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Episode 12: Looking back at 2020 (surprise, it was pretty good for investors) and looking forward to 2021

Craig Maddock and Ian Taylor on 2020 and what’s ahead. Surprise, 2020 was pretty good for investors and there’s plenty of optimism for 2021.



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For the first episode of the MD Market Watch Podcast in 2021, we once again check in with Vice-President and Senior Portfolio Manager, Craig Maddock, and Assistant VP and Portfolio Manager, Ian Taylor. We kicked things off with a quick recap of 2020—performance of major markets, the global economy and of course, MD Funds and Portfolios. With 2021 in full swing, we moved into our outlook and expectations for the year ahead. Lastly, we discussed topics and themes that are top of mind for investors that may impact portfolio performance and the direction of the broader economy.

Overall, investment performance was positive in 2020. What did we see from the global markets?

Ian Taylor [1:03] To say 2020 was an exceptional year is a dramatic understatement.

As I recently wrote for the MD website, it really was an unimaginable year as the COVID-19 outbreak led to unprecedented economic lockdowns and market volatility. We started the year with a positive outlook on capital markets following a slowdown in economic growth in 2019. Yet by February, all expectations had to be questioned as we faced the worst health crisis globally in more than 100 years.

It was really a tale of three acts for stock markets globally.

Consistent with our initial view, optimism about the upturn in the global business cycle led the stock markets to be at or near record highs by February.

As soon as the pandemic spread meaningfully beyond China's borders, we witnessed the compounding effect of economic lockdowns, stock markets falling sharply, causing serious cracks in the credit markets to form and ultimately leave us on the precipice of another financial crisis. This required central banks like the U.S. Federal Reserve to step in and flood the financial system with liquidity, or in simple terms money, in an effort to prevent the health crisis from morphing into an all-out financial crisis.

Once it was clear that the financial system had been sufficiently backstopped, a significant portion of the dramatic loss that stock markets experienced were recouped by the end of the summer.

With the news of multiple, very effective vaccines in early November and the abating of multiple geopolitical risks like the U.S. election, and Brexit, markets once again experienced a significant boost through to the end of the year.

Overall, this left stock markets globally up double digits for the year, a fascinating outcome considering the impact of the health crisis that we continue to face on a global scale

How did global market performance translate to MD fund and portfolio performance?

Craig Maddock [2:58] Well, it was a great quarter and surprisingly against the backdrop of COVID-19, a great year.

Looking at our portfolios in the quarter we delivered returns ranging from just over 3% for conservative investors to almost 8% for investors trying to maximize growth. The results for the entire 2020 were even stronger and more consistent across a range of portfolios, with returns ranging from just under 6% to almost 8%. This is great news and as the returns over the past few years have been very strong, outpacing even our long-term portfolio expectations.

And of course, this is very important for clients whose lives and their incomes have been affected significantly by COVID-19. While the savings rates of Canadian physicians has been temporarily reduced, the strong portfolio returns will have made up some of that gap. This means that most physicians working with MD are still likely on track to meet their financial goals.

The strongest contributors to performance in the last year were growth-oriented funds, and in particular, our strategies invested in U.S. growth stocks. These strong returns were followed closely by our international growth investments, which also benefited from the strong focus on stable growing businesses that benefited from the impact of COVID-19. Think of companies like Amazon, Microsoft, Tencent, Alibaba, and Shopify, they are all great examples of businesses that actually improved as a result of the pandemic.

Of course, there are segments of the economy that suffered as a result of the localised shutdowns to combat COVID-19. Travel and transportation have been hit the worst with hotels, airlines, and restaurants just barely operating. These industries that provide services have been unduly impacted and remain fragile until things are back to more normal. So as a result, the investments we have in these areas, typically called value investments, didn't perform well in contrast to growth investments, with our U.S. value investments being slightly negative for the year.

Now the good news is the introduction of the multiple vaccines in the fourth quarter, providing a much-needed breath of hope for these struggling companies. We witnessed a strong rebound in prices for the previous worst performers of the year, resulting in one of the strongest quarters for value investing in several years. Our best performing strategy for the quarter was an international value mandate advised by Earnest Partners in Atlanta. It was up over 23% and contributed to the strength of the MD International Value Fund.

I mentioned that conservative portfolios perform exceptionally well in 2020 and well ahead of our long-term expectations. Bond investments provided the diversification to equities that we typically expect in our portfolios with outsized gains through the equity market drawdown earlier in the year. That was very nice to see, and certainly reinforced the benefit of a prudently diversified, well-managed portfolio approach.

It appears that there are a lot of reasons to be optimistic at this time. What are we expecting for 2021?

Craig Maddock [5:53] We have a positive outlook on the global economy for 2021, which given the current state of infection rates and business closures, might seem too optimistic for some. However, the economic backdrop is far from typical. We've seen unprecedented influence by governments in public markets, quantitative easing keeping interest rates artificially low, business activities forced to slow or stop due to lock downs and government restrictions, and the financial support in the form of government paychecks for those most impacted. This is clearly not a normal business environment.

However, our confidence is linked to the stage of the business cycle we find ourselves in. We would classify it as a middle expansion phase. And for us, middle expansion is where we see global manufacturing PMIs expanding, kind of think of that as a measure of business managers’ views on the near-term future, GDP forecasts, which are quite strong when you look through the gradual reopening of the economy, and generally low inflation.

In this part of the economic cycle, company profits should rise significantly resulting in equities doing very well, along with higher yielding credit. We also expect commodity prices to rise at this stage of the cycle. That may be driven further than normal by the potential for additional infrastructure spending, and the recent fervour over electric vehicles we're experiencing. When you combine that with central banks keeping interest rates low for the foreseeable future, it makes riskier assets look quite attractive. But remember, they are called riskier assets for a reason.

