Stocks had their best quarter in over 20 years as the rebound from the March lows was almost as swift
as the decline. This in an economic environment resembling the worst periods of the great depression.
The unprecedented $1.6 trillion stimulus package from the Fed and Congress (and similar programs
from other developed countries central banks and governments) lifted most stocks. The government
support amounts to over 10% of developed economies GDP. The Fed has indicated that interest rates
are likely to be near zero for at least the next two years. Chairman Powell not only stated that the Fed
is not thinking of raising rates, but that they “are not even thinking about thinking about raising rates”.
Investors are clearly looking through the dire economic situation with expectations of a sharp recovery.
With interest rates almost near zero, only equities have potential for positive returns that are greater
than low single digits.
The Fed and the US Treasury department being “all in” in addressing the recession also led to a rally in
bonds. The Fed recommitted to its monthly pace of buying treasury bonds and agency backed
securities. The current yield on the 10-year treasuries is below 0.7%, and the corresponding yield on 10
-year government of Canada bonds fell below 0.6%. The average yield on US and Canadian stocks is
around 2% and 3%. While stocks are not cheap by most metrics, they are cheap relative to bonds.
The economic picture remains bleak. Nearly 20 million people have lost their jobs, and the
unemployment rate is above 10%. Retail sales remain far below year ago levels and manufacturing
activity has also contracted. The congressional budget office predicts that the US economy will contract
over 35% in Q2. The hope is that with the governments support, the recession will be short.
This quarter also saw protests and rioting related to racial inequality and police violence. Riots, while
tragic, do not directly impact earnings or markets. People are impacted. Small private businesses incur
significant losses, but it does not materially affect large publicly traded companies. Looting is bad but
will probably not change the American political system or bring about the demise of democracy.
Hopefully, it will change the political discussion around racial inequality, but the only concern of the market (and stock prices) is money and not human
liberties.
One potential impact of the unrest is that it may
boost the probability of Joe Biden winning the
presidency in November. While it is still early in
the campaign, we have already seen a marked
increase in support for Biden in the polls. The
odds of a blue wave (Biden wins presidency, and
Democrats retake senate) with Democrats
controlling all 3 branches of government is
increasing. This would imply higher personal taxes
(including capital gains) and more spending
(beyond the COVID extravaganza spend) on social
programs. Analysts say a Democratic-controlled
government would also likely roll back the tax cuts
Congress enacted in 2017, constraining corporate
profit margins. While having a more rational albeit
more geriatric president, a significant move to the
left is not constructive for rising stock prices. It is
uncertain whether Biden will campaign on his
traditional left of center platform, or whether he
will be pulled further to the left by progressives in
the Democratic party.
Western relations with China continue to
deteriorate. Heightened fears of a shooting war or
a world that is split into two economic zones have
increased tensions between the two largest
economies. In the short term these problems are
not as consequential for stocks if the Fed is
providing support and western governments
continuing to subsidize their economies. In the
long term, a continued strain in relations has the
potential for supply chain disruptions, inefficiencies and higher costs which would
impact margins and profits.
Investors have been looking past the current
bad economy and dismal corporate news
anticipating a vaccine some time in the next
nine months with everything then returning to
normal. While optimistic relative to the typical
vaccine development cycle, it is not unrealistic.
Accelerated timelines has multiple drug
companies starting phase 3 trials this summer.
The US government is expediting reviews and
approvals and funding a portion of these trials.
It is also committing billions towards
manufacturing for the delivery of hundreds of
millions of doses.
Unfortunately, even with aggressive vaccine
timelines, the US budget agency has said that
the US economy is not expected to recover from
the pandemic and related shutdowns for the
better part of a decade. This implies that not all
companies will safely make it to the other side.
This impacts smaller companies more than
larger companies, but it will have a dampening
effect on the overall economy. Some states
that contained COVID early in the pandemic are
currently seeing an explosion in COVID cases.
This is not necessarily a second wave, but part
of the initial surge. This has resulted in delays in
reopening the economy or in some cases a
re-closing of previously opened states. The
recovery will be bumpier and take longer than
the best-case scenarios.
Even with a vaccine, social distancing will still be
prevalent as it will take time for entire populations
to be inoculated. We remain cautious, even with
stocks being cheaper than bonds, as they are not
cheap relative to historical levels. While the
pandemic will be controlled, it might take longer
than investors are anticipating. The road to
recovery will be choppy, as evidenced by the
failed reopening in some states following a surge
of new cases. Stock have priced in a lot of good
news. A lot needs to go right to justify these
valuations. We do not foresee another significant
decline as central banks and government support
will prevent the economy from falling into a
depression. Client portfolios are conservatively
constructed with an emphasis on capital
preservation.
