By Louis Lizotte, CFA, FRM, Vice President, Investments, FÉRIQUE Fund Management
Keep Calm and Carry On
If you had the chance to visit London, back in the day, you undoubtedly came across this famous slogan. It was originally part of the British government’s strategy to boost public morale during the Second World War. The slogan was created with a possible German invasion in mind, so it was not used during the conflict. More than 60 years later, it reappeared by chance. People used it to express the prevailing sentiment during the 2008 financial crisis and then it became the subject of many Internet memes [1].
This old slogan aptly sums up the year we have just gone through. In March, we needed to stay calm and resist the temptation to cash out of the markets. Moreover, despite the advent of vaccines, we will have to keep following the health guidelines for an extended period if we are to overcome the COVID-19 pandemic. Our cautious optimism at the start of 2020 dissipated amid the upheaval – hence the need to revise our forecast parameters. So here’s a review of a year that was anything but tranquil, and a look at what we can expect in 2021.
With the reversal of the trend toward tighter monetary conditions in 2019, the bond market’s performance exceeded expectations that year. As a result, the outlook for 2020 was more modest, given the starting level of interest rates and the context of accelerating economic growth. It would have taken a clever person indeed to foresee that extraordinary circumstances would lead us 12 months later to declare bonds one of the best-performing asset classes of the year!
Rapid, all-out monetary easing
In addition to lowering their key interest rates to the floor, the central banks haven’t skimped in their efforts to keep the debt market functioning smoothly with low-cost financing. The Bank of Canada finally opted to follow in the footsteps of its G7 counterparts when it too adopted quantitative easing.
By becoming a major buyer of fixed-income securities, our central bank has certainly helped reduce borrowing costs for households and businesses alike, but it has also pushed bond prices up. In this context, it is not surprising that this asset class exceeded forecasters’ expectations for 2020.
Fixed-income instruments will eventually have to deal with the consequences of the circumstances that have made them so successful over the past two years. The current level of interest rates makes bond yields unattractive and limits their potential for appreciation. So it is unlikely that bonds will record another performance equal to their recent returns.
Even though inflationary expectations remain well anchored at about 2%, the current level is a concern that the Bank of Canada cannot ignore. The monetary authorities’ efforts to get inflation back up to its target, such as by purchasing longer maturities, limits the downside risk of bonds. Moreover, in a continuing economic recovery, corporate bonds should respond well and contribute positively to performance.
Returning to target inflation
The excess capacity that the pandemic has created in the economy is weighing on inflation and some time will be needed to absorb it. So it is unlikely that excessive inflation will put an end to monetary easing and force a tightening over the next 12 months. The odds that the current recovery will falter, leading to a double-dip recession, are low, but not nil. In such a scenario, fixed income would offer protection as well as modest, low-risk returns.
The exceptional circumstances of 2020 affected stock market returns in different ways. They created a sector divergence that led to a clear-cut split between winners and losers: some companies were battered by the pandemic, whereas others couldn’t have asked for anything more. The geographical returns for the year were due partially to the composition of the stock markets of different countries around the world. Generally speaking, the stock markets did well, although their performance was based mainly on record fiscal stimulus, which we will have to come to terms with down the road.
The Canadian stock market was not ideally equipped to cope with the conditions created by the health crisis. Its exposure to the energy sector – three to five times that of the other stock exchanges – worked against it. Moreover, the financial sector accounts for more than a third of its composition, or about double that of markets elsewhere in the world.
These high concentrations in hard-hit sectors were not the only headwind. The Canadian market’s low exposure to the best-performing sectors also played a major role. A low weighting of information technology, communication services and health care limited the opportunities for gains.
Despite these disadvantages, the Canadian stock market had a positive return of 4.4% in 2020, as measured by the MSCI Canada Index.
The context of a cyclical recovery with the advent of various vaccines and an eventual end to lockdowns would be very positive for the Canadian economy. An acceleration of global growth, combined with a reversal of the large valuation divergence created during the year between winners and losers, would provide the necessary ingredients for a rebound on the Canadian stock market.
A simple way to describe what is likely to happen is that last year’s winners may become this year’s losers and vice versa. Value stocks could finally emerge from their long torpor to outpace growth stocks, many of which are companies that have benefited from the pandemic.
The greatest risk to this scenario is that the health care system could reach its breaking point. If so, containment measures even more stringent than those imposed thus far would be required. In addition to derailing the recovery, an extension of the crisis would cause permanent damage to some parts of the economy.
An election year in a highly polarized country signalled increased volatility for the U.S. stock market. Moreover, the record number of mail-in ballots for the presidential election lent credence to the attacks on the legitimacy of the result. The sources of concern were numerous and recurrent, but in the end the main ingredient was present to ensure that this market’s dominance would continue. As shown in the following graph, the U.S. market clearly decoupled from the rest of the world when the World Health Organization (WHO) declared COVID-19 a global pandemic.
