Market Commentary - Q4 2020
Updated: Feb 26, 2021
How did investment markets perform in 2020?
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Equity markets performance summary
What a year it was for equity markets! Actually, it was quite a year for the world in general. Most people will remember 2020 for the significant disruption it brought to their daily lives. As it relates to investing, it was also quite eventful. Equity markets reacted very negatively when the COVID-19 pandemic reached North America. It may seem like a distant memory now, but global equities sold off over 30% in approximately one month, just this spring. Central banks and governments reacted swiftly to restore confidence with plenty of stimulus and support. With this support, investors responded by looking past the continued virus challenges and economic weakness. A bit surprisingly, all major equity markets finished in the green for the year with continued strength in the fourth quarter as investors cheered the start of vaccine delivery. The US equity market was the clear leader for the year given the technology bias, but we did see a shift towards the lagging Canadian and International markets in the fourth quarter as investors began to favour value opportunities.
This investor enthusiasm we just discussed had an outsized benefit for Canadian equities, which carry a higher cyclical component versus their US counterparts. The S&P/TSX Composite returned 9.0% in the fourth quarter to finish the year in positive territory (+5.6%). Breadth across sectors was wide with nine of eleven sectors offering positive returns. The two lagging sectors were Consumer Staples (-6%) and Materials (-4%) as investors moved funds from defence to offence. Health Care (+30%) and Consumer Discretionary (+21%) offered the strongest returns for the period but their contribution to the benchmark was relatively modest given their combined weight is only 5%. The strength in Financials (+17%) and Energy (+15%) was much more impactful as these companies represent a combined 40% of the S&P/TSX Composite index. Investors were clearly feeling better about an economic recovery and wanted to be exposed to companies that would benefit.
After COVID-19 triggered the fastest market correction in market history, it took just over a month for global equities to start marching forward and gradually making their way to new all-time highs. The fourth quarter was no different as equities continued their ascent. Overall, US equities surged, up 12.2% in USD, helped by an increase in risk appetite. The strength of the loonie against the US dollar weighed on performance with the index ending the quarter up 7.6% in Canadian dollar. Financials (+23%) and Industrials (+16%) were some of the principal winners of the rotation given their cyclical nature. For similar reasons, Commodities also performed well, led by optimism in an economic recovery and the weaker US dollar as Energy (+28%) and Materials (+14%) vastly outperformed the index. Defensive sectors like Consumer Staples (+6%), Utilities (+7%), and Health Care (+8%) were left behind, the latter being impacted by concerns around potential changes in the US healthcare system under the Biden administration. Consumer Discretionary (+8%) also underperformed, which is primarily explained by the large exposure to Amazon which benefited less from the risk-on sentiment.
International equities also surged, up 10.7% in Canadian dollars, outperforming its US counterpart given its higher exposure to more cyclical sectors. Financials (+20%), led by the banks, and Consumers Discretionary (+17%) were some of the principal winners of the rotation given their cyclical nature. For similar reasons, Commodities also performed well, led by optimism in an economic recovery and the weaker US dollar with Energy (+25%) and Materials (+15%) vastly outperforming the index. Like it was the case US equities, defensive Health Care (-1%), Consumer Staples (+2%) and Utilities (+8%) were laggards.
During the March correction, we felt that fearful investors were discounting too harshly the negative consequences that the pandemic would have on the global economy. It made sense to be adding to equity positions on weakness. After experiencing the subsequent equity rally, we believe investors are choosing to be optimistic about the speed of the economic recovery helped by the beginning of vaccine distribution. We feel there is little margin of safety with equities from a valuation standpoint. However, equities are benefiting from very low interest rates, significant government support and stimulus and a recovering economy. There are pockets of overvaluation in certain sectors but some attractive opportunities as well. 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. We expect equities to offer reasonable rates of return on a go-forward basis to patient investors.
