Apr 20, 2020

Global Time Out

In our quarterly commentary, our research team reflects on what has been the quickest bear market to date and provides a deep dive on how COVID-19 has impacted different asset classes. 

  • COVID-19 pauses global economic growth
  • Get ready for more negative news
  • Markets tend to look forward, not backward

 

March will forever go down in history as the month COVID-19 truly went global. Governments came to terms with how serious the virus was, and began acting with urgency. Previously, there appeared to be an impossible tug-of-war between the importance of economic growth and limiting the loss of human life. The world has now gone all-in on limiting the loss of life. Most people will agree that this is the right approach, however it does come with significant economic costs.

 

Many nations are now effectively trying to put their economies into hibernation until the worst of COVID-19 has passed. This means we will almost certainly see a global recession, and this recession will be like nothing we have experienced before. For instance, the number of Americans filing for employment insurance benefits jumped to 6.6 million in the week ended March 28, 2020, the highest value recorded since the data series began in 1967. Prior to this recent downturn, the previous high was 692,000 for the week ended October 2, 1982. We expect to see more job losses, businesses closing and consumers having a generally harder time making rent and mortgage payments. We also expect the news flow in the coming weeks to be very negative, and there will be lots of it.

 

As usual, capital markets anticipated what was going to happen before it happened. Global stock markets fell into bear market territory (down 20% from the peak) in record time. It took just 22 days for the S&P 500 to fall 20%. While the fall occurred at an unprecedented speed, we bear in mind that these are also unprecedented times. Bonds, which are usually a safe haven, performed much better than equities but were also lower as many traders were forced to sell what they could, rather than what they wanted to, in order to meet their obligations.

 

As we write this in early April, it is unknown when life will return to normal. COVID-19 cases and deaths have yet to peak in many countries, but we do see signs of encouragement in the markets. As of late, markets are behaving more rationally. They are still more volatile than usual, but nothing like the 10% daily swings we were seeing a few weeks ago. Governments have stepped up to the plate with massive spending plans to bridge our economies through this shutdown period. In Canada, over $250 billion will be spent to help consumers and businesses, while in the U.S., this number is over $2 trillion. Interest rates have been cut to virtually zero and central banks have announced various programs to maintain market liquidity. Authorities have acted very quickly when compared to other downturns such as the Global Financial Crisis.

 

Despite encouraging signs, the road forward is still murky. In Canada, the ongoing oil price war has not made it any clearer. We believe, however, that the picture is starting to come into focus. We know things will get worse for the economy before they get better. This explains why the market is down – it is already looking forward, anticipating the downturn. Just as the market slid before we knew the full impact COVID-19 would have on our lives, it will also rebound before our lives are back to normal. The market always looks ahead, which makes trying to time it so difficult.

 

There has been a lot of talk about whether or not markets found the bottom after the recovery in late March. We do not know, as no one does, and will not try to predict the low. Instead, we continue to focus on companies with great business models, reasonable leverage and excellent management. We are also looking for opportunities to own shares in quality businesses that have traditionally been too expensive for our valuation parameters.

 

As always, bear markets are painful. Nevertheless, they also offer great opportunities for patient, long-term investors.

 

 Commodities/Currency Performance
  Q1 - 20 QoQ YoY 2019
WTI Oil (USD/bbl) 20.48 -66.5% -65.9% 34.5%
Gold Spot (USD/oz) 1,577.18 3.9% 22.0% 18.3%
Copper (USD/lb) 2.23 -20.3% -24.1% 6.3%
USD/CAD 0.7109 -7.7% -5.1% 5.0%

Source: Bloomberg

 

Fixed Income

2019 was an eventful year for the fixed income market, dominated by falling yields and a yield curve that was often inverted. Although January and February saw yields down slightly, the yield curve began to shift to a more normal, upward sloping shape. The justification for these slightly lower yields seemed to be investors questioning if the record-breaking economic expansion in the U.S. would continue further.

