By Chhad Aul, Vice-President, Portfolio Management and Portfolio Manager, Sun Life Global Investments
With the market on a 15-month bull run, the risk/return trade off has become less attractive.
Highlights
Major indexes hit record highs
Oil prices surged from US$59 a barrel to nearly US$74
Canadian dollar climbed slightly from US$80 to US$0.80.72
Bipartisan $1.2 trillion infrastructure package announced
After spiking in March, yield on U.S. 10-year Treasuries retreated to 1.45%
U.S. Federal Reserve indicated that it might raise interest rates earlier than expected
At quarter end, 3.04 billion vaccine doses had been given globally
The market’s recovery from its COVID-19 selloff is starting to read like a three-act play. In the opening act, as the work-from-home trade kicked in, growth stocks led the market off the March, 2020 bottom. In the second act, with the economy opening up, value stocks took the market to new highs. Now, a less clear third act is coming into sight. On one side major markets are at all-time highs and valuations appear stretched. On the other, investors are focused on rising inflationary pressures, and the U.S. Federal Reserve appears willing to raise interest rates sooner than expected. And since those concerns came into view late in the quarter, markets have had difficulty pushing higher.
What will the outcome of the third act be? That remains to be seen. But with the market on a 15-month bull run, the risk/return trade off has become less attractive. And given the lack of catalyst to move the market higher, we expect returns to be range bound over the summer. As such, we reduced our equity overweight from 4% to 1.9% in Q2. Even so, we remain somewhat bullish longer term on the market overall, which continues to be supported by strong economic growth, solid earnings and the steady rollout of vaccinations.
Even against that positive backdrop, COVID -19 still poses a risk to the market as it continues to mutate. The more contagious Delta variant is now spreading rapidly in 98 countries. In Britain it accounts for 91% of new cases and is rapidly becoming the dominant strain in under-vaccinated U.S. states. We have yet to see whether its advance will slow attempts by countries to reopen their economies, particularly those where vaccinations have been limited by supply. If it does, it may have a negative follow through in the market and that is something we’re watching closely.
Taking profits on value, adding growth
Last September to take advantage of the reopening trade, we reduced our exposure to growth and started to overweight value stocks through a value factor ETF in the Sun Life Granite Tactical Completion Fund. We continued to hold the ETF in Q2, with value still outperforming growth. That said, at quarter end it appeared as if the easy money had been made in value stocks and we began to take some profits. But we still hold high-quality value names.
At the same time, we also continued to hold other sectors tied to the reopening trade, which also moved higher. This included financials and energy. Energy is one of the strongest sectors in the market, with benchmark oil prices more than doubling to the $US74-a-barrel range. Financials, which may benefit from higher interest rates, also rallied on the possibility that rates could rise in the second half of the year on inflation fears and stronger economic growth. We are also still overweight global mid-caps, which we believe could outperform larger companies.
Growth also came back onto our radar in Q2 when the yield on 10-year Treasuries spiked to 1.74% in the middle of March. This triggered a sell-off in the interest-rate-sensitive technology sector. However, given the earnings power of the tech titans, led by the so-called FAANG stocks, we did not expect these quality names to remain out of favor for long. Hence, we increased our weighting in growth and it now equals our exposure to value (Chart1). As well, we purchased call options that benefitted when yields retreated, and the tech-heavy Nasdaq climbed to new highs.
Chart 1: Growth bounces back in Q2
Source: Bloomberg. Data as of June 10, 2021
Bonds shrug off inflation – for now
At its last meeting in Q2, the Fed focused on the gathering strength of the U.S. economy. And it indicated that it could potentially raise interest rates twice in 2022, after earlier saying there would not be an increase until 2023. That caused the spread between 10- and 30-year bond yields to narrow dramatically, which normally occurs when the Fed raises interest rates. Rates at the short end of the yield curve anticipated an increase in the key Fed rate, but longer duration yields fell in anticipation of a tightening Fed slowing the economy.
As a result, the yield on benchmark U.S. 10-year Treasuries continued to captivate investors. As noted, after hitting 1.74% in March, yields retreated to around 1.45%. We believe yields will remain range bound but may ultimately grind higher as the year progresses.
For now, even though inflation indicators were running above the Fed’s target range, 10-year yields held to the 1.5% range before dipping lower in the first week of July. This perhaps suggests that the bond market is buying into Fed Chair Jerome Powell’s argument that inflation will be transitory and he will hold the line on interest rate increases. Or perhaps the bond market is telling us that economic growth will not be as strong as expected.
However, given the clear risk rising interest rates pose to bonds, we are underweight duration sensitive issues, including U.S. Treasuries and Canadian government bonds. Alternatively, we are overweight high yield corporate bonds, with a specific allocation to intermediate-term corporates (Chart 2).
Chart 2: Prefer credit risk to duration risk
Source: Macrobond. Data as of June 30 2021
Is the U.S. bull market over extended?
After rallying off the March bottom – one of the longest runs in history – most major equity indices are trading at or near record levels. For its part, the S&P 500 was up 15.3% for the year at quarter end, and the S&P TSX Composite Index was up 17.3% (Chart 3). While we believe the S&P 500 could still move higher in the second half of the year, the current rally appears to over extended. In response we dialed back our U.S. equity overweight to 1% at the end of Q2, from 1.6% in QI.
Our decision to reduce our U.S. weighting should not be interpreted as a negative call on the American economy. Indeed, the Conference Board forecasts that the U.S. economy will grow by 8.6% on an annualized basis in the second quarter of 2021. As well, monetary, and fiscal stimulus measures have flooded the U.S. economy with liquidity. Moreover, further fiscal stimulus may be on the way as a $1.2 trillion bi-partisan infrastructure renewal bill makes its way through the U.S. Congress.
