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.

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.

Third Quarter Commentary

After a challenging summer, equities rallied into September resulting in mild gains for the Canadian and US equity markets.  In response to a continued slowdown in economic growth, US and European central banks lowered interest rates.  The lower rates led to a solid quarter for Canadian bonds.

An inverted yield curve, negative interest rates and fears of a recession contributed to stock volatility.  The US yield curve briefly inverted (short term rates are higher than long term rates) during the third quarter.  Inverted yield curves typically precede recessions by six to nine months. One can argue that this indicator is not as relevant today as over $15 trillion of sovereign bonds currently trade with negative interest rates. While we do not typically subscribe to the “this time is different” camp, we acknowledge that the yield curve barely inverted for a few days so maybe we should focus on other indicators.

The ISM Manufacturing Index dipped below 50 indicating that the Manufacturing economy is weak.  Although this is not positive, manufacturing accounts for a small percentage of the US economy.  The US – China trade war is also generating business uncertainty contributing to lower investment in the US and slower economic growth in China.

On the positive side, the US consumer remains healthy.  Consumer confidence declined slightly from elevated levels and consumer spending has remained robust. The tightening cycle of the last few years is over as most central banks are easing. Employers are continuing to hire, especially when they can find people who have the skills to fill open vacancies.

When considering the future direction of equity markets, investors are looking at a muddled picture.  There appears to be a tug of war between slowing growth, a short-lived inverted yield curve and recession fears on one side with fair valuations and central banks easing on the other side.  We currently do not envision a recession, but we will continue to monitor the data to evaluate if a change in strategy is warranted. 

These mixed signals point to muted stock returns with increased volatility. There are still opportunities to make money but making significant returns will be challenging.  To be clear, we do not envision a recession or a significant drop in the market, but also can make a case where stock market returns will be more subdued than they have been over the last 10 years.

The stock market remains near record levels which is partly related to historically low interest rates. We are still positive on the outlook for stocks, even though valuations can best be described as full, being neither cheap nor hideously expensive.  We continue to believe that stocks are more attractive than bonds even if our equities outlook is increasingly subdued. 

Due to slowing earnings growth and the run up in prices since the beginning of the year, stocks are vulnerable to a pull back. We are getting increasingly conservative with respect to the stocks we hold for clients and are gravitating to companies that are not particularly economically sensitive.  If anything, we prefer stocks where performance will be a function of something other than the economy.  We prefer catalysts that involve a turnaround, a restructuring or being dependent on a cycle that is independent from the economy. We have also trimmed positions that have performed particularly well leading to cash being at more elevated levels.  We will redeploy cash into stocks if better opportunities are presented.

As always, we welcome your thoughts and comments.

Second Quarter Commentary

Stocks finished the quarter near record highs despite a slowing global economy. There was little change in the economic data or the outlook from the prior quarter. The on again, off again Chinese – American trade negotiations achieved little progress. Interest rates extended their decline, as central banks became increasingly accommodative. US treasury prices increased as investors anticipate multiple rate cuts through year end.

As the quarter progressed, volatility in equities increased. Stocks initially rallied on an accommodative fed, upbeat growth prospects and decent earnings reports. As global economic forecasts moderated in May, stocks declined. Stocks rallied into the end of the quarter once equity investors realized that the probability of a Fed rate cut was increasing.

Escalating global trade tensions is the primary explanation for the global slowdown. The US threatened to impose punitive tariffs on Mexico unless it was more serious about stemming the flow of illegal immigration. While this spat was eventually settled, the trade dispute with China has endured. This trade conflict could become problematic as it involves the two largest economies in the world. The US also threatened to impose tariffs on European manufacturers. Trade uncertainty led to diminished business investments and curtailed consumer consumption.

