Episode 15: Ongoing recovery and interesting changes in global markets

There was a lot to feel good about at the end of 2020 regarding global markets and the global economy. How did they fare in the first quarter of 2021?

Ian Taylor [1:02] Well Alex, it was another strong quarter for capital markets. You know, financial conditions continue to remain easy. We got some more good news for the global economy in the quarter. We've seen vaccines roll out. We're seeing fiscal packages being released and we're seeing very easy monetary policy.

So, all those things have come together to continue to fuel what has been a pretty impressive stock rally. The MSCI World Index was up 4.5% in local currency terms. But up slightly less, 2.9%, in Canadian dollar terms as the Canadian dollar actually performed very well throughout the quarter. Consistent with the Canadian dollar being quite strong, the TSX also had a very strong return – up 8% in Canadian dollar terms – benefitting from rising energy prices and rising bond yields which helped the financial sector, a very prominent part of the Canadian market. And banks, in particular, did quite well throughout the quarter.

Maybe one change is that we saw IT stocks stall. Not necessarily delivering negative performance but not delivering as strong performance this quarter. We saw the NASDAQ up only 2%. Not a bad return, but relative to some other markets, not as strong. And the MSCI China, which has benefited strongly from tech stocks in that market – it was basically unchanged for the quarter. So, some interesting developments on that front.

There seems to have been a change in what is driving the markets forward. Some areas have appeared to have turned the corner and others seem to have hit a wall. What happened there?

Ian Taylor [2:34] It's really a good thing, at the end of the day that we saw a bit more, I would say breadth to what's driving stock prices higher. So, as you mentioned, a few notable changes. So we talked about tech stocks, but really growth stocks overall, when you look within the composition of the stock market, the stocks that have benefited the most from the outbreak of the pandemic, those sort of took a bit of a backseat over the last quarter.

We mentioned energy and financials – I mean energy prices at one point even went negative in the second quarter of last year. And now we're seeing it, you know, oil prices up into the $60 range. So that's quite a recovery. And a lot of that recovery helped stocks, like energy stocks, recover quite a bit this last quarter. And financial stocks – so financial stocks, you think borrowing or lending out money, and really, they get paid back in the form of interest rates and interest rates rose over the quarter. So generally, that's good, that attracts some more deposits, but it also allows them to lend at higher rates. And as long as the economy can absorb that, then those stocks do well. So those are the stocks that really did well over the quarter.

Those stocks are a little bit more prominent in value indices. So, it's certainly something we've talked about Alex, as you're aware, over the last few quarters. And expecting some of that change to start to price through. And it really did over the last quarter.

You know, another big change that we saw, and I just alluded to it with the financial sector, and this was probably the biggest change that we saw over the quarter, was the rise in interest rates. And the rise in bond yields in particular, so maybe not at the short end of the curve, but certainly bond yields overall were a lot higher by the end of the quarter than they were at the start of the quarter. And it's not just that yields went up, it's why yields went up.

So when we look at that, inflation expectations are rebounding, growth expectations are rebounding, and that helped the Canadian 10-year bond yield or you know, propelled the Canadian 10-year bond yield to more than double in the quarter. So, there's a good thing around that, which I said is the recovery of growth and inflation expectations, meaning we're getting back to more, expectations that there'll be more of a normal economy going forward. The bad thing about that is that we're at such exceptionally low interest rates that they can even double in a quarter. So that speaks to the fact that we're not completely out of the woods as far as the long-term prospects for growth.

And of course, with rising bond yields, the Canadian bond universe had a very difficult quarter. One of the worst quarters on record, down 5% which you know, when you're buying bonds, you're looking for capital preservation, and that obviously wasn't the case over the last quarter, although bonds had performed so well in some of these crisis periods, that it's clear it’s still very beneficial as part of an overall portfolio.

Some other changes we did see in the commodity markets – so, like I said, energy prices were up significantly. We had oil up more than 20% in the quarter. But gold prices, another big beneficiary of the uncertainty around the pandemic, the real decline in interest rates, which changes the opportunity cost of holding gold, goes down when that's the case. That obviously changed in the quarter as well. So, we saw gold prices down 10%.