The U.S. also added 850,000 jobs in June alone after recording slower than anticipated job growth earlier in the year. As well, household wealth grew by $850 billion as we entered Q2 to a record $136 trillion. U.S. consumers buoyed by their improving financial health (including steadily rising home prices) should help fuel a surge in economic growth in the second half of the year.
Still, a significant headwind remains, with nearly 7.4 million Americans still unemployed. This, even though the record number of U.S. job openings in Q2 almost matched the number of unemployed people. This could be because their skills are not needed in the areas of the economy that are now growing rapidly. Or it may be that ongoing government benefits paid to individuals to offset COVID-19 job losses are keeping people from returning to work. Regardless of the reason, Powell has repeatedly stated that returning the bulk of the unemployed to work is the key to extending the country’s economic recovery beyond its post-pandemic rebound.
Chart 3: Major equity markets hit record highs
Source: Bloomberg. Data as of June 30, 2021.
Canada: neutral but positive on the economy
We remained neutral on Canadian equities in Q2 and may reduce our position after the S&P/TSX Composite’s strong performance this year. Still, we are positive on the Canadian economy. It could get a comparatively stronger boost as it re-opens given that it has been locked down longer than many others. As well, like their American counterparts, Canadians consumers are well positioned to go on a spending spree when the economy fully opens. In fact, Statistics Canada calculates that Canadians amassed $212 billion last year in savings, versus $18 billion in 2019. That works out to $5,574 per Canadian on average in 2020, compared to just $479 in the previous year.
The Canadian economy also continues to benefit from a strong housing market and the surging demand for commodities, including oil and base metals like copper. As noted, the price of oil, has more than doubled. This should help the struggling Canadian energy sector, with benchmark Western Canadian Select selling in the US$65-a-barrel range. As well, if interest rates trend higher, as we suspect they will, we could see further gains in the Canadian financial sector.
A comparison between where U.S. stocks were valued late in the quarter with the S&P TSX/Composite Index also suggests room for further growth. The S&P 500 is trading at 21.4 times forward earnings, the highest level since the tech bubble burst in 2000. However, the S&P TSX/Composite Index trades at 17 times forward earnings. This amounts to a two-standard-deviation discount to the S&P 500 – the steepest since the tech wreck. However, given its weighting in energy, materials, and financials there is room for the TSX to potentially catch up if the global economic recovery stays on track (Chart 4).
Chart 4: Energy leads the S&P/TSX Composite higher
Source: Bloomberg. Data as of July 5, 2021
Emerging markets: growth but headwinds
Emerging market equities are now our largest overweight position at 1.7%, but we may trim our position back slightly. China, with the largest weighting in our benchmark, is primarily free of the virus and its economy has come back strongly. However, Beijing’s recent regulatory clampdown on China’s large technology companies could hurt the sector. As well, shipments from China could slow, as exports from rival emerging market countries pick up.
For now we believe the demand-driven growth were seeing in developed economies will continue to support growing exports from emerging markets. Indeed, the global Markit/JPMorgan Purchasing Managers’ Index (PMI) reported the strongest private-sector expansion in 15 years.
Still, there are potential headwinds facing emerging markets. Historically, when the Fed tightened, the U.S. dollar climbed in value and capital flowed out of emerging markets, As we’ve seen, interest rates have already jumped this year on inflation fears. And the greenback rallied higher when the Fed considered pulling forward its timing on interest rate hikes.
The response to COVID-19 has also been uneven in emerging markets. For example, 72% of people in developed markets are expected to be vaccinated by the end of the year. This compares to only 28% for those in emerging markets. This vaccine disparity could become increasingly problematic if the COVID-19 Delta variant or other mutations take hold in vulnerable emerging market countries, further delaying their reopening.
Europe: improving but trailing the U.S. recovery
The European economy is improving, but at slower pace than the U.S., with growth expected to come in at 4.2% in 2021. A slower rollout of vaccines compared to the U.S., has led to longer lockdowns and has been a major factor in holding back the recovery. At 6% of GDP there has also been less fiscal support for the Eurozone economy, compared with 14% in the U.S.
Still, there are signs that the European recovery is gaining ground. In fact, despite rising commodity prices and supply chain issues, European manufacturing (on rising export demand) has been robust. Indeed, business activity expanded at its fastest rate in 15 years in June with COVID-19 restrictions easing in many Eurozone countries. One key indicator, the IHS Markit’s Purchasing Managers’ Index jumped to 59.5 in June from May’s 57.1, its highest level since June 2006.
Investor sentiment was also positive, reaching its highest level since 2018. However, we continued to underweight international equities which comprise the smallest component of our equity weighting. But we will be looking for opportunities to invest in the coming months.
Outlook: reducing our equity overweight
Overall, we were overweight equities in Q2. Within our equity mix, we were overweight U.S. and emerging market equities and neutral on Canada and underweight international stocks.
Trimmed our overweight position in equites
Reduced our overweight position in U.S. equities and rotated to a more balanced value/growth bias.
Continued to hold a neutral weighting on Canada
Remained underweight MSCI EAFE equities.
Overweight, but may reduce our weighting in emerging market equites.
Moved to overweight position in high yield corporate bond
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 series of funds are positioned.
This article contains information in summary form for your convenience, published SLGI Asset Management Inc. Although this article has been prepared from sources believed to be reliable, SLGI Asset Management 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 SLGI Asset Management Inc. Please note, any future or forward looking statements contained in this article 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 article.
Chhad Aul, Vice-President, Portfolio Management and Portfolio Manager