Episode 19: Is the post-pandemic equity rally over
Craig Maddock, VP and Senior Portfolio Manager, and Ian Taylor, Assistant VP and Portfolio Manager of the Multi-Asset Management team at MD Financial Management review the third quarter of 2021 – market events and performance, MD fund and portfolio takeaways – and what lies ahead in the fourth quarter and beyond.
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In this episode, we welcomed back Craig Maddock, Vice-President and Senior Portfolio Manager, and Ian Taylor, Assistant VP and Portfolio manager. We kicked things off with the biggest stories of the third quarter – emerging markets and inflation. Next, we moved into the state of the global economy and where things are likely headed. Finally, with all that context, we reviewed the performance and positioning of MD funds and portfolios.
What is happening in emerging markets, particularly China?
[Ian Taylor 0:53] Well Alex, it's hard to under emphasise the materiality of the changes underway in China right now. It really is a pretty drastic shift in policy that will have a significant influence once again on capital markets over the next decade. We saw this in the 2000s, with China becoming a material global influence on markets and, in particular, the rapid growth in demand for commodities to support the build out of its economy. We saw it again over the last decade with the rise of the Chinese domestic economy. And that culminated with the U.S.-China trade dispute.
And we are now seeing once again with the shift to focus further inward and this notion of common prosperity. Clearly the combination of both U.S. hawkishness and now even domestic hawkishness towards Chinese technology companies, for example, which have contributed to widening inequality in China, has not been well received by markets.
The MSCI China Index is now down close to 30%, since its peak in February, when tensions between Beijing and Alibaba founder, Jack Ma surfaced. At the same time the MSCI World Index remains up more than 7%, reflecting that, at least so far, the impact has been contained to the domestic stock markets in China.
[Craig Maddock 2:05] I think that's a great point Ian. It's a good reminder that China – they’re not a capitalist society but you know, certainly more socialist. That means common prosperity is more valued than individual prosperity. And I'm pretty sure they're committed to innovation and technology and they're investing a lot in things like green energy. But the Chinese government's crackdown on all these industries, whether it's fin(ancial) tech(nology), or education, music, food delivery, all of these things, are going to hurt the profitability of companies.
But, I think long term, is actually good for China overall. I think that's the challenge for us as it makes investing in China very different from investing in developed capitalist societies such as Canada or the U.S.
Inflation concerns continue to persist. What are the latest developments?
[Craig Maddock 2:54] The best example right now that's probably very obvious to our listeners is oil prices, or I guess gas prices, gas pump prices. For those who still drive a car with an internal combustion engine, that sadly is still about 99% of us, about a year ago, gas prices were running around $1 a litre in Canada, and now they are up over $1.40. That's clearly inflationary, you can see it, you can feel it.
And the dynamics that go underneath that, really hit the heart of supply and demand. Oil supplies were reduced following the onset of COVID(-19). And of course, travel was reduced as well. Now, we're seeing demand picking back up, especially with vaccine progress as good as it is and reopening in most parts of the global economy. And of course, demand for oil and gas has gone up significantly. That's driven prices.
And this of course has happened to all kinds of other goods as well. Think of low interest rates, the combination of a work from home, shift in behaviour, has created demand for larger houses also driving up the cost of homeownership.
Earlier in the pandemic, we saw lumber prices soar as consumers who were staying at home decided to build, well just about everything – fences, decks, sheds, I don’t know, lots of them. Lumber was getting almost back to normal and then we've just seen another rush again, as maybe the lower prices of lumber have caused people to go back and do the projects that they put on hold before.
But coming back to energy prices, we're seeing the high cost of oil now it's turned into natural gas. And interestingly, utilities like coal are back in vogue as countries like China are firing up their coal electrical generation because they need more electricity. And of course, coal is an easy and quite frankly, fairly cheap way to generate lots of electricity very quickly.
So, I think in short, there's a lot more consumer demand, whether that's cars, computers, or everything, versus supply, and supply like microchips or shipping containers. And this short-term issue, and that's certainly what we believe, it's more a short-term issue, will get resolved, but in the interim, definitely driving inflation higher.
[Ian Taylor 4:49] We're approaching sort of the peak challenge for the global economy when it comes to the recovery meeting some of the challenges that came out of the aftereffects of the COVID(-19) recession and lock downs. So, when you think about demand recovering and the economy reopening, those are all good stories, that's more demand. That means things are improving.
