If it weren’t for all the parts that are still working, this economy would have nothing going for it.
It was with reluctance that we closed the book on summer. The warm weather allowed us to get out of our COVID-induced cocoons and enjoy the outside. The sun was shining, the weather beckoning, and the markets co-operating. As August turned to September, I recall many conversations that went the direction of “I don’t know what we’re going to do this winter,” with the general acceptance that the potential for a second or third wave of COVID infections would reinforce social distancing. My guess? As there was a run on bicycles, swimming pools, and hot tubs, this winter will see a shortage of ski equipment (downhill and cross-country), snowmobiles, and fat bikes. My advice — mainly to myself — is to embrace it.
As far as the equity markets were concerned, July and August were a show of strength on improving economic data while September fell back into the seasonal norm for that month. The S&P 500 Index gained 8.47% (USD) during the quarter, on a price-return basis. That was after giving back 3.92% in the month of September. But as mentioned in other articles, a weaker September has been the norm. Since 1950, September has produced a negative return 52% of the time, with an average return of -0.43%. If we were going to see volatility in the equity markets after a 60% gain in the S&P 500 Index off the March 23 low, September was as close to a sure thing as we could get. However, knowing that September tends to fall on the more volatile side, and with a better understanding of where we were in the economic recovery, our attitude towards any market weakness was to embrace it. We say the same for October, as since 1952, October holds the title as the worst-performing month of the year in election years. But more on that later.
The strength of the equity market rally bewildered many investors. The narrative was that this was the worst economic disaster in our lifetime; how could the equity markets not only recover in such a short period of time but also ascend to new heights? First off, we don’t pretend to have the foresight to have predicted a complete recovery like the one we just had. History would suggest that a full equity recovery wasn’t forthcoming until well into 2021. However, the circumstances around the recession (which we believe is over in Canada and the United States) were vastly different than anything we had seen in our lifetimes. As we wrote about at the start of the pandemic, this is more a disruptive event rather than a destructive event. Therefore, while we’re surprised at how fast the market recovered, we understand why. And it’s for those same reasons we’ve become more confident in equity market returns for the coming 12 months.
There has been much discussion as to the shape of the economic recovery. The latest is that this is a “K-shaped” recovery. It’s described as such because parts of the economy are recovering well — we’d say this includes the housing and manufacturing sectors, while other parts are lagging — specifically, the services-based sectors. To this we would say two things … One: every recovery is a “K-shaped” recovery. No recovery is equal across all economic sectors. In fact, we’d suggest that the recovery following the Great Financial Crisis (GFC) was also a “K-shaped” recovery by this definition, only perhaps it was the opposite of today where the services recovery led. Two: the math geek in me asks, “Wouldn’t it be better to use ‘<’ (less-than sign) as the proper shape?” It then could be referred to as the “less-than recovery.” Less-than perfect. Less-than optimal. But I digress.
There’s the economy, and then there’s the equity-centric economy
Last quarter we wrote, “We love when markets go up, we just like to know that the markets are going up for the right reasons — because profits are (or will be) going up.” We’ve been seeing those signs over the last few months. To understand this, we need to segment the economy and adjust our viewpoint. The equity market isn’t the economy. This phrase has been repeated time and time again. There are aspects of the economy that matter to the equity market, and there are many that don’t. It’s important for investors to focus on the former, as the latter will guide you down the wrong path.
Recently, we’ve relied on some alternative sources of data for a new and timely perspective lately. Google Trends data is a great source to uncover or verify trends that aid in economic and market analysis. For example, two recent search trends highlight the improvements in the unemployment data but also the continued strength in the housing market.
Recent unemployment data continues to show a jobs recovery in the United States. The September U.S. Nonfarm Payrolls report showed that slightly more than half of the jobs lost in March and April have been recovered. What’s encouraging is that the Google search trend for “how to file for unemployment” that reached its peak in March has been steadily declining. It’s not back to the pre-COVID level (2% of the peak search activity), but is at levels that are encouraging for continued improvements (6% of peak).
