Episode 9: The ongoing recovery – Q3 2020 review and outlook

What are our expectations for the rest of the year and the early part of 2021?

Ian [3:55] Our view continues to be one of recovery of the economy and ultimately further expansion. One development is that we now believe that we’re progressing beyond the earliest stage of recovery, and this has implications for both the economy and the stock market.

For the economy, it means we’re going to start reverting to a more normal pace of expansion. Much of the economic data we’ve seen over the quarter reflected a quicker than expected rebound in the global economy, as extra economic restrictions were lifted, and large parts of the economy returned to work. We can track this directly through the City Group Economic Surprise Indices, where the global index measures whether or not incoming economic data is exceeding, meeting, or falling behind expectations that economists had prior to the data release. This index rose to record highs through the quarter as employment, housing, consumer spending and economic survey data all contributed to positive surprises relative to expectations.

What this means for the stock market is that the focus will turn more towards the sustainability of the expansion and also the durability of corporate earnings. Along with the economy, earnings surprises were significant in the second quarter. And we think there is definitely scope for further recovery on this point, even if we are out of perhaps this honeymoon phase of this recovery, where data just reflects the opening of the economy, but now moving into more an expansionary stage.

Key risks to this view are well known, well publicised. We continue to have the global pandemic as a very much, a real, you know, health crisis and headwind to the economy and markets as a result. The potential for further lock downs. And then also we have geopolitical uncertainty including the U.S. election.

On the virus front, we believe the economy is adopting quickly. And perhaps that speaks to some of the data that we saw over the last quarter. Widespread testing, increase sanitization, social distancing, are becoming the norm. And fiscal policy remains significant for those who maybe have lost their jobs as a result of the crisis or whose businesses are struggling.

For the U.S. election resulting uncertainty, the market continues to price in a volatile period around the election. It’s expected. But once the dust clears, we think on a 12-to-18 month basis that the focus will return to the ongoing economic recovery and expansion, and ultimately lead to higher stock markets over the period.

What are we seeing over the longer term?

Craig [6:19] Thanks, Alex. It’s a very important question for our clients right now. And actually, good timing, we’ve just recently updated our capital market assumptions. These are the 10-year forecasts across a wide variety of asset classes and investment choices that we use to define our portfolios. Using those, we developed over 100 different portfolio options for clients, ranging from people who are very conservative to those who are quite aggressive, and a range of different choices between passive, active, using liquid alternatives, and even private alternative investments.

And the new reality is that bond yields are very low. Exceptionally low. 10-year government bonds are paying around 60 basis points, or you know, just over half of 1% a year, hard to think you can generate a lot of returns long term with those kind of bond rates. And unfortunately, we expect that they will stay that way for many years to come. That means the return for more conservative investors has declined going forward by around one and a half percent per year, just in the past year.

That’s why we continue to innovate our investment approach, are developing new solutions like private investments that can make a meaningful difference in portfolios. Additionally, the value of active portfolio management is even higher today, in a world of very low interest rates. Let’s say if you are a conservative investor, I encourage you to review your portfolio options with your MD Advisor and make sure you’re still on the right path.

Now in contrast to the low rate environment, we expect equities to perform slightly better going forward, compared to our last estimates. That’s partially due to the lower starting place. Stock markets are, as much as they’ve recovered as Ian mentioned, they’re still at a lower point compared to the last time we did our capital market assumptions. And they also reflect this low interest rate environment. Low interest rates are supportive of company profitability, as well the longer-term relative attractiveness of stocks compared to bonds is certainly stronger in a low interest rate environment.

Of course, there’s no free lunch, our return expectations have changed, so have our risk estimates. I’d say the good news is if you are an aggressive investor with long term outlook, the opportunities look pretty good from here with returns approaching 7%. A moderate-risk investor should expect their equity investments to do more of the heavy lifting in the years to come compared to bonds in the past. But still an overall return of around five and a half percent, is still quite reasonable.

