By Sadiq S. Adatia, Chief Investment Officer, Sun Life Global Investments
With so much uncertainty, we held to our cautious view on equities in Q2, remaining slightly underweight. However, within our equity mix we increased our overweight position in U.S. equities, and maintained our overweight exposure to emerging market equities.
Highlights
COVID-19 surges in U.S., continues to spread globally
Major indexes recover from Q1 selloff, S&P 500 up 20%
Bond yields flat after rallying off near-record lows
U.S. Federal Reserve broadly expands asset buy-backs
EU introduces US$826-billion stimulus program
Oil rallies on Saudi/Russia deal from US$22.74 a barrel to US$40
Canadian dollar climbs from US$0.71 to US$0.73
March ended with the S&P 500 in the grip of a bear market as COVID-19 spread and the U.S. economy crumbled, leaving nearly 23 million Americans unemployed. In Q2, the market soared on massive monetary and fiscal stimulus, with the S&P 500 gaining nearly 20% in its best quarter since 1998. This, even as COVID-19 cases were surging across the U.S., with nearly 15 million Americans still out of work. Investors, buoyed by stimulus spending, rising job numbers and hopes for a vaccine, appeared willing to look beyond this grim reality to a rapid economic recovery – something we believe is far from certain.
So far, the U.S. has failed to bring the epidemic under control to the same extent that Canada and Europe have (Chart 1). The number of new COVID-19 cases was trending down in the U.S., but as the economy began to reopen, it surged again. There are now nearly 50,000 new cases a day, with major states, including Texas and Florida, again locking down parts of their economy. In total, at quarter end the virus had infected 2,606,211 Americans, more than any other country. Elsewhere, COVID-19 was surging in Brazil, Mexico, India and Pakistan, with nearly 11 million cases worldwide on June 30.
Source: World Health Organization, Johns Hopkins University, Sun Life Global Investments. Data as of June 30, 2020.
As COVID-19 continues to spread, it has left many questions in its wake. Could we see a second wave of infections across the world this fall, forcing another, even more problematic economic lockdown? Will there be widespread bankruptcies and how deep will the hit to corporate earnings be? As well, could there be permanent structural changes in the economy, with large numbers of workers left behind?
The market is also watching the potential development of a vaccine and has rallied on positive news. But until one is developed, and circulated in billions of doses, the potential for COVID-19 to break out again and disrupt the market will continue.
Against this troubling backdrop, political tension between Washington and Beijing intensified as China pushes to take full control of Hong Kong. In addition, the American presidential election is just five months off and U.S. President Donald Trump’s poll numbers are sinking. The market may not react favourably to a possible Democratic victory, fearing a reversal of the president’s 8% corporate tax cut. Which, if repealed, could drastically reduce earnings-per-share forecasts for the S&P 500, at a time when COVID-19 is already biting into them.
Charting a cautious course in an uncertain market
Clearly, many investors are looking out to 2021 and betting on an end to the COVID-19 crisis. But there are a number of issues, beyond the pandemic that will affect the pace of the recovery. For starters, the massive amount of fiscal and monetary stimulus that has fuelled the market rally could begin to slow next year. Congress may then attempt rein in the country’s deficit spending with austerity measures. And instead of hiring, companies could cut workers in response to a drop in earnings. Given these issues, we expect increased market volatility in the months ahead with the S&P 500 possibly correcting at some point.
With so much uncertainty, we held to our cautious view on equities in Q2, remaining slightly underweight. However, within our equity mix we increased our overweight position in U.S. equities, and maintained our overweight exposure to emerging market equities.
The American economy was the world’s strongest heading into the crisis, with U.S. companies and consumers in better shape than those in many other countries. We feel it is still the strongest economy with the U.S. Federal Reserve broadening out its asset buyback program in Q2.
Moreover, both the government and the Fed have the ability to do even more. In fact, Congress may soon approve another $1 trillion stimulus program with direct payments to individuals. There could also still be a $1 trillion infrastructure-building program.