Fixed income markets performance summary
Words do little justice to summarize the magnitude of events that took place in 2020 from the spread of the Novel Coronavirus into a full-fledged global pandemic with immense monetary and fiscal support on a scale that previously could not have been imagined. Most notably, the pandemic has resulted in a significant human suffering, as well as the widespread disruption to the fabric of our economic and social existence. While risks pervaded most of 2020, the stability of financial markets and development of a vaccine produced an optimism that has been a formidable offset. To some degree, fixed income markets exhibited some of this optimism in the fourth quarter as yields rose moderately, led by longer-term yields, and the curve steepened, perhaps also supported by the prospect of more fiscal stimulus post election in the US. The upward move in rates was limited, however, as the market remained focused on the near-term risks associated with rising virus case counts and renewed closures. A degree of uncertainty surrounding the vaccine as well as added political risk relating to the question of control of the US Senate helped keep bonds within a tight trading range. The early days of 2021 suggest a change in the outlook for fixed income has begun, driven by faster than expected vaccine production and distribution, combined with a Democratic House majority that opens the door for added fiscal spending to support the recovery. Bond yields are currently re-pricing to the higher end of the current range, with a marked steepening of the curve as the bond market changes focus from near term COVID case counts and closures to a post vaccine recovery phase. Over the period, two- year Canada bond yields declined 5 basis points to 0.19% while five-year yields increased 4 basis points to 0.39%. Ten-year Canada yields rose 11 basis points to 0.67% while thirty-year bonds increased 10 basis points to 1.21%.
The final quarter of the year produced better than expected economic growth in Canada with an annualized gain of approximately 5% anticipated, leaving overall annualized growth for the year of -5.5%. Needless to say, recovery has been slower than hoped as the fight against the virus has been difficult and prolonged. Following a strong recovery in Q3/20, the fourth quarter gains have been centered around manufacturing and goods sectors while service and leisure related segments remain weak. Economic growth in Canada and the US is estimated to retrace losses with projected annualized GDP growth in 2021 of 5% and 4.5%, respectively. In Canada, we expect the bulk of the economic recovery to begin in the second half of the year when vaccination levels take hold, reopening is complete and confidence levels return to households and businesses. As a result, economic data and interest rates are expected to remain relatively range bound until the prospect of a widespread re-opening and establishment of a new normal becomes closer to a reality in the second half of the year. Central Banks around the world were quick to respond in March/April to the pandemic and indicate they will remain supportive, maintaining their highly accommodative monetary policy until employment fully recovers and inflation targets are met. The recovery in labour markets has slowed recently with job losses in Canada and the US posted for the month of December, the first since the March/April employment shock. Unemployment remains above pre-pandemic levels with Canada and US rates of 8.6% and 6.7%, respectively where the number of people collecting various government support benefits vastly exceeds those officially unemployed. Like the
2009 financial crisis, job losses have been focused around the 20-30-year old portion of the population, a segment where recovery has been slow, contributing to slower wage gain and price pressures. Inflation in Canada remains weak, below that of the US but better than countries such as Japan, China and the Eurozone which are experiencing price declines. November inflation data in Canada remains well below the desired target of 2% with a headline CPI rate of 1% yr/yr and core rate of 1.5%.
The Bank of Canada’s overnight lending rate of 0.25% is expected to remain in place until 2023 based on the trajectory for economic recovery. More recently, the onset of a second wave of the virus and widespread closures have increased the odds of another cut to 0.10-0.15% at their January meeting. The US Fed Funds Target range of 0-0.25% is similarly expected to remain in place until at least 2024 as the Fed reiterated their desire for employment to fully recover and inflation to meet or exceed target before any change to short term interest policy is initiated. Further out the yield curve, monetary policy in North America is expected to remain supportive with further tools including forward guidance, increasing the term of asset purchases, yield curve control and wider inflation targeting standing at the ready if needed. While bond issuance to fund fiscal spending programs is expected to reach record levels and vaccine distribution continues to help improve the outlook, any significant rise in interest rates should be contained as central banks will remain willing buyers until we are through the worst of the health outcome and labour market and inflation targets are fully recovered. They stand at the ready to utilize any of these additional tools as needed to help achieve their goals.
We remain hopeful that the near-term effects of the global pandemic will start to abate as the vaccine rollout takes hold, likely in the second half of 2021. If this unfolds, and the vaccine remains effective, 2021 will enjoy a unique set of conditions where both fiscal and monetary policy remain highly supportive despite the strength in improving economic data and the continued strength in financial asset prices through the recovery, re-opening and reflation stages. Market inflation expectations have been rising steadily since news of the vaccine was released, with 10-year US TIPS break evens now pricing in an implied inflation rate of over 2%, reflecting the optimism of both improving fundamentals and the supportive fiscal and monetary policy framework. Like the path of 2020, which had little forewarning and predictability, we may enjoy these unique market conditions for a shorter period than expected if wages and inflation recover too quickly. With households in both countries hoarding cash in the presence of supply chain disruptions from covid-idled production, we may see inflation rise more quickly than expected. Central banks clearly have the tools to hold inflation pressure down, however, it seems unlikely they will do so until the labour market is well on its way to more permanent recovery. Under this scenario, the market is left to return to fundamentals driving asset prices, which may in turn fail to support the added risk taking in the market that has increasingly taken place.