But you know, all this supply chain disruptions that we've talked about, it's colliding at this point in time. We're almost maximum policy and in recovery driven demand, meeting the supply challenges, but as Craig pointed out, this will work through over time. And I think, you know, as we get beyond that, we have to start looking at what the economy looked like before the COVID(-19) crisis.
So certainly, some things have changed, but not everything has changed. And those disinflationary pressures that kept inflation in check for the entirety of the last decade, for the most part – and we're talking about long term secular challenges in Japan, an ageing demographic in Europe and a slowing China – they remain and are likely to keep inflation in check more broadly.
So while some of these themes may shift towards the end of the decade, our expectation would be over the next 12-to-18 months, you're going to see inflation become less of a concern and the focus return to a more sustainable growth and whether that's something that's achievable.
How did markets fare in the third quarter?
[Craig Maddock 6:17] I'd say it was a tale of two halves. The first two months of the quarter were strongly positive and September, we saw a pretty good pullback overall in markets. Bonds don't tend to get a lot of attention compared to stocks, but they had a negative month. They were also down for the quarter and now if you look year-over-year, they're down for the year ending September. So, it was kind of an interesting quarter in that regard.
And then looking at equity markets, even though it was strong at the beginning and soft at the end, generally, markets we're, I'm going to call it, relatively flat. So, think of the S&P 500 in local terms was pretty much zero, yet in Canadian dollar terms was up 2.9%. So, not a great quarter, but not a terrible one. Canadian markets were up 0.17%, so just slightly positive. And international markets were a little bit better. But emerging markets, as Ian mentioned, with the pullback in China, were down quite significantly over the quarter.
You look at the dynamics beneath that, and I think this is the interesting part, in the past, in these podcasts, we've often talked about broad themes really driving things. It's a lot more difficult to figure out exactly what's at play right now in the last quarter. As I mentioned, the first half, basically strong, second half, weak, and lots of turbulence within the market. So, you know, growth definitely outperformed value, but it seemed less concentrated as to what that growth or where the drivers of growth were coming from. It's more nuanced and diversified then we've seen in the past.
Large caps outperformed small caps, we saw developed markets strongly outperform emerging markets – yet luxury goods stocks were soft – earnings momentum was rewarded along with quality, which was not unusual. But as I said, it was really less obvious what was driving the markets.
We also saw volatility pick up from its lows, we pretty much saw the low in the quarter, but certainly moved up at the end of the quarter.
And I would say, you know, don't let this kind of muted stock market return fool you. There are lots of different things bubbling under the surface, some really strong performers, and some really weak performers, maybe netting out to an average of not too much. But realistically, a lot of, a lot of things happening under the surface.
And then when you look at where we ended up, things are still relatively expensive. So, you know, Russell 1000 Growth (Index) is still trading at extremely high multiples, you know, 34 times earnings is quite high. Even the U.S. Value (Index) at 18 times earnings is still quite expensive and more expensive than international markets which are trading around 17 times, or Canada at 15 times earnings and then back to emerging markets, which has plummeted recently, really trading at 9 times earnings. So, a huge difference in what people are willing to pay up for, for the earnings potential of the different markets around the world.
And then of course, growth rates are different. So emerging markets, no surprise, slower growth, which is also a function of its lower multiple, but you know, 14 times versus Russell 1000 Growth (Index) running around 31 times, still very high growth rates expected within the growthier parts of the market.
I'd say as well though, it's pretty much priced for perfection, right at those high multiples, no matter where you look, it's relatively expensive, at least pockets of the markets are relatively expensive. There's not a lot of margin of error at this point in the cycle. So if things do slow down significantly, or we don't see earnings continue to move up from here, it's really hard to see what supports the elevated multiples of some parts of the market, or frankly, to see much more expansion from this point.
Is the post-pandemic equities rally over?
[Ian Taylor 9:47] Well certainly the recovery from the market depths early in the outbreak of the pandemic has been exceptional. The MSCI World Index recovered 90% from the bottom, taking the index to levels that were 30% higher than where the peaked prior to the pandemic.
