Not Your Normal Third Quarter
The third quarter of 2007 will likely be the most memorable quarter of the year. Unfortunately, this title will not be awarded for returns, but for the credit environment which drove equity markets lower and the response which heightened volatility. Yet, even with a temporary 15% decline for the TSX from its record high, the TSX Index escaped the third quarter with a positive 1.4% simple return including a 0.2% loss in July, a 1.5% loss in August and a 3.2% gain in September.
TSX weakness was triggered in mid-July as defaults on U.S. sub prime mortgages increased. This raised concerns about the U.S. housing market and whether or not consumers would continue to support the U.S. economy or allow it to fall into a recession. The potential for material economic weakness south of the border would eventually translate into a decline in economic growth for Canada and thus investors responded by selling. Selling pressure was accentuated by the prospects for tighter global monetary policy, fund redemptions, short selling and a general lack of liquidity.
When credit/liquidity concerns first emerged, investors were trying to determine if the financial problems were going to develop into broader economic problems. As the weeks have passed and economic data has been released, it would appear as though the economic effects of the credit/liquidity problems have been limited thus far.
Commodity prices remain strong for base metals, gold and crude thanks to a persistently strong global economic outlook and a weaker U.S. dollar. This strength has allowed the TSX Index to recoup its losses since the beginning of July as the Materials and Energy subsectors combined to contribute 77% of the past quarter’s gains. With global growth continuing to look strong for 2008 and the potential for a sharp U.S. dollar rebound unlikely, it is quite possible that Materials and Energy stocks will continue to support the TSX during the remainder of 2007.
In the challenging credit environment Canadian banks have been sluggish. However, they have managed to distance themselves from the woes of U.S. sub prime mortgages and third party asset backed commercial paper. Looking forward, investors expect the financial system in this country to stabilize; however, this is not expected to occur overnight and may take a number of months.
If there was one lesson to take away from the third quarter it was that diversification is important when minimizing volatility and protecting returns. Although the markets have rebounded, it is still advisable for investors to have some form of exposure to defensive investments. U.S. investments have also become more interesting thanks to the 7.5% gain in the Canadian dollar during the past quarter. The continued strength in the Canadian economy combined with easing U.S. monetary policy could see the loonie remain at par or above for the remainder of 2007.
The third quarter was challenging for Canadian markets, but the resilience of the Canadian economy combined with continued global economic strength and easing U.S. monetary policy could provide the momentum required to deliver positive returns during the last three months of the year.