Last quarter, we discussed the winners and losers over the second quarter. Have those trends carried over?

Craig [8:48] Well, the story for the quarter continued to be dominated by value versus growth, and probably even greater than the last time we spoke. You might also describe it as, you know, characterising it as the old economy versus the new. The performance gap in growth versus value is now extended to the largest amount ever, such that the 1-year period ending September, growth outperformed value in the United States by 43%. As I said – the largest since the history of these indices were started in 1979. The only other time it came even close was February of 2000, when growth outperformed value by 34%. It was in the height of the IT bubble.

Now maybe to foreshadow a bit, but by the end of February 2001, value outperformed growth by over 50%. Not to say that’s what we’re in turn for the next year, but definitely we are at extremes. So that means if you’d invested in U.S. growth a year ago, your return would have been a staggering 39%. However, it was driven almost entirely, and we’ve talked about this in the past, by just a few large companies. The likes of Apple, Amazon, Microsoft, and clearly the COVID pandemic has helped other companies in this environment as well, such as PayPal or Zoom, as people have changed some of the behaviours.

Ian alluded to that earlier, that we are pretty adept at moving our activities and behaviours to adapt to the environment and certainly there’s some companies that are benefiting from that. I think another interesting one is, and this is maybe where some of the issues with respect to growth and the strong outperformance versus value, maybe not being sustainable. Tesla was up almost 800% in the last year.

You compare that to the traditional automakers like Ford and GM, which were down 20% for the period. Now granted, Ford and GM are cheap stocks on a relative basis, I’d say they’re pretty good representation of the old economy. Well Tesla, with a price earnings multiple of over 1000 is arguably is ridiculously expensive. Yet, it’s the poster child for this new economy. You know, with a market capitalization of over US$500 billion, it is 10 times more valuable than Honda. And it’s half as big as all the other automakers combined. And, of course, in contrast, you look at Toyota, which sells way more cars — call it 11 million in 2019 versus 300,000 for Tesla — and trades at somewhere around 10 times earnings. Oh, by the way, they also make electric vehicles. I think it’s a good reminder that regardless of how good something is, or may be perceived to be, there is a point at which it could become a little bit too expensive.

So those are some of the extremes, unfortunately, we’re seeing in the markets now in this environment where growth has significantly outperformed value.

Coming back to maybe more normal relative ranges between growth and value, but still a contrast between the old and new economies, is maybe Amazon versus Walmart. Amazon’s trading at about 130 times earnings, pretty lofty valuation, but arguably a very good company and growing quite well, versus the bricks and mortar Walmart, that’s trading it more like 23 times earnings. Still a relatively high multiple given where we are, but in the backdrop of lower interest rates, probably a reasonable enough valuation. Walmart’s not cheap, but Amazon is relatively expensive. At the same time, similar to my comments around the autos, both Amazon and Walmart sell stuff. Walmart has stores, arguably big box stores, they have big buying power and have good margins as a result of it and can sell things at very low prices. But they also sell other merchants’ products online, just like Amazon.

So again, we maybe are coming to some extremes where some companies are trading a little bit higher or more expensive than they might otherwise be. And maybe some of these other companies that have been overlooked, may deserve a second look, as the economy comes back to something a bit more normal in a post-COVID world.

Now I’d say the good news or maybe glimmer here is that we did see this trend towards the new economy stocks hit a bit of a collapse in September. Ian alluded to the fact that we saw a pretty good pullback in consumer and tech stocks. The question is, was this a bubble bursting? Was it just a reset? Is it a sign that things have run their course and markets will move back to being more normally priced based on their long-term fundamentals? So maybe some of these expensive companies become a little bit cheaper. Maybe some of the cheap ones become a little bit more expensive, and we get to something a bit more normal.

I’ve certainly learned from all my years experience that it’s better not to speculate. And I’d rather have a well diversified portfolio than try to guess exactly where we are in the context of that.

What are some of the actions we’ve taken recently to fine-tune our strategy?