As always, we welcome your thoughts and
comments.
Tuesday, July 21, 2020
Tuesday, April 28, 2020
First Quarter 2020
It was an ugly quarter for stocks as COVID-19 progressed from a regional virus to a global pandemic.
Equity markets experienced the fastest fall into bear market (defined as a fall of 20%) in history, taking
22 days vs an average of 86 days (Chart 1). The COVID-19 pandemic is a classic exogenous demand
shock, tipping the global economy into recession. In response to the developing healthcare crisis and to
slow the spread of the virus, countries have instituted social distancing and stay at home policies. This
led to the first ever stoppage of non-critical economic activity. Initial jobless claims have exploded with
over 10 million claims over the last two weeks vs. an average of 225,00 per week. Compounding the
blow from the healthcare crisis was a cratering in the price of oil (See Box 1). The US and Canadian
stock markets declined 35% (aided by margin calls and forced selling) from their highs and then
bounced over 20% in a very quick time frame. While the volatility in the markets has been anything but
pleasant, we must remember that at some point there will be a historic buying opportunity as crises
always end.
Stock volatility is typically a result of the fear of the unknown. Equity investors hate uncertainty and fear of a financial or liquidity crisis led to the sudden drop in stock prices. From Feb 27 till the end of the quarter, 19 of the 23 days saw moves of greater than 2%. This includes the biggest percentage gain in over 80 years, and the second biggest percentage loss since 1940. We expect a cessation of extreme volatility when we have a better idea of the shape and duration of the crisis.
Bonds have a place in a diversified portfolio due their ability to provide stability during times of stress. They did exactly what they were designed for delivering a small positive return despite their low yields. During the final month of the quarter bond prices declined as corporate bond spreads widened. Elevated refinancing and repayment concerns drove the decline until the Fed stepped in to calm the markets.
The current COVID-19 shock is akin to a natural disaster which generates a sharp but short-lived disruption. The hope is that we see a normal and rapid economic recovery. However, the global scale of the disruption is both unique and historic. Synchronized global downturns typically take longer to heal and production losses are rarely made up in full.
We continue to grapple with the severity of the downturn and how long the economy will be closed for business. Investors are cognitively still trying to get their arms around these issues and the shape of the recovery. This time really is different, and not in a positive way. We are not overly optimistic of a quick return to the old ways. Countless individuals and companies will see their balance sheets take a hit as there will be little money coming in the door for two to three months. When life returns to “normal”, we will not see an immediate economic recovery to prior levels. It will take a while to rebuild consumer confidence and for individuals to return to their regular routines. Social distancing will remain in place for longer than is currently contemplated which will prohibit certain activities where many people congregate in tight confines. Individuals who saw a reduction in cash flows will also be hesitant to spend at pre-crisis levels until they rebuild a portion of their savings. The market has correctly priced in a recession, but we suspect the market has also priced in a swift recovery, which is not a foregone conclusion.
On the positive side, stocks typically bottom four months before the end of a recessions. Recessions normally do not end with the end of bad data, but with a sequentially positive inflection of the bad data (i.e. data is less bad on a sequential basis or second derivative turns positive). Again, we are back to looking at the duration and depth of pain of the recession.
Governments are pumping liquidity into the financial system by providing financing for businesses and wage supplements for individuals. The US alone is planning on over $2 trillion in support to soften the severity of the recession and prevent it from turning into a devastating liquidity or financial crisis. While providing a backstop for both individuals and businesses is positive, it will not make the recession any shallower or shorter. This recession is the result of a virus, and all the money in the world will not change that. Governments are ordering their populations to cease all economic activity and stay home for an indeterminate amount of time. Unfortunately, the pandemic needs to run its course.
The Federal Reserve has also stepped in with bazooka. They have stated that they will do whatever it takes to help the American economy. For the most part, central banks have dusted off the playbook from the 2008/2009 crisis and further augmented what they did during that time period. This includes, but is not limited to, extending loans to businesses, purchasing unlimited amounts of corporate debt and introducing a new lending facility for the commercial paper market. These actions are designed to prevent a corporate liquidity crunch turning into a solvency crisis. They have been very quick to respond as the credit markets briefly froze in March. The Fed and most central banks have also significantly decreased their lending rates. Typically, the Fed using its unlimited balance sheet and “doing whatever it takes” to backstop the economy has been a buy signal for stocks. Government and central bank interventions are designed to ensure that individuals, small businesses and companies do not drown before they see the other end of the enforced shut down.
