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Episode 8: Living through the pandemic - Q2 2020 review and outlook

Craig Maddock and Ian Taylor recap the second quarter of 2020 – the impact of re-opening economies, a sharp stock market rebound, and expectations for what’s ahead.

 

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In this episode of the MD Market Watch Podcast, Vice-President and Senior Portfolio Manager, Craig Maddock, and Assistant VP and Portfolio Manager, Ian Taylor reflect on the second quarter of 2020 – how financial markets have recovered much of the pandemic-driven losses, factors that played a pivotal role in the recovery, the performance of MD Funds and Portfolios – and what’s ahead over the next 12-to-18 months.

Why did equity markets perform so strongly in the second quarter despite pandemic-related uncertainties persisting?

Ian [0:50] Well, it's really been a story of two completely different quarters to start 2020. As we all know now, the first quarter culminated in really the fastest peak to bear market in S&P 500 history. Volatility spiked to unprecedented levels as the coronavirus pandemic spread and economic lockdowns were widespread.

The second quarter however, proved to be the best quarter in over 20 years. Aggressive, both fiscal stimulus – so politicians joining together to provide targeted stimulus and job support for those who were losing their employment – and monetary policy – so central banks. And then also we saw the economic re-opening’s, we saw risk appetite really return and this started to support equity and credit markets.

Over the quarter, government bonds didn't really change all that much. However, due to the significant support that we just mentioned, in particular, the efforts of central banks, corporate bonds outperformed as credit spreads, which is really the difference between bonds that have credit risk associated with them versus safer treasury bonds, as that spread narrowed. And this was really backed again by the significant stimulus that was in place amidst the re-opening of the global economy.

We also saw some recovery in the commodity side. Energy prices at one point were slightly negative, which is an unusual circumstance. But commodities rallied as oil producing countries agreed to temporary production cuts and demand started to recover.

And even in the currency market side, so where we saw significant strength in the U.S. dollar in the first quarter, that started to weaken out, and really the U.S. dollar in times of crisis tends to strengthen. So, as some of those risks abated, we saw that soften out.

Despite the strong stock market performance, the state of the economy remains mixed. Unemployment is in double digits across most of the developed world and it has been recovering over the last 3 months, but there's a long way to go. Several data points indicate that we're experiencing a bit more of a V-shaped recovery, at least in the short term, with Purchasing Manager’s Indices data rebounding strongly and even signs that the housing market is recovering.

Given still the dire unemployment situation, all eyes remain turned to policymakers and the potential for ongoing stimulus throughout this recovery. So, as we look forward, social distancing has accelerated the need for digital transformation and de-globalization has also challenged the value of what we call “super optimized,” but also deeply integrated supply chains across the globe. In recent years, we've talked a lot about the U.S.-China relationship, through previous podcasts and blog posts. And it remains the preeminent issue over the next decade as these two economic powers exert their influence internationally. The sentiment underpinning the trade dispute has only been amplified by the virus outbreak, and it's likely that there will be a significant push to ramp up onshore, in particular, manufacturing of key goods like medicine and medical supplies.

All told, the quarters gains were ignited by promises of massive amounts of aid from central banks and governments and were further supported by progress on the economic re-openings. This is ultimately a story of economic recovery, albeit a highly uncertain one.

What it means for markets? Low interest rates make stocks relatively attractive vs. bonds. For example, the difference in the S&P 500 dividend yield at this time, relative to say the U.S. 10-Year Treasury is at one of its highest levels in history. It really goes back to levels that were only seen in the depths of the Global Financial Crisis. And, if you look at the S&P 500, almost 90% of stocks actually have a dividend yield higher than the U.S. 10-Year Treasury.

That being told there are still risks. Despite seeing declines in new cases in areas that were initially hit the hardest, so East Asia and Europe, and the northeastern U.S., worldwide cases continue to climb at an increasing pace. This includes Latin America, South Asia, and South Africa as all regions [are] reporting elevated infection rates. So, there's a real concern here that health care systems of these developing countries may get overwhelmed. And additionally, recently, we've seen a sharp reacceleration in new cases in many parts of the U.S., which shows that we're clearly not out of the woods yet.