Ian [13:31] As mentioned before, we think there is continued scope for further gains in the stock market and with bond yields at or near record lows, our preferences to maintain an overweight to stocks versus bonds at this time. And that’s really supported by what we think is a story of economic recovery, supported by significant monetary and fiscal policy.

One thing to note is that employment may not recover as quickly as the economy overall. Think of measures of GDP or corporate profits. This was the case through the last two economic recoveries and may mean policy measures will remain stimulative for a longer period, in particular, looking at fiscal policy. This is in fact what the Federal Reserve has communicated over the quarter, indicating it will accept a higher pace of inflation, should it materialise, to ensure a full recovery in employment.

Given the nature of this recovery, in that it is a recovery from an economic shock, and that the global pandemic continues to be a headwind, we are not taking a procyclical stance in all of our positioning, preferring to be a bit more selective. To begin the quarter we had a view that the yield curves would steepen out as a result of rates at the short end of the curve being held down by easy monetary policy, while yields at the long end of the curve, so think out past 10 years, would gradually rise as inflation expectations rebounded. Now this did play out through the quarter and provide us the opportunity for us to close these positions. With us now taking a more neutral stance on the potential for fixed income over the next quarter.

In our relative equity decisions, we do have exposure to some cyclical markets like Sweden and emerging markets, but also to the U.S. where growth stocks, which Craig touched on quite a bit, continue to provide stability in the face of the uncertainty of the global recovery.

As for currency markets, we continue to believe there is further scope for a weakening of the U.S. dollar, and we maintain our hedges on most of our U.S. dollar exposure.

How did all of this translate into performance for our funds and portfolios?

Craig [15:27] Well, the good news, Alex is that performance for the quarter and for the year for portfolios was quite good. Portfolio returns ranged from about 2.4% to around four and a half percent, which is a quite good quarter. Look at a 1-year result ending the end of September, portfolios range from about 5.2-to-6%. This is actually well ahead of our long-term expectations, which range around 2-to-7% on the more conservative portfolios.

Within the funds and pools, it was also a good quarter. Our bond funds performed very well with both absolute and relative performance to their indices being strong. And a lot of that coming from the more opportunistic portion of our funds. Opportunistic is where we invest in a diversified portfolio of global higher yielding bonds. However, we are quite conservatively invested right now within that component of the portfolio, compared to how we’ve done so in the past.

Our Canadian equity funds were also strong contributors with total returns around 6%. Well, ahead of the S&P/TSX Composite for the quarter. Driven by both growth and momentum.

U.S. equities produced a solid return of almost 6%. But it was bifurcated based on that growth and value dynamics, as I mentioned earlier. As a result, outperforming the very concentrated S&P 500 Index remained a challenge for most investors, including us. The glimmer of hope we did see in September, when value outperformed growth for the first time in a while was quite good. As I mentioned previously, I wouldn’t say it’s time to jump out of growth and into value. It’s likely we’ll see pockets of outperformance like this from value investments as improvement to the management of the coronavirus leads to continued improvement in the economy. But clearly, it’s not time ever to jump from one style to the other. In fact, that’s why we always use a balance of both.

In international equities where we did increase our allocation to our portfolios last year, it was a similarly strong quarter. But unlike the U.S. funds, a large portion of the return over the quarter was outperformance versus the index from some good quality growth names performing very, very well.

I think it’s a good reminder of the value of our approach. We use that same diversified investment approach, whether it’s in Canadian, U.S., international equities, and we use the best investment advisors across all of our investment pools that we can find. And the recently concentrated nature of certain markets, like the U.S., don’t favour diversification and prudent risk management, but instead reward highly concentrated and arguably speculative investments. Not to say that we won’t own most of these companies, we just know that a prudent approach must include lots of different businesses and more compelling valuations in order to be successful over time.

If you have any questions about these topics, questions about your portfolio, please don’t be shy. Reach out to an MD advisor. Whether you’re a client or not, we are here to help.

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