So, you know, it's an interesting quarter, very strong capital markets, but definitely a rotation within it. So, some of these themes that really created some opportunity for investors like us who were interested in taking advantage of those risks, they've kind of moved to the side. So, we've seen that recovery theme really get priced in and you know, a lot of things are expensive at this point of time. So certainly, going forward, we're going to be looking more on fundamental growth prospects and the balance between both upside and downside risks, given what's been priced in here.

How did these developments impact fund performance?

Craig Maddock [6:15] Well Alex, I'm always remiss to talk about performance over just a quarter. It’s usually not very useful, and it causes all kinds of unintended behaviours, you know, my view is you’re best not to look. It doesn't really tell you what's going to happen next.

Say this quarter, the case is even greater – really depends on what time period you look at, as to whether you're really happy or perhaps not so happy with performance results. So, it's been a very interesting quarter. The drivers were, you know, wildly different this quarter as well, compared to others recently. In fact, we've seen a lot of return volatility across sectors, geographies and investment styles. As the impact of COVID continues to move through our global economy.

In particular, Canadian equities were very strong in the quarter, they were up about 8%. And our funds were approaching 9% for returns, which is fantastic. And that actually outpaced U.S. and international investments, which range from minus 1.6%, up to 6.5%, talking about the volatility I was referring to earlier. And on top of that, bonds lost money over the quarter. This is not representative of typical quarter for a variety of different assets.

And portfolio performance?

Craig Maddock [7:29] Portfolio's ranged around 0.7% to 2.8%, for the quarter. That is above average, based on our long-term return expectations. So, another good quarter for investors. We've maintained a tactical overweight to equities, which has been very beneficial to our portfolios and contributed to the strong returns for the quarter.

And so, while the markets are kind of gyrating all over the place, as I already mentioned, it's a bit of this and a bit of that, but very different performance from a bunch of different areas. A combination of these decisions actually worked out very well. So, clients should be pleased. And I guess maybe my guidance would be don't look at anything else. That's really all you need to know.

We already talked about the performance of different parts of the market. What parts added to performance? What areas detracted?

Craig Maddock [8:14] Yeah, so I mentioned asset class strength, right, so we've seen some areas doing really well and some doing poorly. And overall, it came together, and it still delivered great returns for our portfolio. But when you look deeper, the strongest performers in the quarter were value-based strategies – so, you think of larger investments, so things like financials, gold and energy stocks. And the weakest were actually growth-based strategies and technology stocks.

You know where rising interest rates, and perhaps the fears of inflation have caused investors to question, you know, how durable this technology run and these growth stocks are going to be, and what is truly their leadership going forward.

So, looking at our best performing strategy in the quarter was actually our small cap Canadian mandate devised by Hillsdale. The portfolio was trading at a discount to the TSX Composite, so it's trading at 15X earnings. So not cheap, but really not an expensive strategy. And we expect probably 17% earnings growth out of that portfolio in the next three-to-five years. So on that backdrop, it achieved a return of 11% in the quarter, it's phenomenal.

And although the S&P 500 Index returned 4.75% in the quarter, our U.S. value strategy also achieved a return of over 11% in the quarter. It too traded at a discount to the broad U.S. market with respect to price earnings multiples. And at 23X multiple, it is cheaper than the broad market at over 30X and way cheaper than our growth strategy, which is trading around 43X earnings. But in contrast, our U.S. growth strategy was up less than 1% in the quarter.

The challenge for investors at this stage is what I just described as the reversal of the trend that we've seen for several years where expensive growth stocks significantly outperformed low-growth and low-priced stocks. If price matters, it's clear that Canadian value stocks offer a much lower price at 15X versus either the U.S. value at 23X or surely the U.S. growth at 43X. In contrast, Volkswagen was up 72% in the quarter and Tesla was down 7%. Tesla is trading at over 1000X earnings versus Volkswagen at 14X. I guess investors finally woke up to the fact that Volkswagen, which also owns Audi, Porsche, Bentley, Lamborghini, Skoda, Bugatti, Ducati, and MAN Trucks might actually be able to make an electric car or two as well.

