Investment Commentary - Q1 2020
Updated: Aug 21, 2020
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Equity Markets Well, it seems this was a “black swan” event! Most of the planet’s habitants have been collectively sent to their rooms. Business activity has been shut down, which clearly will cause a recession. From our perspective, corporate earnings and macro economic data should be ignored for the moment. What is important is how we progress through the COVID-19 crisis. How long and how deep will the collective timeout be? Monetary and fiscal measures to minimize the damage during the crisis and to help the recovery on the other side are also key considerations. With this virus came a severe market correction, where we saw all risk asset classes experience significant weakness in the first quarter. The level of weakness mirrors many other historic crisis drawdowns. In Canada, the market faced more than one headwind this quarter. As the COVID-19 pandemic rippled through the global economy, Canadian investors also had to consider the impact of an oil price war between Saudi Arabia and Russia. It has quite possibly been the opposite of what would be considered business as usual for Canadian companies, explaining the historic weakness for the S&P/TSX Composite, which was down 20.9% for the quarter. This was the worst calendar quarter since Q4 of 2008 and only the ninth time we’ve seen the benchmark down more than 20% since 1919. None of the eleven sectors were spared in this weakness as they all generated negative returns for the period. Energy (-37%) was the worst performing sector and had a significant impact on the benchmark given its size. Health Care (-37%), Consumer Discretionary (-33%) and Real Estate (-28%) were also very weak. Financials sector (-21%) weakness, with its large weight, was impactful since investors are used to more stability from Canadian banks. Defensive sectors were clear outperformers with Technology (-4%), Utilities (-5%), Communications (-8%) and Consumer Staples (-9%) mostly resisting the broad-based weakness.
US equities were clearly weak, ending the quarter down 19.6% in USD. For Canadian investors, the performance was aided by the weakness of the loonie given the economic reliance on the energy sector with the index ending the quarter down 12.0% in Canadian dollars. In this period of heightened uncertainty and rapid economic slowdown, we’ve seen a strong rotation to defensive sectors with Health Care (-13%), Consumer Staples (- 13%), and Utilities (-13%) the clear winners. The best performing sector, however, was IT (-12%), which outperformed every other sector despite being more cyclical. Energy (-50%) on the other hand, was hit hard on two sides. As global demand for oil has weakened significantly, Saudi-Arabia and Russia (or more broadly OPEC-plus) failed to agree on a production cut to balance supply. This was followed by Financials (-32%), Industrials (-27%), and Materials (-26%).
International equities were not spared from the weakness, ending the quarter down 15.3% in Canadian dollars. As was the case with North American equities, the market saw a strong rotation into defensive sectors with Health Care (0%), Utilities (-5%), and Consumer Staples (-5%) performing the best. Energy (-30%) was the weakest sectored followed by Financials (-25%), Real Estate (-20%), Consumer Discretionary (-20%), Materials (-20%) and Industrials (-20%). The performance was aided by favorable currency movements as the Canadian dollar depreciated significantly given the economic reliance on the energy sector.
Investors have become more fearful and the pandemic will certainly impact economic growth and corporate earnings. We do believe that this is a significant global disruption but one that we will recover from. Significant fiscal and monetary stimulus will certainly support this recovery, which should be uneven across sectors. Equity valuations have evidently come down, but we believe we are likely to see continued volatility as the market digests news flow. Surely, the progress being made in containing the virus is key as will be the severity of the crisis on corporate balance sheets and earnings. Overall, we believe investors who can look through significant noise will ultimately be rewarded. We advocate maintaining neutral exposure to equities relative to your investment policy. The drawdown has been significant but also very broad-based, which has afforded us the opportunity to emphasize more defensive sectors without the need to pay up for these companies. Fixed Income Markets The impact of COVID-19 on the global population and the global economy has been unprecedented. As the dispersion of the virus accelerated into March, many countries, provinces and states all but shut down hoping to temper the impact on the population and local healthcare systems. The effect on markets has been secondary to the impact on the health and welfare of civilization, which has been disturbed in a way few living people have ever experienced. As a result, the economic fallout and resulting market activity has mirrored the virus’ impact on society. Efforts to contain and slow its spread have come with their own economic consequences and have created a large degree of uncertainty. What is known at this point is that the virtual shut down of global economies has produced record breaking economic contraction and widespread unemployment this quarter. In addition, markets reacted quickly with a flight to quality in early March and then, as risks rose, a flight to cash where bonds and equities sold off in the second half of the month. No market was immune to the outflow and market liquidity was limited as the magnitude of the rapid move out of risk assets drove asset prices to extreme levels. As a result, widespread central bank and government intervention was quickly implemented with emergency inter meeting rate cuts, quantitative easing actions, liquidity support facilitates, and broad fiscal stimulus geared toward small business, the unemployed and sectors suffering the most hardship. The support spending and loan programs in Canada continue to be tweaked as the impact grows deeper and wider in breadth, while central bank activity is focused on preserving market liquidity and keeping interest rates low through bond purchases which will help stabilize government and credit markets and offset the upward pressure on interest rates as the government issues debt to fund its massive fiscal spending programs.
Subsequent to the widespread government intervention, economic fundamentals have started to come back into focus and market liquidity has steadily improved with corporate bond credit spreads coming back down into a reasonable range and bond issuers across the risk spectrum able to access the market through new bond issues in large scale. In both Canada and the US, real GDP growth is expected to contract by up to 30% in the first quarter of the year while real GDP growth overall in 2020 is expected to contract by 5% and 5.5%, respectively. These projections could change dramatically as they depend heavily on the duration and severity of the crisis. During the quarter, the Bank of Canada lowered the overnight lending rate by 150bps to 0.25% while the US Federal Reserve also moved their policy rate by 150 bps lower to 0 - 0.25%. The timing and nature of economic recovery remains unknown, but it is expected that short terms rates will be kept low until a strong recovery is underway which may take at least a year or two given the severe nature of this disruption. During the quarter, yields across the curve declined dramatically, led by lower short-term rates. The flat curve we experienced at the start of the quarter re-steepened as policy intervention measures stepped in and risk assets sold off. Over the period, two-year Canada bond yields declined 127 basis points to 0.42% while five-year yields dropped 110 basis points to 0.58%. Ten-year Canada yields declined 101 basis points to 0.69% while thirty-year bonds fell 46 basis points to 1.30%.