Financial Letter Third 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

The third quarter of this atypical year leads us to believe that we have collectively won the first round of this battle against the pandemic. Despite what some critics may say, the measures that have been taken, along with our ability to adapt, have turned the situation around. To convince ourselves, we need only to look at the economic and market data: they are in a much better position now than they were in the second quarter.

However, those who were expecting a return to normality once a vaccine is developed will have to think again. The events we have experienced this year have wrought fundamental changes that will persist long after we overcome COVID-19. These new ways of doing things and of living our lives have created winners and losers in the short term, but will also dictate the criteria for longer-term success.

Politicians have also had to adjust their game plan to new voter priorities. At a time of numerous societal challenges, a highly polarized electorate and constant media coverage, political considerations are vitally important because they can overturn certain investment theses. The end of the third quarter also brought a risk that experts had warned us about: the emergence of a second wave of the virus. We are without a doubt better equipped now to deal with it, but governments’ ability to provide support measures is diminishing month by month.

THE MARKETS IN CONSTANT PROGRESSION

Following the spectacular rebound in the second quarter, the markets were expected to record a more modest performance for the rest of the year. This cautious optimism was based on the positive momentum of economic and health-related data, but also took into account the risk factors associated with the unpredictability of forward-looking business data and uncertainty about the time needed to produce an effective vaccine on a large scale. With the exception of Europe, however, such caution does not seem to have been in order, and most of the world’s stock markets experienced a steady growth throughout the period.

Globally, the best-performing sectors were Consumer Discretionary, Materials, Industrials and Information Technology. In contrast, Financials, Real Estate and especially Energy lagged behind.

REASSURING ECONOMIC DATA

Initially stimulated solely by the hope of what the unprecedented support measures would bring, the markets were later able to rely on the release of economic data confirming that the transmission mechanisms were working well. One of the indicators that particularly pleased the markets was the record increase in real household disposable income.

 
Source : Statistics Canada

In Canada, the combined effect of support income measures and reduced spending during the lockdown pushed this statistic to more than four standard deviations from its 60-year mean.

Beyond the ability of households to spend, several other indicators confirmed that money was being reinvested in the economy. Surprisingly, statistics for retail sales, new and existing home sales, housing starts and durable goods' orders were up sharply, returning to their pre-crisis levels or going even higher.

 
Source : Bloomberg

THE START OF THE SECOND WAVe

The third quarter exceeded expectations, but the cloud in the picture was the gradual deterioration of COVID-19 data towards the end of August. Going back to school had already been identified as a challenge to overcome, but there was every indication that other aggravating factors would join the list. Among these was a growing lack of compliance with public health guidelines and directives, due partially to mental fatigue on the part of the population, but more importantly to the stubbornness of a small group of individuals who refuse to believe in the merits of the containment measures. Globally, the new cases can be divided into three groups: countries whose data continue to improve (Australia and Japan); those with deteriorating data (Canada, Italy and Germany); and finally those whose current situation is more serious than it was during the first wave (the United States, France and the United Kingdom).

Source : Our World in Data

This turnaround  in the progress made since March in most parts of the world weighed on stock market results in September. It also prompted the authorities in some countries – those advocating the limitation of transmission vectors as tools to fight the pandemic – to implement new, more restrictive guidelines and directives.

Despite this undeniable setback, we must not lose sight of a more positive aspect that confirms, among other things, a better understanding of the disease: the number of deaths no longer follows the same upward trend in relation to the number of cases.

Source : Our World in Data

This trend indicates an improvement in treatment plans, but it could also be due to mutations that have made the virus more contagious, but less deadly. The wearing of masks also reduces the viral load transmitted and thus gives an infected person’s immune system time to mount a defense. The flip side of this encouraging observation is the rising number of cases among younger and healthier people. With this development comes the risk that the health care system could be overwhelmed with prolonged hospital stays and an increase in the number of deaths not directly related to coronavirus infections.[1] The consequences of such an outcome would be equally damaging for the health of people and the health of the economy.

