The Great Pause of 2020

In the old legend, the wise men finally boiled down the history of mortal affairs into the single phrase: “This too will pass.”

— Benjamin Graham

As we reflect on what has transpired over the last six months, we find ourselves somewhat shocked and speechless. Collectively, the team has worked through decades of economic and market cycles and numerous global crises, and we’ve never experienced an environment like we have today. The COVID-19 global pandemic has thrown all market dynamics up in the air. In trying to put things in context, we often use this statement with colleagues and clients:

If I told you six months ago that in the first half of 2020 the world would suffer a global pandemic, economies would be literally shut down and forced into the sharpest recession since the Great Depression, unemployment in Canada and the United States would exceed 13% as millions of people would be thrown out of work, oil prices would go negative as inventories surge and demand collapsed … and yet the stock market (the S&P 500 Index) would be down only 4% (USD price return), you probably would have told me I was crazy. And yet, here we are.

Truth be told, the above statement does exclude several important details. Equity and fixed income markets did suffer sharp downturns between February and March. Governments and central banks have stepped in to support their respective economies with unprecedented levels of fiscal and monetary support and have effectively sponsored equities and bonds alike. And many markets have since recovered much of their losses through to the end of June.

Nonetheless, the speed and strength of the recovery in equity and bond markets has left many market participants (us included) scratching their heads. Don’t take this the wrong way. We love when markets go up, we just like to know that markets are going up for the right reasons — because profits are (or will be) going up. That hasn’t been as clear since March as companies were navigating the impact of the lockdowns and consumers were effectively “shut in” from shopping (other than online). With some of the very recent June data, however, our indicators would suggest that the steep earnings declines through the second and third quarters will give way to the beginning of an earnings recovery in the fourth. We aren’t so optimistic as to offer up a forecast of a repeat of the market gains we’ve enjoyed since the lows were reached on March 23, but the implied improvements to forward earnings are promising.

We mentioned that central banks have stepped in and effectively sponsored the market recoveries. That is true — monetary inflation can be a powerful market stimulant. Since the end of February, the US Federal Reserve (the Fed) has increased its balance sheet by US$2.9 trillion. The direct impact has been an expansion of the US money supply (as measured by M2) by US$2.8 trillion. Of the four specific quantitative easing initiatives by the Fed since 2008, we would argue this has been the most effective as to monetary inflation. Money eventually finds a home. In today’s case, monetary inflation has led to asset price inflation. The question we must ask is, where do we go from here?

According to medical research, people respond to stress in a typical fashion. This is referred to as general adaptation syndrome, or GAS, a theory created by Dr. Hans Selye. GAS typically follows a three-stage process that describes the physiological changes the body goes through when under stress. Selye identified these stages as alarm, resistance, and exhaustion. Alarm is the initial phase that results in a panicked response to the stimuli. Typically, this is the fight-or-flight response to stress. Resistance, the second phase, is when our bodies adapt and learn to cope with the stress. We may feel as if we’re managing the stress well but, in truth, we’re masking the symptoms and can find ourselves in a state of denial. This leads to the third stage — if we remain in the elevated stress level for too long, resistance will lead to exhaustion. Is it possible for equity markets to exhibit GAS? We think so.

If we treat the market as a person and the economic impact of COVID-19 as the source of the stress, we’d argue the first stage, alarm, was the bear market experienced between February 19 and March 23. Investors panicked as the fight-or-flight response took hold, selling equities into the fastest bear market in history. In fact, according to the Investment Company Institute, March exhibited the greatest selling pressure of equity, balanced, and fixed income mutual funds ever, with US$348 billion redeemed during the month.

The resistance stage took place as investors became more accepting of the fact that the economic data that would follow the lockdowns were going to be the worst we’ve seen in our lifetimes. Assuming the worst, anything even modestly better than the worst was treated as a reason to bid markets higher. For example, it’s difficult to suggest that the US employment situation is anything but tragic. Investors, however, are more likely focusing on the fact that US first-time jobless claims have declined since the initial bomb of 6.8 million jobless claims the week of March 27 to 1.4 million for the last week of June. Markets are resisting the fact that while this is an improvement, weekly first-time jobless claims have remained above 1 million for the month while continuing claims have stalled out at 19 million for the last three weeks; or put another way, these numbers are 4 and 10 times their respective pre-COVID-19 levels. But resistance may be causing investors to look past even these numbers to a better day.