That being said, the world is now universally more prepared for the potential for further outbreaks. With lockdown measures biased towards easing and economic activity at very low levels, we are really in the recovery phase of the business cycle – and often this is the most opportunistic time to invest.

Who were the winners and losers during the quarter and what opportunities did we see?

Craig [5:37] Well, the most obvious is probably that growth has continued to outperform value significantly in the quarter with a 22% rebound for the Russell 1000 Growth [Index] and only a 9% return for the Russell 1000 Value [Index]. For the year so far, growth is now ahead of value by over 25%. That's the widest margin for a 6-month period we've seen since 1999, back in the IT bubble days.

Growth stocks have been benefiting from the work from home effort that's been going on and in addition, the inflation trade – so investors are hedging against the possibility of deflation. And then by virtue of that they're seeking growth stocks. At the same time there is another set of investors that are hedging against inflation buying things like precious metals.

Growth has outperformed value for the better part of a decade now. However, there have been times, very few, when value has made a comeback. Like the fourth quarter of last year we saw brief outperformance by value. And in Q2 we saw a small amount of value outperforming. That was really based on this idea of a V-shaped economic recovery. This rotation coincided with the banks reporting quarterly results that weren't necessarily as bad as they were expected. However, that value trade did lose some momentum amidst the significant increase in the U.S. COVID-19 cases, that now puts this V-shaped recovery, I'd say, in jeopardy going forward.

Another theme that we've been looking at is market cap. So certainly, from a market cap standpoint, trends shifted in Q2 as well. U.S. investors showed their appetite for risk. You mentioned the fact that the performance in Q2 was substantial and within that we saw small caps starting to eke out a small gain over large caps. Year-to-date small cap still trails large cap by little over 10%. In Canada, we're seeing a very similar trend with the very strong outperformance in small caps for Q2, but as well, for year-to-date, not such a good return out of the small cap market.

Driving that, start looking at the sectors behind the styles, IT was the biggest gainer in Canada among the sectors in the quarter, on the back of Shopify, which became the largest stock in the index by market capitalization. And then the second one, kind of in contrast, was materials. Due to strong gains in both gold and precious metals, five of which those stocks were in fact the in the top 10 index contributors for the quarter.

A similar theme you'll see in the U.S. was sectors outperforming like consumer discretionary, IT and energy which rallied over 30%, and your more defensive sectors like utilities and consumer staples lagged as the market really was risk-on in the second quarter. And of course, for the year, IT has been the clear leader with a 15% return year-to-date. And yet energy and financials, the opposite side of the equation, still remain in negative territory, down over 20%.

From a geographic standpoint, the Canadian markets, equity markets, are up about 16% in Q2. That's the strongest quarter for [the] index since Q2 of 2009 and 86% of the stocks reported a gain. So, a pretty broad-based recovery in Canada. Also, the Canadian market underperformed the U.S. market in home currency terms, once you adjust for the currency, but did outperform in Canadian dollars or in local currency terms.

And then international equities underperformed the real strength that we saw in the U.S. market, that was led by technology in the consumer area. Within the international area, emerging markets outperformed developed markets for the quarter. So, we did see some recovery coming out of predominantly Asia and China, being more earlier on obviously to be infected with COVID but also sooner to get their economy back up and running.

Some strong performing countries as well were Australia, South Africa and Germany, all up more than 25% in the quarter. China now is actually one of the only countries to post a positive return year-to-date for their stock market. And yet, we're still seeing some of the emerging economies such as Latin America, Brazil and Mexico continue to struggle, given the fact that they're still facing surging levels of COVID-19. They're also hurting a little bit from the lower commodity prices we've seen around the world.

I'm just looking at valuations, [the] S&P 500 is currently [trading] around 22x earnings – price earnings multiple – which is historically high, that may stay elevated due to historically low interest rates, which we expect to stay low for a much longer period of time. We've also got low inflation and a lot of stimulus as Ian mentioned, to spur on global economic growth. It's also normal for a valuation to get a little bit high out of recessions as the market discounts the economic recovery. As you do look out in the future, it does look relatively attractive for equities compared to the very low interest rates that we're seeing, and therefore the low returns to be expected from alternatives like bond investments.