Central banks have been quick to react to the economic slowdown by tilting towards a more accommodative stance. There were strong hints at the last Fed meeting that a rate cut was likely at their next meeting (late July) if there is no acceleration in GDP growth. Slow downs are not atypical during expansions, especially at this late stage of the business cycle. With the Fed willing to cut rates, it is likely that growth will re-accelerate in the second half of the year.

With lower interest rates, Canadian bond prices rose and provided a robust 2.5% return during the quarter. As we currently do not anticipate a recession, interest rates have probably bottomed. Future bond returns should reflect the prevailing bond yield, which is in the low single digits.

The stock market remains near record levels which is partly related to historically low interest rates. Valuations can best be described as full, being neither cheap nor hideously expensive and modestly above their long-term average. We are still positive on the outlook for stocks, but have difficulty making a case for significant upside. Although we still believe that stocks are more attractive than bonds, we are beginning to temper our bullishness. Stocks are vulnerable to a correction due to slowing earnings growth and their run since the beginning of the year. We are getting increasingly conservative with respect to the stocks we hold for clients and are gravitating to companies that are not particularly economically sensitive. If anything, we prefer stocks where performance will be a function of something other than the economy. We prefer catalysts that involve a turnaround, a restructuring or being dependent on a cycle that is independent from the economy. We have also trimmed positions that have performed particularly well leading to cash being at more elevated levels. We will redeploy cash into stocks if better opportunities are present.

As always, we welcome your thoughts and comments.

MARKET REBOUND

Stock are off to their best start in over 20 years. A more benign Fed with respect to future interest rate increases and solid earnings reports drove the sharp reversal from Q4. The bond market also performed well reflecting declining interest rates. While the US economy has lost some momentum, it remains on sold footings.

Most issues weighing on stock prices during the fourth quarter were resolved in a positive fashion. US recessionary concerns proved to be overblown. Reported economic data revealed a slowing US economy albeit one that is still growing. Worries that the Fed would make a policy mistake by raising interest rates too far or too fast were assuaged when the Fed said that it would pause hiking interest rates to gauge the state of the economy. Fears of a trade war with China leading to a global recession dissipated as productive talks increased the likelihood of a resolution. Jitters that a long-term government shutdown would impact the economy disappeared once a budget deal was reached. Finally, the Mueller investigation concluded with a report that there was no collusion between Russia and President Trump. While none of these add to US or global growth, eliminating these potential negatives relieves the stock market of uncertainty. This led to expanding stock valuations as investors were increasingly confident in the outlook.

Although several potential negatives and uncertainties are “off the table”, risks remain. There is no guarantee that the China – US trade dispute will be successfully resolved. China and particularly Europe are exhibiting slower growth, which could still impact global growth.

The stock market is at a crossroads. As stock prices near their all-time highs, decreases in corporate earnings estimates have stock valuations close to their historical average. At this late stage of the business cycle, it is unlikely that valuations will expand materially. Upside for stocks will have to come from earnings growth.

Earnings growth is typically a function of corporate revenue growth and margins. Revenue growth should be additive as we currently do not forecast a recession. Expanding margins have been an important component of the current bull market. Declining labour costs, increasing international sales and lower taxes have all contributed to margin expansion. Unfortunately, most of these tailwinds are peaking or are at risk of being unwound.

Labour as a percentage of Gross Domestic Income has been falling since 1980. This was partly due to declining union membership, less bargaining power on the part of workers and the rise of China (with significantly cheaper wages) as a global manufacturing hub.

The US – China trade dispute (and punitive tariffs) has led US corporations to seek other manufacturing sources besides China. The rise in labour costs in China has also made that country less attractive for low-cost production. Unfortunately, few other countries have the scale or infrastructure to be a global manufacturing powerhouse to replace China as a source of low-cost goods. This means that corporations will have to absorb higher wage costs and tariffs (impacting margins) or pass them along to customers.

Worries about income inequality is also on the rise. The democrats have made this a central plank of their platform which could result in a higher national minimum wage. This would impact corporate margins in labour intensive sectors of the economy.