Eventually, the resistance phase gives way to exhaustion. The exhaustion stage is the result of prolonged or chronic stress. Struggling with stress for long periods can drain your physical, emotional, and mental resources to the point where your body no longer has strength to fight it. What we’d imply by the exhaustion phase is that the markets, having staged a very strong and impressive rally, may have to take a breath and reassess. That takes us to our base case assumptions for the markets over the next 18 months.

The first thing we should note is the fact that we’re forecasting 18 months ahead rather than 12. When it comes to our model portfolio, we typically build our assumptions and set our asset allocation with a 12-month outlook. In this unique environment, we believe the uncertainty is too great over the next 12 months to build reasonable expectations. The uncertainty in the near-term includes COVID-19 (the potential for a second or third wave and what the economic consequences may be, potential for a vaccine and its manufacturing and distribution to a global population), renewed trade tensions between China and the United States, and the U.S. election — to name but a few. We often downplay geo-political risk, but the risk with COVID-19 is that it reduces our confidence to forecast the next 12 months. In contrast, and while trying not to be too optimistic, we believe we’ll be well on the path to recovery by the end of 2021.

If the market is indeed exhibiting general adaptation syndrome, then we would argue we’re about to move into the third phase. However, while the market may experience exhaustion, we don’t believe it will include a retest of the March lows. Rather, we believe the exhaustion phase will include continued market appreciation and would argue the broad global economy will be accelerating into a recovery. But if you give it all you have in the first mile of a five-mile run, you’re not going to be able to run very fast for the next four.

In a nutshell …

• Our base case assumes a gradual economic recovery despite any COVID-19 relapse over the next 18 months to a full earnings recovery for the S&P 500 Index by Q4 2021/Q1 2022, and similarly for other markets.
• The recovery is enjoyed globally but perhaps at a different pace market by market. In general, equity market gains are unlikely to reflect the full earnings growth as price-to-earnings (P/E) multiples adjust lower (as they typically do in a strong earnings recovery).
• Global equities (U.S. and international) are favoured over Canadian equities as oil prices and the correlation to energy weighs on the S&P/TSX Composite Index.
• Despite higher inflationary pressure into 2021, central banks will remain accommodative through the entire period, not looking to raise rates until well into 2022.
• Yield curves steepen as the recovery combined with the inflationary forces of fiscal and monetary stimulus push longer-term yields higher.
• Credit outperforms sovereign debt and a short duration bias performs well on a relative basis as curves steepen and spreads tighten.
• The Canadian dollar (CAD) remains tied to oil and continues its appreciation relative to the U.S. dollar (USD).

Taken together, we believe it‘s a good opportunity to continue gradually increasing the equity weight in our model portfolio by 5% — to 60% total — bringing our asset allocation back to neutral.

Source: The Capital Markets Strategy team, as of July 2020

As mentioned above, it’s entirely fair to say that the change in the economic data over the last few months has been the worst we’ve ever seen in our lifetimes. There are few, if any, comparisons to how bad the data have been. We suggest that historical charts are irrelevant other than to show that the speed and degree to which the economic data have dropped is unlike anything else we’ve ever seen. It’s more important, therefore, to focus on what a recovery may look like and how markets will respond.

From a valuation perspective, the low inflation and interest rate environment shift the dynamics to support a higher P/E multiple across equities. When it comes to valuation, one size doesn’t fit all. Looking at P/E multiples solely by historical context can lead to misrepresentation of value. We look at valuation in a number of ways: index valuation relative to inflation, interest rates, relative to other indices historically, money supply, etc. What our work has found is that, in general, valuation is a poor predictor of short-term returns and, at best, a moderate predictor of long-term returns. Only at the extremes (under- or over-valued) have we found valuation to be a reasonable guide to short-term performance, and this is in the context of valuation relative to inflation.

