July 9, 2021

Financial letter, Summer 2021 – 56^th edition

An extraordinary cycle

Each cycle is different, but they have several elements in common:

1. In a depression, a cycle begins.
2. The strength of the recovery surprises even the most optimistic.
3. The longer it stretches out, the more forecasters worry about inflation and the lax response from central banks.
4. Lastly, it fades with euphoria, exuberance and habit.

The unusual, spectacular response of public authorities has made it possible to preserve the gains of the past, quickly enable an exit from the crisis and allow for a recovery. "The unprecedented protective policy net that governments deployed has preserved the economic fabric, firms and jobs in most advanced and some emerging-market economies. Never in a crisis has policy support – be it health, with the record speed of vaccine development, monetary, fiscal or financial – been so swift and effective." (OECD)

Overall, Desjardins Group is predicting global GDP growth of 5.9% in 2021 and 4.5% in 2022. North Asia, the US and Canada will act as a conduit for the global economy over a 12- to 18-month horizon. The reopening of economies and the recovery of the service sector, as well as the momentum of global trade and manufacturing could propel economic activity beyond this outlook.

There are still many risks! COVID-19 and its variants are the two main risks in this scenario. Despite the good news about vaccination, the pandemic is not over. Even if we know what to do to stop it, a new pandemic wave would see the recovery seesawing.

Other risk factors, including China's economic outlook, inflation, and normalization of public policies, will attract attention in the short and medium term.

According to the Fed and the Bank of Canada, inflation will be temporary. "As expected, CPI inflation has risen to around the top of the 1-3 percent inflation-control range, due largely to base-year effects and much stronger gasoline prices. While CPI inflation will likely remain near 3 percent through the summer, it is expected to ease later in the year, as base-year effects diminish and excess capacity continues to exert downward pressure." (Bank of Canada)

According to BCA Research, the recent correction in resource prices (excluding oil) will help deflate the price bubble in the short term. We should add that the effect of mitigating supply and production bottlenecks will also ease pressure on prices.

Fixed income and bond strategies

Unless there is a slippage due to the Fed and the Bank of Canada mismanaging expectations, interest rates will be representative of the economic and financial backdrop. A gradual increase in rates is expected for the entire curve. At the end of the year, Desjardins Group expects the rate on 10-year Treasuries to be 2%, and 1.90% for Canada 10-year bonds. Overall, the economic backdrop calls for a prudent strategy and an underweighting of bonds in portfolios over a 12-month horizon. Duration management becomes all the more important against the backdrop of a gradual rise in yields. The average duration of our portfolio is 3.5 years versus our benchmark of 5.5 years. During this period of interest rate hikes, the preferred share weighting did add value to the fixed-income portion of the portfolios.

Strategic share allocation

Equities and fears of inflation

With inflation officially reaching more than 5%, some are worried about the pressure that rising input prices could cause on profit margins. Currently, most companies are able to pass on cost increases and protect their profitability.

Equities and high valuation?

The S&P 500 has grown by just over 40% in the last 12 months. However, the earnings multiple at which it trades remained stable at 21.2 times profits for the next 12 months, while the increase in profits did the job. Given that earnings should continue to grow for at least the next 4 quarters, the ratio could even be overvalued.

In the short term, we favour an approach with a small dose of caution. We believe that the current climate calls for a slight overweighting of cash, an underweighting of bonds, and a neutral position in equities. We do not expect a sharp pullback in the short term; however, erratic periods this summer could lead us to take advantage of weaknesses (5% to 10% pullback) to redirect the excess cash to equities.

Beyond the short term, we maintain an underweighting in bonds, but opt for a neutral cash position combined with an overweighting in equities.

A word on financials

The financial sector, especially banks, particularly in Canada, is posting an excellent start to the year. However, its potential remains interesting. Not only is the sector still one of the lowest-valued, the outlook is conducive to surprises for the next 6 to 18 months.

After taking provisions for bad debts last year, they seem to have turned out too large 12 months later. Although the Superintendent of Financial Institutions is maintaining its moratorium on share buybacks and dividend increases, such a decision should be made by the end of the year. As a result, banks will end up with extraordinary profits, significant excess capital, and a promising economic environment.

Thus, despite already attractive gains, Canadian banks still have potential that justifies their overweighting in portfolios.

Conclusion

Despite an extraordinary context, a pandemic exit, emergency measures that will have to fade and some investors' complacency, we are maintaining a modestly optimistic positioning. Short-term downward fluctuations will have to be seized in order to add a little more octane to investment portfolios.

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 are committed to working ever harder to find solid opportunities in the financial markets, so as to help you reach your long-term goals.