How should we think about the rest of the year? Our annual back-to-school Investment note

It pays to be an eternal optimist

A pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty.

– Winston Churchill

What’s your favourite holiday of the year? According to statuaryholidays.com, 41% of Canadians surveyed selected Christmas as their favourite holiday followed by Canada Day (15.5%), Halloween (7.6%), and Thanksgiving (6.8%). For those who have children, you may agree with us that Back to School is the best time of the year, especially after last year!

In our minds, early September signals not only back to school but also when Toronto Maple Leafs fans begin prognosticating a championship, as hockey season is just around the corner. There are times being an eternal optimist comes at the expense of one’s mental health—for example, a Toronto Maple Leafs fan. If that means nothing to you, just think of a group of people that annually plan a parade to celebrate a championship only to see opportunity after opportunity wasted—leading to early exits let alone a championship.

While Leafs fans have yet to be rewarded for their optimism, investors, more often than not, are rewarded for being eternal optimists. It just doesn’t pay to be negative as an investor. In this year’s back-to-school Investment note, we:

• take a look at year-to-date capital market returns
• look at the factors that may trigger a pullback
• discuss reasons to be optimistic
• highlight the pitfalls that may exist within portfolios.

Let’s take a look back

Before we move ahead, it’s always a good idea to know where we came from. The majority of major global equity markets have continued their strong rally from 2020 through the first eight months of 2021. The U.S. equity market, represented by the S&P 500 Index, has led the way with a price return of 20.4% (USD), closely followed by Canada and Europe, with the S&P/TSX Index and MSCI Europe Index returning 18.1% (CAD) and 17.6% (USD), respectively. The only equity market that has been struggling is emerging markets, represented by the MSCI Emerging Market Index with a return of 1.3% (USD). Chinese equities have been the primary cause for the underperformance, as the region’s equities have faced challenges stemming from monetary and regulatory concerns. Kai-Kong Chay (Senior Portfolio Manager, Asia ex-Japan Equity, Manulife Investment Management) recently wrote an excellent analysis of the current regulatory developments in China—“Navigating the regulatory environment for China equities.”

In fixed income, high-yield bonds have been the lone bright spot, as the ICE BofA US High Yield Constrained Index returned 4.6% in USD terms over the first eight months of 2021. Government bonds have been hurt by a steeper yield curve and remain underwater despite a rally over the last five months. Despite the recent fall in yields, the U.S. 10-year yield is 40 bps higher than where it started the year.

Bookending the chart below are commodities, with oil, as measured by West Texas Intermediate (WTI), having the strongest year-to-date performance, growing by 41.2% in USD terms, and gold performing the worst, down 4.5% in USD terms.

The equity markets have performed very much in line with our expectations set out earlier in the year, as highlighted in our “Capital Markets Strategy team 2021 outlook – the rapid reopen” note. We drew comparisons between the environment today and what took place in the early 1990s. Following the recession and bear market of 1990, the S&P 500 Index had a strong performance fueled by a sharp expansion in price-to earnings (P/E) ratios despite negative earnings growth in 1991. Subsequently, the following three years saw strong earnings growth while delivering positive market returns. The P/E multiple receded back to the historic average over the next three years while the Index produced annual returns of 7%, 10%, and 1% between 1992 and 1994. What we saw last year, was much the same as 1991, as the S&P 500 had a strong rally on the back of P/E expansion while earnings were a drag on performance. This year, the P/E multiple has begun to moderate and returns have been driven by strong earnings growth.

The team believes that the next few years could see average returns with risk to the upside, as the P/E multiple continues to moderate and earnings growth slows.

Contribution to return by earnings growth, P/E ratio, and dividends
1970 – 2021

Also, very similar to the early 90s is the level of complacency by investors. In 1992, the S&P 500 only had two very brief pullbacks greater than 5%, while this year, we’ve yet to see even one. It’s extremely rare for the S&P 500 Index to not experience at least one pullback of greater than 5% during a calendar year. Since 1980, only once, in 2017, did the S&P 500 not drop at least 5% from its peak with the average correction per calendar year coming in at 14.3%. Investing is a probability-based decision and history would suggest that downside volatility is likely to occur at some point before the end of the year.

S&P 500 Price Index drawdowns greater than 5% (2015 – current)

Source: Manulife Investment Management, Bloomberg, as of September 7, 2021

Reasons for a pullback?

Despite the robust global equity returns and lack of volatility, talking with clients, we get the sense that there’s some hesitancy about the return profile for the rest of the year. Some of this can be explained by behaviour biases. In their study, “Prospect Theory: An Analysis of Decision under Risk,” behavioural finance pioneers Dan Kahneman and Amos Taversky found that investors are more sensitive to loss than to risk and possible return.¹ In short, people prefer to avoid loss over acquiring an equivalent gain. We believe there are three main factors that may be causing investors to be cautious.

Increase in the delta variant

The world is dealing with the highly transmissible delta variant, which has led to a renewed surge in cases and hospitalization rates—leading to stricter rules in certain countries. We’ve also seen the increase in the delta variant in the United States have an impact on consumer confidence. There’s a strong correlation between the fall in consumer confidence since April and the increase in the delta variant during the same period. In the University of Michigan’s August survey of consumer sentiment, the surge in the delta variant was identified as one of the key reasons for consumers’ negative sentiment, as it highlights the “dashed hopes that the pandemic would soon end and lives could return to normal.” ²

Moving 7-day average—new COVID-19 cases

University of Michigan Consumer Sentiment Index (April 2020 – current)

Risk of a taper tantrum impacting equity markets

The debate about whether the U.S. Federal Reserve’s very accommodating policy will result in either transitory or enduring goods inflation is still occurring. However, there’s no doubt that it has led to inflation in financial assets. For example, the S&P 500 Price Index has rallied 100% from its pandemic trough of 2,237.40 on March 23, 2020, on a closing basis. It took the market 354 trading days to get there, marking the fastest bull-market doubling off a bottom since World War II. Investors have grown accustomed to very loose monetary policy and a change may alter sentiment.

September is historically the weakest month for the S&P 500

Since 1950, September has been provided investors with the weakest monthly return, averaging –0.2 percent. November through January has historically been a very positive period. The odds of positive monthly return for September are also the lowest at 45%. December by comparison has been positive 75% of the time since 1950. There’s some truth to the Santa Claus rally.

S&P 500—odds of a positive monthly return
1950 – 2020

Reasons to be optimistic

Monetary policy

The markets liked what they heard from Federal Reserve Chief Jay Powell during his speech at Jackson Hole at the end of August. While it’s likely that the Federal Reserve will begin to taper the amount of bonds it buys in the coming months, it’ll be a very slow removal of its pandemic-era stimulus measures. The proverbial Federal Reserve punch bowl is still here but we’ll likely have to use a spoon instead of a ladle to fill our cups.

Peak doesn’t mean weak

Equity markets seem to be reacting more to day-to-day headline news than longer term fundamentals. Some of the negative headlines surround the resurgence of COVID-19 cases and the potential impact on global markets and economic growth, while other headlines cover the risks associated with peak data, as the base effects from last year’s trough roll over. Hitting the peak of something conjures images of the best being behind us. While that may be the case, when it comes to underlying market data, peak doesn’t necessarily mean weak. Any rolling over of data merely suggests that the growth rate is slower, not negative.

Take the Institute for Supply Management’s Manufacturers Purchasing Managers’ Index (ISM PMI) as an example. The results for the August survey indicated a slight bump to 59.9 from July’s 59.5 but much further away from the peak in March at 64.7. A figure above 50 indicates growth and August marks the 15th consecutive month of a reading above 50. While the Index has declined slightly and we expect it to continue declining, we also fully expect it to remain well above 50 for the foreseeable future. Many supply chain disruptions and elevated backlogs remain, not to mention strong demand for goods that should continue throughout the global economic reopening.

Strong earnings growth

A continued strong ISM PMI level should also lead to solid earnings growth. However, the recent Index results would suggest that year-over-year earnings growth for the U.S. will likely peak in the third quarter but should still be attractive well into 2022.

ISM Manufacturing PMI vs S&P 500 Index earnings growth YOY 
(advanced six months) 2000 – current 

Markets are less expensive today

We’ve seen a very strong earnings recovery globally, which has been the primary driver of returns. Despite global markets being at or near all-time highs, valuations based on trailing price-to-earnings ratios have moderated due to strong earnings growth. Today, investors are paying anywhere between three to five multiple points less than they were at the beginning of the year, depending on the region.

Trailing price-to-earnings ratio (year-to-date)

Strong returns can continue

Don’t underestimate the markets’ tendency to produce above-average returns. With the average calendar-year price return for the S&P 500 Index being 12.2%, many investors may be surprised to learn that the actual return is rarely average. In fact, calendar-year returns are more often above 20% than they’re negative. Calendar-year returns have been greater than 10% nearly 60% of the time since 1970 and greater than 20% nearly 35% of the time!

S&P 500 Index
Frequency of calendar-year price returns
1970 – 2020

Source: Manulife Investment Management, Bloomberg, as of December 31, 2020

Odds are in your favour

The equity markets reward those investors who are eternal optimists despite the headlines. The table below illustrates that over the past thirty years, investors’ returns have been positive nearly 75% of the time on a one-year rolling basis.

Probability of positive returns by timeframe

Watch out for pitfalls!

Despite the need to maintain an optimistic view, it’s always important to keep an eye out for potential pitfalls in our asset allocation. Atari’s classic video game, Pitfall, from Activision, comes to mind. For those of our readers that don’t remember the game or might be too young to have ever played it, here’s a quick synopsis. The player controls Pitfall Harry and is tasked with collecting all the treasures in a jungle. As Harry runs across the screen, there are various hazards that he must face: quicksand, tarpits, rolling logs, crocodiles, snakes, scorpions, campfires, and swinging vines. While keeping his eye on the prize, Harry must avoid these pitfalls. In this context, it’s very similar to how investors need to treat their portfolios—optimism over the longer term while keeping an eye on potential near-term bumps.

Inflation will remain above 2%

The U.S. Federal Reserve has been using the term transitory to explain the current level of inflation, which is hovering near 5% year-over-year. But what exactly is transitory ? It depends on how you define it. Is it a measure of time or magnitude? While we certainly agree that the Consumer Price Index won’t remain at current levels into next year, we still believe that it’ll remain above the Federal Reserve’s target of 2% for some time. While it’s unlikely that the Federal Reserve will begin to increase their overnight rate over the next year, it’s more likely that they will begin tapering soon. The bond markets will likely react ahead of it to incorporate the change in policy decision.

CPI YOY vs CMS inflation model
1998 – February 2022 (including forecast)

Source: Manulife Investment Management, Bloomberg, as of July 31, 2021

Real yields are well below where they should be

So far, the bond market hasn’t fully digested the potential for higher rates. Today, there’s a negative real yield for the U.S. 10-year Treasuries, and history suggests this is unlikely to continue. The real yield is what investors are left with after adjusting for inflation. A simple way of looking at the real U.S. 10-year Treasury yield is to reduce the yield by current inflation. Over the last 10 years, the median real yield has been 32 bps. If we were to apply that to inflation between 2.0% and 2.5%, that would imply a 10-year yield of approximately 2.3% to 2.8%.

U.S. 10-year Treasury yields vs CPI 
Last 10 years through July 2021

Source: Manulife Investment Management, Bloomberg, as of July 31, 2021

Our team spends a lot of time trying to understand where the balance of risk lies. When it comes to the current fixed-income markets, we must ask ourselves, “What’s the risk of being wrong?” If you’re positioned with a shorter duration and yields fall, you may gain a little on your fixed-income investment. However, if you‘re positioned with a longer duration and yields rise, then you‘re at risk of having a negative return. Given the strong economic growth and what we believe is sustainable inflation above 2%, it’s more likely that the 10-year Treasury yield trends higher, not lower, over the next 12 months. For this reason, we continue to favour a shorter-duration posture, with a tilt toward credit within a fixed-income portfolio.

While being an eternal optimist can be both exciting and frustrating at the same time, like a good sports fan, investors always need to keep an eye on the short-term reality. This doesn’t mean that we should be pessimistic either. It merely suggests that the reality of investments requires a logical approach to portfolio construction.

Kevin Headland, CIM
Senior Investment Strategist
Manulife Investment Management

Macan Nia, CFA
Senior Investment Strategist
Manulife Investment Management

1 Daniel Kahneman and Amos Tversky. “Prospect Theory: An Analysis of Decision under Risk.” Econometrica, vol. 47, no. 2, 1979, pp. 263-291. 2 Richard Curtin. “Surveys of Consumers.” http://www.sca.isr.umich.edu/. Accessed 10 September 2021.