I'm actually most excited about the opportunity we have for one of our private investments in the MD Platinum [Global] Private Equity Pool, Rivian, which is a U.S. based electric truck manufacturer, with a huge order for Amazon delivery trucks. I think that one's going to be one to watch.

And we did see a similar theme across our international and emerging markets investments with respect to this rotation towards value, and perhaps a little bit away from growth stocks. So why this reversal now? And why are investors all of a sudden seeming to care about valuation and the price they pay for a stock? Well, who knows for sure. You know, even after the fact, it's never obvious what exactly caused prices to move as it did. Or why people are now willing to push the price to a certain level.

Rational answer – if we actually thought it through, would be because they had new information and different expectations of what's possible for future profit of the businesses that they're looking at. And they compare it against all other businesses and the competition and compared that opportunity to all other available opportunities and shifted their assets to a better choice. That's the rational answer. Of course, we saw a lot of volatility in this quarter, so maybe the irrational answer is that someone on Reddit said it and people just jumped-in and we'll see what happens next.

With a good idea of what worked and what didn't work in the first quarter, can you talk about some of the shorter-term tactical adjustments we've made? Let's start with our overall overweight to equities.

Ian Taylor [11:36] Yeah, Alex. So, we continue to have a positive outlook on stock markets. When we take a look at the combination of both the benefit of reopening the economy and the growth that we anticipate to really pick up over the back half of this year, in particular, out of the U.S. currently, and then into Europe later this summer, as the vaccine rollout progresses and accelerates, and really allows the economy to, you know, really open up with warm weather as well, then we think, you know, all the pillars of the global economy, be it China, Europe, and the U.S. will be expanding. Which is great, and they'll be expanding at different speeds, but all that provides a pretty significant tailwind to stock markets and we don't think that there's a high probability of recession.

So, with all that considered, we continue to favour equities. But as I mentioned earlier in the call, it's not surprising if you look at where the stock markets are now, relative to where they were before the pandemic, it's going to become extremely important that this recovery theme that's been priced in to the market, that we get the realisation of those expectations, which is stronger earnings and a more stable economic outlook.

So, we think there's room for that to continue. But at some point, the impressive run that we've had in stock markets will be challenged and that's something that we're very much focused on. And we're looking for signs that, you know, maybe the pace of acceleration starts to slow in that maybe when markets start to price in some more of the downside risks that will ultimately materialise as the economic cycle matures.

We shifted some of our developed market equites around. Can you explain some of the thinking there?

Ian Taylor [13:17] Coming into the quarter, we had moved into more international markets, more cyclical markets, and we continue to maintain that stance today. So, I would say we didn't make material changes within our developed market and equity allocation, but we are always looking for opportunities to adjust our positioning based on market performance.

So where we began the quarter with positions in Canada and Australia, and a bit of a larger position in the U.K., as we saw some of the commodity induce gains propel those markets higher, we did take the opportunity to rotate out of those markets. And still remained fairly positive on countries that are going to benefit from further growth in the industrial sector and consumer discretionary, you know, as people get back to work. So we're talking about markets like Japan, Germany and Sweden who’ve also done quite well over the quarter, but we think have more potential going on from beyond here.

More defensive markets now, we continue to be somewhat underweight Switzerland. We've reduced but still maintain a pretty significant position in the U.S. as we do see more opportunity outside of the U.S. at this point in time. Given the U.S. has fared quite well, the U.S. market has benefited disproportionately relative to those markets due to the pandemic. So, some of the benefits of the pandemic to those stocks will now start to abate and that's where we see more opportunity elsewhere.

Last quarter, we spoke about our negative view on the U.S. dollar versus other currencies. Where do we stand now?

Ian Taylor [14:48] So broadly, we still think that the U.S. dollar has room to weaken. And one supporting factor to that is that it does remain overvalued on a few metrics. And some of that is partly due to the some of the strength we saw pre-pandemic. And then of course, the exceptional strength that we saw in the pandemic. Both those things continue to reverse.

