Monday, August 23, 2010

12-month outlook for North American stock markets: gloom and doom ahead

The Fed statement on August 10th was a wake-up call for many investors. Ben Bernanke acknowledged the weakness of the U.S. economic recovery, and promised to use quantitative easing measures to boost the economy. He pledged to use proceeds from mortgage-backed securities to purchase U.S. Treasuries, in order to keep the lending rate low.

Many investors were stunned that U.S. economic growth was fizzling with most of the stimulus having been spent. In addition, they realized that, this late in the economic recovery, the U.S. economy still needed quantitative easing. Some investors had been expecting more aggressive measures from the Fed, so the announcement left them disappointed.

The numbers spoke for themselves. The week of the Fed announcement, the S&P 500 fell 3.8%, while the Dow dropped 3.3%. In the next week, U.S. initial jobless claims rose to a 9-month high, while a mid-Atlantic manufacturing index showed a contraction for the first time in a year. The markets responded with the Dow falling 0.9% for the week, while the S&P 500 declined 0.7%.

The situation in the euro zone has not been any better. The worst of the Greece crisis is over, while worries about the Spanish financial industry collapsing has mostly faded. However, austerity measures will leave economic growth in the euro zone weaker than the historical average for years to come.

While Germany posted a 20-year-high quarterly economic growth of 2.2% last week, Greece posted a decline of 1.5% in the same quarter. The logical outlook for the euro zone in the next 12 months is relatively strong economic grow for Germany, accompanied by weak grow in the smaller periphery euro zone economies.

With the overwhelming majority of economic data from the U.S. in recent months being worst than expected, it is logical to conclude that data in the coming weeks and months will continue to disappoint.

As we head into the traditionally volatile month of September, I expect North American equities to continue falling in September and October on the back of weak consumer sentiment, economic and housing data from the U.S. In fact, I expect markets to retest the May to July 2009 levels.

I expect to see a 5% to 10% rally in November and December (combined), after a brutal September and October. The holiday season should provide the usual boost. However, November will also see the midterm elections in the U.S. All of the seats in the House of Representatives and 37 of the 100 seats in the Senate up for election. The results will be in the Republicans' favour, which will make the passing of any stimulus package extremely difficult.

Beginning in early January, I expect markets to start falling again on weak economic data. With a possibility that the U.S. would enter a double-dip recession in the summer, the markets will price in this concern about 6 months ahead. This means that markets will face the most weakness in January to March, as they retest the May 2009 levels.

From September to January, the U.S. Fed would have attempted more aggressive quantitative easing measures to boost economic activity. However, the fact that the key lending rate is already at 0% to 0.25% means the Fed's most effective tool is unavailable. The result is that a new stimulus package will be needed. However, with the Republicans having expanded control in the House and Senate, and fears among some Americans that the high national debt would lead to a Greece-style crisis, the passage of a new stimulus package will be extremely difficult.

I expect a long and drawn-out attempt in the House and Senate in trying to pass a new stimulus package in January to March, while stock markets slide on an imminent double-dip recession in the coming months, and the uncertainty of whether the stimulus will be passed. With that backdrop, I expect markets to fall to May 2009 levels.


Factors for potential upside to my 12-month outlook:

1) M&A activity

This week's $39 billion bid for Potash Corp by BHP Billiton, and Intel's $7.86 billion purchase of McAfee shows that M&A activity is about to increase. North American companies have accumulated significant levels of cash during the recession from cost-cutting. In addition, easier access to loans also enhances companies' abilities to make acquisitions.

Meanwhile, Chinese state-owned companies have done many deals in the Canadian energy sector in the past year. Examples include the $4.6 billion acquisition of a 9% stake in Canadian Oil Sands Trust and a $1.6 billion purchase of a 60% stake in Athabasca Oil Sands properties. Direct investment by Chinese companies is not going to slow down in the second half of 2010. This will provide a significant boost to select Canadian companies that are involved in M&A activities, and provide a smaller boost to the entire sector.

2) Hurricane Season

A tropical depression in the Atlantic could become a hurricane on Monday August 23rd. U.S. government scientists predict a very active 2010 season, with 14 to 20 tropical storms, and 8 to 12 of them becoming hurricanes. In addition, The National Oceanic and Atmospheric Administration expects 4 to 6 “major” hurricanes, which have top winds of more than 110 mph.

A strong hurricane season would disrupt oil production in the Gulf of Mexico, sending oil prices higher and benefiting the TSX's one-third weighing in the energy sector. According to Jeff Rubin, hurricanes also jeopardize 40% of the U.S. refinery capacity. The 2005 hurricane season raised oil prices by 10%, while prices at the pump rose by 50% to $3/gallon. In 2008, hurricane Ike's direct hit on the Houston refining area sent pump prices to $5/gallon.

3) Military Conflict in the Middle East

This is probably the least probable factor among the three. Iran's Bushehr nuclear reactor became operational this week. Newspaper articles from credible sources have been quoting Israel military officials for years about how much they want to hit the reactor. Numerous military exercises have already been conducted in which the Israeli Air Force plan to strike the reactor. Such an action is not without precedent, since Israel attacked Iraq's nuclear reactor before it became operational in 1981.

An air strike by Israel on the Bushehr reactor, and the subsequent political firestorm in the Middle East would send oil prices and the TSX's energy sector surging. An example is the military conflict between Israel and Lebanon militants in December 2008 and January 2009. Suncor Energy's shares went from a low of C$21.51 in the week of December 24th to a high of C$29.78 in the week of January 2nd (a 38% gain in less than 2 weeks) simply because of the military conflict.

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