While we are optimistic that we have seen the bottom, we are not as confident that we will not revisit the lows. Companies have yet to confess how bad it is and the impact on their finances. The current consensus is that this will last another two to six weeks, but we think that this is optimistic. While we believe the “lock down” will be lifted at some point this quarter, social distancing will be in place for the foreseeable future as there is currently no way to treat the virus.
Current predictions are that new COVID-19 cases will peak in most countries sometime in April. Social distancing is working. Unfortunately, we cannot simply declare victory and return to our normal lives. There is still no cure, vaccine or widespread tests. We do not know what proportion of people are infected without symptoms due the lack of extensive testing. As can be seen from countries that are past the peak of new cases (i.e. Singapore, Japan), lessening of restrictions might allow the virus to flare up again.
We believe the best course of action is risk mitigation. Having said that, some companies stock prices were pricing in a severe recession and their stocks were buyable. To reiterate, we need to be selective about which companies we buy and at what price. Client portfolios have cash, but we will be very discriminating on how we invest the money.
We adhere to the adage “that the better that we can define the problem, the closer we are to the bottom”. We know that COVID-19 is an insidious disease, that is easily spreadable, and has lower mortality rates than other viruses. We know that the economy has shut down, and central banks and governments are throwing money at the economy to ensure that the current recession does not morph into something larger. What we do not know, is how long we will purposely impair the economy to contain the virus, what the recovery looks like, and when it will begin in earnest. We also do not know when there will be a vaccine or universal testing. Companies will report OK March quarters, and guide to ugly June quarters (if they provide guidance at all), but everything beyond that is unknown. Based on being able to quantify the present and the next three months, but nothing after that, we remain cautious and would look to put money into stocks on a pull back as the unknowns either are better defined or become a concern for investors.
As always, we welcome your thoughts and comments.
Stock volatility is typically a result of the fear of the unknown. Equity investors hate uncertainty and fear of a financial or liquidity crisis led to the sudden drop in stock prices. From Feb 27 till the end of the quarter, 19 of the 23 days saw moves of greater than 2%. This includes the biggest percentage gain in over 80 years, and the second biggest percentage loss since 1940. We expect a cessation of extreme volatility when we have a better idea of the shape and duration of the crisis.
Bonds have a place in a diversified portfolio due their ability to provide stability during times of stress. They did exactly what they were designed for delivering a small positive return despite their low yields. During the final month of the quarter bond prices declined as corporate bond spreads widened. Elevated refinancing and repayment concerns drove the decline until the Fed stepped in to calm the markets.
The current COVID-19 shock is akin to a natural disaster which generates a sharp but short-lived disruption. The hope is that we see a normal and rapid economic recovery. However, the global scale of the disruption is both unique and historic. Synchronized global downturns typically take longer to heal and production losses are rarely made up in full.
We continue to grapple with the severity of the downturn and how long the economy will be closed for business. Investors are cognitively still trying to get their arms around these issues and the shape of the recovery. This time really is different, and not in a positive way. We are not overly optimistic of a quick return to the old ways. Countless individuals and companies will see their balance sheets take a hit as there will be little money coming in the door for two to three months. When life returns to “normal”, we will not see an immediate economic recovery to prior levels. It will take a while to rebuild consumer confidence and for individuals to return to their regular routines. Social distancing will remain in place for longer than is currently contemplated which will prohibit certain activities where many people congregate in tight confines. Individuals who saw a reduction in cash flows will also be hesitant to spend at pre-crisis levels until they rebuild a portion of their savings. The market has correctly priced in a recession, but we suspect the market has also priced in a swift recovery, which is not a foregone conclusion.
On the positive side, stocks typically bottom four months before the end of a recessions. Recessions normally do not end with the end of bad data, but with a sequentially positive inflection of the bad data (i.e. data is less bad on a sequential basis or second derivative turns positive). Again, we are back to looking at the duration and depth of pain of the recession.
Governments are pumping liquidity into the financial system by providing financing for businesses and wage supplements for individuals. The US alone is planning on over $2 trillion in support to soften the severity of the recession and prevent it from turning into a devastating liquidity or financial crisis. While providing a backstop for both individuals and businesses is positive, it will not make the recession any shallower or shorter. This recession is the result of a virus, and all the money in the world will not change that. Governments are ordering their populations to cease all economic activity and stay home for an indeterminate amount of time. Unfortunately, the pandemic needs to run its course.
