest of the world will remain subdued."

Capital Economics did not look at how U.S. yield inversions have affected the Toronto stock market, but the group projects the S&P/TSX Composite Index will sink to end the year at 15,000.

The trade war

There’s no Fed model for this one.

"There's always that nagging doubt," said CMC Markets chief analyst Michael Hewson, "that we're only a presidential tweet away from another sharp selloff."

There is now a "fragile truce," as Mr. Hewson put it, with the two sides planning further talks, which is what sparked last week's optimistic trading finish.

But, really, we've been here so many times before that it would be ridiculous to count on anything.

Oanda's Mr. Moya, for one, isn't counting on anything soon.

"Calls for China to delay any immediate trade deals and play the long game are raising the spectre that we will not see a deal until after the 2020 U.S, presidential election," Mr. Moya said.

"The world’s second-largest economy could choose to continue to grow their domestic consumption and see them try to diversify their supply chains away from the U.S.," he added.

"Trump and Xi [Jinping] are playing heads-up no-limit hold ‘em, and the latest hand of escalations may have given Xi a slight lead in chips. This high stakes trade war will likely be dragged out a while longer, but September will be pivotal in finding out if we see talks completely fall apart and drive a market correction with U.S. equities."

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Senior economist Andrew Grantham of CIBC World Markets also has a trade-related warning for investors as we head toward autumn.

"As trade tensions have spiked then faded and then spiked again in recent years, the 125 companies with the largest foreign earnings in the S&P have naturally underperformed during periods of uncertainty," Mr. Grantham said in a recent report.

"However, as tariffs have risen and peaks in the trade uncertainty index (based on news quotes of certain phrases) have gotten higher, the sensitivity of those companies appears to have lessened," they added.

"That’s particularly surprising given that global economic growth is slowing, and could suggest possible further softness for those companies going forward."

Read more

• Tim Shufelt: Wall of worry: Why the rest of the year could be a wild ride for stocks
• Rosenberg, Belski, Lascelles and four other market pros reveal their best advice for investing in the rest of 2019
• Rob Carrick: If stock markets plunge this fall, these websites can help you cope with the carnage
• Countdown to recession: What an inverted yield curve means

A scene I’d love to see

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Markets at a glance

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• Follow our Inside the Market

Pound suffers

The British pound is suffering again, sinking to its lowest in about three years as Prime Minister Boris Johnson threatens a snap election should he not get his way on Brexit.

“The market’s instinct seems to be to take snap election talk negatively,” said Elsa Lignos, Royal Bank of Canada’s global head of foreign exchange strategy in London, though she noted the moves are also driven by strength in the U.S. dollar.

Indeed, the euro also weakened.

“While the value of the pound is getting all the headlines, falling to its lowest level against the U.S. dollar since the October 2016 flash crash lows, below the 1.2000 level, it hasn’t been the only casualty against a U.S. dollar that appears to sweeping all before it,” said CMC’s Mr. Hewson.

“The euro is also trading at its lowest level against the greenback for over two years, while the Australian dollar is also down near its lowest levels against the U.S. dollar in the last 10 years, with the [Reserve Bank of Australia] painting a weak economic picture.”

Read more

• Pound slides to weakest level in three years as Brexit fears grow
• Paul Waldie: Johnson seeks early election in the face of parliamentary shutdown, pushes toward Brexit

Ticker

U.S. factory sector contracts

From Reuters: The U.S. manufacturing sector contracted in August for the first time since 2016 amid worries about a weakening global economy and rising trade tensions between China and the United States, an industry report released on Tuesday showed. The Institute for Supply Management said its index of national factory activity decreased to 49.1, the lowest level since January 2016.

Crescent Point sells assets

From The Canadian Press: Crescent Point Energy Corp. is selling its Uinta Basin asset in Utah and certain southeast Saskatchewan conventional assets for about $912-million. The Calgary-based company says the agreements include 27,000 barrels of oil equivalent a day of upstream assets.

Argentina imposes currency controls

From The New York Times: Trying to put the brakes on a financial crisis that has engulfed Argentina in recent weeks, President Mauricio Macri imposed new restrictions on access to foreign currency.

South African growth better than expected

From Reuters: South African gross domestic product grew more than expected in the second quarter, at 3.1 per cent, thanks to a recovery in mining and manufacturing, official data showed Tuesday, in a boost to President Cyril Ramaphosa’s efforts to revive a troubled economy.

Required Reading

Air Canada challenges WestJet deal

Air Canada has filed a challenge with federal regulators to Onex Corp.’s takeover of WestJet Airlines Ltd., arguing the deal could give foreign investors majority ownership of the Calgary-based airline, in violation of Ottawa’s rules. Onex said only that it is “engaged” with the Canadian Transportation Agency on regulatory approval. Stefanie Marotta reports.

CannTrust expected to be dropped from index

CannTrust Holdings Inc. likely will be dropped from Canada’s benchmark stock index this month, the latest setback for a company that was rocked this summer by a Health Canada investigation into unlicensed cannabis production and subsequent executive departures. Andrew Willis reports.

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No rate cut expected this week

Bank of Canada governor Stephen Poloz and his colleagues aren’t expected to trim their key rate Wednesday, but economists say the central bank will likely start laying the groundwork for a cut that could come as early as its Oct. 30 announcement, Barrie McKenna writes.