Companies have used havens and other avoidance schemes to lower taxes over the last few decades. The 2018 tax cuts capped a multi-decade decline in corporate rates with tax rates likely bottoming. Left leaning candidates are campaigning on everyone paying their fair share, including corporations. If the Democrats win in 2020, we should assume they will be aggressive in raising corporate tax rates.

With the recent slowdown in economic growth, bond prices increased as yields decreased. This resulted in bonds returning a robust 3.9% during the quarter. With the decline in yields, bonds are less attractive than they were three months ago. We expect bond returns will track bond yields which are currently in the low single digits.

This cycle is one of the longest on record, but that does not necessarily presage its impending doom. The economy continues to grow and there has not been a substantial change to corporate earnings prospects. Although we expect stocks to provide positive returns, they are less attractive than they were at the beginning of the year due to their big upward move. We have become increasingly defensive with respect to stock selection. We have sold some companies that are more cyclical in nature and added stocks where the business model is more durable. With bonds providing low single digit returns, we continue to prefer stocks over bonds.

Market Correction

2018 ended on an ugly note as December was one of the worst months ever for stocks. The final quarter saw a marked increase in volatility as investors demanded a higher risk premium in the face of tighter monetary policy (rising interest rates). Trade tensions between China and the United States provided an additional overhang for stocks. Overall, it was an awful quarter for stocks as the S&P 500 declined by 14.0% and the S&P / TSX fell by 10.9%. Many stocks fell more than 20%, putting them in bear market territory. Since reaching their lows in late December, stocks have rebounded. The bond market provided a measure of stability returning 1.8%.

While earning reports this quarter were solid, they were not as robust as in prior quarters. Investor fears related to a peak in economic growth and earnings weighed on stocks. We currently do not envision a recession this year but acknowledge that growth will not match the level of 2018. A deceleration in earnings growth warrants a reduction in stock prices but corporate America is still healthy notwithstanding the slower earnings growth. With the recent pull back, stocks are currently trading below 15 times 2019 earnings, which is close to its long-term average. Lower equity prices, no material change in earnings prospects and no impending recession puts equities at more attractive levels than three months ago.

As expected, the Fed increased short term interest rates in December. They also signaled that they would be less aggressive with respect to raising rates in 2019. Inflation is a more serious threat than at any time in the last ten years due to low unemployment and a shortage of skilled workers. This threat is offset by slower economic growth. The net result is a Fed that will take a wait and see stance that is more data dependent. Chairman Powell has also stated that interest rates are currently near a neutral level (neither too restrictive or accommodative) which is beneficial for economic growth.

The US yield curve briefly inverted during the quarter. This means that longer dated bonds were yielding less than shorter term bonds. Investors were spooked as this is typically looked on as a recessionary indicator. We are not overly concerned as this indicator gives plenty of false signals and the inversion was ever so slight (5 basis points) between the one- and five-year bonds. Typically, investors who follow this indicator tend to monitor the spread between the two and the ten-year bonds and this segment of the yield curve never inverted.

The Bank of Canada held its benchmark interest rate steady at 1.75% during their December meeting. Lower oil prices and slower economic momentum were the primary reasons for officials striking a more cautious tone and casting doubts about future rate increases. This dovish tone from the Bank of Canada resulted in a meaningful decline in the Canadian Dollar vs the US Dollar.

We can’t write about the quarter without mentioning the US Political situation. The midterm elections resulted in the Republicans adding to their slim majority in the Senate, and the Democrats convincingly taking control of the house. A divided government is typically positive for markets as gridlock and a do-nothing government allows businesses to thrive. Unfortunately, we are not in a normal environment. The political environment is divisive, with little civility between the two parties. Democrats winning a majority in congress results in their chairing house committees. They will probably use this new power to search for proof of Trump’s malfeasance. Whether they are serious about impeaching President Trump or just making noise to embarrass the president is moot. The investigations will create additional political uncertainty which is never positive for the markets.