Has this impacted our long-term positioning (strategic asset allocation)?

Craig [10:18] Well, we made large strategic changes back in 2019, that have served us very well through 2020. And we believe that should continue to serve us well for a long time to come. We do review our strategic asset allocation annually. I'd say the only change that might be brought on as a result of COVID-19 would be adjustments to our strategic fixed income positioning. As I mentioned interest rates are very low and expected to stay low for a long period of time. That means we should probably make some adjustments to our forward-looking expectations on fixed income and maybe adjust some of our positions as well.

But the coronavirus pandemic has really led us to a recession. It's collapsed earnings expectations –we’ve seen interest rates and inflation fall, massive amounts of unemployment, unprecedented fiscal stimulus, enormous budget deficits and aggressive stimulative monetary policy. The long-term capital market assumptions based on these underlying inputs are as important as ever to serve as a beacon for where we expect to land and what could change that trajectory.

It's important to remember that equities in particular are very long duration assets. And even a sharp multiyear decline in earnings shouldn't have an overwhelming effect on long-term expected interest rates. The net effect for most of our fixed income is a reduction in forward-looking expected returns.

Equities have similar offsetting considerations. You've got lower growth, but a lower discount rate and a lower starting point due to the recent equity market declines. So, the net effect is, in most cases, a slightly higher expected return than we might have had previously. And since the change in our SAA last year added exposure to foreign equities, that's certainly paid off for our portfolios as well.

What about short-term positioning (tactical asset allocation)?

Ian [11:57] We entered the second quarter with a preference for more defensive positioning, mostly due to the extreme economic uncertainty associated with the virus outbreak and lockdown measures, but also due to some very sharp changes in financial conditions. So, we saw that credit markets had frozen up into mid-March. But as the quarter progressed, and it became, clearly evident across a number of key financial indicators that the efforts of policymakers, in particular central banks, who would be doing really whatever it takes to stabilize financial markets, that that was working. So, we began to gradually increase our allocation to stocks relative to bonds to the point where now we maintain what we would call a modest risk on position. Actually, more stocks than we would hold strategically for a number of reasons that we've already addressed.

So, there's a number of issues that we need to monitor with that. The risk of a second wave remains, and it is – well that it's likely that we will see further outbreaks. It's unlikely that the economic closures that we saw back in earlier in the spring, will be reimplemented on such a broad basis and most countries are better prepared at this point in time to handle an outbreak. We continue to monitor the situation very carefully though. Overall, still, we believe that this is a story of economic recovery. And although there are risks, the most likely path for stock markets is for further gains over the next 12-to-18 months.

How did all this translate to our funds and portfolios?

Craig [13:26] Overall, the MD Funds and Pools had a very strong rebound over the second quarter, as equities got back much of the losses that occurred in the first quarter. So, a large majority of the MD Funds and Pools performed very well against peers. 69% of our funds are in the top two quartiles. 45% are ranked either four- or five-stars and 17% are in the top decile.

As I mentioned earlier about the delta between value and growth, it would be no surprise, value strategies are generally weaker. So, funds like MD American Value [Fund], [MD] International Value [Fund] or MD Equity Fund, [did] not perform very well in the recent run up of growth relative to value.

In addition, you would see dividend strategies were very challenged in the Q2 recovery. So, think of the high beta names such as IT, strongly outperform the broader market. In addition, gold within Canada performed very well. Neither of those types of investments would traditionally be found in a dividend-focused strategy. And therefore, dividend funds were left behind in that massive run up in Q2.

On the international side, our [MDPIM] International Equity Pool has an overall bias towards quality growth. So that's what has really been in favour in both the downturn and the recovery. It's very odd to see it work in both environments, but due to this quality bias, the pool is ahead of its benchmark over the past 12 months. And the growth component of that fund is certainly holding up and doing much better than the value aspects.

And then finally on emerging markets, they also followed developed markets higher, outperforming [the MSCI] EAFE [Index], although lagging North American markets, and then most of the benchmark relative performance came in June when emerging markets, led by China and Chinese growth stocks, surged much higher. We didn't fully participate in that.

At the portfolio level, we're pleased to see that a well-diversified portfolio helped to preserve capital in Q1 and to offer a smoother investment experience. But it still demonstrated a strong upside capture in this dramatic Q2 recovery.

