September 3rd, 2015

Interim Commentary: A Note on Volatility


The purpose of this interim commentary is to communicate with our clients in regard to important recent developments in the markets, whether positive or negative, that we believe clients may be interested in hearing an explanation about. If you are not interested in receiving these communications, please let us know and we will take you off the mailing list. If we do not hear from you, we will continue to send along communications such as this when the situation warrants it.


For the last few weeks, global stock markets have been exceptionally volatile, which, justifiably, has caused concern as to whether this activity is the proverbial canary in the coal mine before an ensuing market collapse. It is our view that nothing has materially changed enough to shift our long-term view on North American stock markets, however, we also believe it is our responsibility to explain why the current market volatility is occurring.


As we mentioned in our recent monthly commentary, the Chinese stock market has been experiencing corrective behaviour as of late, in the wake of an extraordinary bull run. In the period of a year, the Chinese market was up 100%, before a shift in market sentiment caused the market to retrace a sizable amount of gains in a short period of time. The primary reason cited for this correction was simply over-valuation, as many Chinese companies were trading at absurd valuations. The market correction, however, was less worrisome than the reaction from the government, who instituted numerous immediate changes in order to bolster the stock market. Such desperate activity to save an elevated stock market caused some investors to fear that the Chinese economy is doing much worse than the government is letting on. Alas, the government’s intervention was able to stop the bleeding and stabilize the market, with minimal effect on North American stock markets; at least, for a short period of time. Last Monday, despite continued efforts from the Chinese government, the Shanghai stock market opened 8.5% down, and the negative sentiment finally spilled over to almost all global markets, resulting in what some investors are calling ‘Black Monday’. This market drop caused further loss of confidence in the Chinese government’s ability to control the market. To get an idea of how bad the Chinese stock market crash has been, see Chart below, which contrasts all major international stock market corrections over the last seven years. The columns indicate the peak volatility reading during the correction, the total ‘peak-to-trough’ correction distance, and the length of the total event. The chart shows that the period was – assuming the worst is behind us – short, and violent, but not exactly historic


The most important thing to note, however, is that the notional drop in the Chinese stock market, in and of itself, has very little effect on North American or European corporate profits. For example, despite the recent correction, the Chinese market remains up 43% year-over-year and is only down 1% year-to-date. During the Chinese market boom, there was no spillover of over-exuberance into North American stocks; why, then, would a corresponding correction have any significant effect on North American stock market activity? The reason that this correction has affected our stock market is due to speculation on the meaning of the government’s activity, and fear of a Chinese ‘hard landing’. In our view, a possible Chinese economic slowdown is not a new development, and we have already been positioning ourselves and our clients away from areas of the market with significant Chinese exposure. The only areas of the market which would be significantly affected in the event of a Chinese economic slowdown are the commodities and oil and gas sectors, as well as, to a lesser extent, large international companies who are subject to currency fluctuations. As the world’s leading consumer of almost every major commodity, as well as oil and gas, the real danger inherit in these sectors is fairly clear. A weakening China would hamstring demand and likely destroy commodity prices further, which would in turn obviously hurt the companies operating in the industry. The same would likely occur for oil prices and thus oil and gas companies. Although there are always certain exceptions, this is a major reason why we are largely avoiding base metal commodities and energy names in the near future. Please note that it is not impossible for unrelated stocks to fall as a consequence of China fear, such as what happened last week, but any correction to unrelated names should be viewed as purely sentiment-based and a likely reactionary, temporary movement.


The other side of the story is the continued strength of the U.S. economy and U.S. dollar, which has resulted in global currency depreciation and capital outflows from emerging markets. As we have frequently discussed, the United States is currently the strongest market in the global context of sluggish economic growth. Additionally, we are also experiencing a global economic environment where many countries are slashing interest rates. In contrast, the United States are growing their economy at a decent pace, are home to most of the largest companies in the world, have an appreciating currency and a forecasted schedule to raise interest rates. All of these forces combine to attract a large amount of international capital, which has had a significant economic effect on certain countries which rely on capital inflows to balance their fiscal budgets. These countries flourished when the U.S. was persistently cutting interest rates, driving capital flows to flow internationally, and now they are experiencing the opposite effect. Although capital inflows and a strong currency may be positive for many U.S. companies, this development is hurting a lot of international economies, and thus acts as a negative trend for American companies which have large international product sales. In addition, with such a strong currency, American manufacturing companies are seeing depressed international demand for their products.


In summary, there are certainly risks that are prevalent in the international economy, but all companies and countries are not effected equally by these developments. Noted economist David Rosenberg stated that the U.S. economy has only an 18% correlation to the Chinese economy. Even if China does slow down, North America will not plunge into depression, and as such, any short term negative movement such as what was experienced last week should be seen as temporary fluctuations of sentiment, unless the stock is directly tied to commodities or the Chinese economy. We continue to prioritize locally-focused companies, preferably with large North American presences, which will be insulated from anything that happens in China as well as depreciating international currencies.


The following quote, taken from an article by Neil Irwin in the New York Times, aptly summarizes our feelings on the recent correction: “What’s fascinating is that there is no clear, simple story about what is different about the outlook now for interest rates, for U.S. and European corporate profits or for economic growth compared to a week ago, when the S&P 500 Index was 10% higher.”


All of the best.







David A. MacNicol, 

B.Eng.Sci., CIM, FCSI


Portfolio Manager

MacNicol & Associates Asset Management Inc.

September 2015