The economic outlook remains bright but not without risk. This cycle is one of the longest on record, but that does not necessarily presage its impending doom. Political, trade and potential monetary mistakes are all risks that could derail this cycle or the bull market. We do not expect these risks to materialize this year, but we will remain vigilant for any changes to the outlook. From a “glass is half full” positive perspective, the recent swoon in stocks has resulted in more attractive valuations with no change in the fundamental outlook. The economy continues to chug along and there has not been a material change to corporate earnings prospect. Consequently, we continue to prefer stocks over bonds and will maintain this stance until a change is warranted. As always, we welcome your thoughts and comments.

THE RETURN OF VOLATILITY

Equity markets underwent a significant transformation during the first quarter. Volatility increased markedly after an extended period of calm as investors became increasingly concerned about rising interest rates and a potential trade war. This led to the cessation of the sustained market uptrend and a severe correction. A high level of complacency also contributed to the stock price vulnerability. The US stock market declined 1.2%, while the Canadian market declined 5.2%. Bond markets also fell as interest rates rose on inflation fears. Bond markets were responding to improving economic conditions and Central Banks removing previously injected monetary stimulus.

The recent rise in volatility and the stock market correction coincided with a changing of the guard at the Fed as Janet Yellen concluded her term as Fed chair. This should not be too surprising as the markets also experienced increased volatility when the previous Fed chair retired. The incoming fed chair, Jerome Powell, has signaled a continuation of the current policy of gradually raising interest rates. The economy is at a critical juncture due accelerating growth, near capacity employment and accommodative interest rates. Investors are fearful of a resurgence of inflation due to the government's tax cuts. Although it was Janet Yellen who began this tightening cycle, it will be Jerome Powell's Fed that does the heavy lifting with regards to monetary tightening. The trick will be to raise interest rates just enough to return interest rate policy to neutral (vs. the current accommodative stance) while at the same time not raising them too far or too fast and snuffing out the economic expansion. Federal Reserve tightening cycles always tend to be messy, and this one should be no different.

President Trump has been making a lot of noise of late about increasing tariffs on US trading partners and winning a trade war. Optimistically, his bluster is only a negotiating strategy to get US trade partners (and specifically China) to negotiate more balanced trade agreements. Unfortunately, the market has been focussing on the negative consequences of a potential trade war, and the theoretical impact on the economy. Investors are keying in on the tail risk that negotiations are unlikely to be successful which would lead to a full out trade war. This would obviously be negative for the global economy. Contrary to President Trump's recent statements, there are never any real winners in a trade war. While we believe a full blown trade war is unlikely, President Trump has created ambiguity as to the eventual outcome, and the market abhors uncertainty. Increased uncertainty implies lower valuations, which results in increased volatility.

As the market has recently been focused on issues that could derail the bull market and the economy (trade and interest rates), earnings estimates have continued to creep upwards. Positive estimate revisions are based on increased capital spending, benefits from the recently enacted tax cuts and better foreign earnings due to a weaker US dollar. This has translated into 2018 earnings estimates that are 16% higher than 2017, with a further 10% increase projected for 2019. Valuations towards the end of 2017 appeared expensive when in reality stock investors were anticipating the acceleration in earnings. With rising earnings estimates, we now have a market that is reasonably priced based on historical valuations.

We continue to prefer equities over bonds. Although bond yields have improved, bond yields are still only returning low single digits. US equities are trading at 15 times next year's earnings which is pretty close to the historical norm. While the Canadian market is a little cheaper than the US market, we continue to prefer the US market due to its diversity, higher growth profile and lower cyclicality. With the Fed tightening and with the current, uncertain political climate, we expect volatility to remain elevated.

By providing strategic portfolio diversification, Condor's client returns have significantly outperformed Canadian stock and bond markets over the last five years. As always we welcome your thoughts and comments.