Fidelity to asset-allocation targets requires regular purchase of the out-of-favor and sale of the in-favor, demanding that investors exhibit out-of-the-mainstream, contrarian behavior.
David F. Swensen (1954-2021)
Between the stronger-than-expected U.S. economic data and earnings and reaching a +70% vaccination rate in the adult population by July, good news keeps coming regarding the health of the U.S. economy. Expectations continue to improve despite already looking strong. The global vaccination campaign remains uneven, led by the U.S. and U.K., with Canada’s pace at par with Europe, while Japan has barely begun mass inoculation. Overall, our expectations to see major economies re-opening this summer will be confirmed by further vaccination progress, even though some major economies might continue to enforce some COVID-19 restrictions, possibly on borders or mass-crowd events.
Global Markets: Higher highs
Global equities (MSCI ACWI, +4.4%) extended their gains in April with broad regional gains as the vaccination campaign allowed for the lifting of some health measures in several countries, with the U.S. and U.K. well ahead of other major Western economies on re-opening. The U.S regained its leadership last month, led by large caps (S&P 500, +5.3%) and tech (Nasdaq 100, + 5.9%) on strong earnings, whereas small caps (Russell 2000, + 2.1%) lagged after posting a strong performance (+100%) since the March 2020 lows. European equity markets lagged last month (Eurostoxx, +1.8%) as the region’s economic activity remains heavily restrained by the pandemic, but there too earnings have surprised to the upside. Japanese equities were soft again in April (Nikkei 225, -1.3%) as the vaccination campaign yet to get off the ground with less than 3% of the population vaccinated, compared to 44% of the U.S. population. Emerging Markets (EM) equities rose (MSCI EM, +2.5%), led by Taiwan (+6.9%) equities as semiconductor shortages are raising the outlook for the tech-heavy export island, which sources just over half of the world’s semiconductors. Finally, Canadian equities (S&P TSX, +2.4%) had a middle-of-the-pack performance despite a good performance from financials and energy.
After an awful first quarter, North American long-term interest rates stabilized in April. The yield on Canada’s 10yr bond ended the month at 1.55%, just a basis point below its March close. Inflationary pressures from commodities intensified in April, with oil prices rising to $63.58/barrels of oil (bbl) (from $59.16) as supply restrictions, coupled with the reopening of the economy, support higher prices. Lumber prices surged to $1500/per-thousand-board-feet (+48.7% m/m) in April alone. Back in February 2020, the price of lumber was only $400. The U.S. Dollar (DXY, -2.1%) softened broadly in April as U.S. interest rates stabilized while expectations for global growth kept improving. The loonie (+2.2%) benefited from the broad USD weakness and by a surprisingly optimistic Bank of Canada (BoC). Finally, the VIX volatility index fell slightly to 18.6% as the global economic outlook continues to improve.
Global Equity Factors: Tight range across styles
While 2020 saw a wide dispersion in style performance, equity styles have been running in a tighter group lately as the cyclical tide is lifting the broad equity market. Momentum (+6.1%), Growth (+5.8%) and Quality outperformed global equities (MSCI ACWI, +4.4%) by a small margin. Meanwhile, High-Div (+2.0%), Value (+3.0%) and Low-Vol (+3.0%) lagged global equities. Year-to-date, only Value (+12.2%) has outperformed global equities (+9.3%), whereas Low-Vol is the weakest style (+4.2%), which we think is due to the style having a lower sensitivity to the economic cycle, by contrast to Small-Caps, which are the most cyclical.
In contrast to their global peers, Canadian Low-Vol equities (BMO Canadian Low-Volatility Equity ETF, ticker: ZLB, +3.4%)* outperformed the broad BMO S&P TSX index (ticker: ZCN, +2.4%)** for a second consecutive month, even as the energy sector outperformed.
Growth vs Value: A look at long-term economic trends
The Growth/Value rotation is often debated in the context of the economic and market cycles, with an emphasis on interest rates given that Growth stocks are more sensitive to interest rate variations.
However, we think investors should look beyond noisy valuation metrics such as Price to Earnings Ratio (P/E) and instead consider the long-term economic forces at play. For over a decade, the transition from the Old to the New economy has seen the rise of large tech companies that now dominate the S&P 500. We proxy these disrupting companies by using the basket for FAANGMT stocks: Facebook, Apple, Amazon, Google/Alphabet, Microsoft, Netflix, and Tesla, which we think represent poster child companies of today’s new economy. To proxy the Old-economy champions, we use the top seven U.S. Value companies: Exxon, J.P. Morgan, Bank of America, Intel, Verizon, Disney, and Berkshire Hathaway. To illustrate how the New-economy champions have been eating a greater share of the economy since 2006, we compare the revenues of the two groups of champions and measure it against U.S. Gross Domestic Product (GDP). The image is striking: the largest U.S. Value companies have collectively failed to grow their revenues faster than the broad U.S. economy in recent years. Their economic weight in the U.S. economy fell by about 4 percentage points from their 2008 peak of 16%. Meanwhile, the New-economy, disruptive champions have boosted their share of revenues to GDP from 2% to 16% in a noncyclical fashion.
