This month, CIO Rob Edel takes a closer look at ‘The Harsh Reality’ of the current market, including the impact created by COVID-19 and climate change. Rob also provides an in-depth analysis of fixed-income, equities, alternative strategies, stocks and credit in this edition of our Market Commentary.
Highlights this Month
July in Review
CNBC headlines last month claimed markets were in turmoil, which in hindsight, appear overly dramatic. While it is true that the S&P 500 and the S&P/TSX fell 1.6% and 1.3%, respectively, on July 19th, all was well by month-end. For July, the S&P 500 still managed to increase 2.4%, while the S&P/TSX recorded a 0.8% gain. Turmoil averted.
However, Canadian and U.S. bond yields continued to grind lower, ending the month at 1.22% and 1.20%, respectively, after falling as low as 1.19% and 1.14% on July 19th. Small-cap value stocks also failed to recover their losses, with the Russell 2000 Value ETF down 3.6% by month-end. Where we did see some real turmoil was in Chinese stocks and the technology sector in particular. The Shanghai Composite lost 4.7% (local currency) last month, but the NASDAQ Golden Dragon China Index fell a concerning 23.8% amid a crackdown by Chinese regulators against technology and education stocks.
While we concede some markets, like Chinese stocks, are exhibiting some signs of stress, what is even more remarkable about this market is the lack of any real sense of anxiety about anything. No concerns over the new COVID-19 variants, extreme weather events, non-transitory inflation, and very little clarity of when, or even if, we will be going back to the office anytime soon. Stocks continue to melt higher, despite declining bond yields appearing to signal that more caution may be required.
The market’s current reality.
This month we are going to start with the market itself, rather than trying to determine if recent performance makes sense given what’s happening in the economy, by assessing what we see as the market’s current reality. While some refer to this assessment as ‘The Harsh Reality’ current conditions appear anything but, with no end in sight to the current bull market.
Goldman Sachs recently increased their year-end target for the S&P 500, leaving room for stocks to drift another 7% higher before ending the year with a nice 25% gain. Even next year, Goldman sees the rally continuing, though they are forecasting only a 4% gain. After assessing one’s current harsh reality, the next step is typically to articulate what “good” looks like. Yet, perhaps the harshest reality of this market is that this is what “good” looks like. Is this as good as it gets? Current valuations are high, not just in stocks but in all asset classes, which historically has meant that future returns will be more challenging.
According to asset manager GMO, the only asset class they see delivering positive real returns over the next seven years are emerging market value stocks. GMO sees U.S. stocks as the biggest loser, but even cash is forecasted to lose 1% a year after inflation over the next seven years. It doesn’t get harsher than that!
AQR Capital, a quantitative hedge fund, is a little more optimistic, forecasting positive real returns in stocks over the next five to ten years, but fixed income returns are still predicted to face very challenging conditions, with cash and government bonds expected to lose money after adjusting for inflation, and credit barely scraping out a positive return. One thing to consider is that while these projections may indeed prove accurate over the next five to ten years, it doesn’t preclude returns from continuing to be strong in the near term.
Valuation is a better predictor of returns over the longer term, but not so great over the short term. In the short term, expensive markets tend to get more expensive, until they eventually correct and get a whole lot cheaper. It is also worth mentioning that these forecasts are for the broader market benchmarks. Individual stocks, sectors, and geographies can do much better, or they can do worse. It can be misleading to draw conclusions based on broad benchmarks if this is not how you invest.
To avoid making this mistake, we will take a closer look at the harsh reality of the relevant asset classes and geographies to determine if this is indeed as good as it gets. As there are a lot of asset classes and factors to consider, we are going to break up our analysis into two parts. This month we focus mainly on the current reality as we see it. Next month, we’ll delve a little deeper into what is currently happening in markets to determine whether this is indeed as good as it gets.
The harshest reality is in fixed income.
Right now, the harshest reality is to be found in fixed income, making it a good place to start. With fixed-income investments, there are essentially three main return generators: rates (meaning yields decline driving bond prices up), coupon, and credit. None of these return generators look very attractive right now.