The Federal Reserve has also stepped in with bazooka. They have stated that they will do whatever it takes to help the American economy. For the most part, central banks have dusted off the playbook from the 2008/2009 crisis and further augmented what they did during that time period. This includes, but is not limited to, extending loans to businesses, purchasing unlimited amounts of corporate debt and introducing a new lending facility for the commercial paper market. These actions are designed to prevent a corporate liquidity crunch turning into a solvency crisis. They have been very quick to respond as the credit markets briefly froze in March. The Fed and most central banks have also significantly decreased their lending rates. Typically, the Fed using its unlimited balance sheet and “doing whatever it takes” to backstop the economy has been a buy signal for stocks. Government and central bank interventions are designed to ensure that individuals, small businesses and companies do not drown before they see the other end of the enforced shut down.
While we are optimistic that we have seen the bottom, we are not as confident that we will not revisit the lows. Companies have yet to confess how bad it is and the impact on their finances. The current consensus is that this will last another two to six weeks, but we think that this is optimistic. While we believe the “lock down” will be lifted at some point this quarter, social distancing will be in place for the foreseeable future as there is currently no way to treat the virus.
Current predictions are that new COVID-19 cases will peak in most countries sometime in April. Social distancing is working. Unfortunately, we cannot simply declare victory and return to our normal lives. There is still no cure, vaccine or widespread tests. We do not know what proportion of people are infected without symptoms due the lack of extensive testing. As can be seen from countries that are past the peak of new cases (i.e. Singapore, Japan), lessening of restrictions might allow the virus to flare up again.
We believe the best course of action is risk mitigation. Having said that, some companies stock prices were pricing in a severe recession and their stocks were buyable. To reiterate, we need to be selective about which companies we buy and at what price. Client portfolios have cash, but we will be very discriminating on how we invest the money.
We adhere to the adage “that the better that we can define the problem, the closer we are to the bottom”. We know that COVID-19 is an insidious disease, that is easily spreadable, and has lower mortality rates than other viruses. We know that the economy has shut down, and central banks and governments are throwing money at the economy to ensure that the current recession does not morph into something larger. What we do not know, is how long we will purposely impair the economy to contain the virus, what the recovery looks like, and when it will begin in earnest. We also do not know when there will be a vaccine or universal testing. Companies will report OK March quarters, and guide to ugly June quarters (if they provide guidance at all), but everything beyond that is unknown. Based on being able to quantify the present and the next three months, but nothing after that, we remain cautious and would look to put money into stocks on a pull back as the unknowns either are better defined or become a concern for investors.
As always, we welcome your thoughts and comments.
Monday, January 20, 2020
Fourth Quarter Review
Global equity markets hit record highs capping a strong year for stocks. Easier monetary policy and re-accelerating economic growth fuelled the gains. The strengthening economy and the completion of the Fed’s easing cycle in the fourth quarter drove a bump in interest rates and a decline in bond prices.
At the end of October, to almost no one’s surprise, the Fed cut interest rates. This was the third time since August that they reduced the Fed’s fund rate. They stated that they would pause to assess incoming data before lowering rates further. The rational for the rate cut was to provide insurance from ongoing risks. The Fed’s chair, Jerome Powell stated, “there’s plenty of risk left” but some of the challenges are subsiding. The recent easing should buoy confidence and aide the economy.
The US consumer is in pretty good shape. The US economy remains resilient to most of the headwinds impacting other countries growth profiles. Data from recent jobs reports is strong despite Boeing’s issues and its impact on its supply chain. Rising average hourly earnings continues to induce more workers to enter the workforce leading to an expanding labour pool.
Corporate earnings reports were better than feared, which tends to be supportive of a continued upward movement in stock prices. Companies have been maintaining future guidance, which is positive considering the trade rhetoric and tariff fears. Industrial companies have communicated that the mid-year inventory destocking is nearing an end. This is most evident by the bottoming of the Purchasing Managers Indexes (PMI’s).
Green shoots from Europe signify a pick-up from near recession levels. Autos, housing and manufacturing PMI’s all have been positive recently. The Chinese economy appears to be rebounding based on accelerating industrial production data. After lengthy on-again / off-again negotiations, China and the US have reached a tentative mini trade deal. While positive, it is not the all-encompassing deal that the market hoped for.
The presidential impeachment trial and the upcoming 2020 election are both risks that should not be ignored. As the Republicans control the senate, it is unlikely that President Trump will be convicted for impeachment. Based on publicly available evidence, it is improbable that enough republicans senators will be persuaded to change their stance and vote against the president.
