Finishing the week where we started

After the Easter holiday weekend, investors returned to the market and were indecisive as North American indices finished the week almost where they started. However, three key themes provided ebbs and flows in market sentiment as the week progressed.

First, we had a continuation of the Quantitative Easing 3 (QE3) debate as more investors became convinced that such a policy is clearly being considered. This helped bullion advance, although some of those gains were erased come Friday. Second, we have now moved into Q1/12 earnings season as Alcoa assumed its traditional role to be the first Dow Component to report results. Those earnings were better than expected which supported markets on Wednesday and likely helped them advance during a strong day of performance on Thursday. Third, China reported Q1 GDP figures that showed the economy grew by 8.1%. This figure compared to the 8.4% forecast by economists and the 8.9% reported last quarter. Since the report was below expectations, the media was squarely focused on a possible Chinese economic “hard landing”, but we feel it’s too soon to make that conclusion when the Chinese have a number of policy tools at their disposal to stimulate economic growth.

It should come as no surprise that oil prices came under some pressure once the Chinese economic data was released; however, for the most part crude oil prices stayed relatively flat for the week. Gold was the commodity that reacted most following the GDP release, falling over US$20 per ounce, but finished the week higher and avoided technical selling pressure. Since there was little movement on oil and only a slight gain for gold, the Canadian dollar was essentially flat and will likely see more market attention next week when the Bank of Canada makes its interest rate decision.

In corporate news, Alcoa likely offered the biggest headline over the past five days, but other companies reported decent earnings as well including Google which also announced its intention to split its stock in the near future. Investors will be looking for the corporate earnings momentum to continue next week when a good number of large cap companies will release their Q1/12 reports.

TOO MUCH TOO SOON?

As we are now into the second quarter of 2012, many global investors can look back on returns from the first quarter with a smile. Most major market indices were very strong in Q1 when measured in their local currency, so naturally the question on the mind of the market has been whether such strength would be sustainable over the next three months. Our chart of the week shows you that some of the first quarter momentum has run out of steam as profit taking has put downward pressure on stock prices. While most countries are nowhere near giving back all of their first quarter returns, others such as France, the U.K. and Canada are approaching the break-even level for 2012. Did the market appreciate too quickly in the first quarter? Well it is fair to argue that such returns may have been too high when you consider that Europe will be struggling for some time and that signs have emerged indicating a slowdown for the global economy. Just because Greece received a second bailout doesn’t mean that it’s smooth sailing for equity investors in 2012. At the beginning of this year, we thought that 2012 would start off slowly and hopefully improve as the year progressed. We were surprised to see results so strong in the first quarter, but the recent pull back brings returns more into line with our 2012 expectations.

TRADING WEEK AHEAD

With Alcoa kicking off Q1 earnings season, quarterly reports out of U.S. companies will start to pick up pace as we head into next week, including a number of companies that make up the Dow Jones Industrial Average. Johnson & Johnson, Coca-Cola Co, IBM, American Express, EI du Pont de Nemours, Bank of America, Verizon Communications, Microsoft Corp, General Electric and McDonald’s will all report quarterly results by week’s end. Considering this list of companies, investors will be given a diversified view of the current health of the U.S. economy. Earnings season will barely begin in Canada as Metro Inc. and CP Rail are the only two major companies that will report their earnings.

Instead of quarterly reports, Canadian investors will be focused more on the interest rate decision due out of the Bank of Canada on Tuesday. Three months ago investors were trying to figure out if a rate cut might be in store for the Canadian economy, but now traders are pricing in a higher likelihood that rate hikes will be the next move for the Central Bank. The magnitude and timing of these future hikes is what is still being debated, but we don’t expect much change in rates here for the rest of the year and especially if the U.S. doesn’t expect to increase interest rates until 2014 at the earliest. Policy watchers will also be watching the Canadian inflation report with interest as it is due out on Friday. Core inflation rose to 2.3% year over year last month which was creeping towards the upper end of the 1% to 3% band targeted by the Bank of Canada. However, this month’s forecast is for 1.9% which is more in line with what the Bank of Canada wants to see. In the United States, the economic data will be focused on housing and manufacturing with a few consumer retail metrics thrown in for good measure.

Looking at commodities, the market will likely remain focused on the slowdown in Chinese GDP growth reported Friday morning, which could put some near term pressure on crude oil prices. Gold and silver prices will also care about economic outlooks in China and the U.S. as speculation will continue that a third quantitative easing plan will be announced by the Federal Reserve later in the quarter before the U.S. Presidential Election campaign gets under way.

QUESTION OF THE WEEK

This week I heard people say that the market was concerned because Spanish bond yields went up. What does this really mean for someone that may not follow the market on a day to day basis?

This is a great question because sometimes the media can forget that most investors don’t necessarily use market jargon on a daily basis and the meaning of what is said can easily be lost if you don’t follow the markets in great detail. First, we will establish what is meant by “yield” and that essentially refers to the return an investor can make on a bond if it’s bought today. So if a bond is yielding 5%, then an investor buying that bond today should make 5% if he/she holds it to maturity. You might ask, isn’t a rising bond yield a good thing if I want a higher return? While that conclusion is fair, it only holds true if you are paid the amount of the bond in full when it matures. This is where we need to establish a relationship that exists with bond yields and bond pricing – when a bond yield goes up, the price of that bond goes down and vice versa. Therefore, if Spanish bond yields are going up, that means that Spanish bond prices are going down. So why would Spanish bond prices go down? Because the Eurozone debt crisis has investors worried that Spain won’t be able to repay all of its debts. If this happens, existing bonds in the market place will be worth less or could be worth nothing at all if Spain defaults on all outstanding debt. Eurozone debt concerns have influenced the yields on many sovereign debt issues, with Portugal, Italy, Ireland, Greece and Spain being the most popular as they take drastic steps to balance their budgets while encouraging economic growth at the same time. So rising bond yields are not a good thing in this case as the market is making an increased bet that Spain could face financial trouble in the not so distant future.

Gareth Watson is the Vice President, Investment Management & Research at Richardson GMP in Toronto. This team of research experts is responsible for monitoring and interpreting economic, geo-political situations, current market environments and trends. @Gareth_RGMP