By the FÉRIQUE Fund Management Investment team
|First Quarter of 2021|
The backdrop we described at the start of the year continues to take shape. Unprecedented fiscal and monetary support measures are providing immunization process time to be deployed. Despite setbacks and uneven progress, we are likely to emerge from the crisis sometime in 2021 if the vaccines continue to be effective against the new variants of COVID-19.
Moreover, the markets’ performance is telling us that conditions are favourable for further appreciation. The only shadow over the financial markets is concern about a resurgence of inflation. After more than three decades of deflationary effects and an inflation rate more often than not below the 2% target, does it make sense to worry about inflation? History shows us that monetary and fiscal authorities sometimes get things wrong. The sums of money that have already been injected and will be injected in the near future are unprecedented. They far surpass central bankers’ previous attempts to combat deflation in their economies.
In this context, a significant imbalance between supply and demand could occur if the stimulus package does not live up to its promises. As explained elsewhere in this text, this scenario is unlikely, however, and the indicators lead us to believe that the environment will enable the markets to continue functioning properly.
Given the starting level of interest rates (rock bottom) and the accelerating economic recovery, expectations of the bond market’s potential return during the quarter were modest. Even so, the decline in fixed income instruments was surprising. Despite the uncertainty associated with fluctuations in the number of new cases of COVID-19 and continued support from the monetary authorities, yields rebounded significantly. Their upward movement exceeded expectations in terms of scale and speed alike.
Canadian sovereign yields rebound from historic lows
It is worth remembering that the markets reflect investor expectations. So what got into them to make them suddenly decide to shun bonds? The answer is that investors are twilling to pay to protect themselves from inflation. Indeed, the yield spreads between conventional and real-return bonds, which is used to estimate investor expectations of inflation, has surged since the end of last year. In other words, the bond market now expects inflation to accelerate and even overshoot its target in the United States.
Investors are concerned about a resurgence of inflation
We stated in the previous quarter that inflation would eventually start to rise again, but that, given the amount of excess capacity in the economy, the rise would be gradual. This statement is borne out by the statistics; despite an upward trend in the last quarter of 2020, inflation in Canada is not only still well below its target, but is stagnant if gasoline is excluded.
Inflation remains tame
For the coming quarters, the question is therefore whether investors’ concerns are exaggerated or whether they are well founded or even underestimated. In the short term, we know there will be a temporary base effect combined with an environment where demand (a high level of savings is looking to be deployed) will continue for some time to exceed a supply that is limited by procurement glitches. This type of inflation is transitory, however.
For inflation to materialize and persist, a feedback loop is required: expectations must be confirmed in the observed data and thus feed even higher expectations. For example, inflation would have to be so worrisome that a majority of workers asked for and received higher wages to offset the loss of their purchasing power. As there are no indications of such a scenario, the only conclusion we can draw at this time is that the current environment is conducive to increased volatility in the coming months, especially in the bond market. For active managers, this context will provide opportunities to add value.
Despite the headlines about a few specific companies (GameStop, Archegos Capital Management) or certain issues surrounding the vaccination process (AstraZeneca), the market optimism we noted at the start of the year prevailed and our basic scenario materialized. As expected, we saw a healthy rotation from those sectors that benefited from the pandemic to those that will benefit from an end to the crisis, and the acceleration of the cyclical recovery enabled all the stock markets to close the quarter in positive territory. What is even more important is that, despite significant differences in the progress made, the vaccination campaigns, which are the backbone of the plan to combat the pandemic, are making solid progress around the world.Progress in vaccination efforts around the world
The pendulum swung back in favour of the Canadian stock market. Buoyed by the steadily rising oil price, the energy sector played a key role in the market’s strength. Even though the financial sector slightly underperformed the energy sector, it was the main contributor to the return because of its large size. Canada’s strong concentration in these two sectors, which was its greatest weakness in 2020, proved to be its primary asset this time.
As a result, as measured by the MSCI Canada Index, the Canadian stock market recorded the best performance during the quarter with a return of 8.3%.
A number of factors suggest that the Canadian market can continue to rise. The cyclical recovery of the global economy continues to accelerate, and the large valuation discrepancies between value and growth stocks have narrowed only marginally. In this context, the relative outperformance of the value bias is likely to continue, especially if interest rates continue to rise at a moderate pace.
