By the FÉRIQUE Fund Management Investment team
Most of the results we expected from the financial markets materialized in the second quarter. The backdrop was conducive to further stock market gains, particularly for the more cyclical sectors, while fixed income securities were able to navigate the headwinds and avoid detracting from the overall performance. Emerging markets fell short of our expectations, however. Even though the economic environment pointed to a strong rebound, their performance still lagged that of the developed countries.Printable version (pdf)
|U.S. equities (CA$)|
|MSCI Asia Pacific (all countries)||▲1.2%||▲2.2%|
|MSCI World (excl. Canada)||▲6.2%||▲9.9%|
|MSCI Emerging Markets||▲3.6%||▲4.6%|
|Interest rates %
|EUR / CAD||0.68||▲0.4%||▲6.0%|
|JPY / CAD||89.53||▲1.7%||▲10.0%|
|USD / CAD||0.81||▲1.4%||▲2.7%|
As expected, inflation continued to fuel discussion, whether among savvy economists or ordinary people. Even so, during the second quarter the yield curve barely budged in the face of this threat and the bond markets emerged unscathed. This matter is open to debate, and in these pages we will try to shed light on it.
In a context where economic and epidemiological results are surprisingly positive and a number of stock markets periodically set new records, it is important that as investors we temper our enthusiasm and maintain an overview. We will therefore also look at the indicators to watch as well as portfolio positioning for the coming quarters.
|*There was an error in the previous financial letter. The change in the price of oil for the first quarter of 2021 (column Q1-2021) should have been 22.4% and not 47.8% as indicated. Our apologies.|
|Net of fees returns as at June 30, 2021 (%)|
|Q2-2021||YTD||1 year||3 years||5 years||10 years|
|Short Term Income
|Global Sustainable Development Bond
|Globally Diversified Income
|Aggressive Growth Portfolio
|Canadian Dividend Equity
|Emerging Markets Equity
|World Dividend Equity
|Global Sustainable Development Equity
|Global Innovation Equity
Three months ago, our opinion on the transitory nature of inflation was cause for moderate optimism about bond yields. Observed dnflation remained low and the lifting of lockdown measures would gradually alleviate the pressure on specific sectors. Even so, some skeptics will argue that since the last quarter inflation has begun a convincing upward trend that goes well beyond the central banks’ targets. So why has the bond market reacted so little? .
The answer is relatively simple: the increase observed so far is due largely to a base effect1 rather than a genuine trend. To verify this matter, we can measure the annual variation and compare it to the pre-pandemic level by annualizing the change over 24 months. The following table shows that adjusted inflation is well below the published figures and still below the target.
Observed inflation adjusted for the base effect
Performing the same exercise for the U.S. economy leads us to the same conclusion: the base effect amplifies the variation, and the adjusted metric remains below the Federal Reserve’s new target, namely an average that compensates for declines below the 2% level.
In this way, we can see why fixed income has not suffered from the alarmist headlines about the CPI and instead has benefited from an environment that tends to maintain current yields.
Despite all the words of caution about an inflationary spiral, the fact remains that the economic situation is favourable to rising interest rates in the coming quarters. And we must bear in mind that interest rates also reflect real economic growth and that the IMF forecasts that we will see the strongest two consecutive years of expansion in 20 years on a global basis. That being said, even though the probable direction of rates seems to be known, what matters above all is the speed at which they move up. To avoid stifling the current recovery, central bankers will have to manoeuvre carefully and above all clearly communicate their intentions.
Thus, the next quarter may well resemble the one we have just experienced, with a gradual and controlled flattening of the yield curve and conditions that maintain credit spreads. In this context, the bond market should provide modest but positive returns as well as assurance that fixed income can preserve capital in the event of an unexpected correction.
The cyclical recovery continued in the second quarter, propelling the markets to new highs. Even though returns were positive across all regions, the developed countries of North America and Europe enjoyed a distinct advantage.
This observation coincides with the vaccination statistics, which pointed up disparities in terms of access to vaccines, the ability to deploy an effective campaign and the population’s willingness to take part.
Uneven progress of vaccination efforts
In line with our expectations, the accelerating global recovery smiled on Canada’s resource-based economy. As a result, the energy sector once again found itself among the main contributors to performance. In a sign that some of the changes brought about by the pandemic are here to stay, the ecommerce platform Shopify regained its status as the Canadian stock with the largest capitalization, recording a return that made the information technology sector the leading contributor in the second quarter of the year.
As a result, as measured by the MSCI Canada Index, the Canadian stock market remained number one in our universe2 with an 8.6% return during the period.
The good news for the Canadian market is that the economic recovery will continue for several quarters. In addition, progress with the vaccination campaign suggests a full and safe reopening in the coming months. Even so, two headwinds have just appeared: the market’s valuation, which has become less attractive, and, what is even more important, the Chinese economy, which is showing signs of a slowdown. It would therefore not be surprising to see China’s appetite for resources moderate and undermine future results. In short, the outlook for the domestic market is still positive but less so than at the start of the year.
