August 26, 2020

Financial letter, Summer 2020, 52^nd edition

The pandemic has knocked us for a loop, destabilizing the global economy and our daily lives. Economies have been hit by a supply and demand shock previously unknown in peacetime, with one government after another hitting the pause button, shutting down borders and decreeing extraordinary lockdowns to protect populations against COVID-19. These actions have throttled economic activity, global trade and labour markets.

Governments and central banks have responded with support measures of unprecedented scope and rapidity.

With the lifting of the Great Lockdown, economies have begun to recover. However, the rebound has been uneven and economies remain exposed to a potential second wave of infection. Stimulus policies will remain in place until economies can sustainably support themselves through domestic demand from households and businesses and, eventually, foreign demand. The strength of the recoveries, including in domestic demand, will depend on household, investor and business confidence. The rate at which unemployed people find work will influence consumer confidence and spending. The United States lost some 22 million jobs in March and April and new claims for unemployment benefits have increased by about 47 million since March 20. The country’s unemployment rate climbed from 3.5% in December to a peak of 14.7% in April, still well below the Great Depression-era peak in the 1930s but higher than at any time since the Second World War. It subsided to 11.1% in June, though the US Labor Department said the rate would have been about one point higher had it not been for persistent data collection problems.

American households will be in a position to support demand by drawing on their savings. The US savings rate hit 33% in April, an all-time high. In May it fell back about 10 points to 23.2%. The FDIC reports a record $2 trillion increase in aggregate bank account balances since January. April alone saw an unprecedented $865 billion increase. This influx reflects measures deployed by the US government, including stimulus cheques sent to Americans ($1,200 per adult and $500 per child) and increases in unemployment benefits. Household personal income increased 10.5% in that period. In early June, deposits in commercial banks exceeded $15 trillion, a colossal sum that will be spent by households and help support the recovery. Retail sales jumped 17.7% in May, a sign that households remain a force to be reckoned with and that the recovery is getting underway as the economy reopens.

In Canada, job losses totalled 2.2 million and the number of applicants for the Canadian Emergency Response Benefit (CERB) was 8.4 million as of June 4. Ottawa has extended the program from 16 to 24 weeks.

The rebound story: TINA and FOMO

What explains the rally on the equity markets after their March lows? First, it’s important to keep in mind that Wall Street takes a future-oriented perspective, typically of a four-to-six-month horizon, and what it sees is the sum of investor expectations. Since March 23, the S&P 500 has been signalling an improvement in the economic outlook. Several indicators have since confirmed that most large economies got through the worst of the pandemic’s consequences in Q2. The emergence from the lockdowns points to an improvement beginning in Q3.

Wall Street is also signalling that it expects fiscal and monetary stimulus to continue until the economic recovery is sustainable. Before policymakers tighten the purse strings, they will need to ensure that science has found a treatment or vaccine for COVID-19.

TINA (There Is No Alternative) and FOMO (Fear Of Missing Out) had investors dancing on the edge of a volcano. TINA here means no alternative to equities, since their dividend yield is on average higher than the risk-free interest rate. Among S&P 500 companies, 78% have dividend yields that are higher (by an average of 2%) than the yield on 10-year Treasuries. In Canada, 75% of TSX-listed companies have an average dividend yield of 3.45%. In other words, the decline in bond yields has given wings to equities.

FOMO, meanwhile, led to high demand for popular stocks like Big Tech. The equity rebound since March 23 (S&P 500 +39.31%, Nasdaq +47.01%, TSX +39.65%, Euro Stoxx +32.18% from their respective lows) can be mainly attributed to extraordinary government and central bank intervention, low interest rates, TINA (with a handful of large caps standing out), FOMO, the perceived stemming of the pandemic, the easing of lockdowns and the anticipation of a V-shaped recovery.

Portfolio strategies

Geographic allocation

We are slightly underweight to equities relative to the benchmark. In our view, a cautious stance is warranted in the current environment. Hot on the heels of last quarter’s sharp rebound, stock valuations now raise a number of questions. Equity markets have rebounded, but not necessarily profits. Investors’ renewed enthusiasm for the stock markets may wane if expectations of declining profit growth in the coming quarters hold true. While the worst of the economic data may now be behind us, profit figures will only bottom out once Q2 earnings reports are released. Our cash position is proving to be a strategic asset, which we will carefully leverage when the right opportunities arise.

In fixed income, the global duration of the bonds in the portfolios is 4.5 years, which is in line with our benchmark index. Bonds offer an excellent safety net in the event of renewed upheaval on the markets.

Geographic allocation is proving key to optimizing returns in the portfolios’ equity component. In Q2, we modified our benchmark for stocks, changing its composition from 60% TSX / 40% MSCI World to 50% for both indexes. Back in November 2019, we had decided to make the transition to responsible investment and to eliminate oil stocks from the portfolios. Given the dominant position of energy shares on the Canadian market, we felt that the TSX’s 60% weighting was no longer justified.