Since current yields are already so low, there is not much room for rates to decline further to push bond prices higher. According to JP Morgan, based on current levels, even if bond yields were to drop to zero, price returns for the Barclays U.S. Aggregate Bond Index would be just north of 5%. With the addition of the coupon payments, which are also very low, the best-case scenario total return for bonds would be just under 10%. Not a bad return, but you can handicap the odds of yields falling to zero as relatively low.
A more likely scenario, in our opinion, is an increase in yields which, depending on the term of the bond, would be much more problematic. JP Morgan estimates a parallel 1% shift in interest rates would result in 10-year bonds falling nearly 9% and 30-year bonds dropping just over 19% in price. The risk/return trade-off for government bonds is currently very poor due to a low coupon rate, and more downside than upside room for future movements in price. While it is true that coming into 2021 bonds had outperformed stocks over the last two decades, we find it hard to believe this will continue to be the case this decade. The prospects from high-yield, or credit, are better, but still far from ideal.
Current credit spreads are very low, leaving both a lower coupon return and less room for price appreciation due to credit spreads moving lower. Working in high-yield’s favour is the relatively short-term duration of most issues and the current low default rates. Even if rates move higher or credit spread widens, as long as default rates remain low, the higher coupon rates should mitigate much of the loss of capital.
Passive high-yield strategies require added scrutiny, however, and can be particularly perilous in times of market stress given liquidity in passive high-yield ETFs, which can be greater than the underlying positions they hold. If High Yield investors sell their ETFs, market makers need to sell the underlying positions, regardless of price, thus causing large price gaps to occur, especially if potential buyers are scarce. High-yield investors need to be aware of which issues are included in passive portfolios, especially if they believe market conditions could change.
Prospects for preferred shares are not that much better from an overall return perspective, though they do provide a bit more protection if rates start to move higher. Most preferred share yields reset every five years based on a fixed spread over short-term interest rates, thus providing a rare hedge against the risk of higher interest rates.
In fact, one of the biggest headwinds for preferred shares the past few years has been persistently low 5-year bond yields. Preferred shares are also taxed as dividends, thus proving a higher after-tax return than interest income for taxable accounts, especially those taxed as corporations. Preferred shares became oversold in 2020 during the pandemic market correction, but have since recovered.
According to Capitalight Research, the preferred share market presently fairly values against 5-year government bonds, corporate bonds, and bond proxy equities, but undervalues versus REITs. The supply of preferred shares is also limited, and becoming more so as financial issuers redeem outstanding preferred shares in favour of Limited Recourse Coupon Notes (LRCN), thus driving current yields even lower.
We mentioned there are three return generators for fixed income returns: rates, coupons, and credit. There are actually a couple more one can draw on, which can be particularly attractive in today’s low-rate world, namely currency and liquidity. Most global bonds suffer the same low-rate problem we have in Canada, with nearly $17 trillion of global debt with negative nominal yields. Emerging market debt, however, not only has positive yields, but the spread over Canadian and U.S. government rates are also positive. China is a case in point. At over 3%, Chinese 10-year government bond yields yield nearly 2% above 10-year U.S. treasury’s, and with China taking a more disciplined approach towards monetary and fiscal policy of late, there is also more room for China to lower rates if needed in the future. As an added kicker, investors have benefited from an appreciating Chinese currency as the Yuan rose against the U.S. dollar for much of last year.
Investing in Chinese bonds is enticing.
From a diversification perspective alone, investing in Chinese bonds is attractive given the potential decoupling of the Chinese and U.S. economies. Liquidity has also increased due to the large cumulative issuance of new corporate Chinese bonds. It’s not for the faint of heart, however, as the Chinese government puts less emphasis on investor rights and the free movement of capital.
Private debt is an attractive alternative to public markets.
From a liquidity perspective, if investors are willing to forego the advantages of being able to transact on public markets, private debt is an attractive alternative, providing favourable, volatility-adjusted returns versus the public high-yield market. While the lack of liquidity can be an issue for some investors, we would point out that while public markets do provide more liquidity, in times of market stress effective liquidity becomes scarce, even in the public markets.
