The remarkable spring rally on stock markets looks set to keep rolling on after economic data further convinced many investors last week that the economy is genuinely on the mend.
The week started off with triple-digit advances in Toronto and New York after data showed improvements in the American and Chinese manufacturing sectors. That momentum was maintained on Friday by a U.S. employment report that showed a dramatic falloff in layoffs during May.
The showing left the main TSX index up almost 40 per cent from the lows of March 9 while the Dow industrial index is up about 35 per cent.
“The way I interpret the big move over the last three months is basically you’re taking Armageddon off the table,” said Doug Porter, deputy chief economist at BMO Capital Markets.
“There was all kinds of loose talk in late February and early March about how we were going into the Great Depression 2. And I think that nightmare scenario has been taken off the table in financial markets.”
Markets are forward-looking and the gains reflect the hope that economies will shake off recession and start to recover late this year or early next.
But investors shouldn’t lull themselves into thinking it’s smooth sailing as analysts warn there are some serious headwinds being encountered.
“After this kind of gain, one would think there’s some room for potentially some disappointment, said John Johnston, chief strategist, The Harbour Group at RBC Dominion Securities.”
“We’ve had a big runup in energy prices — a tax increase on consumers — and the Canadian dollar has run up and is squeezing the economy. And bond yields are giving us higher mortgage rates.”
Oil prices have doubled since mid-February to about US$70 a barrel. That move has been wonderful for energy stock prices and Porter pointed out that while it’s a risk for the economy, the higher prices are symptomatic of an improving economy.
On the other hand, there is really no upside to the sharply rising Canadian dollar, which surged about 12 cents during April and May because of a weak American currency.
The Bank of Canada made the rare move of talking about the danger of continued upward spikes in the currency last week and the currency ended the week below the 90-cent level.
There is a price to be paid for the massive borrowing necessary for the huge stimulus measures being undertaken by most countries and that’s higher Treasury bond yields, which can affect all kinds of borrowing including mortgage rates.
“Long term interest rates are starting to bump up against mortgage rates in both Canada in the U.S. — we’re seeing mortgage rates creep up for longer term rates,” said Porter.
The big banks raised rates on five year mortgages by a fifth of a point last week even as the Bank of Canada kept its key rate at a quarter point.
“Those longer term mortgage rates aren’t driven by the Bank of Canada’s rate, they’e driven by long term bond yields,” observed Porter.
“And bond yields have forged higher in recent weeks. It’s actually even more of an issue in the U.S. where we’ve seen the 10-year yield rise by almost 40 basis points (last) week.”
He noted that Canadian rates are up by a more modest 20 basis points over the past two weeks.
“The biggest driver of yields has been market concern over the massive budget deficits we’re seeing, especially in the U.S. and lesser extent in Canada,” said Porter.
“As a share of the economy, we haven’t seen budget deficits like this since the Second World War.”
Many analysts expect some sort of a correction in markets at some point after such a strong rise as investors demand more of a reason to send prices higher.
“We’re at a stage now where we need to see some of this optimism in the markets begin to translate into some hard economic data — most of the improvement in economic indicators has been on sentiment, surveys and consumer confidence and that sort of thing,” said Porter.
“And now we actually need that to start to translate into some of the hard economic numbers, which I think will happen this summer. But they’re not to going to be uniform and there will be some negatives.”