 

As we flipped the calendar to the month of March, we were quickly presented a very different view. Markets started to rapidly adjust to the realization that COVID-19 induced policies, such as business shutdowns and social distancing, would take a very significant toll on the global economy. In the fixed income markets, effects were felt almost immediately. There was a flight to quality, causing government bond prices to rise and yields to fall. There were sharp, emergency cuts to bank interest rates by the U.S. Federal Reserve, the Bank of Canada, and many other central banks across the globe, causing sovereign yields to fall even further. There was a shunning of any type of risky asset, causing credit spreads to widen. Finally, there was a flight to cash, causing liquidity bottlenecks and pushing credit spreads to widen even further. While we had been predicting higher volatility in 2020, what we witnessed was beyond our expectations.

 

For context, we last saw movements in credit spreads like this from 2007 to 2009 during the Global Financial Crisis. Looking at ‘A’ rated bonds, the 10-year spread over government bonds was just 95 bps (or 0.95%) in January before shooting up to 225 bps (2.25%) in March. A significant change, all in just two and a half months. Now, looking back to the 2007-09 period, the trough for ‘A’ rated bonds was 65 bps over government bonds at the beginning of June 2007. From that point, it took 13 months to increase by 100 bps and 16 months to increase by 130 bps. This illustrates that the market disruption was very rapid and very extreme. Not only did we see the spreads expand, we also saw the difference between a bond’s buy price and sell price widen substantially. Under normal circumstances, the difference between the price a buyer will bid for a bond and the price a seller will offer for a bond is measured in just cents. In March, this difference turned into dollars.

 

Following the Global Financial Crisis, new rules were put in place that reduced the ability of brokerage houses to take undue risks. This new rule also had the side-effect of reducing their ability to provide liquidity during times of crisis. As we know, there are always trade-offs, but March delivered a massive and rapid response by various central banks such as providing “buyer of last resort” support, introducing new buying programs, and expanding the lists of permitted securities that they will buy. All of these programs are meant to provide liquidity and credit support through this COVID-19 crisis. As we enter April, there is a certain degree of calmness slowly returning to bond markets.

 

Governments have also stepped up with various income support measures, credit support for businesses, and support for front line workers. All of this should serve to help the economy as the focus has shifted to public health. However, with all of this comes a longer term concern. While governments are generally adept at providing economic support when it is needed, they are generally inept at removing the stimulus once it is no longer needed. Near term, we expect these programs to provide support for an economy in need. Longer term we are concerned that these programs could lead to credit deterioration, inflation, and a drag on growth.

 

While 2019 was an eventful year for the bond market, this year’s first quarter was really one for the record books. Despite this, we believe that some of this market activity is overdone and look for some return to normalcy in the next month or two. We are continually reviewing the credit quality of the bonds we hold in your portfolio and are confident that the issuers behind these bonds remain in good financial shape. Therefore, our longer-term thesis for holding these bonds remains intact.

 

Rates are itemized in the following charts.

 Canada
  Q1 - 20 QoQ YoY
3 Month T-Bill
0.26% -140 -141
2 Year Bond 0.43% -127 -112
10 Year Bond 0.70% -101 -92
U.S.
  Q1 - 20 QoQ YoY
3 Month T-Bill 0.06% -148 -232
2 Year Bond 0.25% -132 -201
10 Year Bond 0.67% -125 -174

Source: Bloomberg

 

Equities

While it may now feel like a distant memory, the S&P 500 reached new all-time highs during the month of February before COVID-19 uncertainties sent the market on an unforgettable rollercoaster ride. At the close of Q1 2020, the S&P 500 posted a negative year to date return of 20% in U.S. dollars, the index’s worst quarter since the Global Financial Crisis. In Canada, the S&P/TSX Composite followed a similar story, closing the quarter with a negative return of almost 22%.