So, on the one hand, you know, we do not think stocks have suddenly become significantly more profitable longer term, almost overnight as a result of the COVID-19 related recession. Although this type of crisis will have a positive impact – we saw how quickly the economy had to adapt, with a significant pulling forward of digitalization, changes in the way we work or interact socially, the way we shop and the way we save as well.
You know, there's a huge buildup in savings that has amassed throughout the pandemic. And combined with ultra-low interest rates, clearly a significant amount of that wealth has been redirected towards stock markets. So, while our take is that we no longer face the best environment to invest in stocks, it's probably too early to position for a meaningful decline.
Investors will definitely need to be more selective going forward as the rising tide that lifted all boats, you know, early in the pandemic, may begin to recede. However, you know, generally, if the broader economy can avoid a recession, or sharp economic contraction, stock markets generally do quite well. Or at least the risk of a meaningful sustained drawdown is lower than later in the economic cycle when those recession risks are a bit more prevalent.
So, while the opportunity in some markets has passed, the balance may still favour assets that are tied to fundamental growth, and one of those assets is definitely stocks.
We're starting to see central banks around the world start to think about post-crisis policy – interest rate increases and asset purchase tapering – is the global economy ready for that?
[Craig Maddock 11:36] I'd say not yet, but we are definitely getting closer. I'd say it's probably going to be like a 2022 story. It'll have a really flashy title and it'll get picked up by the media, but there's really not all that much to it.
At the same time, not all economies, we talked about globally, but not all economies are at the same place in the cycle. If you looked at GDP forecasts, they're definitely elevated, you know, about 5% globally, but off the peaks that we would have seen back in the spring.
We talked a little bit about inflation, but you know, it's running hot, right? There's much higher inflation today, and expected, than we've seen in recent years. And it's predicted to be strong going forward. But strong is a relative term, when you think of inflation. Most developed markets are targeting 2% inflation, and yeah, we're going to head a little bit above two, but it's not like we're going up significantly from here. So I think most central banks are generally hawkish, meaning they're willing to allow their rates to move a little bit higher, but I don't think we're going to see massive increases in interest rates from here or massive amounts of inflation to be concerned with on a longer term perspective.
At the same time, visibility is poor, and this is why we haven't seen it happen yet. And why it's you know, maybe we're getting close, but not for sure. COVID(-19) is still impacting things, right – the natural flow of goods and services, employment, all these things are impacted. Ian mentioned a lot of positive things that have changed and likely will continue to change – our habits and behaviours going forward. You know, but we're not back to normal yet. So, until we actually get back to normal, it's hard to know exactly what will be required.
And then Ian talked about pre COVID(-19). But you know, we still needed an awful lot of stimulus, pre-COVID(-19), to feel good about market prices. Any hint of taking away the punchbowl years ago was viewed negatively by markets. So, I don't think those structural drivers have really changed because of COVID(-19), in fact, to some degree, might be worse. There's been a lot of stimulus put into the system, and you're going to have to see higher taxes likely to pay for it, someone's got to pay for it.
We've also been talking, there's lots of discussions now about, you know, converting to green energy. That's going to be a very expensive transition. So, these headwinds are, I think a bit, maybe more challenging possibly going forward. So, I think rates can and will likely stay low for quite a long time.
Another example is, we often talk about central banks increasing interest rates, but they're not the only ones that set prices. The bond market itself is also a forecasting tool and a rate-setter for interest rates. The bond market will and can move higher without the central bank. So, you think of U.S. 30-year bonds, they bottomed out near 1%, in the summer of 2020, have now recovered to about 2%, which is a pretty good increase. But they're still well below the 3% rate we saw pre COVID(-19) at the end of the last cycle. So, bond markets have yet to price in a long-term sustained recovery that would suggest rampant inflation and a really strong economy, which would require central bankers to respond with overly aggressive interest rate policy.
It's hard to judge coming out of COVID(-19) because we're not back to normal yet. So, policy actions aren't normal yet. I think it's time for the fiscal stimulus to pick up the slack. Not to mention the reopening, then we'll get around to thinking about what the real interest rate policy needs to be.
What are we seeing for the fourth quarter and the early part of 2022?
[Ian Taylor 14:56] Yeah really this is an opportunity to really build on what Craig has been saying. Goes without saying it's an important time for markets. There needs to be a transition within the economy and the associated actions of policymakers related to that.
