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Outlook on a market correction: a lot of candidates to cause ‘something bad’

Fragility in economic conditions has experts worried, with a housing bubble and decades-high inflation rate at the top of the list

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While no one can predict the future, there is certainly speculation among those in the financial world that the market is due for a correction in the next 12 to 18 months. But the causes, the duration and the overall repercussions will remain a mystery because that all depends on how the markets react to this correction.

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But there are some circumstances happening in the economy that are making the current environment particularly fragile, according to economic experts – not the least of which is the current housing bubble and decades-high inflation rate.

“The way you get any sort of correction in equity markets is anything that would hit profits,” explains James Orlando, senior financial economist for TD Economics. “We saw that with the Omicron news and just how much volatility you could get in such a short period of time based on the fact that you might be temporarily hit.”

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His advice for the short term, is to keep an eye on any earnings news that could negatively hit a company’s profits. “Because when you look at where valuations are right now,” he adds, “we’re expecting a huge continuation of the profit cycle for big multinational corporations in the U.S. and Canada and anything that damages that narrative is going to be problematic.”

The long-term concern, explains Orlando, is when there is a stagflation scenario, meaning inflation rates are high, but economic growth is slow, topped off with high unemployment. When this is the scenario, like what is happening right now, the policies and actions that governments and central banks would employ to counteract this financial environment could actually work to exacerbate the issue.

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“For example, if the central banks put their foot on the accelerator again or if governments decide to stimulate the economy even more than what we’ve seen, what that does is it puts more money into the system,” says Orlando, “and more money in people’s and corporations’ pockets means they might spend more money which might only exacerbate the high inflationary time we are having right now.”

“So if we go into an economic backdrop where that’s the case and those policies don’t function the same way anymore then you get into a really big predicament,” he adds.

Indeed, there is a general thought that interest rates may rise in the coming months and years to stave off soaring inflation, but it’s the speed in which these increases materialise that will impact how the market responds.

“If you move too fast, that can be too harsh on the market,” explains Benjamin Tal, deputy chief economist of CIBC World Markets Inc.

It is a delicate balance of inflation cooling policies and throwing the market into turmoil, he adds.

Many economic experts have expressed concern over the current market environment and how it is giving off a sense of déjà vu to the late 1990s and early 2000s, which was marked by the lowering of interest rates, the housing boom that followed and then the move by the federal reserve to hike rates to slow bubbles and inflation. What followed was the worst credit crisis since the Great Depression.

“I think that kind of rapidly increasing rate can be very risky to the market,” says Tal.

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Canadians are also taking on an enormous amount of debt right now and it is making households even more vulnerable to economic shifts.

According to Statistics Canada, Canadian households were carrying approximately $2.5 trillion in outstanding debt one year into the pandemic, approximately two-thirds of which is mortgage debt and one-third of which is every other type of debt, such as car loans, credit card debt and home renovations.

“Things are getting a bit out of control,” explains Daniel Riverso, chief investment officer at Jesselton Capital Management.

“A lot of people are taking on a lot more debt to afford a so-called middle-class lifestyle, or at least the [middle-class] lifestyle that you may have seen 20, 30 years ago.”

The main culprit continues to be the rising housing market, particularly among single-family homes, according to Statistics Canada, as mortgage debt rose by a record $99.6 billion from the onset of the pandemic to January of this year.

“So the federal reserve is painted into a corner because, on the one hand they’ve got high inflation and typically the solution is to raise rates,” says Riverso, “but they can’t really do that because of the amount of debt [people have].”

And then there are the things that no one can predict, explains Riverso. From a declaration of war by a global powerhouse to a meteorite hurtling towards earth, these events would all have a significant impact on the economy.

“The thing is you don’t know what the catalyst is, but eventually something bad happens,” says Riverso. “No one knows what it’s going to be, but there are a lot of candidates right now.”

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