While the rate of change may be slowing comparatively, the job gains and improvement in unemployment is much faster than what we experienced following the GFC. The unemployment rate has fallen from 14.7% to 7.9% in five months, with half of the jobs recovered. Following the peak in unemployment in October 2009, at 10% and 8.7 million unemployed, it took 28 months to recovery half the jobs lost and 35 months to get to an unemployment rate of 7.8%.
The housing data is also a bright spot in this economy. One of our recessionary indicators is the decline of housing starts. Aside from the COVID lockdowns, housing activity has been the strongest in years. This certainly isn’t a sign of an economy in trouble. For the months of June, July, and August, Google search activity for “buying a house” was at its highest in five years. Housing starts have recovered right back to their pre-COVID levels. And housing is key to an economic recovery and an equity market recovery.
We’d suggest that while not all the economic data is trending in the right direction, some of the data that‘s most important to the equity markets is trending in the direction we want to see — including retail sales, durable goods orders, and purchasing managers’ indices, to name a few. We’d compare the evaluation of the current economic conditions to that of a roller coaster ride. A market strategist and an economist exit a roller coaster. The economist is green and holding his stomach; the market strategist is smiling. Whether it was a good ride or not depends on who you ask.
Our three key themes haven’t changed much since last quarter
Our base case assumes a gradual economic recovery, despite any COVID relapse over the next 12 months, but perhaps at a different pace market by market.
- We expect a full earnings recovery for the S&P 500 Index by Q4 2021/Q1 2022, and similarly for other markets.
- In general, equity market gains are unlikely to reflect the full earnings growth as price-to-earnings (P/E) multiples adjust lower (as they typically do in a strong earnings recovery).
- Global equities (U.S., international, and emerging markets) are favoured over Canada, as oil prices and the correlation to energy weigh on the S&P/TSX Composite Index.
Rising inflation will be a key theme to watch for into 2021.
- We expect yield curves to steepen as the recovery combined with the inflationary forces of fiscal and monetary stimulus push longer-term rates higher.
- Despite higher inflationary pressure into 2021, central banks will remain accommodative through the entire period, not looking to raise rates until well into 2022.
- Credit outperforms sovereign debt, and a short duration bias performs well on a relative basis as curves steepen and spreads tighten.
The USD devaluation may be a longer-term by-product of the monetary and fiscal stimulus.
- We expect the USD to continue to weaken to a basket of currencies, including the Canadian dollar.
- The Canadian dollar remains tied to oil and continues its appreciation relative to the USD.
- Gold and other commodities that are inversely correlated to the USD will continue to grind higher, contributing to inflation.
- Emerging market debt and equity are favoured in a USD devaluation scenario.
Taken together, we believe it’s a good opportunity to continue to gradually increase the equity weight in our model portfolio by 5% to 65%, bringing our asset allocation to a modest equity overweight.
We’ve moved into the third stage of the bear-market cycle
In recent notes, we’ve outlined our theory that the pattern of the equity market will follow that of the three stages of General Adaptation Syndrome. These are the alarm stage, the resistance stage, and the exhaustion stage. We suggest that the exhaustion stage starts once market P/E multiples have reached their peak. This isn’t to suggest that the equity market can’t enjoy further gains during the exhaustion stage, rather the gains will be a trade-off between valuation (P/E multiples declining) and an earnings recovery.
These three stages of the bear-market cycle are clearly evident during the 1973‒74, 1980‒82, 2000‒02, and 2007‒09 recessionary environments (with 1990 being the outlier). In each environment, we can clearly define each stage. Following a strong bear market recovery (a new bull market), the market enters an exhaustion phase. This is marked again by a peak in P/E multiples and typically coincides with an earnings recovery. Stage 2 can be short or long — it has ranged from 9 to 17 months. But in each case, it ends (or exhaustion begins) with a peak in P/E multiples. It warrants watching, whether or not the new high on the S&P 500 Index, in terms of the Index level and P/E multiple on September 2, was the end of stage 2.