That being said, we are being selective as to which currencies may benefit from a trend in the weakening US dollar. We've been very bullish on the Canadian dollar. And certainly, referencing the comments made already about the Canadian dollar, that has benefited positioning to the end of this quarter. We started to reduce some of those positions and focus a little bit more on other currencies. But we still think that there's room for recovery in a number of more cyclical currencies. And as a result, remained underweight the U.S. dollar across most of our mandates. We continue to monitor that very closely, but we certainly expect further weakness when it comes to the U.S. dollar.

About a month ago, we saw bond yield spike. Did that impact our tactical strategy at all?

Ian Taylor [15:53] Well absolutely, Wes is part of our Tactical and Risk Allocation Committee, and really focuses in on the fixed income piece, not surprisingly. You know, I must give credit where credit is due – he has been very good about positioning the portfolios for the change in interest rates that we have seen.

So earlier in the quarter, and I think we may have talked about this last quarter, we were positioned for a shorter duration, but expecting – which means, you know, less interest rate exposure, a bit more defensive relative to the prospects for rising interest rates, which obviously hurt bonds – and the expectation for a steepening out of the yield curve. And that materialised fairly quickly. At that point, basically reducing those positions, focusing a bit more on the long end of the curve.

And this is where we're going to talk a little bit about the short term nature of inflation and expectations for monetary policy, and the long term outlook for growth, and the secular outlook for growth, which, if you dial your brain back two years or three years ago, and start to look at the secular trend for growth, we don't think the pandemic has necessarily changed the prospects, the long term prospects for the global economy. And that's what we're starting to see priced in the market. So very long end or long dated bonds continue to be very suppressed. And so, you're actually seeing a flattening of the yield curve. As the 10-year kind of rebounds to where it was prior to the pandemic, you're seeing that long end of the curve hold a bit more stable from that perspective.

So those are, you know, we very much adjusted our positioning for that and right now would expect, again, a little bit more of that flattening to occur where the long end, which is fairly well priced in from a structural and secular growth perspective, versus more the middle end of the curve or the 10-year area of the curve, where you know, we still think there's expectations for more pricing in of higher interest rates later in this cycle. And then that should be reflected a bit more in the 10-year.

So again, adjusting, being very dynamic with our positioning when it comes to interest rates, given the changes that we've seen in the economy.

Speaking of fixed income, could you describe the current state of the asset class?

Craig Maddock [17:55] As I mentioned before, one of the possible catalysts for value stocks and Canada to performs so well in the quarter was the rise of interest rates. The yield on the FTSE TMX Bond Universe Index rose from 1.2% to over 1.7% in the quarter. This overall yield is still historically low. And knowing that in the long term returns for bonds is best represented by its starting yield, 1.72%, it doesn't imply a great outcome for bonds for the foreseeable future.

Additionally, during a period of rising bond yields, the investment returns are reduced. So, in fact, the first quarter of this year was actually the worst performance for bonds since the index was started in 2000. With a decline of over 5.6%, it was not the capital preserving characteristic investors are used to from bonds. Now our funds performed much better as our positioning in higher yielding credit and our duration positioning definitely helped to reduce some of the impact of this rising return environment.

Going forward, we anticipate more volatility in bond fund returns. As interest rates move towards a more normal environment through the economic cycle, we are more active in our positioning to try and take advantage of these opportunities for higher returns from things like corporate bonds and high yielding bonds and foreign bonds.

Additionally, we're more dynamic and looking at this risk, and being willing and able to change our positioning as the opportunities come and go through the bond market that might potentially hurt returns that we can get away from.

And I'd say in further response, because of where we are in the interest rate cycle, we launched the MD Platinum [Global] Private Credit Pool. I'm so happy to see so many of our clients following our advice to include this new and innovative way to improve performance of the portfolio, especially in this low yield environment. We've had almost 1000 clients sign up to our webinars recently, and with the potential return in the high single digits, that's a vast improvement over the 1.72% yield currently in the Canadian Bond Index. If you haven't looked into this opportunity yet, I'd encourage you to do so. The subscription period is only open until the end of August.

You mentioned the MD Platinum Global Private Credit Pool. How does it address some of those issues you've highlighted?