 

Stock Indices Performance
Country/Region Index Q1 - 20 QoQ YoY 2019
U.S. S&P 500 2,584.59 -20.0% -8.8% 28.9%
  S&P 500
(in $C)
3,666.50 -12.6% -3.2% 22.8%
Canada S&P TSX
Composite
13,378.75 -21.6% -16.9% 19.1%
Eurozone Euro Stoxx
50
2,786.90 -25.6% -16.9% 24.8%
Japan Nikkei 225 18,917.01 -20.0% -10.8% 18.2%
China Shanghai
Composite
2,750.30 -9.8% -11.0% 22.3%

*returns based on price performance ex dividends
Source: Bloomberg

 

Canada: The Canadian market started the New Year off on a positive note but all risk assets sold off sharply as the economic impact of COVID-19 became apparent. As we write this commentary, the country is in virtual lockdown. Only businesses deemed essential are still open for business, much of shopping has moved to online and most people who are working are doing it from home. A recession is certain and in fact, when the data is counted we will find out we are already in one.

 

The Canadian government has launched a variety of programs and initiatives to help individuals and businesses get through this difficult situation. According to the National Post, about $250 billion has been committed by Ottawa to help our economy through this period, with the breakdown being $105 billion directly to individuals and business, $85 billion in tax deferrals and $65 billion in loans. To put this value into perspective, $250 billion is over 10% of our annual GDP. Most governments are fully committed to doing whatever it takes to “bridge the gap” from economic shutdown to reopen. We are likely to see more programs put into place as we go through Q2 as the mantra is to make this recession as short as possible.

 

The global slowdown in economic growth has meant less driving, flying and shipping. Accordingly, the demand for energy products has fallen. Global demand for oil in 2019 was just over 101 million barrels per day and was forecasted to increase in 2020, along with supply. Most estimates now project a decline in demand in 2020 from 1% to 3% with Q2 2020 falling by upwards of 10%. If that is not bad enough, Saudi Arabia recently ramped up their supply as their talks with Russia over cutbacks failed. Oil prices in the U.S. (WTI) have fallen towards $20 a barrel, with Canadian oil prices (WCS) falling towards $5 a barrel. The Canadian Energy industry will require significant government assistance to bridge it through to a more robust demand environment. Until then, we will see smaller and more indebted energy companies worldwide struggle to stay solvent.

 

No sector in the Canadian market posted positive returns in the first quarter. From a performance standpoint, however, defensive sectors such as Communication Services (telecommunications) and Consumer Staples outperformed, as you would expect in an economic slowdown. More economically sensitive sectors, including Energy and Consumer Discretionary, underperformed the market. The Real Estate sector also lagged as property owners are now at risk of not being paid with tenants out of work or businesses closed.

 

No one knows how this controlled shutdown of our economy will develop or what things will look like on the other side. As stated earlier, we do believe the Canadian government will do everything it takes to soften the COVID-19 blow. Once cases peak we should start to see a gradual lifting of our current constraints. The economy will likely experience a sharp bounce back but it will take time to fully get us back to pre-COVID-19 levels.

 

U.S.: Similar to Canada, while the year started optimistically with the anticipation of global growth recovery, things quickly turned sour and by mid-March the U.S. had entered a bear market. The main culprit, of course, was the spread of COVID-19 and the unprecedented measures taken in an attempt to begin to contain the spread. As we have discussed, with significant parts of the world under some form of social distancing measures or mandatory quarantines, the U.S. economy is more than likely already in a recession. As is true for countries across the globe, the depth and length of the recession will depend on how fast we are able to go back to “normal”. The estimated range for U.S. GDP estimates is very wide with some economists predicting Q2 2020 GDP to decline as much as 25%.

 

The U.S. economy is a consumer-driven economy, with about 70% of GDP coming from consumer spending. Today, the U.S. consumer is being forced to stay home. The actual hit to consumer spending is hard to pinpoint, but with most of the service sector closed for business, essential goods being the exception, it will be substantial. In addition, it has been reported that less than 30% of people in the U.S. are actually able to work from home. As we discussed in the opening commentary, the effect on employment is staggering. Unfortunately, none of these facts are surprising; after all, the economy has been put in a hibernation mode since mid-March.

 

However, it is not all bad. The U.S. government has stepped in with unprecedented fiscal stimulus to attempt to support the economy while the isolation measures are in place. The CARES Act (Coronavirus Aid, Relief, and Economic Security Act) is unmatched in both size (more than $2 trillion USD) and urgency (the time it took to sign the bill). The package includes one-time rebates to individuals, an additional $600 per week to top unemployment, small business loan forgiveness, and loans to distressed industries amongst others.