With massive stimulus support, and as the market rallied off its March lows, we had a bias toward large-cap U.S. growth stocks and active management. As Q2 progressed, we put some money into U.S. value stocks. This included adding call options on U.S. financials where we see long-term potential. We also bought call options on oil as the price rebounded.
With emerging markets recovering, we maintained our overweight position. Overall, we are concerned that some emerging market countries may have difficulty reopening their economies. Others, including Brazil and India, have seen a surge in COVID-19 cases. However, China (with the largest weighting in our benchmark) has largely contained the virus; its economy is improving and could be the first country to fully recover. That said, there could still be flare-ups in U.S./China tensions, triggering increased volatility, especially as we get closer to the U.S. election.
The European economy was struggling before we saw COVID-19 spread across the continent. The European Central Bank has less room to cut interest rates, but responded to the pandemic by expanding its quantitative-easing program. As well, the EU (after a protracted debate) finally agreed in May to introduce a US$826-billion economic rescue package. Now with the added stimulus, the EU economy reopening and the virus more contained, European equities could play catch up as growth improves. And we moved from underweight to neutral in EAFE equities, our most significant shift in weightings in Q2.
The Canadian market, hit by both the COVID-19 selloff and falling oil prices, was our largest underweight. Even before the pandemic hit, the Canadian economy was hardly robust, growing by just 0.9% in 2019. Household spending, a key driver of the economy, has been damped by the near record levels of debt Canadians hold and was further slowed by COVID-19. With low oil prices (almost 40% below their pre-crisis highs) also hurting the economy, we see little upside and increased our underweight position in Q2.
In fixed income, ultimately, yields could remain relatively low with central banks holding the line on interest rate increases until an economic recovery is fully rooted. However, as part of a longer-term strategy, we added to our weighting in high yield corporate bonds when spreads contracted significantly. And for the first time in its history, the U.S. Federal Reserve has intervened in the market to purchase high yield corporate bonds.
Markets claw back toward previous highs
In February, the S&P 500 was setting new record highs. As COVID-19 spread, the index started its rapid descent into a bear market, bottoming out on March 23, down 37.7% (Chart 2). But in its Q2 rally, the S&P 500 gained nearly 20%, its best second quarter since inception in 1957.
Chart 2: Major indexes rally as investors return
Major indexes rally as investors return
Source: Bloomberg. Data as of June 30, 2020.
The MSCI Emerging Market Index also rallied, finishing up 18.1%. Broadly, EM markets benefitted from slowly-improving growth in China. As well, there was a sharp rebound in a number of hard-hit markets, including India and South Korea. The MSCI World Index, rose 19.6% in the quarter, and the MSCI EAFE Index climbed 15.1%, with EU stimulus and the containment of COVID-19 in Europe giving a boost to equities. At home, the S&P/TSX Composite Index rose by 17.0% led higher by technology and materials stocks (Chart 3).
Chart 3: Technology and materials sectors lead S&P/TSX Composite higher
Source: Bloomberg. Data as of June 30, 2020.
Bond yields: largely flat in the quarter
U.S. 10-year Treasuries rallied at one point in the quarter but then retreated with yields largely flat at 0.66% at the end of Q2 compared to 0.7% in March. By comparison, Canadian 10-year bond yields fell from 0.71% on March 31 to 0.52% on June 30 (Chart 4).
We don’t believe a rise in yields would be sustainable. It predicates a quickly improving economy and a sharp rise in U.S. interest rates, which we don’t anticipate happening. Indeed, the Fed has indicated that may hold its key interest near their current rock-bottom range into the foreseeable future (Chart 4).
Chart 4: Bond yields retreat after rallying
Source: Bloomberg. Data as of June 30, 2020.
Don’t fight the Fed and the tidal wave of stimulus
On the fiscal side, at the end of May the International Monetary Fund (IMF) estimates that governments worldwide had spent US$9 trillion fighting the pandemic. This included a broad range of measures, such as direct support to individuals, public sector loans and equity injections.
On the monetary front, central banks (including the Bank of Canada) cut interest rates to effectively zero. Still others pushed interest rates into negative territory.
