There has been a lot negative economic news recently with some analysts forecasting a significant economic slowdown and even a recession in the near future – and hence rates to remain low for the foreseeable future.
For example, the IMF and OECD have issued economic growth warnings for Canada. Europe is headed towards a deflationary period and significant slowdown, which will be exacerbated if Greece exits the EU and Eurozone. China's GDP has also been slowing down. Bloomberg-Businessweek reports that the actual growth rate of China may be closer to 5 per cent than 7.4 per cent, if one considers electricity output, traffic on freight trains and growth of credit. And many doubt the early signs of economic growth in the U.S. given recent comments by the Fed's chairman.
Is the current economic scene similar to that of January-March 2008?
Could we be heading towards a recession or a significant economic slowdown with a further dampening effect on interest rates and a severe stock market correction?
In my opinion, the answer is no and yes, respectively.
Let's first deal with the "no." There is a well-known seasonal effect in the financial markets that, in my opinion, is not showing a recession in the near future. It relates to the maxim of "sell in May and go away," namely that stock markets do better in the November-to-April period than May to October.
My research shows that stocks have experienced a positive return between November and April in 43 out of the 53 years of my sample (1957-2010) and a negative return in only ten years.
Out of the ten negative return years, eight years – 1960, 1970, 1973, 1974, 1982, 1990, 2000 and 2008 – were recession years. That is, the November-to-April period has been dominated by positive stock returns, except during recessions when returns turn negative.
To understand why, you need to understand the drivers of this phenomenon, which relate to the behaviour of institutional investors.
Portfolio managers invest throughout the year to outperform benchmark portfolios and secure their Christmas bonus. To do so, they put their money in risky securities at the beginning of the year and move away from risky securities toward year end. As a result, for risky securities, returns in January tend to be, on average, quite high. In such cases, the second half of the year tends to be weak in relation to January, as managers bail out of those securities in order to lock in profits. As they disinvest from risky securities, managers tend to move to less risky or risk-free securities pushing up those securities' prices. As a result, large, low-risk companies' stocks and risk-free securities experience strength towards the second half of the year in relation to January (weakness in the early part of the year).
While this is what we should expect in theory, my research further shows that the games institutional managers play do not take place all at once in January. Instead, portfolio rebalancing is spread around the first and last few months of the year. In practice then, seasonal strength is documented not just in January, but rather from November to April.
What is interesting, however, is that the strength in risky securities in this period is not a sure thing; it largely depends on what institutional investors think of the year ahead. Portfolio managers do not invest in risky securities indiscriminately, irrespective of whether the year is expected to be a recovery or a recessionary year. In other words, there is no "November-April" strong seasonal effect when a recession is expected. And recessions normally coincide with bad and recoveries with good stock markets.
In early 2008, financial conditions were tightening up, banks were becoming more stringent in giving loans to individuals and businesses, capital spending and global growth were starting to show signs of weakness. The November-April period was turning out to be a bust for stocks and it was signalling bad news for the economy. For example, the S&P 500 was down 5.3 per cent year the first couple of months of 2008 and 10.3 per cent since the end of October 2007. The corresponding numbers for the S&P/TSX composite were a loss of 2.1 per cent and down 7.4 per cent, respectively. The year, as we all know, turned out to be bad both for the economy and the stock market.
What are the numbers telling us now?
The November-April period is not turning out to be a bust for stocks and it is not signalling bad news for the economy. For example, the S&P 500 is up 1.43 per cent year to date in 2015 and 3.33 per cent since the end of October 2014. The corresponding gains for the S&P/TSX composite are 1.2 per cent and 2.24 per cent, respectively.
As things stand out so far, there is little evidence to support the argument that the economy is currently in a recession or is heading towards one. The implication of this is that economic recovery will force the Fed to start raising interest rates by the fall of 2015.
I know, economists have been crying wolf for years about the possibility of rising interest rates. Their time to be right has now come.
But here is the paradox. While the economy will turn out to be in a relatively fair shape, this will not be the case for the stock market. Low interest rates have supported the stock market for the last five years, but rising rates will act as a drag since, while the economy will recover, GDP and earnings growth will not be sufficiently strong to offset the negative effect of higher interest rates. And this has to do with my "yes" in the question posed earlier.
George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario