October 26, 2020

Financial letter, Fall 2020, 53^th edition

The recovery took only 100 days, but caution remains in order.

Seven months have passed since the COVID-19 outbreak was declared a pandemic. COVID-19 triggered an economic shock the likes of which we haven’t seen since the Great Depression, and the virus continues to wreak havoc on our everyday lives. Many countries saw a record-breaking economic contraction, and the pandemic’s impact on different sectors and jobs continues to be uneven.

After the initial downturn, production recovered rapidly with the lifting of lockdown measures and a restart to economic activity.

This improvement in the economic backdrop was also felt in the labour market. In the United States, 51.5% of workers who had been laid off in March and April (22 million people in total) found a job by the end of September. The numbers are even higher for Canada (76.1%) and Quebec (86.2%).

Governments and central banks will continue providing support as long as necessary to maintain confidence, limit uncertainty and protect the assets of households and businesses, even if it means giving the economy another boost following the pandemic’s second wave.

Fiscal and monetary stimulus helped the markets rebound from their March troughs. Like seeing a beacon on the horizon, investors realized that fiscal and monetary support would be ramped up to propel economic activity when public health measures are relaxed. After hitting lows, the stock markets rebounded all summer long with the exception of September, when the pace of growth slowed. Some observers fear the recovery lacks traction as we face a second wave of COVID-19 infections, negotiations stall on a new stimulus plan in Washington and the US elections loom on the horizon. In other words, the strength of the rebound exposed the markets to profit taking and portfolio rebalancing.
Would you have believed us if we told you that Canadians’ finances (including factors like disposable income, the savings rate and debt) would improve while the economy was hit by an unprecedented shock? In fact, this is exactly what happened.

The increase in the savings rate is the result of the impact of lockdowns on consumer spending. Before the pandemic, Canadians saved an average of 3% of their disposable income annually. During the pandemic, the savings rate soared to 28% (33.7% in the United States).

Household debt, long viewed as a major risk to the Canadian economy, fell from 175% to 158% of disposable income from the first to the second quarter.

Equity

Judging solely by the performance of the stock markets, the economy looks like it’s never been in better shape! Of course, the reality is different. There are several factors that help explain this apparent discrepancy:

1. The stock market only represents listed companies. Thus, it excludes privately owned companies (small businesses, restaurants, construction firms, etc.) and the role of government.
2. The sector breakdown on indexes like the S&P 500 differs from the true weight of the sectors in the economy.
3. The stock markets reflect how the economy is expected to perform 6 to 9 months in the future, as it projects the future cash flows of businesses.
4. Stock market performance sometimes reflects the strong emotions of investors rather than the fundamentals.

We’re living in an unprecedented era that defies comprehension. The history books will look back on this period as a defining moment in a generation. They’ll mention “TINA” (There is No Alternative) and “FOMO” (Fear Of Missing Out) and recall how the MSCI ACWI global equity index plummeted 35% from its February peak to its March trough, only to rebound by 57% to reach a new high in early September. On September 30, the index posted a decline of only 2.5%.

Taking a 12- to 18-month horizon, the economic backdrop continues to look more favourable for equities compared to other asset classes. This forecast is based on the assumption that the public authorities will offer unconditional support for a sustainable increase in production and inflation and that a vaccine or treatment for COVID-19 will be found.

Canada | Underweight

We continue to recommend a cautious stance toward the TSX due to the challenges facing Canada’s energy and real estate sectors in the wake of the pandemic and the vulnerability of domestic demand due to household debt. While there has been a significant recovery since March, the TSX remains just over 3% short of where it was at the beginning of 2020.

The composition of Canada’s domestic market makes it difficult to compare valuations with those in the United States. This is because it contains very few high-growth technology firms that investors could reward with higher multiples.

Back in the spring, concerns about the financial sector were warranted given that millions of households opted to defer their mortgage payments and it was unclear where property prices might be headed. For both these variables, the situation today is proving to be much better than anticipated. Firstly, banks’ recent financial performance and remarks made at industry conferences suggest that nearly all households managed to resume their payments without too much difficulty when their deferment periods ended. Secondly, while some players like the Canada Mortgage and Housing Corporation feared a drop in the value of residential properties, the actual situation is very different. Thus, in the event that a borrower is unable to resume their monthly payments, the financial institution would not necessarily suffer a loss because the mortgaged property could likely be sold without losses. As a result, Canadian banks’ existing provisions could be enough to offset or even exceed actual losses.

United States | Overweight

The United States continues to outperform in 2020 even though some technology segments are clearly overvalued. Accounting for over 60% of the world’s market capitalization in the technology, communications and healthcare sectors, the US stock market is not about to lose its star power.

While investors are keeping their money in the winning stocks of the work-from-home era (e-commerce, telemedicine, remote work, etc.), a day will come when we’ll need to contemplate a return to the workplace. This shift back will depend on achieving conclusive results in terms of potential vaccines and treatments.

Europe | Underweight

For years now, investors have been patiently waiting for Europe’s economy to take off. Unfortunately, every time it tries to lift off the ground, it gets dragged down by a strong euro. Try as they might to step on the gas, governments and the European Central Bank have been unable to switch on sustainable economic growth. We continue to recommend an underweight position to Europe as part of an adequately diversified portfolio.

Emerging markets | Overweight

The emerging markets could pleasantly surprise us. Valuation multiples in these economies are relatively affordable. Meanwhile, investors continue to shun these regions. The story of the emerging economies is essentially that of China, Taiwan and South Korea: 3 markets in which the technology sector is overrepresented and more affordable than in the United States. In China, robust household savings, capital controls, low interest rates and declining wages all bode well for the stock markets. Taiwan and South Korea, meanwhile, are showcases for the technology sector. A weak US dollar is positive for growth and infrastructure projects in the emerging economies given that they mostly borrow in American currency.

Conclusion

Confounding many skeptics, the stock markets posted a second consecutive quarter of extraordinary gains that few would have predicted back in March. It’s clear that 2020 will go down in history as another fantastic lesson of the need to have a plan, stick to it and take advantage of excessive fluctuations to rebalance portfolios. Rebalancing frees up value and reflects investment discipline.

Given the low yields at the beginning of the year, expectations for bonds were modest. And yet, this market continues to impress! In fact, the bond market performed particularly well when equities were down. Investors typically seek out bonds with the sole intention of capturing their term yields. However, the biggest advantage of these investments may prove to be their ability to protect value in the face of sporadic market shocks by equipping investors with assets that can be sold at an attractive price when opportunities to buy discounted shares arise.

Barring a significant change in an investor’s personal situation, it’s better to stick with their existing investment strategy and take full advantage of portfolio balancing. A properly diversified portfolio is designed to help investors achieve their goals over the long term.

We hope that this information helps you better understand the markets. Please don’t hesitate to contact us if you’d like to discuss our investment strategies in more detail. We’d like to reiterate our commitment to keep working hard to help you meet your long-term financial goals by seizing the best opportunities offered on the markets.