The Fed started its own battle against COVID-19 on March 2, with what in hindsight looks like a timid 0.5% rate cut. But the speed of virus’s spread and the quick unravelling of the U.S. economy forced the Fed’s hand again. On March 15, it cut its key rate by 1%, bringing the Fed rate down to effectively zero.
The market though, continued to tumble. On March 23, it was off by 33.7%, in what turned out to be the bottom of the bear market. Coincidently, on the same day, the Fed announced that its original asset purchases, which were to be capped at $700 billion, would now be unlimited in scope. This appeared to start bringing investors back into the market in a bullish mood. In fact, the S&P 500’s subsequent run-up from March 23 to June 8 was one of the biggest rallies in history.
However, the Fed wasn’t done on March 23, with the market rallying each time it rolled out a new program. Among those, on April 9 it announced a $2.3-trillion lending program that extended credit to banks, facilitating the purchase of up to $600 billion in loans. On the same day, it also introduced a $500-billion program to buy bonds from state and municipal governments.
The U.S.: a second wave of COVID-19?
From March to April, the pandemic wiped out 10-year’s worth of U.S. job gains, leaving 22 million Americans unemployed. The reopening of many states’ economies in May and June ushered the return millions of jobs, but not all of them. At quarter end, job losses totalled 14.6 million (Chart 5) and the number of COVID-19 cases was growing again in 35 states. Nearly 40% of Americans were facing renewed lockdown restrictions.
The IMF suggests the U.S. economy will contract by about 8% this year. The best-case scenario calls for a rapid, V-shaped recovery as the year progresses. However, the process could be much slower as the economy moves through what we believe will be more of a W-shaped recovery.
As noted, there are a number of issues that will impact the pace of the U.S. economic and market recovery. Key among those is what will happen when the huge amount of fiscal and monetary stimulus that has fuelled the market rally begins to wind down. The so-called deferral-cliff also looms. This will occur when mortgage and loan payments that were put off, come due later this year. At one point in Q2, three million Americans had deferred mortgage payments. It remains to be seen how many will be forced to default. But if widespread, it could have a direct impact on lenders and the housing market.
The wild card in the U.S. recovery is whether the current surge in COVID-19 cases can be contained. Earnings estimates for 2020 for the S&P 500 have fallen 22% since the beginning of the year, while 2021’s have declined 13%. However if not contained, with states like Texas and Florida in protracted lockdowns, it could push a full economic recovery further out, with negative implications for earnings.
Canada: in deeper trouble than the U.S.?
Like the U.S., Canadian investor sentiment improved with a stronger-than-expected jobs number. However, by many measures, U.S. economic fundamentals were stronger than Canada’s heading into the downturn.
For one, the Canadian economy was hit by both the COVID-19 selloff and falling oil prices and the IMF expects it to contract by 8.4% this year. Partly as a result, job losses in Canada were deeper than they were in the U.S. and a smaller percentage have been recovered (Chart 5). Further, consumer spending, accounts for nearly 60% of economic activity in Canada. But as noted Canadians, with near record personal debt levels, have little room to spend more and have actually increased savings. This suggests the economic recovery may be more drawn-out in Canada than the U.S.
Canada also faces its own deferral cliff. Over 500,000 Canadians have put off mortgage payments, representing nearly $1 billion in debt – 20% of the debt owed on credit cards and personal lines of credit has also been deferred. Ultimately, the extent of the defaults may bring more houses on to the market, putting pressure on housing prices, which we believe are over valued in some parts of the country. A softening in real estate prices would reduce the net wealth of many Canadians at time when COVID-19 is putting a drag consumer spending. It could also have a negative effect on Canadian banks, which are broadly exposed to the real estate market.
Low oil prices also complicate Canada’s recovery. Oil, which was trading around US$70 a barrel in January, fell to $12 a barrel in April before rebounding to US$40 a barrel. With the spread of COVID-19 devastating the global economy, we believe that oil prices could remain range-bound in months ahead.