Canada | Underweight

While the Canadian valuation multiple is more reason­able than its American counterpart, caution is in order for the TSX. The main reasons for this are post-outbreak challenges in the energy and real estate sectors and the vulnerability of domestic demand arising from high household debt. Also, while the TSX recovered almost $300 billion in capitalization in the second quarter alone, it is still down 10% from the beginning of the year. Its perfor­mance has been anything but uniform. IT and gold producers dominate on the upside, but 8 of the 11 sectors are down. The easing of lockdowns offers a ray of hope, but it is too soon to gauge the potential for regaining all of the lost GDP. Moreover, the pulse of the heavyweight bank­ing segment can only be taken in the upcoming earnings season. For now, mortgages with deferred payments are not being counted as nonperforming. The true state of things will be measurable once the relief programs end. Until then, caution is in order.

United States | Overweight

The S&P 500 Index accounts for 60% of the worldwide market cap of the IT, telecommunications and healthcare sec­tors. Its star is not about to dim. There will be a changing of the guard among countries one day, but not this year. For the US equity market to forfeit its leading position to other countries’ exchanges, value investing would have to gain the upper hand over growth investing. Such a reversal would depend on a sustainable rebound in the structure of interest rates, an unlikely development given the army of central bankers minding the store. The United States will continue to stand out in 2020, even with a few overvalued IT segments. Absent a lasting rise of interest rates stemming from a U-turn in monetary policy, the growth style will continue to predominate. Investors who prefer value investing could, at a minimum, limit spreads in performance by adopting more neutral sector exposure.

Europe | Underweight

For years now, investors have been waiting for Europe to take off. But every time it picks up speed on the runway, it hits a pothole: the appreciation of the euro. National governments and the European Central Bank may well try to put the pedal to the metal, but the continent’s economy has not managed to take off sustainably. A recovery is in the cards, but 2020 will not yet suffice to tip the scales in favour of the Euro Stoxx. Unlike the S&P 500, this index is less exposed to growth investing than to value investing. We continue to recommend underweighting Europe in an appropriately diversified portfolio.

Risk factors

The evolving COVID‑19 pandemic remains the main source of uncertainty clouding economic and financial out­looks. The situation has improved in Europe and North America, but is still deteriorating in many other regions. The risk is now focused on a potential second wave, given that a reinstatement of public health measures would further hobble economic growth. The adverse effects on corporate earnings and the stock markets would be more severe as a result, and the risk of a financial crisis would increase.

Other uncertainties concern what might happen after the pandemic. Economic activity may not catch up as hoped after the main restrictions are lifted. Some sectors could be affected by the ongoing setbacks in consumption, production and trade for a long time to come. The long-term consequences of the fiscal and financial measures could also disrupt outlooks beyond this year. In Canada, it could prove harder than expected to get back to normal after the COVID-19 pandemic. Despite the recent upswing, oil prices remain relatively low from a historical standpoint, which could lead to major re­percussions for the energy sector. It is difficult to predict the scope of the long-term impacts on the industry. In addition, the reduction of key interest rates to their effective floor could heighten concerns over high house­hold debt if rates remain low for too long. Similarly, the robust stimulus plans announced by governments could cast doubt on public finances and put upward pressure on bond yields, especially if the economic crisis persists. If the economic recovery is slower than forecast in some provinces, households and businesses could face more financial difficulties, with greater consequences.

November’s US elections are also a significant variable, and here again the scenarios are numerous. On the eve of the 2016 election, few observers thought Donald Trump could win. Today he trails in the polls but should not be counted out. On the contrary. Unable to run on the economy, renewal and social justice, President Trump may be tempted to revive a talking point that brought him major gains in 2016: direct protectionist confrontation with China. That would hurt not only the global economy but the US economy as well. And while some observers may be pleased with the Demo­crats’ gains in the polls and the prospect of a more pre­dictable White House, it should be kept in mind that a Joe Biden presidency could mean tax increases, which would be very bad news for Wall Street. We will be keeping close tabs on these developments.

Conclusion

A very wise person recently said to me that statistics offer a perspective and it’s important to stick to the numbers. And in the end, wisdom, like logic, always comes out on top. The numbers don’t lie: an investor who invested in the S&P 500 in December 1996, when it was at 741 points, would certainly make money if they held on to their investment—the S&P 500 closed at 3,130 in early July of this year. In other words, an investor’s greatest ally is time. That is, if they can stay above the fray and resist the panic constantly fuelled by Wall Street and the media. I’ll share a little secret: some days, nothing happens, but you’re sure to find something alarming if you stay glued to your screen for 12 hours. Another important lesson is to avoid anxiety-fuelled transactions made on the spur of the moment. In addition, an investment strategy should reflect the investor’s profile and risk tolerance and its allocation should be rebalanced regularly to account for asset class trends.
 
So when is the right time to invest? The answer is that it’s always the right time, since the probability that you’ll enter at the ideal moment is negligible. The same goes for putting money to work and balancing your portfolio on a regular basis. Wisdom pays off!

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.