Financial Letter Second Quarter of 2020

Market Review

By the FÉRIQUE Fund Management Investment team Print Financial Letter

Source: MSCI

Sources: Bank of Canada, Federal Reserve Bank of St. Louis, U.S. Energy Information Administration

SUMMARY

After experiencing the worst of the turmoil and navigating through times of high volatility, investors are wondering what comes next. Unprecedented measures have been successfully deployed to minimize the economic damage, and significant progress has been made in terms of health. But we still have a long way to go before we can claim victory and relegate the first half of 2020 to the past. At this stage, while human activity has adapted and to a certain extent has resumed, it is still difficult to accurately assess the medium-term impacts of the COVID-19 crisis.

Technically, as the markets represent investors’ expectations of the future outlook, current valuations seem to indicate a relatively smooth comeback of economic activity. However, we should not be overly complacent nor should we ignore the pitfalls along the path to recovery. These include a significant lack of forward guidance from companies. This difficulty in forecasting could cause them to hold back on their investments. Another possible negative surprise is the extent of non-performing loans, which remains unknown.

Given the support measures that have been deployed, a gradual recovery is still the baseline scenario for the coming quarters. But there is no reason to conclude that the markets will continue to rise at the same pace. The U.S. election in the fall or the extension of the OPEC+ agreement to reduce the oil supply are risks that could be discounted by the markets.

AN IMPRESSIVE MARKET REBOUND

The quarter just ended serves as a reminder that investors are better off if they stick to their retirement plan and stay the course, rather than give in to panic and make decisions based on emotion. The markets’ rebound during the period was just as spectacular as the March decline. Unfortunately, some investors were left on the sidelines at a particularly crucial time. Driven by historic monetary and fiscal support measures and encouraged by the hope of a gradual return to more normal economic activity, financial assets overall had a strong second quarter.

In terms of the global markets, all sectors made a positive contribution, but some stood out, either for their resilience throughout the period or their spectacular rebound from the lows of late March. As shown in the following table, three sectors – Information Technology, Consumer Discretionary and Materials – posted very stable returns that allowed them to rank among the best of the quarter, but also from the market bottom. In contrast, the Energy sector staged a strong comeback and managed to climb to 5th place in terms of its second-quarter return.

Source : MSCI World (in Canadian $)

ANtiracism protests and riots

At the beginning of the pandemic, the failure to contain the virus were mainly due to the management approach advocated by the authorities. We were able to assess the competence and leadership of some politicians by their effectiveness in containing the spread and gradually flattening the curve.

As statistics in the developed countries continued to improve, the scourge of systemic racism created further disruption at the end of May. Management of physical distancing suddenly became an extreme challenge for the authorities. Investors, galvanized by the surging optimism that had taken hold, were initially not concerned about this new variable, and the markets continued to move forward. From a propagation point of view, a question remained: How would the numerous and sometimes chaotic gatherings affect the efforts to control the spread of COVID-19?

 
Source : Our World in Data

Recent data suggest that the greater prevalence of antiracism demonstrations in the United States may have contributed to a resurgence of COVID-19 cases there. Even so, a recent study published by the National Bureau of Economic Research1 shows that this appearance of causality is unfounded. It seems that reduced social distancing at these gatherings was offset by the wearing of masks, an orderly process  at most of the events and an incentive for non-participants to stay home. Therefore, the Black Lives Matter movement is apparently not responsible for the increase in cases in the United States.

Other reasons for the step backward may be the failure to follow basic guidelines (such as wearing masks and washing hands), undue haste in reopening the economy and a feeling of invulnerability on the part of young people, who know they are less at risk of complications, even though they are significant spreaders of the disease. The unenviable results observed in some U.S. states are evidence of the consequences of trivializing the disease.

1 https://www.nber.org/papers/w27408.pdf  

gradual reopening

Despite the fact that some countries have failed to contain the number of new cases, for most of them the situation is conducive to further deconfinement. In Quebec, the resumption of economic activities is well under way; only festivals and other major events as well as overnight summer camps are still not allowed. However, that does not mean things are back to normal.

One of the important factors in extending deconfinement is the COVID-19 data trend. A deterioration of the situation, as seen in some parts of the world, awaits those who fail to continue applying the health guidelines. The following graph shows the stringency of containment measures in different countries using an index composed of nine metrics, including school and workplace closures, restrictions on public gatherings, and transportation controls. According to this index, the United States is less advanced in terms of national deconfinement than Canada. The reason may be the need for some states to reintroduce more restrictive measures after an upsurge of cases.

The index is not intended to be an accurate representation of the countries’ relative level of deconfinement. That would require adjustments taking into account cultural criteria (for example, the wearing of masks is already a common practice in Asia). The objective is simply to demonstrate that, generally speaking, there is a move toward easing restrictions and that, sometimes, there may be a need to reverse the trend (e.g., Germany and Australia).

Source : Our World in Data

COVID-19 STATISTICS

As Sir William Thomson (Lord Kelvin) said, “When you can measure what you are speaking about, and express it in numbers, you know something about it.”2 When it comes to data, the machine is now well-oiled. For example, in the time elapsed since the beginning of the pandemic, the statistics for the various countries have become more standardized some approaches have been refined.