Unfortunately, we never know we’ve hit the peak until well after the fact. However, we’re starting to see more signs of an impending earnings recovery. Global purchasing managers’ indices continue to improve on a month-over-month basis. And one of our favourite charts, South Korean Exports YOY (year-over-year), has recently turned positive. If we’ve emerged into the third stage of this bear market cycle, then the next two years are going to deliver closer-to-average returns as we move into an earnings recovery. It only stands to reason to expect that future equity returns will be somewhat more average following such an impressive rally against a backdrop of a modest economic recovery. It isn’t a reason to sell equities, merely a reset of return expectations.
In our mid-year outlook, we set expectations for the S&P 500 Index to return 5 to 15% through to the end of 2021, with risk to the upside. Since June 30, the S&P 500 Index has gained 8.5% through quarter end. We believe the market is entering the exhaustion stage and, therefore, Index return expectations over the next couple of years are likely to be much closer to average (upper single digits), with risks remaining to the upside on the potential for an accelerated economic recovery.
Passive investing has made it look easy through the current rally but may leave investors disappointed in a sideways market. In such an environment, we believe active management and, in particular, a greater emphasis on security selection will be key to portfolio performance in the exhaustion stage.
Seasonality and the election may contribute to continued volatility
At the onset, we mentioned how September’s equity market volatility was typical. In election years, however, while September averages a negative return since 1952, October tends to be the worst month of the year. We speculate that this may be due to uncertainty and a contentious political environment as we head to the November polls.
This election may be more contentious than any in the past. Given President Trump’s recent response, or lack thereof, to the question whether he would accept the results of the election should he lose, we believe this election may be a perfect example of politically charged volatility. Investors would be well served to prepare themselves for additional volatility up to November 3, and perhaps beyond should the winner be determined by the courts.
On the results of the election itself, we’ve spent a significant amount of time over the past few months speaking to what the election might mean for equity markets. In truth, we don’t put a lot of emphasis on the election or the make-up of government. This may seem as if we’re casting aside all the variables and consequences to the make-up of the U.S. government, especially towards a topic that can trigger a very passionate response from investors; however, our work would show that, in the end, it doesn’t matter.
We’ve spent many hours analyzing past elections and market performance, listening to political experts and their views. We’ve looked at every combination of government since 1945 and the truth is, in every case, equity markets go up. There may be differences in the gains between Republicans and Democrats, but markets gain, nonetheless. We believe the reason for this is that good companies find a way to succeed in any political environment. While politics can drive an emotional response in us, we should refrain from allowing those emotions to drive our portfolio decisions.
Given seasonality and the election, we believe we’ll see continued volatility that could extend well into November, until the political noise subsides. As our expectations over the next 12 months are for an S&P 500 Index return potential of 5 to 10%, with risk to the upside, we would take any volatility as an opportunity to add to equities.
We continue to favour U.S. and international equities over Canadian equities. The S&P/TSX Composite Index returned 4.73% over the third quarter on a total return, underperforming the S&P 500 Index (6.62% on a total return on a Canadian dollar basis) while outperforming international equities, as measured by the MSCI EAFE Index (2.65% on a total return on a Canadian dollar basis). We continue to believe that the S&P/TSX Composite Index will face headwinds of an underperforming energy sector. Our expectations are for oil prices to increase to a target of US$50/bbl over the next year, yet we don’t believe that will be enough to drive performance comparatively to global equity markets. Other areas within the Composite Index are attractive though, and we’d suggest selectivity and high active share are the keys to successful investing in Canada.
Inflation will be worth watching, from a fixed-income perspective
Is inflation dead? We don’t think so. And in fact, we believe inflation may play a key role in fixed-income positioning into 2021. Through its aggressive monetary policy, the Federal Reserve prevented what may have otherwise been a return to the financial crisis of 2008-09. The extent of the monetary stimulus, in the form of a zero-interest rate policy and trillions in quantitative easing, provided ample liquidity to the markets, fixed income and equity alike. There’s a balance to everything, however, and in this case, we believe the consequence of the monetary stimulus will be higher inflation. And the Fed fully supports this.