A DECISIVE ELECTION

We are entering the final stage of an event whose outcome could have major repercussions on the markets: the U.S. presidential election! The extreme polarization of the electorate combined with the stance of the current administration – the Republicans view the process as fraught with fraud and have threatened to challenge an outcome unfavorable to them – could plunge the United States into prolonged political chaos in the event of a close vote.

According to Dr. Lawrence Douglas, Professor of Law, Jurisprudence and Social Thought at Amherst College, all the ingredients are now in place to make such a scenario a reality.[2] The 79-day period between the day after the election and the inauguration ceremony on January 20, 2021, is unlikely to end as peacefully as the recount of the election that pitted former President George W. Bush and Democrat Al Gore in 2000.

Given Joe Biden’s lead in the polls, it makes sense to look at the potential impacts his presidency could have on different sectors of the market.

 

Source : BBC

Given the known policy initiatives in trade, education, health care and other areas, the majority of sectors would see little impact. However, some sectors would likely benefit from a changing of the guard, while a small number would undoubtedly be penalized.

Source : FÉRIQUE Fund Management

A second term in office for the Trump administration would not cause such significant changes from a sectoral perspective, but would accelerate existing policies, such as more restrictions on immigration and trade, further tax cuts, more deregulation, as well as infrastructure projects.

Regardless of the administration in place after the presidential election, the tech behemoths will come under increased pressure from a tax standpoint. These giants have long been criticized for their low taxation rate, and the U.S. government will need significant tax revenues to offset the massive deficit resulting from the crisis. 

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.

AN ECONOMY IN ADAPTATION MODE

The pandemic has created winners and losers in a sudden and unprecedented way. We are witnessing many such cases: commercial real estate versus suburban residential properties; travel and air transport versus local tourism and recreational vehicles; jobs that require direct contact versus those that can be done remotely. The transformation of several business models is already under way.

As we reconcile ourselves to the longer-term effects of the health crisis, a number of industries will be given new impetus. Many governments around the world will have to increase their investments in the health care sector to bring it up to standard. The biotechnology sector should benefit from this trend. Companies whose business model is based on a competitive advantage derived from one or more technologies will also be in demand. Some will argue that securities of this nature have already risen a great deal. A glance at the historical valuation of the main sectors where we find such businesses shows we are still far from the level reached during the technology bubble of the early 2000s. The following graph shows the price-to-book-value ratio of such sectors within the MSCI World Index. If we look at another common metric, the forward one-year price-to-earnings ratio, we come to the same conclusion.

Source : BCA Research and MSCI

The supply problems that became apparent at the beginning of the crisis and in some cases still persist will force a return to domestic production. To compensate for the loss of cheaper foreign labor, intensified automation will be required in North America. Capital goods and robotics will benefit from this shift.

THE NEW NORMAL

The arrival of a new wave (a second or a third wave depending on the region) and the U.S. election are major risk factors for the markets. From the epidemiological standpoint, however, past experience works in our favor: intervention protocols are well established and several sectors of the economy have already adapted. The economic slowdown that would be caused by a return to tougher containment measures is likely to be perceived as temporary by market players. We must not lose sight of the progress made so far in the development of a vaccine. It is difficult to predict when a vaccine will arrive, but it may come sooner than the usual development timeline would suggest.

 

The possibility of a few more uncertain months should not be viewed as a road map for the long term. A more comprehensive vision of the situation allows us to foresee the eventual disappearance of the fall risk factors and to focus on the opportunities that the transition of the economy and business models will offer.

As with health measures, good old investment ground rules must be followed! Attempting to predict short-term fluctuations and applying market timing to your portfolio is a recipe for failure. Maintaining discipline is the key to getting through the pitfalls of a year that is forcing us, collectively, to reinvent ourselves.

 Wishing everyone a fine end to the year,

The FÉRIQUE Fund Management Investment team

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.

TO JOIN US

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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 [1] https://www.lapresse.ca/covid-19/2020-10-07/une-deuxieme-vague-plus-jeune.php

[2] Will He Go? Trump and the Looming Election Meltdown in 2020, Grand Central Publishing, May 19, 2020.


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