Craig Maddock [20:04] Well, the main issue we have is that interest rates are low. And even companies that borrow in the public bond market are priced at a level above government bonds, but it means you're still getting pretty low returns, as I mentioned, out of the public bond market. With everyone scrambling for higher yields, the prices have gone up, and therefore the yields or returns are even lower, tighter in that market as well.

So, the difference is, when you get into the private lending market, because we're talking about a private credit pool, we are arranging private loans with a business. So, they're often smaller loans than you would get in say, the bond market, they have a specific purpose for the business to achieve over a period and that period tends to be shorter in nature. So, this private nature combined with a finite purpose of the loan actually allows us to command a higher price, and in some cases, a much higher price. And the companies are willing and able to pay for it because it's a short period of time for a specific purpose within their business.

And because these loans are also priced off of what we say floating rates, so as interest rates move up, the return we generate moves up too. So, with a rising rate environment, we get a good premium from the company. Plus, we benefit as or if interest rates start to move up a little bit. So that's some protection against that rising rate environment.

Of course, the catch is the loans are private. So, we have to wait until the loan is repaid before we can return the funds back to our clients. So as long as you limit yourself to 10 or 20% of your portfolio, I don't see that ever being an issue.

Let's turn our attention to the future. What are we expecting for the rest of the year?

Ian Taylor [21:38] It's certainly an interesting time, Alex, because, you know, there will be an inflection point here, at which point, you know, the recovery theme will be behind us. And then policymakers are really going to have to deal with crisis tools that they've employed and determine whether or not – how they’re basically – what's their exit strategy.    

So, there's a few things that have certainly changed and a lot of times when we're assessing this, you know, we're assessing in the context of prior recoveries. So, if we think back to the Global Financial Crisis, a lot of the tools like the Federal Reserve deployed in the depths of the COVID crisis did not exist. They were not part of their tool belt coming out of the Global Financial Crisis. And, in fact, it was quite controversial, in some sense, when really the sense that policymakers were bailing out the financial system. That sentiment did not exist, when it came to the COVID crisis. They were able to, unimpeded, introduce a lot of big policy, and there generally has been support for it because the pandemic generally, the sense is that this is no one's fault – let’s transition the economy from where it was before, through this crisis, and get it to be a healthy place at the end of the day, and have as minimal amount of damage to the economy as possible.

So, it is interesting in assessing in that lens. It's different than the recovery from the Global Financial Crisis. Another difference is the use of fiscal policy. So pretty shortly after the Global Financial Crisis, you started to hear things like the debt ceiling in the U.S. and the willingness, potentially, for policymakers in the U.S. to prohibit further fiscal policy. That discussion is less in place here now. We've seen the Biden administration introduce significant fiscal policy packages and have them pass relatively easily. So, there is this more of a universal view that the support for the economy will be in place, it'll be significant, and it'll be there for longer.

So, we don't expect interest rates to go up at the short term. Very short term, we don't expect interest rates to come up, certainly this year and into next year. But at some point, at some point that will change. The Fed has changed some of its framework to allow for more inflation. But, you know, as we get later in the cycle, it can only stay easy for so long.

So, it's not something we're focused on too closely right now. But certainly, as we look out beyond this year, and into the post recovery period, it's going to become very important how policymakers deal with, you know, the decisions that have been made over the last year as we work through the pandemic and the crisis.

So in other words, policymakers will remain ultra supportive?

Ian Taylor [24:06] Yes. And there's, you know, that really is our view. They are not going to pump the brakes anytime soon. That's certainly the signals that they've been giving, and actually their actions. So, if you see, you know, what they're doing, it's pedal to the metal in that sense.

We'll be monitoring for changes on that because that's going to be very important. It's obviously been very beneficial to investing or being invested over the recent period. Like I said, at some point, that's going to change and markets will have to digest that as well. But it's likely not over the next quarter and through to the end of the year.

Our last episode was about rising inflation expectations. For those that might have missed that episode, can you reiterate our thoughts on that?