As of the end of June, the trailing 12-month price-to-earnings ratio for the S&P 500 Index was 21.8. Inflation, as measured by the U.S. Consumer Price Index, as of the end of May (the most recent data we have), was 0.1% year-over-year. In that regard, our conclusion is that despite the run-up in markets and relatively high price-to-earnings level on the S&P 500 Index and its developed market peers, valuation is fair. Stocks are neither expensive nor cheap. And therefore, their attractiveness should be guided by their earnings potential.

One of our benchmarks for the health of the global economy, the Manufacturing Purchasing Managers’ Indices, has been a sea of red these past few months, as every major economy around the world has suffered at the hand of COVID-19. As we look forward, we’re starting to see signs that the global economy may have bottomed and has shifted from contraction to recovery. For the month of June, the U.S. ISM Purchasing Managers’ Index showed that manufacturing activity is starting to increase on a month-over-month basis. This trend is confirmed by the new orders to inventory spread that shows new orders are growing faster than inventories. Historically, the ISM PMI leads S&P 500 earnings growth by six months. This would suggest that while it’s likely the second-quarter, and most likely third-quarter, earnings will show steep declines on a year-over-year basis, we believe earnings will stabilize in the fourth quarter as the recovery takes hold.

Another of our favourite indicators, South Korean exports, also suggest that a bottoming may be in place. It’s only one datapoint and it can be volatile on a month-over-month basis, yet South Korean exports, which are a good barometer for global earnings, may be showing signs that the worst is over and, therefore, a near-term earnings recovery is becoming a higher probability.

And one last one is copper prices. Early on, we were asked what would make us more comfortable with respect to a recovery and we responded that copper prices recovering would be a good sign. Year-over-year improvements in copper prices has historically indicated year-over-year improvements in Chinese imports (a proxy for the Chinese economy). We’ve seen substantial improvement in copper prices, which would imply a Chinese recovery is well underway.

Taking this into context, our estimates are for a year-over-year earnings recovery in the S&P 500 Index of 20-25% for 2021, returning us to or near the 2019 earnings-per-share level.

We are aware, however, that equity markets rarely see further multiple expansions in a strong earnings recovery. Since 1970, when the S&P 500 Index has enjoyed earnings growth of 20% or more, the trailing P/E multiple falls by an average of 3.2 points. As such, even with a stellar earnings recovery, we would temper expectations that the market can repeat the performance since March 23. Taken together, our expectations are for a return potential over the next 18 months of 5-15%, with risk to the upside. For the time being, we extend this forecast into the international equity space (represented by the MSCI EAFE Index), as the recovery is likely to be global. We’re starting to see improvements in Asian and European economies, while correlations between equity markets remain high.

Our outlook for the S&P/TSX Composite Index is a little less clear than the U.S. or broad international picture, as we believe oil prices will trend higher but not necessarily high enough to support a similar recovery in the Canadian index earnings. While not perfect, the year-over-year change in oil prices correlate to the year-over-year change in TSX earnings and, therefore, offers insight to what forward returns may look like.

Oil prices have been absolutely fascinating to watch through the first half of 2020. Who could have ever forecast negative price for oil? Yet, the reality is that as oil prices have recovered to US$40/bbl (West Texas Intermediate) through to the end of the second quarter, and we believe the price per barrel of crude can continue to climb to US$50 over the next 12 months, it isn’t enough to fill the hole from the start of the year. Crude began the year at US$60 and a higher production level. According to the International Energy Agency, “Oil demand in 2020 is expected to fall by 8.1 mb/d, the largest in history, before recovering by 5.7 mb/d in 2021. Reduced jet and kerosene deliveries will impact total oil demand until at least 2022.” A tepid demand recovery for crude is likely to keep prices below their 2020 highs. The energy sector, therefore, may likely be a drag on the TSX. As such, we prefer U.S. and international equities (or global equities) over Canadian. Other areas within the S&P/TSX Composite Index are attractive though, and we would suggest selectivity and high active share are the keys to successful investing in Canada.