In sifting through the various metrics, we notice that not only have most countries regained control over the transmission factor, but also over the mortality rate. The successful flattening of the mortality curve may explain why the markets have shrugged off the increase in the number of cases south of the border, despite the absence of a vaccine for the time being. Another factor is the growing effectiveness of health care protocols that allow for a better treatment of people with complications.

Source : Our World in Data

2 Lord KELVIN, “Lecture to the Institution of Civil Engineers”, in Popular Lectures and Addresses, vol. 1, Macmillan and Co., London & New York, 1891, p. 80.

RESULTS AND EXPLANATIONS

The U.S. market also had its share of trouble, but fared better thanks to the countercyclical nature of its currency. The recent market downturn and increased volatility have once again confirmed the U.S. dollar’s status as the “safe-haven currency par excellence”. The market’s performance, led by online commerce stocks (such as Amazon) and consumer staples (such as Walmart), was enhanced by the greenback’s substantial appreciation against the Canadian dollar.

Also led by Energy and Financials, the U.S. stock markets, in a context of massive isolation, found comfort in their high exposure to the Information Technology sector. Like the rest of foreign markets, the United States also benefited from the more defensive nature of its Health Care and Consumer Staples sectors.

A FOGGY OUTLOOK

To date, more than a third of the companies in the S&P 500 Index have decided not to provide earnings-per-share (EPS) forecasts for fiscal year 2020 because of pandemic-related uncertainty. In the second quarter, only 49 of them have disclosed such figures, a decrease of 54% from the average of the last five years. In fact, this number represents the lowest total ever recorded, surpassing the previous record set following the great financial crisis.

Source : Factset3

While not indicative of the direction that earnings will take in the next few quarters, this situation nevertheless testifies to the degree of difficulty that analysts face in preparing their forecasts. In other words, a fog has descended on a large number of companies. In the absence of forward-looking figures, it can be risky for some companies to commit to projects that require major investments.

3http://insight.factset.com/topic/earnings

THE ECONOMY AND THE MARKETS IN THE POST-COVID ERA

The efforts made during an extraordinary spring have not been in vain. In terms of economy and health, the numbers have been moving in the right direction for quite some time.

 

Several lessons have been learned from this adventure, even though it is still not over. For individuals, it translates into a change of lifestyle and, for companies, a rethinking of their business models. For investors, the post-COVID era means they must take into account the acceleration of some already established trends, such as deglobalization and the digital economy, but also reassess the criteria used to determine the attractiveness of companies. They will certainly be paying more attention to the resiliency of the companies they invest in.

Several attributes make a company resilient. Traditionally, resiliency was measured primarily by the ability to maintain a healthy balance sheet and to cope with economic cycles. Recent history tells us that investors will be prepared to pay more for companies that can limit shutdowns of their operations, regardless of the cause. First, we are talking about the ability to operate flexibly and to keep the supply chain functioning, but also to avoid any other form of disruption by properly integrating ESG criteria4 into their management.

Have a fun and healthy summer!

The FÉRIQUE Fund Management Investment team


4 Environmental, social and governance.

OUTLOOK AND ISSUES

Given the U.S. dollar’s significant appreciation since the beginning of the global stock market correction, despite an interest rate differential that has for the most part disappeared relative to other countries, we should expect some rebalancing of this dynamic in the coming months.

 

DXY and short-term interest rate differential

 

 

Source: FÉRIQUE Fund Management

 

The strong U.S. dollar is creating difficult market conditions for some countries and could lead to coordinated intervention to lower its value. A weaker U.S. dollar is equivalent to an easing of global monetary conditions, a situation that would only contribute to a resumption of growth. This measure would come on top of all the others measures put in place recently to reassure the financial markets.

 

Monetary and fiscal support measures elsewhere in the world



Sources: BCA Research and FÉRIQUE Fund Management

 

In addition to reassuring the markets, all of these measures will stimulate a sustained recovery until we return to pre-crisis growth levels. Another point to consider for the overseas markets is the evolution of the situation in Italy, where the most recent data seem to indicate a turning point in the retransmission factor.

 

Italiy - COVID-19 Progression

 

Source: European Centre for Disease Prevention and Control

 

The situation is similar to what happened in Asia.

 

Asia - New COVID-19 cases / day
(3-day moving average)

 

 

Source: European Centre for Disease Prevention and Control

Conclusion


Undoubtedly the coming economic data will be highly unfavourable and their unprecedented nature is likely to create anxiety. Although uncertainty remains as to the progression of the virus, several elements allow us to look ahead with cautious optimism. First, central banks have done their job, having responded far more quickly than in the past. Governments have also been prompt, at least in terms of adopting economic support programs.

 

The experience of the countries that had to take action before us and have done so effectively serves both as a roadmap and gives us hope for a gradual return to normality. Considering the impact that the support measures will have once they are fully deployed, as well as our ability to adapt our supply chains and work methods, we have reason to hope for an outcome comparable to other crises that we have faced in the past and successfully overcome. For investors with a long-term approach, it is worth remembering that markets recover before the end of a recession and that historically, such rallies have always taken us to new heights.

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