You know, the extreme imbalances created by the pandemic are not limited to just commodities and the stuff we buy. It extends to the impact of fiscal policy supports on the labour market as well. As at the end of August, the U.S. Bureau of Labour Statistics estimated that there were 10.4 million job vacancies in the U.S. This compares to an estimated 8.4 million unemployed workers. So, when you think about that, that statistic alone speaks to the untapped potential that still exists in the economy. It's one reason why earnings expectations remain optimistic for markets and keeping stock markets elevated.
But the transition needs to happen. It cannot be delayed indefinitely. And our expectation is that it will happen over the coming months and you know, it's unlikely we'll see those widespread coordinated lockdowns of major global economies again, as a result of the improvement in the pandemic situation globally. But the financial markets are going to need to adjust to this as well. And we've seen early signs of this, we expect financial conditions to continue to tighten at the margin, and that this will likely continue to see some push and pull from investors as they incorporate that.
However, for longer term investors, we still see the environment is being one conducive to further gains, albeit more moderate than what we saw in prior quarters.
What does this mean for investors and for our clients?
[Craig Maddock 16:37] I think it's very simple. The backdrop for investing remains favourable, we're going to see rates moving up slightly and slowly, which is good for fixed income investors. It's not really a challenge, we believe for equity investors, regardless of what some say. We think equities are supported here by the economic backdrop, low rates, the current stage of the business cycle. So, portfolio returns, they look favourable going forward.
Regarding MD Funds and Portfolios, did anything happen over the quarter that materially impacted our long-term expectations for performance?
[Craig Maddock 17:09] Nothing significant. We obviously talked about this maybe a transition period, there's lots of stuff, you know, bubbling under the surface and leadership changing from company to company, but nothing seismic like the financial crisis of 2008, or even, you know, the onset of COVID(-19) to materially impact our forward looking estimates.
And in both of those cases we saw, you know, long term returns be significantly higher, because we saw major draw downs in the market. As Ian mentioned, there's really no signs of a recession on the forefront. There's no material pullback to the be expected from markets. So as a result, you know, muted but positive returns seem to be a reasonable base case right now, going forward.
We did however see volatility pick up. So, there is, volatility is the pricing-in of uncertainty. So, we are seeing more uncertainty based on all the things that we've already discussed, whether its monetary policy, potential tightenings or a change in fiscal policy. But overall, portfolios returned an okay return – you think of 40-to-70 basis points for the quarter, so positive, but yeah, like, you know, half a percent on average, that's not the most impressive quarter. One-year returns, however, still very impressive with returns for portfolios ranging from somewhere between 6% to probably 11%, but pretty strong year-over-year returns, irrespective of the fact that we saw a pullback in the quarter.
I mentioned a few times that you know, when you kind of peel away the layers and look beneath the surface, and there's different things at play right now. So, for instance, our Canadian equity investments did very well in the quarter on the backdrop of rising energy prices, companies like Birchcliff Energy did extremely well. You know, yet bank stocks were kind of flat. And then consumer stocks like Canadian Tire, Magna and Dorel didn't perform particularly well.
And in the U.S., the non-bank financials, with companies like Blackstone, AIG, Aon, were all up around 20% in the quarter, which is pretty strong actually. One of our best performing stocks in the quarter was Dexcom, which is up 31% -- our listeners might understand it's a continuous glucose monitoring system company. And in contrast we saw FedEx, one of the beneficiaries of all of us buying goods and services at home, was down 25%. And then in the auto sector, both GM and Ford were down over the quarter, yet Tesla was up significantly. Coming back to multiples I mentioned before, you know, GM and Ford are still trading at reasonable multiples at, you know, seven times earnings or 18 times earnings. Tesla was up in the quarter, it's now trading at 400 times earnings. People are definitely pricing in that transition to electrical vehicles and think Tesla's the only one that will win.
Then in international markets, Icon which supports clinical development and clinical trials was up 30%. Yet Novartis was down. And then no surprise with the crackdown in China, discussions we've had previously on the drawdown in China, Tencent and Alibaba, two main stocks in China sold off significantly. And then Japanese sporting goods manufacturer Shimano was up 27%, that may be the impact of the expensive gas prices.