The election risk is related to the uncertainty of who will be the next president. How will investors respond if it is likely that Trump remains in office for another four years? How would confidence be impacted if Elizabeth Warren was the president elect? Her expansion of government and the big tax increases required to pay for these programs could put a chill on the economy. On the other hand, the markets would probably respond positively if Michael Bloomberg was the president elect as he is viewed more of a centrist.
The Stock market remains near record highs, and valuations remain full. Corporate earnings are expected to grow 8% this year. Low interest rates and no impending recession continues to support an extension of the bull market. The only caveat is that gains in 2020 will not be as robust as in 2019 and we should expect elevated volatility. While volatility is typically not perceived as a positive, it should not impact long term investors.
Bonds had a poor fourth quarter but a remarkably good year considering the low yields at the start of the year. It surprised us that interest rates declined as much as they did in the second half of the year. The slower economy led central banks to reverse course and begin easing. Central banks have again reversed course signalling that the easing cycle is complete implying interest rates are unlikely to decline further.
We continue to prefer equities over bonds. Although bonds had a great year (+6.9%), they still underperformed equities. Going forward, stocks should benefit from an improvement in US business activity, trade deals between Canada, Mexico and the US and a US – China trade deal. A deal to keep the US government operating for another year, avoiding a repeat of this year’s shutdown is also positive. The results of the UK election also eased some uncertainty about the how and when the UK will leave the European Union. We expect moderate economic growth in 2020, with the downside risk being less severe than three months ago.
As always, we welcome your thoughts and comments.
At the end of October, to almost no one’s surprise, the Fed cut interest rates. This was the third time since August that they reduced the Fed’s fund rate. They stated that they would pause to assess incoming data before lowering rates further. The rational for the rate cut was to provide insurance from ongoing risks. The Fed’s chair, Jerome Powell stated, “there’s plenty of risk left” but some of the challenges are subsiding. The recent easing should buoy confidence and aide the economy.
The US consumer is in pretty good shape. The US economy remains resilient to most of the headwinds impacting other countries growth profiles. Data from recent jobs reports is strong despite Boeing’s issues and its impact on its supply chain. Rising average hourly earnings continues to induce more workers to enter the workforce leading to an expanding labour pool.
Corporate earnings reports were better than feared, which tends to be supportive of a continued upward movement in stock prices. Companies have been maintaining future guidance, which is positive considering the trade rhetoric and tariff fears. Industrial companies have communicated that the mid-year inventory destocking is nearing an end. This is most evident by the bottoming of the Purchasing Managers Indexes (PMI’s).
Green shoots from Europe signify a pick-up from near recession levels. Autos, housing and manufacturing PMI’s all have been positive recently. The Chinese economy appears to be rebounding based on accelerating industrial production data. After lengthy on-again / off-again negotiations, China and the US have reached a tentative mini trade deal. While positive, it is not the all-encompassing deal that the market hoped for.
The presidential impeachment trial and the upcoming 2020 election are both risks that should not be ignored. As the Republicans control the senate, it is unlikely that President Trump will be convicted for impeachment. Based on publicly available evidence, it is improbable that enough republicans senators will be persuaded to change their stance and vote against the president.
The election risk is related to the uncertainty of who will be the next president. How will investors respond if it is likely that Trump remains in office for another four years? How would confidence be impacted if Elizabeth Warren was the president elect? Her expansion of government and the big tax increases required to pay for these programs could put a chill on the economy. On the other hand, the markets would probably respond positively if Michael Bloomberg was the president elect as he is viewed more of a centrist.
The Stock market remains near record highs, and valuations remain full. Corporate earnings are expected to grow 8% this year. Low interest rates and no impending recession continues to support an extension of the bull market. The only caveat is that gains in 2020 will not be as robust as in 2019 and we should expect elevated volatility. While volatility is typically not perceived as a positive, it should not impact long term investors.
Bonds had a poor fourth quarter but a remarkably good year considering the low yields at the start of the year. It surprised us that interest rates declined as much as they did in the second half of the year. The slower economy led central banks to reverse course and begin easing. Central banks have again reversed course signalling that the easing cycle is complete implying interest rates are unlikely to decline further.
We continue to prefer equities over bonds. Although bonds had a great year (+6.9%), they still underperformed equities. Going forward, stocks should benefit from an improvement in US business activity, trade deals between Canada, Mexico and the US and a US – China trade deal. A deal to keep the US government operating for another year, avoiding a repeat of this year’s shutdown is also positive. The results of the UK election also eased some uncertainty about the how and when the UK will leave the European Union. We expect moderate economic growth in 2020, with the downside risk being less severe than three months ago.
As always, we welcome your thoughts and comments.
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