Our inflation model suggests that the trend for inflation will continue to be higher into the first half of 2021; our model would imply inflation at levels of 2 to 3% for the coming year. We’ve found our inflation model to be a much better forecast of the trend and inflection points to inflation, if not the absolute level. With that in mind, above 2% will be the likely path over the next 12 months. That’s likely to lead to higher longer-term interest rates and a steeper yield curve, which is the norm in the early stages of an economic recovery. This is to say that long-duration or interest-sensitive assets are likely to underperform in a rising rate environment. At this time, we believe there’s greater interest-rate risk than credit risk. Investors may be better served focusing on shorter-duration high-yield and investment-grade bonds over longer-duration sovereign bonds.
Will it be a cyclical or secular devaluation of the U.S. dollar?
We believe one of the other consequences to the rapid increase in the U.S. money supply will be continued weakness of the U.S. dollar. The U.S. dollar, as measured by the DXY Index, closed the quarter at a level last seen in 2018. The difference in bond buying programs of global central banks, and their efficacy, may lead to a greater increase in U.S. M2 money supply over the coming year (or years), greater than what nominal GDP growth would support. If M2 grows faster than GDP, then we expect the consequence will be a weaker U.S. dollar and higher inflation.
The Fed has been far more effective in increasing the money supply with its latest round of quantitative easing than it was following the GFC. I recall at the onset of QE1, the Fed’s first program of quantitative easing, the expectations by May market watchers was for higher inflation. It stood to reason, if the Fed was going to engage in money printing, the consequence must be higher inflation. However, back in 2009-10, the quantitative easing stopped at the banks. The money didn’t get into the economy because the banks needed to shore up capital and rebuild their balance sheets, and they weren’t making loans. Inflation, therefore, never really materialized. In this environment, as the Fed’s latest QE has resulted in a commensurate increase in M2, nearly dollar for dollar, a weaker U.S. dollar and higher inflation may be that ultimate consequence.
One of my team’s favourite sayings is, “Big deal. So what? How do we make money from this?” A weaker U.S. dollar favours emerging market equities. Historically, weakness in the U.S. dollar has had an inverse relationship with emerging market equities; that isn’t to suggest that just because we believe the U.S. dollar will weaken, investors should embrace the emerging markets. But it’s one supporting reason. Emerging market equities are also much cheaper than the developed markets (S&P 500 Index and MSCI EAFE Index), more than they have been over the past 10 years. Additionally, we’re seeing a faster recovery in the emerging markets, led by China, than what we’re seeing in the developed markets. We believe this will give the emerging markets a lead in the earnings recovery.
The final word
In keeping with our process, and based on reasonable valuations and a positive outlook for earnings into 2021, we’re adding an additional 5% to equities to bring our equity weight to a modestly overweight 65% and reduce our fixed-income weight to 35%. Overall, we’re reducing our weight in global core bonds by 5% in favour of emerging market equities.
Changes to the model portfolio from prior quarter
- Reduced weight to underweight (-5% to 35% overall)
- Maintained corporate bond (high-yield) position (15% overall)
- Reduced global core bond position (-5% to 20% overall)
- Increased weight to overweight (+5% to 65% overall)
- Maintained international position (20% overall)
- Maintained U.S. equity position (30% overall)
- Maintained Canada equity position (10% overall)
- Initiated emerging market equity position (5% overall)
We’ve learned much over the past six months. Global leaders are dealing with COVID outbreaks in new, less economically disruptive ways. We hope and believe this will continue to be the case. The aggregate of economic data may suggest a sluggish recovery, prone to a reversal of trend. However, we’d argue that the economic data that’s most important to equity markets, the data that has historically correlated strongly with earnings growth, continues to trend in the right direction.
Despite our more modest outlook to equity market returns over the next year, our confidence is greater than it was three or six months ago. That’s not to say there won’t be bumps along the way. Over the next couple of months, we fully expect continued volatility as investors project their political views on the markets. History would show that this is to be expected. In fact, it would be uncharacteristic if we didn’t see volatility leading up to the election. But with an improving outlook, to volatility as to the long winter in front of us, we say, “Embrace it.”
Philip Petursson, CIM
Chief Investment Strategist and Head of Capital Markets Research
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