Canadian banks will be closing the books on the fiscal year come Halloween and no matter how this last quarter shakes out in terms of earnings, there will be at least a sigh of relief among executives that some of the intense concerns from back at the end of the third quarter (July) have dissipated. I'm referring specifically to the state of the North American economy and the situation regarding Europe's debt crisis.
Three months ago, bears were in full control of the near-term fundamental outlook, not only for loan demand and default risk, but for the impact on bank trading revenues from a deterioration in equity markets. Indeed, the latter effect showed up in the third quarter and will still have an impact on the final quarter as the TSX ended a seven-month losing streak at the end of September, with October delivering a much needed rebound. Trading revenues should be down for the quarter, but the trajectory going into the first fiscal quarter looks more promising.
Underlying the performance in equities, however, economic activity has turned out to be a little better than previously thought after the mild contraction in output prior to the summer. Here at home, employment has picked up and domestic indicators suggest that the third quarter will see a recovery in output. Meanwhile, the U.S. has just reported Q3 GDP growth of 2.5 per cent with much of this coming from consumer spending. Even though the federal government and Bank of Canada have marked down their 2011 and 2012 growth forecasts by more than half a percent, we're still talking about expansions of over two per cent, respectively. Contrast that with concerns of a technical recession and sub-two per cent growth embedded in the bearish banter of a couple of months ago.
To the degree that equity markets predict the direction of economic activity several months forward, the recovery in sentiment and valuations this past month is encouraging. True, much of the recent improvement can be attributed to efforts to cobble together a more substantive debt rescue package for Greece and other troubled European nations which was agreed to this past week. This by no means is a miracle elixir for the region, as many details still have to be worked out regarding the bolstering of bank capital, not to the mention the ability to do so. Still, there is more confidence of a sustainable resolution to the crisis than there was before. The icing on the cake would be a satisfactory outcome for the U.S. fiscal situation -- namely a credible deficit reduction proposal from the Congressional 'super' committee.
At the time of writing, the TSX had just broken above 12,500 level after starting October below 11,000. The achievement would have been more deserving of applause had we seen the index taken out its Sept. 1 intraday high just below 12,800 -- which capped the August recovery. Far better performance was found in NY, where the S&P took out the Sept. 1 high a couple of weeks ago and is now approaching levels prior to the late July/August meltdown. In both cases, however, we need continued momentum to get back to the highs during the spring. For the S&P this means a return to 1370 (a gain of about seven from Friday's close), while the TSX needs to retrace close to 13 per cent to get back to the March 7 high of 14,329.
Given the higher weighting of resources in the TSX this wider chasm is going to require some real improvement to the fundamental outlook, which will be challenging considering that European growth is going to suffer regardless of this week's package. Austerity will remain the name of the game in the region and not just for riot-stricken Greece. On top of that, let's not forget that much of the trade around this planet is funded by European banks. As they are required to bolster capital ratios, lending will be curtailed and this could affect trade-oriented sectors that are dependent on bank loans. At the same time, all eyes are on China and the degree to which growth and commodity demand is going to soften in this environment.
At the end of the day though, this market needs one crucial element and that is conviction. Investors are still more apt to sell into rallies given the uncertainties of the world than add to equity exposure and this is more acute among retail players than institutional money. Lower volatility will help attract retail investors back from the sidelines and, on that note, the decline in the VIX index has been promising. This week the index slipped below 25 for the first time since early August, but still needs to get back to a 15-20 range before market participants feel comfortable stepping back in. As I discussed in the summer, one should not try to catch a falling knife and, despite the euphoria created this past week, there are still a few blades that haven't hit the floor.