While not major, one of the risks to this scenario is the progress of our vaccination plan. Even though vaccine orders have been placed in large numbers, the lack of domestic production capacity leaves us vulnerable to manufacturing delays which can arise.
The cyclical recovery that has favoured the Canadian market has also been positive for the U.S. stock market. Despite a neutral performance by the information technology sector (in Canadian currency), the market got considerable support from the cyclical sectors, such as energy, financials and industrials. Apart from the sector rotation, it must be said that the circumstances were highly conducive to a positive performance, given that the US$1.9-trillion American Rescue Plan was announced in March.
Fiscal support as a % of GDP
In local currency, the U.S. market saw positive contributions from all sectors. As measured by the MSCI USA Index, it returned 4.1% in Canadian currency during the period.
The Democratic administration’s arrival on the scene is still very recent, but it has set the tone for a new way of doing things. The details of the latest stimulus plan attest to this approach: the goal is to support those most affected by the pandemic and to get the economy back on track as quickly as possible.
By it size, tt ranks the United States as the top industrialized country in terms of fiscal support as a percentage of GDP. With the U.S. vaccination effort making solid progress, it is difficult to see the country’s short-term future in anything but a positive light.
As for global equities, perhaps the biggest detractor from their performance was the Canadian dollar’s across-the-board strength. While the foreign exchange effect reduced European stock market earnings by almost 5%, it reduced the Asian market by 4.5% and the emerging markets by slightly more than 3%.
As in North America, accelerating global growth favoured the cyclical sectors, such as financials, energy, materials and industrials. In contrast, the health care sector adversely affected the results for all regions. From the geographical standpoint, the most notable instance of divergence was the performance of the real estate sector: it was the sector that subtracted the most value in Europe, but was the second-best contributor for Asia and emerging markets.
The MSCI Europe Index closed the quarter with a 2.8% return in Canadian currency, while the MSCI All Country Asia Pacific Index and the MSCI Emerging Markets Index returned 0.9% and 0.8%, respectively.
The combination of accelerating global growth and highly accommodative financial conditions should allow the stock markets to maintain their positive momentum in the quarters to come. In Europe, this environment will continue to be favourable to the financial sector because, among other things, it will reduce the rate of bad loans and bankruptcies.
As for Asia and emerging markets, demand for resources will continue to provide a tailwind and the gradual reopening of stores is also expected to stimulate the consumer sector.
As for the coming months, everything seems to be smiling on the stock markets. Which factor or situation could spoil what looks like the perfect conditions for them to reach new heights? Given the very bullish backdrop, the risk most likely to interrupt their advance, apart from a failure to control the pandemic, would be an inordinate increase in interest rates.
As can be seen in the following graph, the 10-year real government bond yield has a fairly high inverse correlation with the stock market’s price-to-earnings ratio. Let us now imagine that inflation expectations, as shown by the indicator represented by the dark blue line in the right graph, materialize. The initial headwind affecting the stock market would cause multiples to contract.
Spring is here and so are the new variants! The recipe for overcoming the pandemic has not changed, however. We have covered a great deal of ground over the past year and have entered the straightaway that will lead to herd immunity. The same can be said for the economy: progress is being made, but there is still work to be done.
As far as the financial markets are concerned, it’s in their nature to look ahead and try to predict. As discussed in these pages, the current environment should enable the stock market to continue to advance in the coming quarters; global growth is accelerating, financial conditions are accommodative around the world, fiscal stimulus measures are numerous and unprecedented, and finally the immunization process is proceeding apace.
The market environment over the next six months should continue to be more favourable to cyclical stocks and sectors, such as financials, energy, materials and industrials. From the geographical standpoint, it is preferable to remain diversified because some regions are favoured by their exposure to cyclical securities (Canada and emerging markets), whereas others will benefit from earlier immunity (the United States and the United Kingdom). Even though fixed income will continue to come under pressure, for the long-term investor it will eventually offer better interest rate returns. Inflation will become an increasingly frequent topic, but its persistence is yet to be demonstrated. As a result, interest rate volatility is expected to increase during the year. The impact on stocks and bonds should give active managers opportunities to add value.
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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