Market Commentary - Q3 2020
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Normalcy has not returned to our daily lives. At best, we are getting more comfortable in our new normal. Economic activity is still significantly affected by the COVID-19 virus. Still, equity markets continued to add to their second quarter gains. Investors continue to feel better about owning risky assets given the significant support of central banks with very low interest rate policies. COVID outbreaks continue but the population and businesses are adapting. Led by the technology heavy US market, equity returns were generous across geographies for the quarter. With the exception of US equities, most equity indices are still down for the year but much of the COVID damage has been recovered.
Canadian equity investors participated alongside the continued global recovery of risk assets. The S&P/TSX Composite was up 4.7% for the period despite a weak energy sector. Energy companies gave back some of their second quarter gains despite a flat oil price. Breadth was still wide with Health Care being the only other sector offering a negative return for the period. All other sectors generated positive returns with Industrials (+14%), Utilities (+11%), Materials (+9%) and Consumer Staples (+9%) leading the way. Precious metal companies and technology companies continued to perform well but performance was more evenly spread across other sectors during this quarter.
The first two months of this quarter looked very similar to what we had been seeing since mid-March; global equities continued to recover while US equities continued to make new highs. In September, however, equity markets took a breather as the US government failed to agree with itself on another round of stimulus and the virus’ anticipated “second-wave” started to materialize, prompting multiple regions to increase restrictions again. Alongside that, the US election leaped to the forefront of investors’ minds with uncertain outcomes for future of economic policy. Overall, US equities continued their outperformance relative to peers, driven primarily by their favourable exposure to both the IT sector and eCommerce (Amazon), ending the quarter up 8.9%. The loonie continued to regain some of its lost ground relative to USD, resulting in a 6.8% return in Canadian dollars for the index. Looking on a sectorial basis, the “risk-on” sentiment was evident with sectors like Consumer Discretionary (+15%), Materials (+13%), Industrials (+12%), and IT (+12%), vastly outperforming the index. Financials (+4%) remained under pressure as investors continued to worry about the impact of the pandemic on consumers and small businesses’ financial health without government support. Finally, sentiment on the Energy (-20%) sector continued to deteriorate as the oil price remained depressed given the demand shock created by the pandemic.
International equities participated with the rest of global equities, finishing up 3.0% in Canadian dollars, but lagged its US counterpart given the lower exposure to the IT sector and “growth” names. The strength of the Euro and British Pound relative to the loonie had a positive impact on the performance for Canadian investors. Like the US, the “risk-on” sentiment was evident with sectors like Materials (+9%), Industrials (+8%), Consumer Discretionary (+8%) and IT (+6%) vastly outperforming the index. Financials (-3%) and Energy (-15%) were the laggards here as well.
After the first quarter, we stated that investors had become fearful of the prospects that the pandemic would damage economic growth and corporate earnings. We agreed but also offered that this significant global disruption would be one that we would recover from. That confidence came in part from the significant fiscal and monetary measures that were being adopted to support this recovery. At that moment, equity valuations were discounted, offering good compensation to take on the risks of an economic recovery amid COVID-19. We felt it was appropriate to add to positions. Today, we feel that investors are ignoring a fair amount of bad news amid the pandemic fight, which has proven to be difficult to predict. Certainly, investors are being strongly encouraged into risk assets by central banks with very low interest rates, which is proving to be a powerful force. Still, we must remember that some segments of the equity market are very expensive. We are holding a more neutral stance on equities with an emphasis on more defensive businesses.
Fixed Income Markets
The conditions faced by global economies this year have been extraordinary as the fight against the global pandemic continues to dominate headlines and almost every social and economic activity. The passing of time and the positive benefits from the Q2 lockdown have permitted some degree of recovery in activity but the result has been a new normal, where actions are constrained under an umbrella of widespread safety precautions. This “new normal” is expected to persist until an effective vaccine is developed or immunity is reached on a global scale. As a result, we expect monetary and fiscal stimulus to be a presiding theme going forward as central banks and governments have made it clear that they will provide the necessary support to sustain households and the economy during this trying time. Governments want to avoid a more widespread economic crisis where defaults and bankruptcies create deeper and longer-term impacts to the overall health of the economy and prospects for growth. The Bank of Canada and US Federal Reserve continues to remain on hold with overnight lending rates expected to be near zero until mid-2023, when employment is expected to fully recover. Similarly, quantitative easing, where central banks seek to lower interest rates further out the curve, has helped neutralize large government bond issuance, giving the market confidence that long-term interest rates will remain low. Accommodative monetary policy and continuing fiscal stimulus represent primary tools for fighting the virus at the economic level and are expected to remain in place until significant progress is made on the healthcare stage.
While the previous financial crisis was led by the banking sector, this pandemic-led financial crisis is being led by labour markets and employment levels. As a fundamental factor in the performance of the economy, labour markets are the primary focus for the markets’ outlook, as well as a key indicator for central bankers as they attempt to achieve adequate growth and inflation. During the quarter, labour markets improved steadily, with the US now past the halfway mark in the recovery of jobs lost. In Canada, the jobless rate in August beat expectations and the unemployment rate improved to 9% while the US is slightly further along at 7.9%. It is important to note that continued fiscal support initiatives (several expire in December) will be necessary to support the recovery of labour markets and avert rising default/bankruptcies until normal activity is able to resume. In relative terms, Canada has performed well to-date in proactively limiting virus cases while economic activity has exceeded expectations with GDP in Q3 expected to recover 45-50% (annualized rate). Inflation remains weak with August CPI at 0.1% y/y, supporting the likelihood for accommodative monetary policy and further fiscal spending measures.
During the quarter, the yield curve steepened as data improved and economies started to re-open. Over the period, two-year Canada bond yields declined 4 basis points to 0.24% while five-year yields were 1 basis point lower at 0.35%. Ten-year Canada yields rose 3 basis points to 0.56% while thirty-year bonds increased 12 basis points to 1.11%.