With the recent run up in equity markets benefiting our clients, and aligned with our current positioning, I should highlight the potential risk of a market correction at this stage of the recovery. While it is possible and quite probable that we'll witness a pullback in equity markets at some point, our proprietary bear market indicator is currently registering a 29% chance of a bear market over the next 12 months. Given the favourable economic backdrop, barring any major news, we'd expect any pullback at this stage to be temporary.

What are some of the recent tactical portfolio adjustments we’ve made and how are we currently positioned as a result?

Ian Taylor [7:59] Our tactical positioning is informed by the business cycle.

And consistent with what Craig said, it's with this lens that we believe some of the sectors and regions that traditionally would benefit more from being earlier in the cycle—where growth is accelerating and inflation is contained—may benefit more in the coming months as hospitalisation rates and severe incidences of COVID-19 recede. This is further supported by ultra easy monetary and fiscal policies, with commitments from policymakers to help transition the global economy to its pre-COVID-19 trajectory long after the pandemic itself ebbs.

Tactically, where we take a 12-to-18 month view on markets, this has led us to take positions in a number of countries internationally that are geared to a broader recovery in global economic growth. We've taken a pause on our long-standing overweight to U.S. equities to focus more on international developed markets and emerging markets.

We also think bond yields have scope to rise modestly making stocks once again the favoured asset class overall. And we've likewise increased our allocation to stocks.

There obviously remains some risks to this procyclical view and first and foremost is that of the pandemic continuing to play out beyond 2021. We think progress on this front will lead to investors to further discount this risk in coming months, opening up the real possibility of very strong growth in the back half of this year.

What are we doing about the current low interest rate environment? What are some options for our fixed income investors?

Craig Maddock [9:34] We had been positioning for the end of a 30 year bull market in bonds for the past few years. It was our belief that interest rates had gone down as far as they would, and the next real move was likely to be higher. Clearly, we were wrong as the events of COVID-19 stalled the global economy and took interest rates down even further with it. And while we still believe interest rates will eventually move higher, as Ian mentioned, we're only expecting a percent or two perhaps over the next 10 years. That means very low returns for traditional bond investments for the foreseeable future.

Two things contribute to this belief.

Central banks are targeting inflation—and in particular, the U.S. Federal Reserve—firmly on hold with short term rates until the U.S. economy is running at an over 2% inflation rate.

And two, it's going to take a few years to get things back to normal and get people fully employed again following COVID. This means demand driven inflation is also likely on hold for a while. However, with low interest rates and slightly higher inflation, the real return, that's interest rates minus inflation, for traditional bonds, is firmly negative.

So, with low interest rates for us for a few years, we're going to need to use all the tools at our disposal to manage portfolios. We've been gradually and opportunistically increasing our use of corporate bonds, and higher yielding corporate bonds. We're currently about as high as we've ever been in higher yielding corporate bonds within our bond portfolios, like the MD Bond Fund or the MD Short-Term Bond Fund. This comes with the added benefit of shortening duration in these funds, which is additional protection in the event interest rates move up faster than we expect.

Additionally, we've positioned the MD Strategic Yield Fund for the middle expansion phase of the economic cycle, by increasing our holdings in high yield, emerging markets and convertible bonds. This fund currently has a yield to maturity of 3.7% versus the one and a quarter percent of the MD Bond Fund, which should propel it past that negative real yield conundrum.

A new option we're planning to make available soon is the next MD Platinum offering. This is an exciting new offering where we will invest primarily in a portfolio of direct senior secured loans to medium sized businesses across North America and Europe, offering an attractive source of return with a commensurate increase in the level of risk. These investments will also support business activity and in turn, economic growth in these regions. We will identify leading opportunities from multiple origination sources and like our existing fixed income offering where capital preservation is paramount to achieving our target return, we will ensure prudent underwriting and diligent oversight of the outstanding loans. More details on this offering will be available later, including a podcast in this series dedicated to that topic.

We've been getting questions about our currency positioning. How has foreign exchange impacted our strategy?

Ian Taylor [12:16] Good question Alex. I think the impact of currency on investment returns is sometimes missed by investors, but it's certainly a key focus for our strategies.

Traditionally, you had two choices when it came to currency hedging. One would be to leave your foreign exposures completely unhedged and what that means is that if you buy a U.S. stock, for instance, you would also have exposure to movements in the U.S. dollar. If the U.S. dollar appreciated as it did through much of the last decade, it enhanced your return from your U.S. holdings. And if it depreciated, as it did through much of the decade prior to the global financial crisis, your return on the U.S. holdings would be lower.

The other option is to hedge the currency, leaving you exposed only to the movements in the stock and not the currency. Clearly, each strategy would have benefited in one decade, but not the other.

Our approach is to be more dynamic, integrating academic and industry research to decide whether-or-not to hedge currencies as market conditions change. This is applied not just to the U.S. dollar exposure within MD portfolios, but also global currencies, including the Euro, the British Pound and the Japanese Yen.

If you've been following our commentary and positioning, you will know that we have had a negative view on the U.S. dollar and as a result, we've been hedging the exposure within the portfolio with a stronger preference for currencies like the Canadian dollar and the Japanese yen.

As the U.S. dollar weakened through the second half of 2020, these positions helped add return to our U.S. and international funds. We continue to maintain these positions today seeing the U.S. dollar as still overvalued on a relative basis. And this is also supported by the business cycle where the U.S. dollar tends to weaken out when the global economy is in an upswing. We expect this to take hold more durably later in the year as vaccines rollout to more and more of the global population.

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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