[Ian Taylor 20:01] Yeah, building on what Craig has said here as well, I mean, you definitely see the stock market was not as strong as it was in prior quarters. So, you do have to look underneath the hood. We started today's discussion talking about emerging markets, for example, that is one area where we've been cautious as well, certainly been underweight emerging markets entering into the spring and into the summer months. And that's certainly benefited the portfolio.
And as Craig mentioned around the strength of commodities, we do have certain funds like the MD Strategic Opportunities Fund, which benefits directly and indirectly from some of those more inflation concerns that you're seeing in the market. So really contributing to an overall portfolio approach to investing.
We also saw some strength in the U.S. dollar, and if you've been following along, we've been a bit more bearish on the U.S. dollar since sort of late last year. Although we have moderated those positions throughout the year. It did strengthen throughout the quarter, which also gave some benefit to some of the global and more U.S. dollar denominated assets that we have in the portfolio as well.
What are some of the notable tactical adjustments we’ve made recently? How are we tactically positioned?
[Ian Taylor 21:11] Overall, we remain fairly similarly positioned entering this quarter as we did the last quarter. So to your point, we've made some adjustments in relation to the expectations, like we talked about, that financial conditions were likely to tighten at the margin and that, you know, the upside potential for stock markets was beginning to wane.
That doesn't mean we don't think it's going to materialise over a 12-to-18 month period. That's what we've been talking about a lot through this podcast. But certainly, it was prudent to reduce that allocation. And we continue to maintain with some of that more of a cautious overweight as opposed to a full overweight in equities relative to our benchmark.
On the fixed income side, you've heard Craig allude to the fact that we do expect yields to rise. We've reduced some of that positioning on a tactical basis, but remain underweight duration, definitely less sensitive to the potential for higher interest rates within the portfolio. You know, those are two of the notable tactical positions within that.
I’d say on the currency side as well, we've generally been positioned for, we talked about U.S. dollar weakness, but on the other side of that, definitely looking at some of the strength that we might have seen in commodity markets playing through to something like the Canadian dollar or the Norwegian krone, but we haven't totally exited all those positions, some we've exited. But for the most part, we're certainly less exposed to what we would consider higher beta and commodity sensitive currencies entering into the remainder of this quarter.
Also, you know when we are positioning for sectors or more geographically, we moved away from an all out more cyclically geared portfolio, but certainly not into the defensive space – maintained overweights to the U.S. energy sector, which certainly benefited. But we're also looking at what we call more secularly strong sectors that benefit from growth in the digital economy. So we've certainly seen that in info(rmation) tech(nology) and communication services and consumer discretionary, for example, although those stocks are generally priced very high, and we expect some volatility there, as that theme plays through.
If I were to summarise things, is that we've taken a bit more of a moderate approach toward riskier assets with the expectation that you know, some of the transition that we expect to happen over the next, let's say, quarter or two may provide some other entry points to allow us to be a bit more selective and benefit from what we think will be an ongoing economic expansion through 2022.
[Craig Maddock 23:25] Yeah, maybe just to add, it may not be obvious from the fact that Ian and I have spoken a lot about the same things and supported each other's comments. There's a lot more discussion and debate within the team now. These things aren't as clear as maybe they were previously. You know markets are more expensive and the upside versus downside ratio is perhaps more skewed to the negative.
It doesn't mean that we're going to sell out of stocks or that anyone else should, it just the upside is probably more limited. And then if things turn bad, there's more room to drop. So, in that backdrop, I'd say it's a more challenging environment right now to navigate. So, the good news is we're on top of it, and are adjusting portfolios on a continual basis. So, when we meet again next quarter, don't be surprised if our position may have changed.
It sounds like active management and prudent portfolio management is more important than ever. With that, any final thoughts?
[Ian Taylor 24:16] We just mentioned the portfolio approach to investing the importance of being on top of things. I think it's also important to be meeting with your advisors as well, at this point in time.
Lots has changed in the financial markets. And I'm sure a lot has changed in the personal situations of a lot of our investors who are listening. So it's certainly a good opportunity to reach out if you haven't spoken to your advisor recently, and just making sure that your portfolio and your understanding of the markets are solid and continuing that relationship because that is absolutely important here as we enter into the next phase of the economic cycle.
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