TORONTO - Stock markets, and more particularly the financial sector, are in for still more volatility and likely further losses this week as U.S. investment banks report their latest earnings.
Investors are braced for losses but the great unknown is the overall exposure to the collapsed U.S. subprime mortgage market and just what that exposure is worth given the large number of mortgage defaults in the U.S.
"My sense is that maybe the worst is past -- but there's more bad news to come,'' said John Johnston, chief strategist, The Habour Group at RBC Dominion Securities.
Stock markets continued to bleed last week with key indexes below their 2007 finish on a litany of bad economic news since the start of the year and the prospect of billions of dollars worth of further writedowns of securities backed by mortgages.
Indexes dropped at the end of last week after the Wall Street Journal reported that Merrill Lynch might take a US$15-billion hit from its exposure to soured subprime mortgage investments. The largest brokerage in the U.S. is also said to be seeking another capital infusion to help shore up its balance sheet.
Adding to the nervousness was a warning from American Express Corp. that slower spending and more delinquencies on credit card payments will hamper profit throughout 2008. The company plans to reserve US$440 million for the fourth quarter to deal with overdue loans.
This followed a similar announcement from rival Capital One Financial Corp., which set aside US$650 million to prepare for unpaid credit card bills.
These disclosures in turn have continued to carve shareholder value from the big Canadian banks as investors wonder how much mortgage debt they hold that is still to be written off.
However, Johnston thinks that while writedowns are likely, the financial institutions will be anxious to cut their losses quickly "because any firms that put off kind of coming clean are going to get brutally punished.''
"And as you get new management teams in, the incentive is to take it now, start with a clean slate. The question is, is it over yet. When you look at, you can see signs here that we're getting close to maybe a bottom on the financial side. And it doesn't look like we're quite there yet. But it looks like we're a lot closer to the bottom than the top.''
Investors were already braced for a severe downturn in the United States as the damage from the housing sector infects the rest of the economy. But talk of a sharp drop off has turned to worries that the U.S. is either in recession or about to slip into one.
Those suspicions took root in the wake of the Institute for Supply Management's December reading on manufacturing which indicated the sector is in contraction and grew after the December U.S. non-farms payrolls report showed a drop in employment and worse, a rise in the unemployment rate.
Johnston thinks it is too early to tell whether there will be a recession in the U.S., although he adds that if it does, it should be relatively mild and run eight to 10 months.
"It's a close call right now,'' he said, "but the point is right now the markets are heavily discounting a recession. If it's a recession, it's mild, if it's a soft landing, it's very unsoft -- I think is where we are at now.''
During what promises to be a dreary week, investors will be taking in a slew of earnings news from the U.S. before Canadian companies start reporting fourth quarters results.
And given the environment, expectations are minimal.
"I get the sense that expectations are low but if you look at estimates, they haven't really been scaled back,'' said Julie Brough vice-president private wealth management at Morgan, Meighen and Associates.
"I think the mood is different than what the numbers are saying. I don't think people will be punished the way they have been over the past 18 months for disappointing. But what it also means is people aren't pricing in high expectations right now so people who surpass expectations, there is I think for the first time in a long time the potential to be rewarded for that.''
There was one bit of good news from last week that will provide some lift -- U.S. Federal Reserve chairman Ben Bernanke made clear in a speech last Thursday that the central bank will use interest rate cuts to shore up the economy and hopefully stave off a recession.
That greatly increased the conviction that the Fed is ready to move aggressively at its next meeting on rates at the end of the month.
"(Bernanke) has basically ratified the market expectations that rates are going to fall 50 basis points'' followed by two quarter point cuts -- and maybe a third.
"And then he's also suggested that if the data stay weak, he might do more.''