Ian Taylor [24:46] Sure, Alex. Well in the short term, necessarily, as we recover, inflation expectations and inflation itself will recover. We're seeing some pretty phenomenal pricing if you take a look at something like lumber prices. So, I don't know, if you've looked at building a house lately, Alex or even building a deck, lumber prices are through the roof. And a lot of this is just based on dislocation in the economy in the short term. Obviously, you're prevented from spending money on services. If you are making money, it shifts a lot to the manufactured goods and things like lumber, if you want to, you know, build a deck or improve your, you know, your backyard or whatever you want to do.

So that inflation, and we're seeing it, there's backlogs everywhere, sometimes you'll order something, it'll take months to get things. And that's just because, you know, the global supply chain wasn't really built for this post pandemic period that we've had with this significant demand shift away from services and towards goods and manufacturing.

So that inflation – those inflation prospects are real – they’re going to happen in the short term and prices are going to go up for certain things, simply because it's costing more for producers to bring it to you. That's going to balance out at some point. So, there's a lot of fears around inflation, but we really need to differentiate what's between shorter term pop, and what's longer term inflation. And that's where, you know, certainly over the last quarter, we talked about our bond positioning and how we were reflecting on the fact that inflation was going to recover and that was going to play through the interest rates. But the longer-term view on inflation is still fairly subdued. And the reasons for that are that, you know, pre-pandemic, if we look at the factors that were in place, pre-pandemic, a lot of those circumstances remain in place today.

We look globally, China is slowing, and there's a disinflationary force from that perspective. We've seen Japan be fighting deflation, outright deflation for almost two decades here now. And the eurozone is also facing some disinflationary pressures. And when we look at the U.S., it's probably the most well positioned to generate inflation as a result of stronger growth prospects, but ultimately, because the global pressure is so significant more downwards, we don't think inflation really has the potential to go significantly higher at this point in the cycle.

And a lot of this has been based on demographics over the last few decades. We've seen either the baby boomers in the western world or one child policy in China, for example, some of those things be disinflationary. At the end of this economic cycle, some of those trends are going to start to abate, okay, and some of the other disinflationary trends could turn more inflationary.

So, we've got to be ready for that. But I don't think it's something investors need to be too concerned about. Unless, of course, they're building a house right now, which means lumber prices are quite expensive and aren't likely to go down significantly in the short, very short run.

With everything that's happened recently, what would you say is the key takeaway for our listeners from an investment management standpoint?

Craig Maddock [27:49] My key takeaways is that this time is not different. I have been at this for over 30 years, I've seen the ups and downs of the markets. And on top of that the emotions and confidence of investors as they come and go. Additionally, fads come and go. Hot stocks take the spotlight only to get destroyed later.

The recent gyrations of the markets remind me of a book by Ed Viesturs. It's called No Shortcuts to the Top. It's actually a book on climbing the world's highest mountains. But the messages are the same – you need to have a clear goal. Interestingly, Ed's is reaching the summit is optional, getting down is mandatory. So, if you kind of apply that to our goals, I think there's a huge alignment between what Ed's trying to do in climbing the highest mountains of the world and what we're trying to do for investing. Which is really helping each client achieve their long-term investment objectives, like retirement. To do this, you need an intelligent and repeatable process, unwavering discipline that is so critical in these weird and wild markets, and a deep understanding of what you can control and what you can get right. More importantly, what you can't.

All investment processes have been tested in the past year, Alex. And as we noted, many times in this podcast series, value investing has been under pressure for the past few years, it's like people have forgotten that buying something on sale is a good thing. Our process is multidisciplinary, which means we use a wide variety of approaches to build our portfolios. We do have investments in value stocks, but we also have some growth stocks. We own Volkswagen, Tesla and Rivian. But in different amounts to reflect our confidence in both the company prospects and the price we pay for it.

We also incorporate top down views on how the economy is performing to shape our portfolios and combine that with deep research into individual companies to extract an edge. Additionally, we incorporated other methods of selecting securities and building our portfolio, such as factors or quantitative methods.

And finally, we don't make all the decisions ourselves. We know what we know and what we can do best. We also know that we can work with other advisors who are specialists in their domain. And together this ensures we have an intelligent and repeatable process, unwavering discipline and while we always strive to get to the top, we are most concerned with getting our clients ultimately where they need to be.

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