Market Commentary - Q1 2021
Members of the Louisbourg investment team recap investment markets and some of our investment strategies in the first quarter of 2021.
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Equity markets performance summary
In the first quarter, equities offered a positive follow through to the surprising positive year that was 2020. Although the environment remained positive, there were some shifting tides. A significant part of this shift was caused by fixed income markets, which experienced a rather quick ascent in mid to long term interest rates. Investors witnessed an improving economic picture and began anticipating some fiscal help from governments around the world. Furthermore, market expectations started to assume that the economy will not require monetary policy to be as accommodative in the not-so-distant future. This has shifted some attention from long term technology growth stories toward less expensive stories that should benefit from a cyclical upturn. The result was outperformance from Canadian equities to begin the year with smaller caps benefiting the most. US and International equities lagged but still returned attractive mid-single digit returns for the period.
Canadian Equities was the place to be as 2021 kicked off. The increasing appeal of inexpensive cyclical stocks led to the S&P/TSX Composite outperforming its main international counterparts with an 8.1% return. Breadth across sectors was wide with nine of eleven sectors offering positive returns. The two lagging sectors were Materials (-6%), where investors moved away from precious metal companies, and Technology (-1%), where investors moved away from expensive growth stories. Health Care (+37%) offered the strongest return for the period but its contribution to the benchmark was relatively modest given its 1.5% weight. Just like in the previous quarter, the strength in Financials (+14%) and Energy (+20%) was much more impactful as these companies represent a combined 43% of the S&P/TSX Composite index. Consumer Discretionary (+12%) and Real Estate (+10%) also outperformed the benchmark average.
South of our border, improving economic expectations led to the risk appetite staying elevated, demonstrated by investors looking to what we see as speculative investments to generate returns. Demand for initial public offerings hit new highs and were led in large part by SPACs. That said, some of the momentum stocks that had done incredibly well over the past twelve months started to reverse course through February and March as fear of inflation from the economy reopening, rising commodity prices, and widespread supply chain issues led to a rapid increase in interest rates. The sharp moves in longer-dated interest rates led to some market volatility as higher rates pushed investors to rotate into “value” from “growth.” Overall, US equities finished the quarter up 6.2% in USD. The strength of the loonie relative to the US dollar hurt performance for Canadian investors with the index ending the quarter up 4.8% in Canadian dollar. Looking by sector, the market rotation was evident with defensive sectors like Consumer Staples (+1%), and Utilities (+3%), and Health Care (+3%), all lagging the index. Energy (+31%) and Materials (+9%) both benefited from better investor sentiment both benefited from better investor sentiment as commodity prices improved significantly in anticipation of the rebound in economic activity. Financials (+16%) also performed very well as banks generally
benefit from a steeper interest rate curve and benefited from the rotation into “value”. Information Technology (+2%) took a rare breather during the quarter as the index heavy weight, Apple, pulled back after a stellar performance through last year.
International equities finished the quarter up 2.3% in Canadian dollars but lagged its US counterpart where the virus seems more under control and with the economy set to rebound faster. As for currency, the strength of the loonie relative to major index currencies like the Euro and the Japanese Yen was a negative contributor to performance for Canadian investors. Looking by sector, the market rotation was evident with defensive sectors like Health Care (-5%), Consumer Staples (-4%), and Utilities (-4%), posting negative returns. Energy (+9%) and Materials (+4%) both benefited from better investor sentiment as commodity prices improved significantly in anticipation of the rebound in economic activity. Financials (+8%) also performed very well as banks generally benefit from a steeper interest rate curve and benefited from the rotation into “value”.
We think it is time to adopt a balanced approach in equities. There are reasons to be cautious as valuation levels are above historical norms and we have witnessed some areas of exuberance in pockets of the investing universe. There are also reasons to be optimistic as the economy is recovering alongside strong monetary and fiscal support. Some areas of the market offer solid value. We may have borrowed a bit from future returns and the stronger returns do tend to happen in the first year of a recovery. As such, we could experience some corrections as the recovery slows down, but we still expect reasonable equity returns from here onward. On balance, we feel that this is a time to hold a neutral amount of equities relative to your investment policy targets and to emphasize getting paid for the risks you are taking within those equity portfolios.
Fixed income markets performance summary
The first quarter of 2021 brought with it a wave of optimism to financial markets, with a dramatic turnaround in the outlook precipitating a rise in bond yields and a steepening in the yield curve. More certainty around vaccine rollouts led to accelerated timelines for re-openings, resulting in upward revisions to growth, labour markets, and inflation expectations. While vaccine development and rollout has been a “game changer” in terms of the outlook, the combination of highly accommodative monetary and fiscal policy within a re-opening/recovery backdrop has magnified the effect of this optimism and led to higher GDP growth and inflation expectations in 2021. Despite slower vaccine rollout and renewed lockdowns, 2021 GDP growth in Canada is expected to be on par with that of the US at 6.5% y/y as the economy benefits from strong gains in commodities, housing, and employment. In addition, growth in Canada is recovering from a lower level as the economy was hit harder by the pandemic, suffering a decline in GDP of 5.4% versus a decline of 3.5% in the US in 2020. Most notably this quarter was the increase in market inflation expectations, as the US ten-year market implied inflation rate hit a high of 2.37% at the end of the quarter. Headline CPI rates in Canada and the US are currently running at 1.5% and 1.7%, respectively, but the increase in inflation expectations indicates inflation pressures could exceed the central bank’s 2% target going forward. To some degree, this reflects the recent move by central banks in Canada and the US to an average inflation targeting measure that would allow inflation to run above 2% for some time before accommodative monetary policy is removed. As further support to the bear steepening in the curve this quarter, were comments by the US Federal Reserve Chairman, Jerome Powell, in late March. Powell indicated the Fed’s willingness to let longer term interest rates rise without central bank intervention acknowledging that the recent market moves “appear to reflect growing optimism about the economy’s prospects”. Fundamentally, rising inflation expectations reflect the risks that the re-opening and recovery, combined with highly supportive monetary and fiscal spending policies and key production bottlenecks will lead to accelerating inflation pressures. The bond market quickly started to price in additional inflation risk this quarter as well as a central bank stance that will not intervene in the long end of the curve so long as the market remains orderly and the rise in yields is consistent with the growth outlook.
During the quarter the Bank of Canada maintained overnight lending rate of 0.25% while the US also held the Fed Funds Target range at 0.10-0.15%. Central banks have indicated rate hikes are unlikely until 2023 as vaccinations become widespread and labour markets and economic activity fully recover. During the quarter, the yield curve steepened as the front end of the curve remained anchored by accommodative monetary policy. Over the period, two-year Canada bond yields increased 2 basis points to 0.22%, while five-year yields increased 60 basis points to 0.99%. Ten-year Canada yields rose 88 basis points to 1.56% while thirty-year yields increased 77 basis points to 1.98%. Despite rising case counts amidst a third wave of COVID-19 in Canada, recent employment data indicate that the labour market has almost fully recovered (only 300,000 jobs left to recover) with the unemployment rate improving to 7.5%. We expect the Bank of Canada to start tapering asset purchases in Q2/21 as the need for such quantitative easing measures have lessened with the pace of recovery. Furthermore, less ownership of risk-free (government) bonds by the central bank will help improve overall market liquidity.