Given the unparalleled support measures, the likelihood that the U.S. market will disappoint investors is very low. Unsurprisingly, it ranked first in terms of returns in local currency. That being said, the increase in the price of crude oil during the quarter caused the loonie to strengthen and slightly reduced the result in Canadian dollars.
From a sectoral point of view, continuing low interest rates stimulated real estate, which found itself the top contributor. Just behind it, information technology and communication services also reminded us that growth stemmed from the means of operation adopted collectively over the past 12 months.
Illustrating the extent of the U.S. economy’s momentum, only utilities experienced a decline from the previous period, while all the other sectors made a positive contribution. In the second quarter, this market returned 7.3% (in C$), as measured by the MSCI USA Index.
The U.S. Federal Reserve has a dual mandate of price stability and full employment. The atypical nature of the contraction we experienced briefly last year and the measures taken in response have blurred the relationship between certain economic indicators. As a result, the Fed currently has to manage a dynamic involving a higher number of unemployed workers than before the pandemic but also more unfilled positions.
As the following table shows, even though surveys of U.S. households indicate a sharp increase in the ease of finding a job, this situation has not lowered the unemployment rate.
The so-called shortage of workers is due to a number of temporary factors, but in the meantime this situation makes the interpretation of monetary policy more complex. In principle, it is logical to think that once the extension of COVID-related unemployment benefits expires and herd immunity is achieved, employment growth will accelerate with no sign of labour shortages. The coming months could bring a very favourable environment with sustained employment growth amid little inflationary pressure. We therefore have reason to remain optimistic about the U.S. market.
For global equities, the second quarter brought mixed results, depending on the region. Europe did not disappoint, delivering a solid performance across almost all sectors. As with the U.S. market, only the utilities sector ended in the red. Then came emerging markets, which fell short of expectations despite their exposure to resources. Limited access to vaccines in the poorer countries combined with the emergence of a new variant delayed the reopening of some economies. Finaly, the Asian market disappointed the most, mainly because it was very much affected by the situation cited above, especially in India, but also by the Chinese central bank’s preventive tightening of credit conditions.
As a result, the MSCI Europe Index closed the quarter with a 6.1% return in Canadian currency, while the MSCI Emerging Markets Index and the MSCI All Country Asia Pacific Index returned 3.5% and 1.1%, respectively.
An upturn in emerging markets and Asia requires better deployment of vaccines in these regions. This was one of the major topics of discussion at the most recent G7 meeting, held in the United Kingdom. China’s tightening has paid off, and signs of slowing have appeared. Despite this headwind, growth is expected to remain above its potential, and the Chinese authorities will certainly not seek to stifle it unduly. We can therefore hope that in the coming months Asian and emerging stocks will catch up in terms of their valuation.
The coming months point to several small risks that should, at worst, slow the recovery rather than derail it. The first is the lofty valuation of some markets, which are at historic highs. That being said, this aspect must be seen in a context where we are expected to experience unparalleled global growth until 2022. Then there is the new Delta variant (and possibly others, such as Lambda), which could continue to spread. Even though the latest studies tend to show that the vaccines are effective against this variant, statistics in the United Kingdom still indicate rising cases, even though a high percentage of people have been vaccinated.
Impact of the Delta variant
Still, it is reassuring is that this increase in the number of cases comes with far fewer hospitalizations.
There is also a risk, albeit unlikely, that the U.S. Federal Reserve will panic in the face of inflation and tighten monetary conditions too fast. In short, it is difficult to identify any one factor that has a high probability of occurring with an impact strong enough to interrupt the stock markets’ bullish trajectory.
So far this year, the financial markets have met investors’ high expectations in several respects. The conditions for a continuing recovery require that we have the ability to shift gears smoothly and make the necessary adjustments to our investments with a view to the future.
At this point, the stock markets that have seen strong gains have less attractive valuations, but the outlook remains positive. In the United States, recent indications of tightening by the Fed surprised the markets briefly; that being said, the central bank’s actions will remain conducive to further strong growth and will avoid a stock market correction.
China’s slowdown will reduce the demand for commodities, which should hurt margins in Canada as well as in emerging markets but not prevent all stock markets from continuing to advance. We must keep in mind that monetary conditions will continue to be very accommodative and that the savings accumulated during the lockdown should logically be deployed.
The bond market will continue to come under pressure, probably because of rising real rates rather than persistent inflation. Corporate bond risk premiums should remain at current levels and partially offset the low yield on government securities. Finally, it might make sense at this stage to favour cyclical securities in a selective fashion within consumer discretionary. The hotel, restaurant and transportation subsectors will benefit from the final phase of a return to normality.
Have an enjoyable summer as the economy reopens!
To discuss the markets and your investment strategy, contact your Financial Planner and Mutual Fund Representative of FÉRIQUE Investment Services, main distributor of FÉRIQUE Funds.
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Toll free 1 855 337-47833
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