This past autumn, we saw the kind of stock market performance that Dickens would have appreciated. The steady recovery in secondary equities markets since early September, with the S&P/TSX composite index rising by 9% and the S&P 500 composite index up by 13%, provided welcome relief for investment dealers coping with the relentless grind of inhospitable market and business conditions.

But there are mixed views about how long this rebound will last, with many market-watchers convinced that we are in the early stages of a bull market and others skeptical of any extended momentum.

The sudden rebound in equities markets reflects a number of factors, including some improving economic statistics, events in the U.S. (including the Republicans’ victory in the House of Representatives) and the U.S. Federal Reserve Board’s decision on quantitative easing.

Skeptics, on the other hand, argue that the markets are overstating the discounted benefits of these developments. Business confidence, especially in the U.S., remains depressed. In addition, the deleveraging of financial and household balance sheets continues and the U.S. government is mired in large deficits and escalating debt. Finally, the overstretched fiscal position of the U.S. economy places the bur-den of engineering an economic recovery on monetary policy — at the risk of igniting inflationary pressures and protectionist sentiment.

However, the rising markets have boosted revenue in both the retail and institutional investing markets. While the challenges faced by the investment industry will continue to gnaw away at earnings, better conditions will at least provide a cushion and some scope to address these challenges.

In this environment, the business challenges come from many directions. First, despite a firmer tone to equities markets, many investors are still reluctant to participate in stock markets, partly due to uncertainty about the economic and financial outlook, and partly because of the prospects of substantial downside risks.

Indeed, large cash balances in Canadian dealer accounts, totalling almost $36 billion at the end of September — almost 40% above the pre-crisis level — have moved to the sidelines, even though interest rates continue at historical lows. Moreover, dramatic structural changes in equities markets — notably, the advent of high-frequency traders — have raised investor caution, as many investors view themselves as disadvantaged compared with computer-assisted HFTs. This was illustrated by the sharp pickup in net mutual fund redemptions through the early summer months, partly reflecting the publicity surrounding the May “flash crash.” The financial services industry has argued for effective safeguards for HFTs, taking into account such factors as registration, pre-trade risk management and surveillance of HFT activity.

Second, the regulatory burden at all firms continues to escalate. Aside from changes from the Investment Industry Regulatory Organization of Canada and the Canadian Securities Administrators, the proposed — and onerous — tax reporting obligations of U.S. client accounts at Canadian financial services firms have added heavily to the overall compliance burden. (The Investment Industry Association of Canada is making representations to the U.S. Internal Revenue Service and U.S. Treasury to lessen the reporting burden for Canadian dealers.)

Third, net interest earnings from the spread earned on client cash balances has plummeted in the post-financial crisis period. These earnings have been almost cut in half from average levels before the crisis, with little prospect of near-term recovery for this relatively small but significant source of retail revenue.

Fourth, small and mid-sized dealers, particularly in the retail business, have found business conditions tough sledding, with operating margins squeezed by falling revenue and rising fixed costs from compliance and technology requirements. Unlike large, integrated firms, smaller firms do not benefit from significant scale or diversification to cushion the effects of weak retail markets.

Further, many small firms assist small and mid-sized businesses in raising equity capital, and these companies have encountered difficulty issuing new equity shares in the past year or so.

In this regard, the IIAC has urged Canada’s federal finance committee to recommend the forthcoming federal budget reduce the effective tax rate for capital gains.

Almost one-quarter of firms earning less than $20 million per year — roughly 30 firms — have incurred consistent operating losses for much of the past 18 months. Even with some improvement in the markets, merger and acquisition activity among the smaller firms is likely to gather steam. Twelve IIROC-registered firms have resigned in the past 18 months. Unless markets improve, industry earnings will remain under pressure and more firm amalgamations will
result. IE

Ian Russell is president and CEO of the Investment Industry Association of Canada.