[In] Q2, the MD PIC portfolios returned somewhere between just under 3.5% for an all fixed income portfolio to a little over 13% for an all equity portfolio. You're going to see similar ranges for the [MD] Precision Portfolios, as we saw within the MD Private Investment Council ones.

Looking at some specifics, I mentioned Canadian equities already, but the [MDPIM] Canadian Equity Pool did do well in Q2, outperforming its benchmark. We saw strong performance through some of the underweights in consumer services, financials and then an overweight to IT certainly helped. The largest contributor to performance in the quarter would have been the smaller cap component of the fund, which was up 34% over the period. So, a pretty strong quarter overall for the recovery out of Canadian equities.

As I mentioned, the [MDPIM] Dividend Pool unfortunately didn't fare anywhere near as well. Some areas of strength, but for the most part, having no exposure at all to gold, and no exposure at all to Shopify, which is the IT stock that did extremely well in the quarter, definitely means the [MDPIM] Dividend Pool was held back relative to other investment strategies.

Finally, in fixed income, broadly, we've seen government bond yields diverge over the quarter. U.S. and German 10-year yields were little changed, but those more sensitive to risk sentiment declined. And then except for a short-lived increase at the beginning of June, Government of Canada bond yields declined materially in Q2 as safe haven flows remain positive and unprecedented monetary support was implemented in support of the domestic and global economies. And yields at the longer end of the curve fell [a] disproportionally large amount and along with their higher duration led to outperformance versus short-term bonds.

We also saw credit spreads tightened almost as quickly as they widened in the first few months of 2020. They remain wider than at the start of 2020. Both provincial and corporate bonds outperform their Treasury peers in the quarter. The Canadian bond universe, as an example, had a 3-month return of around 6%. Corporate bonds leading the rebound, in particular some very strong returns from energy names over the quarter.

And then within our funds, we maintained a shorter than benchmark duration position within both our domestic and opportunistic exposures. The former is more dynamic, while it was positioned with a lower than benchmark duration at the end of the quarter, it had been temporarily increased to take advantage of expected rate declines on multiple occasions.

The short-term bond funds on the other hand achieved a 3-month return of 3%, outperforming its benchmark by a massive 1%, mainly due to the higher than benchmark exposure to outperforming corporate and provincial bonds, and a longer than benchmark duration exposure as policymakers made it abundantly clear that short-term rates are unlikely to be increased in the near future.

What is our outlook? What are we seeing for the next 12-18 months?

Ian [18:16] Well, as we've discussed throughout the call, even though the current environment is still with a high degree of uncertainty, this really is a story of economic recovery. And it's not necessarily going to happen in a straight line. We understand now, certainly the significance of the health crisis and the risks associated with that and the potential for further lockdowns and really, that is a base case expectation that there will be steps taken to manage further outbreaks in most parts of the world.

That being said, there is significant will from both monetary, so central banks, and fiscal, so politicians, to ensure that this is a fast recovery. And so that is really our base case expectation, even understanding the significant risks from the health crisis. And we are seeing some of those kinds of green shoots play out. Those things may help stocks sort of recover over the next 12-to-18 months or at least continue on that path towards recovery.

Craig [19:17] I’d just add, maybe further, that as the concerns around the pandemic start to ease, we're likely going to go back to some of the previous concerns that were in place. So, the trade war, not going away, weighing on the uncertainty of the market recovery. A strong rebound would normally be an unambiguous positive sign that recovery is underway, but the sharp increases [in] coronavirus infections in the U.S. has raised fears of the recovery might soon stall. [President] Trump says he wasn't even thinking about phase 2 of the trade deal and that he had many other things on his mind. But with relations between Washington and Beijing in freefall, the future of global supply chains is pretty uncertain.

On top of that, you got the Democrats, if they win, which is seemingly more likely, could derail the recovery, cause growth rates and earnings to suffer in the following years. As we transition away from COVID-19 being the main issue and start to focus back on the underlying drivers of the economy and the political uncertainty, we still have a lot of things that we're going to have to stay on top of, manage, monitor and adjust portfolios as we continue to manage going forward.

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