The composition of the U.S. market was ideal: with more than a quarter of its stocks in the information technology sector, it was able to extend its dominance of the past decade even further. As measured by the MSCI USA Index, it returned 19.2% in Canadian currency in 2020.
Taking a closer look at the U.S. market’s strength of recent years, we can see that much of it stems from the disproportionate success of a handful of stocks. Even though they are all technology companies, their common denominator remains, above all, their ability to exploit the vague nature of free-market rules in order to exercise a high level of monopoly in their fields of activity. But the noose is tightening around these tech giants, as lawmakers increasingly seek to reduce their dominance by imposing new rules to preserve competition. This trend is well established, having generated consensus in the United States among Republicans and Democrats alike, as well as elsewhere in the world, as evidenced by the Chinese authorities’ treatment of Jack Ma’s empire and Alibaba.
This growing pressure is not the only factor that should prove unfavourable to our southern neighbours on a relative basis. The macroeconomic environment, with a post-crisis acceleration of global growth, coupled with the weak U.S. dollar, is very promising for cyclical stocks. These conditions should bring value stocks back into favour – a shift that wouldn’t benefit the U.S. stock market.
Despite the likelihood that U.S. equities will cease to lead the way, they are still expected to perform well in 2021. In fact, the backdrop remains bullish for equities around the world. Even if the transfer of power at the start of the year leads to increased volatility linked to the outgoing administration, the rest of the year has the attributes for an attractive stock market performance: further support measures will limit the increase in default rates and the high level of savings accumulated by U.S. households will eventually be reinjected back into the economy.
The fundamental risk of this scenario would be a loss of consumer confidence in the face of deteriorating health data and an unexpected extension of lockdown measures.
Turning to global equities, we find significant disparities between the regions. While the stock market performance in Asia reflected its strong exposure to information technology and communication services, Europe clearly suffered from a dearth of companies in those sectors. But that wasn’t the European market’s only obstacle; the structural problems that Europe has been struggling with for several years haven’t helped. High debt levels in some countries and rock-bottom interest rates have limited the authorities’ leeway.
Not surprisingly, the MSCI Europe Index ended 2020 with a more modest return of 4.1% in Canadian dollars, while MSCI All Country Asia Pacific Index and the MSCI Emerging Markets Index returned 18.0% and 16.4%, respectively.
The economic backdrop for the coming year should limit this kind of regional divergence and help global equities outperform the U.S. market.
In Europe, the Brexit soap opera seems to be heading in the right direction thanks to a provisional application that should lead to ratification in the first quarter. Even though its complexity may cause disagreements, the key to the deal is that it promotes smooth trade flows by avoiding tariffs and quotas.
Then there is the general weakness of the U.S. dollar, which should support emerging markets. The trend toward depreciation of the greenback is due first to a loss of the advantageous interest rate differential on deposits made in that currency, but also to its countercyclical nature. Historically, the dollar tends to appreciate when the economy slows and vice versa.
The cyclical recovery already under way is likely to accelerate, allowing resource countries, such as Canada and a number of emerging economies, to do well during the year. It should also allow the financial sector to get back on track, especially in Europe where it has long been struggling. In 2021, investors are likely to shift into world markets and rotate into cyclical securities as value stocks play catchup with growth stocks.
Global markets should also benefit from the changing of the guard at the White House. The Biden administration is likely to ease trade tensions between the United States and the rest of the world and give impetus to the global green plan, by rejoining the Paris Climate Agreement, for example.
After what we went through in 2020, it’s fairly easy to take an optimistic view of the new year. The conditions for further economic recovery and a return to greater normality are in place. All that remains is to carry out the plan properly, a task that may seem simplistic, but is also the greatest obstacle to success. Governments must address the undeniably serious problem of massive debt, but not necessarily in the short term. Given the low-interest-rate environment and the controls that central banks will continue to use, governments can tackle debt reduction once everything else has been resolved.
The vaccination process will take time, but the markets are less focused on it just now, looking out instead to a horizon of six to 12 months. With this in mind, we must note that the pandemic has forced us, collectively, to rethink many of our ways of doing things and has given us the opportunity to make improvements. For instance, the amount of time lost to traffic jams will never be the same. The past year also left its mark on responsible investment, highlighting the extent of inequality and reminding us of the importance that the recovery evolve into a more sustainable mode of development to avoid the consequences of other issues.
As each new year brings the prospect of better days, let’s hope for an end to lockdowns in 2021. Until then, as the Brits like to say: “Keep calm and carry on!”
Health and prosperity to all!
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