To call for a sustained, multi-year outperformance of Value vs Growth, or Value vs the broad equity market, Value companies will need to increase revenues at a faster pace than the broad economy. While P/E variations drive the bulk of the short-term volatility (less than 6 months) of stock prices, the long-term performance of equities is driven by profits and revenues. For mega-cap tech companies, the law of large numbers is making it increasingly difficult to realize double-digit revenue growth, but as the latest earning season showed, these tech champions are still reshaping the global economy, and they keep growing much faster than the broad economy and remain highly disruptive economic players.
Global Liquidity: Time to fear another taper tantrum?
“Major central banks have expanded their balance sheets by over 21% of GDP and tripled money supply growth to 18% y/y, a liquidity boon for equities. The strong economic recovery means that Quantitative Easing (QE) is likely to start slowing this year and next, opening the door to rate hikes.”- (Source: Bloomberg). In April, the BoC tapered its asset purchases, and investors expect the Fed to taper by early-2022. As we leave the state of economic emergency, central-bank balance sheets should be unwound, but we are a long way from that, especially given that the fiscal policy of major economies is expected to remain deep in deficit territory.
Because Canada’s yield curve is largely driven by the U.S. bond market and because it does not have to worry about spooking global financial markets, the BoC has more leeway to act early than the Fed or the ECB have. The BoC might even start unwinding its balance sheet by 2023, but testing the market’s appetite for government bonds could put some pressure on funding costs and derail the current fiscal scenarios which are based on low rates.
We think there will remain a substantial level of accommodation to allow for a strong economic recovery and support risk assets, especially as rate hikes are unlikely until 2022 at the earliest. Given the heavy debt load in the global economy, we also expect the pace of rate hikes to be slow and modest. Notably, despite ample liquidity and a rise in saving, the velocity of money is at extreme historical lows as bank lending remains anemic with weak credit demand versus the pile of cash sitting at U.S. banks. Excluding government guaranteed programs, bank lending in developed economies has even contracted over the past year. This tells us that current growth cycle is unlikely to unleash inflation, as growth in the money supply is not met by strong credit demand. Tapering will proceed cautiously as a result, especially for the Fed.
Still, tapering means less downward pressure on long-term interest rates as central banks become less of a marginal buyer. Together with an improving economy, short-term interest rates anchored near zero and significant bond issuance thanks to record fiscal stimulus, this sets up a strong case for a steeper yield curve, particularly in Canada. And if inflation fears prove overdone as we expect, real yields are likely to drive the recovery in interest rates. Notably, “shadow” interest rates—accounting for the impact of QE—remain deeply negative across The Group of Ten (G10) countries. One key catalyst for a move out of negative territory will be when the Fed starts signally its own taper, which could happen as soon as next quarter if the U.S. labour market heals quickly with the re-opening.
Outlook and Positioning: Riding the historical economic and earnings recovery
For fixed-income heavy investors, the economic and policy outlook for next 12-18 months remains quite challenging. For equities, however, the expected monetary tightening must be considered in the context of the upcoming strong, synchronized global growth. We also continue to expect central banks to err on the side of caution and keep policy more accommodative than perhaps they should. The ongoing re-opening in the U.S. and the U.K. will be a good indicator for how fast the service sector can normalize as COVID-19 restrictions are lifted. Our high conviction view on global equities vs fixed income is intact as earnings growth remains well supported. We are overweight to Canadian equities vs against Europe, Australasia, and the Middle East (EAFE) as inflationary pressures from commodity prices tends to broadly favour Canada vs EAFE countries. We have an overweight to U.S. small-caps as a play on the re-opening and fiscal policy. Finally, within fixed income, we remain overweight to IG corporate bonds to Federals while our fixed-income heavy portfolios are underweighting duration to reflect our risk-on stance and our bearish expectations for government bonds.
* The performance for (ZCN) for the period ended April 30th, 2021 is (as follows: 33.30% (1 Year); 10.42% (3 year); 9.78% (5 year); and 6.21% since inception (on May 29th, 2009).
**The performance for (ZLB) for the period ended April 30th, 2021 is (as follows: 27.54% (1 Year); 11.10% (3 year); 9.75% (5 year); and 12.84% since inception (on October 21st, 2011).
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