In addition to an illiquidity premium, private credit investors can also expect to earn a complexity and uncertainty premium for lending to markets with less opacity where information is not as widely disseminated as in the public markets.
According to Blackrock, the yield spread of private debt over high yield can be more than 400 basis points, though direct comparisons are difficult due to structural differences between the two markets. Direct lending (Private Debt) tends to focus on small to midsize companies with higher leverage ratios, and while loss ratios are comparable, direct lending deals typically have stricter covenants with lenders preferring a more active relationship with their borrowers.
Rather than default, direct lenders prefer to re-negotiate deals. Investors get a higher return in exchange for taking on more risk, but they have more levers in which to control that risk. In response to low current rates and the inability or unwillingness of banks to lend, the private debt market has grown tremendously over the last decade. Given private debt is also becoming the go-to source of funding for private equity deals, the private debt market’s growth is also benefitting from the tremendous growth in the private equity marketplace. However, investors need to do their due diligence, as the dispersion of returns among private credit managers can be high.
At the lower end of the private debt risk spectrum, non-conventional mortgages also provide an attractive return given they are secured by revenue-producing real estate, and terms to maturity are relatively short, typically under five years. Also, an option in the private market yield space is an investment in infrastructure. It is an equity investment, but like preferred shares, is an income-oriented strategy and could be used as an alternative to fixed income.
High risk equals a high reward for equities.
Turning to the world of equities, the potential for returns increase, and so do the risks. Starting with Private Equity, the trade-offs are similar to that of Private Debt. Attractive risk-adjusted returns have drawn large capital flows into Private Equity. Though similar to Private Debt, manager skill is paramount in getting good results as the dispersion of returns in Private Equity are very high. As with all asset classes, valuations have also increased, with Bain & Company reporting over 60% of U.S. buyout deals in 2020 had an EV/EBITDA purchase price of over 11 times. While we consider Real Estate to be a separate asset class, it also shares many of the same attributes as Private Equity, though generally at the lower end of the risk spectrum.
As for public equities, U.S. stocks have been the clear leaders for almost 14 years, with the MSCI USA index outpacing the MSCI EAFE (Europe, Asia, Far East) index by 237% as of the end of June. Fearing the potential to miss out on a good thing, investors have pushed up the price of U.S. stocks such that on a price/sales ratio, American companies trade at nearly twice the value of the rest of the world. According to Citi Research, U.S. stock valuations are also the most expensive in the world based on a 10-year CAPE (Cyclically Adjusted Price Earnings) ratio.
U.S. stocks dominate, and not just by price.
Based on the MSCI All Country World Index, nearly 60% of globally traded public equities are American. In turn, the technology sector dominates the U.S. market, comprising nearly 28% of the S&P 500 (as of July 30) compared to only 9% of the MCSI EAFE index. Cyclical stocks and sectors are more heavily represented in ex-U.S. markets, especially industrial, financial, and materials. While the cyclical bias of EAFE markets may have worked against them in the past, near-term growth looks to be tilting in their favour, with 2021 and 2022 estimated MSCI EAFE earnings growth expected to outpace the S&P 500 in 2021 and 2022. Dividend yields are also superior, with the difference in dividend yields nearly one standard deviation above-average levels. International stocks are cheaper, growing earnings faster, and pay higher dividends. Looks good to us… What’s the catch?
Canadian stocks look attractive and are experiencing strong growth.
Canadian stocks also look attractive for many of the same reasons: dividend yields for the S&P/TSX index are higher than the S&P 500, and maybe more importantly, higher than 10-year bond yields. With the potential for those dividends to continue to grow and tax advantages for Canadian investors, Canadian stocks appear a better place to park money than corporate bonds, or even preferred shares at present.
Like EAFE stocks, the US S&P 500 has outpaced the Canadian S&P/TSX over the past 10 years, leaving Canadian stocks trading at a material discount to their U.S. counterparts on a 12-month forward P/E basis. This had been justified by superior earning growth south of the border, but the relative forward earnings per share ratio between U.S. and Canadian companies looks like it might be starting to roll over. Similar to EAFE markets, Canadian stocks are cheaper, pay higher dividends, and now might be starting to experience stronger earnings growth.