Concerns about Canada’s overall economic health were also reflected in Fitch Ratings Inc.’s downgrade of Canada's credit rating to AA+ from AAA. It cited the pandemic’s impact on the government’s financial outlook, with Ottawa expected to run a $343.2 billion deficit this year.
Chart 5: Jobs returning but a long way to go
Sources: Statistics Canada, Trending Economics, Sun Life Global Investments. Data as of June 30, 2020.
China: First to recover from COVID-19
China, the first country to be hit by COVID-19, continued to recover in Q2. China’s purchasing managers index showed factory productivity climbing in Q2. As well, exports grew as Western economies started to reopen. And the country’s service sector benefited from an improving domestic economy.
The IMF forecasts that China’s GDP will grow by 1.2% in 2020, and jump to 9.2% in 2021. The IMF also predicts the Indian economy, the only other major economy it expects to grow this year, will expand by 1.9%. It also suggests that the so-called ASEAN-5 (Malaysia, Singapore, Thailand, Indonesia and the Philippines) will see only a slight drop in GDP in 2020.
However, we believe a number of emerging markets will struggle as COVID-19 continues to spread, and will have difficulty reopening their economies. That said, we favor China, where the virus is under control and the economy is well along the recovery path. In emerging market equities, we see strength in the Chinese technology sector.
Europe: gaining strength, welcoming tourists
The European Central Bank’s expanded quantitative-easing program and the EU’s US$826 billion economic stimulus program appear to have stabilized the European economy. This nascent recovery was captured in the European Purchasing Manager Index in Q2 when it rebounded faster than expected from the slump.
Forty five percent of Europe’s GDP is generated by trade within the EU and it slowly began to reopen its internal borders late in Q2. This is also a key factor in the recovery of the tourism industry, which accounts for about 10% of the EU economy. The EU also announced in late June that tourists from select countries, including Canada (and most notably, not the U.S.) would be allowed to visit this summer.
Still there are risks beyond the pandemic. For one, trade negotiations between Europe and the U.K. have stalled – again raising the possibility of a hard Brexit, with the accompanying economic dislocation.
However, European equities responded to improving investor sentiment, recovering some of the ground they lost in the bear market. With valuations more attractive than their U.S. counterparts, we believe European equities still have room to catch up, and we moved from underweight to neural. The EU rescue package also provides us with some downside protection.
Outlook: cautious on equities, buying high yield
Overall, we were slightly underweight equities in Q2. But within our equity mix, we were overweight U.S. and emerging market equities. In fixed income, as spreads contracted we added high yield corporate bonds.
Added to our overweight position in U.S. equities,
Increased underweight to Canada, with COVID-19 and low oil prices hurting the economy.
With the Eurozone economy improving moved from underweight to a neutral position in EAFE equities.
With China’s economy recovering, maintained our overweight position in emerging market equities
Canadian dollar rallied against the U.S. dollar, and expect it to trade in the US$0.73 range.
Reduced cash to add equities and high yield corporate bonds.
Overall, we will continue to manage risk in the short term while looking for longer-term opportunities. However, for now, we are comfortable with how the Sun Life Granite Managed Portfolios are positioned.
This commentary contains information in summary form for your convenience, published by Sun Life Global Investments (Canada) Inc. Although this commentary has been prepared from sources believed to be reliable, Sun Life Global Investments (Canada) Inc. cannot guarantee its accuracy or completeness and is intended to provide you with general information and should not be construed as providing specific individual financial, investment, tax, or legal advice. The views expressed are those of the author and not necessarily the opinions of Sun Life Global Investments (Canada) Inc. Please note, any future or forward looking statements contained in this commentary are speculative in nature and cannot be relied upon. There is no guarantee that these events will occur or in the manner speculated. Please speak with your professional advisors before acting on any information contained in this commentary.
© Sun Life Global Investments (Canada) Inc., 2020. Sun Life Global Investments (Canada) Inc. is a member of the Sun Life Financial group of companies.
Sadiq S. Adatia, Chief Investment Officer
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