The intervention into the credit markets by the Federal Reserve has extended the Fed put beyond equities into investment-grade and high-yield bonds. As we wrote earlier, this iteration of the Fed’s ongoing quantitative easing experiment has been far more effective in inflating the money supply, with the equity and bond markets being the beneficiaries. This isn’t necessarily a bad thing. Expanding its balance sheet and making the unprecedented move to buy corporate bonds was an entirely prudent approach to making sure credit markets remained fully operational. In our view, the Fed has been successful in keeping the credit markets open. All things must come to an end. It’s too early to call but we are already seeing the Fed’s balance sheet modestly taper.

We believe one of the consequences of the Fed’s monetary inflation coupled with the trillions in (necessary) fiscal stimulus by the U.S. federal government will be higher inflation and higher interest rates through 2021. With the Fed’s implied commitment to keep short rates at 0% through 2022, the longer end of the yield curve will be subject to market-driven forces. It’s normal following a recession that the longer end of the yield curve steepens out. In such an environment, the US 10-Year Treasury Yield could see an increase of 100 basis points over the next year as the economic environment normalizes and inflation ticks higher.

In this environment, we believe credit does well and short-duration bonds outperform longer-duration. Investment-grade and high-yield bonds have enjoyed a strong rally supported by the Fed’s actions. Spreads, however, remain above their longer-term averages and we believe will provide a cushion should the government curve steepen. We continue to favour high yield as an attractive income generator and equity proxy. Defaults will continue through the recovery, as some companies will still fall victim to the COVID lockdowns. In this regard, security selection and careful credit analysis is of paramount importance.

Lastly, we come to the Canadian dollar. Historically, the Canadian dollar has been pulled by two (usually opposing) forces: oil and the two-year interest rate differential between Canada and the U.S. Recently, the CAD’s relationship to interest rates has completely broken down. What we’ve seen is a strengthening between the Canadian dollar and oil prices and, as such, would attribute the vast majority of the gains to the loonie’s correlation with oil. In that regard, when we look at the three-month CAD/WTI correlation, it doesn’t look as clean as it had pre-April 2020 negative oil. However, if we exclude those brief days when oil fell below US$20/bbl, including that one negative day, the correlation has remained above 0.75 (we hate to force the data, but did anyone really believe oil would stay below $20/bbl?). Over the next six to 12 months, we believe the price per barrel can continue to trend modestly higher on lower production and recovering demand, as mentioned above. Should the relationship to interest rates resume, at today’s differential that would only put further upward pressure on the CAD relative to the USD. Our target remains US$0.75-0.77 on US$40-45/bbl. We would put the broader trading range at US$0.73-0.77 (CAN$1.37-1.30) over the next 18 months, with risk to the upside.

In keeping with our process and based on reasonable valuations and a positive outlook for earnings into 2021, we’re adding an additional 5% to equities to bring our equity weight to a neutral 60% and our fixed income weight reduced to 40%. Overall, we’re reducing our weight in global core bonds by 5% in favour of global equities.

Changes to the model portfolio from prior quarter

Fixed income

• -5% — reduced weight to neutral (-5% to 40% overall)
• Maintained corporate bond (high yield) position (15% overall)
• Reduced global core bond position (-5% to 25% overall)

Equity

• +5% — increased weight to neutral (+5% to 60% overall)
• Maintained international position (20% overall)
• Increased U.S. equity position (30% overall)
• Maintained Canada equity position (10% overall)

Throughout the Great Pause, we’ve been advocating rebalancing portfolios to target asset allocations and dollar-cost averaging into this market. We continue to emphasize that approach today. We don’t know what the market holds for us over the next 6–12 months. A correction within that timeframe would be entirely consistent with normal market activity. Alternatively, equity markets can continue their ascent, pricing in a recovery that may be more than 12 months away. We don’t know. We do believe that by the end of 2021, we’ll be largely through the COVID pandemic and in a well-supported economic and earnings recovery.