Sources: Bank of Canada, Federal Reserve Bank of St. Louis, U.S. Energy Information Administration
While forecasters announced a return to more sustained global growth in 2020, albeit with cautious optimism, an entirely different scenario emerged and is severely restricting our daily lives. The invisible enemy, as the authorities refer to it, initially hit the economy with a supply shock when it forced an almost complete shutdown of manufacturing activity in China, the world’s main source of supply.
The spread of the virus to the rest of the world and the resulting lockdown measures then brought a second economic blow in the form of a drop in demand.
As if the impact of COVID-19 alone was not enough, a disagreement within OPEC+ over the strategy to be adopted in the face of declining demand led to an increase in Saudi Arabia production and, as a result, a collapse in the price of crude oil in early March. All these events weighed heavily on global markets, especially Canada’s, with its heavy weighting of energy, the sector that was hit hardest. The Canadian dollar was also battered during the quarter, depreciating against many foreign currencies.
However, its weakness cushioned some of the declines in foreign markets for local investors.
During bear markets, fixed income is always a useful asset class because it plays a defensive role within a diversified portfolio. However, given the highly disruptive nature of the pandemic and the lockdown measures on economic activity, the bond market was affected simultaneously by the favourable impact of the flattening sovereign yield curve and the unfavourable impact of widening credit spreads due to higher risk premiums for non-governmental securities, such as corporate bonds and asset-backed securities. These two opposing forces drove bond prices throughout the quarter, depending on which one prevailed: expectations of central bank monetary easing measures or fears about the future solvency of companies.
In this context, the FÉRIQUE Canadian Bond Fund returned 0.2% for the quarter and the FÉRIQUE Globally Diversified Income Fund generated a loss of 5.3%.
The difference between the performances of government and corporate bonds was quite pronounced during the period owing to the unique crisis we are going through. This is not a typical slowdown and recession caused by an imbalance between economic agents. The highly contagious nature of the coronavirus and the health system’s limited ability to care for what could be very large numbers of patients have made a severe clampdown necessary. However, these precautions, which are essential to avoid an even more serious outcome, are having a significant impact on the economy.
The main challenge for investors is to estimate the extent of the financial damage in a context where it is not yet known precisely how long it will take for life to get back to normal. As Pythagoras puts it, “When in doubt, it is better to abstain”. Thus it is not surprising that investors’ appetite for risk has declined, causing the corporate financing premium to rise. This higher borrowing cost has priced in the consequences of a recession. But what kind of recession?
The shape of the recovery: L, U or V?
Source: BCA Research
In the basic scenario, if the number of new cases of COVID-19 can be stabilized within two months, the economy will contract in the second quarter, followed by a gradual rebound in the second half of the year. This possibility is illustrated by the yellow line (U-Shape Recovery) in the graph. However, should the virus continues to spread to the point of a loss of control, prolonged lockdown measures would lead to a much less vigorous and delayed recovery, as shown by the dark blue line (L-Shape Recovery). This pessimistic context is less likely, however, if we go by the experience of China and South Korea, which have been able to contain the spread of the coronavirus and to resume their activities gradually. Even so, in the case of China, the recovery may be slower because it depends on external demand, which has been dampened by the events in North America and Europe.
For investors, higher corporate bond yields are undoubtedly an appealing solution, but what other factors need to be considered? We have to take into account the range of monetary easing measures that have been introduced since the start of the crisis by the U.S. Federal Reserve and, to a lesser extent, by the Bank of Canada. Here is a summary:
Main policies and monetary measures announced in March 2020 in the United States and Canada
Sources: BCA Research and FÉRIQUE Fund Management
The message from the central banks is that they will make sure to protect quality borrowers. Their commitment will limit downside risk and pave the way for a future normalization of corporate bond credit spreads.
The Canadian market was affected above all by the substantial drop in oil prices. The price of crude has fallen by almost two-thirds since the beginning of the year, and its decline hit Canada hard, where the Energy sector is of considerable importance compared to other world stock markets.
To continue the comparison, a second sector – Health Care – also sheds light on the difficulties faced by the Canadian market. Everywhere else, this sector was one of the best performers; it even had positive returns in Europe, Asia and emerging markets. So why was it such a disaster in Canada?
Our Health Care sector consists of only four companies, three of them related to the cannabis industry. In other words, it is anything but representative of the companies found in this sector elsewhere in the world, companies that are theoretically favourably positioned in a health crisis situation.
Finally, Financials, which are a very large sector in Canada, also detracted from the returns on the domestic market. Interest rate cuts, an economic slowdown and potential increases in loan defaults weighed on banks, while the potential for rising claims dimmed the prospects of insurance companies.
Give that the main reason for the selloff on the Canadian stock market was the sharp decline in the price of oil, it is appropriate to review how it reacted in 2015. The following graph juxtaposes the price of crude with the performance of the MSCI Canada Index.
The Canadian Stock Market and the WTI oil price
Sources: MSCI and FÉRIQUE Fund Management
As we can see, the 2015 episode reveals similarities to what we have just experienced. In both cases, the stock market corrections were fuelled by a significant decline in the oil price, to a point well below the breakeven price for producers. At the time, the return to a more sustainable level, rather than a sustained price increase, was enough to revive the stock market. Thus, without resolving the longer-term issues, a potential agreement within OPEC+ could be the factor that turns the tide in the short term and provides some relief for Canada’s Energy sector.
For all the other sectors, the aggressive lockdown measures will lead to better control of the transmission vectors, which, as we improve our knowledge of the virus, will open the door to safe approaches that are less restrictive to economic activity.
Despite a certain margin of error, given all the unknowns, this sequence of events corresponds to the plan developed by the authorities on the basis of recommendations by experts in various fields. That is why it is part of our basic scenario.
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.
The lack of central government leadership in the face of COVID-19 has left the United States in a “catching-up” mode today. This situation exacerbates the uncertainty of an orderly outcome to the pandemic, both for our southern neighbor and indirectly for the rest of the world. Fortunately, in a U.S. election year, the occupants of the White House have realized they must adjust their aim constantly to preserve their chances of re-election.
It therefore comes as no surprise that the support measures in the United States are the world’s most convincing. To date, they are the equivalent of as much as 9% of the country’s GDP.
Fiscal support measures as a percentage of GDP
* In billions, expressed in each country’s local currency Sources: BCA Research and FÉRIQUE Fund Management
In this context, it is realistic to expect that all the resources needed to stabilize the U.S. market will be deployed. This should result, among other things, in a gradual devaluation of the U.S. dollar.
The overseas markets all did better than the Canadian market, thanks in part to a positive contribution from their respective Health Care sectors. The Utilities sector also helped limit losses in Europe, while the Communications Services sector played that role in Asian and emerging markets. In fact, Asia was the region that ended the quarter with the smallest decline globally. This result should not be unrelated to the fact that several countries in that part of the world have a slightly clearer picture of their pandemic situation; their outbreaks began sooner and they have succeeded in flattening the curve.
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
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 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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