 

Another positive is that, unlike during the Global Financial Crisis, the U.S. consumer is not as indebted, with loan to disposable income and the share of the subprime consumer loans both relatively low. Additionally, the U.S. financial system, which has been under a microscope since the Global Financial Crisis, is also in significantly better shape. So, while most economists are predicting a sharp economic downturn in this year’s second quarter, most are also relatively positive on the medium-to-long term, expecting the economy to return to positive growth by year end.

 

In the U.S., the selloff was indiscriminate with all major S&P 500 sectors down double-digits. Some notable exceptions were gold, and certain Consumer Staples and biotech stocks, which performed well, especially on a relative basis. The sectors most hurt were Energy, due to the oil price war between Saudi Arabia and Russia, and Financials, due to expected consumer and corporate credit deterioration. Aerospace, airline, hotel, and restaurant stocks were down significantly for obvious reasons.

 

We reiterate that the path ahead remains foggy. It is clear, however, that the U.S. government will spare no expense in supporting and stimulating the economy during this time of unparalleled uncertainty.

 

International: International markets were not spared in Q1, with most posting double-digit declines in-line with both Canada and the U.S. COVID-19 first popped up in China in December and had its biggest impact on the country in late January through to the end of February. By the end of March, new cases had fallen dramatically and much of the country was beginning to open up again, even in Wuhan province, the source of the outbreak. By mid-February air pollution had fallen by over 30% in China, while by the end of March it was just down slightly, a sure sign factories were moving again. Not all things were back to normal however, as subway and vehicle traffic was still down over 60% in late March.

 

As China started to recover, European nations started to get hit hard, with Italy and Spain at the epicenter and the U.K. not far behind. The playbook in much of the world outside of North America was similar to Canada and the U.S. – social distancing, business shutdowns, high employment insurance claims and massive stimulus put into their economies by government, as well as rate cuts where possible.

 

We view China as a possible guide to how other economies will open up in a post-COVID-19 world. In mid-February, China was reflecting where most of the West was at the end of Q1. Hopefully this means we are only 2-3 weeks before we hit the peak of this pandemic, after which, the recovery will be relatively slow with gradual measures taken to return people to work. By the end of June, we could start to see normalization pickup, especially if warmer weather helps to limit the spread, as many think it will.

There is no doubt 2020 will be a difficult year. While a global recession is almost certain, we believe that policy makers around the world have acted quickly enough to ensure that, although the recession will be deep, it should be much shorter than the Global Financial Crisis.

While that does not mean we will be back to normal, it does mean that 2021 could be a better year.

 

Summary: Superlatives tend to be overused these days, but all will likely agree that the first quarter of 2020 was unprecedented from anything most of us have seen in our lifetimes. Governments across the globe have chosen to significantly and temporarily slow down their economies to stop the spread of COVID-19. Stock markets have reacted as expected by falling in a very quick and volatile manner, although bouncing off their lows towards the end of March. In summary, we provide the following insights:

 

  1. Balance sheets matter more than ever. We focus on companies with prudent balance sheets. In this environment, many companies will experience a marked slowdown in revenues for a quarter or two, making the ability to access capital critical.
  2. Valuations are more attractive. There are many high quality companies in every market we invest in that had been priced to perfection. The market correction gives us a chance to relook at these companies for possible investment.
  3. The market tends to recover before the economy. Did we hit bottom? It is impossible to know at this point. What we do know is economic news will continue to be challenging through Q2 2020 and at some point the market will be looking through the negativity to a post-COVID-19 world. We moved from slightly underweight equities, to slightly overweight equities in March to reflect this view.
  4. Sticking to your plan is key. Long-term investors have been here before, whether it be the Dot-com Bubble or the Global Financial Crisis. Bear markets are part of investing. Sticking to your plan by being patient and disciplined is one of the key parts of being a successful investor.

 

We wish you and your loved ones safety and good health.