Is it time to sell U.S. stocks?
Thinking it’s time to sell U.S. stocks? Not so fast. The US market is very diverse, and while the broader market may not be as attractive as International or Canadian stocks, there are segments and sectors in the U.S. that compare very favourably. Value stocks, for example, have lagged growth stocks over the past couple of decades such that value stocks currently trade at a significant discount to growth, despite the fact earnings growth for S&P 500 Pure Value stocks are forecast by Scotiabank to out-grow S&P 500 Pure Growth stocks this year.
Value stocks have performed very well so far in 2021 and based on relative performance versus the S&P 500, the value appears to have closed the short-term performance gap with growth. Nonetheless, on a 10-year compound annual growth rate (CAGR), value still has a lot of catching up to do in order to close the gap, trailing growth by over 6% per year.
It’s much the same with small-cap stocks. U.S. small-cap stocks have underperformed large-cap since the financial crisis, but have recently shown signs of reversing the trend. Small-cap also trades at a significant discount to large caps. One thing to consider is that larger-cap stocks have historically exhibited more resiliency during recessions, with small-cap earnings falling much more sharply during the tech bubble and the global financial crisis.
Why is it so hard for active managers to beat their benchmarks?
The recent success of large-cap growth stocks is one of the reasons it has been so hard for active managers to beat their relative return benchmarks. Coming into 2021, active domestic U.S. equity managers hadn’t beaten the S&P 500 since 2013. As a result, passively managed mandates have gained a rising share of assets versus their active counterpart over the past decade, and according to Morningstar, managed nearly the same AUM as active by the end of 2020.
Outperformance for stock pickers looks more favourable in 2021, as the S&P 500 Equal Weight Index is beating both the S&P 500 market-cap-weighted index and the large-cap Russell 1000 index. A broader market rally is easier for active managers to outperform, a fact confirmed by Strategas, who recently reported nearly 46% of active managers were outperforming in 2021. A significant improvement from last year’s 27%, and the highest since 2009.
To expand on why it has been so hard for active managers to outperform, consider that at their peak last year, five stocks (Facebook, Amazon, Apple, Microsoft, and Alphabet) comprised 25% of the S&P 500.
While this is a staggeringly high concentration, the situation for active managers was compounded by the fact these 5 stocks returned 56% versus only 11% for the remaining 495 companies.
Basically, if you didn’t own these five names, or even owned them but were underweight, chances of beating the S&P 500 was an uphill battle. Consider the risk a manager must consider in making this decision. While these FAAMG names outperformed the S&P 500 by 32% in 2020, their Chinese equivalents, which up until recently were looking equally as strong, underperformed by 1%. So far in 2021, the gap has widened even more as the Chinese Communist Party has clamped down on Chinese internet companies. Something to consider, as anti-trust drums have started to beat louder and louder in the U.S. of late. These are great companies that have been able to maintain double-digit growth rates for far longer than most companies, but eventually, the index mean reverts.
In 2000, Microsoft, Cisco, GE, XOM, and Intel were the largest companies in the S&P 500, comprising 18% of the index. Today their combined weight is only 8%. Microsoft is the lone holdout in the top 5 list. The rest, like Cisco, have suffered a lost two decades of mean reversion.
One last area to cover before leaving equities: sustainable energy and climate change. This remains an attractive theme for markets and investors. While thematic funds can suffer from concertation risk, the growing sense we are reaching a tipping point regarding climate change is likely to increase the urgency around government-mandated de-carbonization of the global economy.
The solution for both climate change and the pandemic.
In many ways, the challenges provided by the pandemic provide an interesting comparison to climate change. Both require a global solution, with the developed world helping the developing world. We can’t just sit back in our own fortress and let the rest of the world burn, or get infected with new COVID-19 mutations.
Yet so far, this is exactly what we have been doing. Both climate change and the pandemic also require trust in science and quick action, despite the inconvenience and cost. Shutting down the global economy was not an easy decision, nor will be shifting away from readily available fossil fuels. Tragically, both the pandemic and climate change have also become politicized. If you are a Democrat, you are more likely to get vaccinated and believe in climate change. In contrast, if you are a Republican, you are skeptical about both. Up until now, the difference between COVID-19 and climate change has been the immediacy of dealing with COVID-19 versus the feeling we still have time to deal with climate change. Recent extreme weather events, like the record heat waves and wildfires hitting the Pacific Northwest, and flooding in Germany and China, raises the possibility that, like the pandemic, climate change progression is more exponential than linear and more immediate action is required.
It’s mid-August and Canada appears on the verge of the fourth wave of COVID-19 infections, at the same time Vancouver readies itself for its third heat wave of the summer. As for the performance of stocks focused on the alternative energy space, after delivering what can only be described as a spectacular, maybe even bubble-like, performance last year, the sector has experienced a more challenging environment so far in 2021, with many names currently trading in negative territory. Most of the correction took place earlier in the year, with recent performance trending higher, in line with many high growth stocks and sectors.
Precious metals perform best when the market isn’t cooperating.
The last asset class on our tour is alternative strategies, which include hedge funds and precious metals. It’s also one of the most controversial, given hedge fund strategies can be hard to get your head around and performance over the last decade has been disappointing. Longer-term relative performance versus the S&P 500 remains positive, but hedge funds have largely trailed the S&P 500 since the financial crisis. The last three years, however, have seen hedge funds deliver positive returns, helping drive investor flows back into hedge funds in the first half of 2021 to their highest level since 2015. Manager selection is key, with the disparity between the top and bottom decile of funds remaining consistently wide. The best manager provides the best returns, and unfortunately, they also charge the highest fees.
Precious metals provide an interesting complement to hedge funds in that both tend to perform best when markets aren’t cooperating. Gold is typically thought of as an inflation hedge, but this is really not the case. According to Strategas, when comparing annualized returns of gold versus inflation by decade, a definitive pattern fails to materialize.
Sometimes gold does well when inflation is high, sometimes it actually goes down. Gold tends to have a stronger relationship with the US dollar and interest rates, with one and three-month correlations with the greenback and 10-year treasury yields consistently negative over the past couple of years.
Nevertheless, the relationship we feel is most important for gold, is real interest rates, with gold typically moving higher as real rates decline. This has some obvious overlaps with bond yields and inflation, of course, and once all three are factored together, the relationship becomes more intuitive.
Gold is a store of value, as are risk-free Treasury bonds. If one can earn a positive real return from Treasury bonds, there is no reason to hold gold, which pays no yield. Though if real rates are negative, investors who hold Treasury bonds will see their purchasing power eroded. Gold has a long history of protecting purchasing power and serves as a superior alternative in these environments. Real interest rates can move lower by either inflation increasing, or nominal interest rates decreasing, or any combination of the two.
Inflation doesn’t need to be high for real rates to be negative if nominal interest rates are artificially held at low rates (also known as financial repression). Alternatively, even if nominal rates increase, real rates can decline if inflation increases more. Up until late 2018, even though inflation was flat, rising nominal rates drove real rates higher. Bad for gold.
Since nominal rates have been falling and inflation has generally been increasing, the result is real rates dropping well below zero. This should be a good environment for gold.
So where does this leave us?
How “harsh” is our current reality and is this as good as it’s going to get? Fixed income appears to face some headwinds, but equities, alternative strategies, and credit still appear to present attractive opportunities. Tune in next month as we look a little closer at potential risks and opportunities in the market, and the factors we believe will determine their fate. Spoiler alert! Like gold, interest rates and inflation will play a major role, as will fiscal and monetary policy. Apologies for the cliffhanger!
This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information presented here has been obtained from sources believed to be reliable, but not guaranteed. Nicola Wealth is registered as a Portfolio Manager, Exempt Market Dealer, and Investment Fund Manager with the required provincial securities commissions.