The public is looking for free lunches, and the political competition for votes makes the politicians offer them free lunches.
Robert Mundell (1932-2021)
After a year of COVID-19 life, a third wave of infections has begun in many countries, including Canada. Because vaccination campaigns have made significant progress, the number of deaths is not rising as fast as in previous waves even though the path of the pandemic remains challenging. While social mobility remains highly restrained in many countries, global economic activity has been stronger than expected, most notably in Canada and the U.S., and momentum is looking strong as we approach the summer, when a majority of the population should be vaccinated across large Western economies. This should allow for a broader range of industries to re-open, which should unleash some pent-up demand and bring workers back to work.
For investors, the normalization of life and re-opening of the economy, supported by massive fiscal support and cash-rich households, remain the driving themes supporting upbeat expectations for 2021 and 2022. The upcoming earnings season should broadly deliver strong results, especially in North America, which should help alleviate valuation concerns.
Global Markets: Breaking new highs, again
Global equities (MSCI ACWI, +2.7%) registered another decent positive month, again despite an abrupt rise in long-term interest rates and a third wave of COVID-19. Most developed equity markets posted strong performance, but the strength of the U.S. dollar narrowed some of the regional strength. Europe (Eurostoxx, +7.9%) was the strongest region, but a depreciating euro (-2.9%) versus the USD in March tainted that solid performance. U.S. (S&P 500, +4.4%) equities also did well, but the higher-valued segments, small-caps (Russell 2000, +1.0%) and Nasdaq 100 (+1.5%), lagged the broader market as rising rates pressured equity valuation. Meanwhile, Canadian (S&P TSX, +3.9%) equities benefited from strong performance in energy and financials. Japanese (Nikkei, +1.4%) stocks lagged global indices and the 3.8% depreciation of the Yen against the USD detracted performance further. Finally, emerging equities (MSCI EM, -1.5%) were a rare down in March, pulled lower by Chinese equities (MSCI China, -6.1%) as the momentum in growth expectations is topping.
Long-term interest rates in Canada and the U.S. continued to rise in March, ending a brutal quarter. The yield on Canada’s 10yr bond ended the month at 1.66%, bringing its quarterly rise to 88 basis points (bps), the sharpest since 1994. After a strong performance since November, oil prices retreated slightly to $59.16 barrel of oil (bbl) (from $61.50/bbl) as lingering COVID-19 cases are delaying the demand recovery while OPEC+ countries are approaching the end to supply curtailments. With the global economy not yet in synchronized mode, the strong U.S. economic performance, which is driving interest rates higher, has fueled a 2021 rebound for the U.S Dollar (DXY, +2.6%), but the gains are mostly versus low-yielding currencies such as the euro or Japanese yen, whereas the loonie (+1.4%) gained on improving growth expectations. Finally, the VIX volatility index ended the month below 20 (19.4%), a first since February 2020, as fear regarding COVID-19 and the macro outlook continue to improve on vaccine rollout.
Global Equity Factors: 2020 laggards extending their 2021 lead
As the global economy looks set to improve on synchronized growth, global equity factors that lagged in 2020 because of COVID-19 extended their lead in 2021 as the re-opening phase is accelerating in the U.S. High-Div (+6.2%) stocks led the way in March, followed by Value (+5%) and Low-Vol (+4.9%). For Low-Vol stocks, the March gain comes after a challenging start to the year (+1.2% ytd) whereas Value stocks are outperforming global equities (ytd +8.9% for Value vs +4.7% for ACWI). Small-cap (+3.3%) stocks also outperformed in March, but their momentum has slowed markedly in 2021 after a strong second half of 2020. Growth (+0.2%) stocks were flat in March and the quarter (+0.3%), whereas Momentum (-2.5%) stocks was the weakest equity factor as flows towards 2020 losers remained stronger.
After a tough start of the year, Canadian Low-Vol (BMO Canadian Low-Volatility Equity ETF, ticker: ZLB, +8.3%)* surged in March and outperformed the broad BMO S&P TSX index (ticker: ZCN, +4.0%)** as Canada’s tech champion, Shopify, fell 16.2% during the month and gave up its top ranking within the S&P TSX.
Canadian Housing: Real assets shine when central banks keep interest rates below inflation
As the pandemic continued into 2021, red hot home prices continued with it. Prices of single-family homes soared 22% year over year in February, eclipsing the highs last seen in 2017 as most regions across Canada are enjoying solid price momentum.
Condominium prices have been left in the dust, indicative of a structural shift in preferences from COVID-19, though prices have recently picked up. Although mortgage rates have risen 50bps from 2020 lows, they are about 75bps below year-ago levels, and 150bps below 2018 highs. So while the rise in rates may help contain demand, sales are likely to remain supported. Amid Canada’s continued lockdowns and slow vaccination rates, the higher-end luxury segment which has driven much of the price appreciation could continue to see tailwinds. On top of limited housing supply, part of the surge in prices can also be attributed to significantly higher replacement costs as building-material prices have soared because of strong demand and COVID-19 induced supply-chain disruptions.
Post-pandemic, a further albeit modest rise in rates and more normalized preferences as workers return to the office should help cool the exuberance later this year. Meanwhile, a recovery in jobs and population growth will be key to preventing any sharp slowdown, especially if housing supply remains tight. We think measures, such as taxation which fail to recognize the need for more housing supply, would only temporarily cool housing, as previous measures did. More importantly, policymakers should keep in mind that real assets like housing are well-positioned to benefit from a monetary policy that keeps financing costs near or below inflation. Finally, given that about two thirds of Canadian own their residence, Canada enjoys one of the highest home ownership rate in the world (Source: Canadian Mortgage Trends), which helps drive wealth effects as home prices rise.
Canadian Equity Outlook: Upgrading with a defensive twist
The Canadian economy surprised positively in recent months as households and businesses have benefited from one of the most aggressive COVID fiscal responses across G10 countries. The stronger than expected domestic backdrop, which helped drive recent bank earnings, has also benefited from the price rebound of key commodities such as oil, metals, and lumber. We are upgrading Canadian equities from a small underweight to a small overweight because we expect these tailwinds to persist at least until the end of 2021. We also think Canadian equities would outperform if commodity prices significantly fueled the global reflation tide and drove yields sharply higher in coming months. That gives Canadian equities a defensive tilt in case rising yields would become a headwind to equity valuation. This overweight is expressed against EAFE equities, where we think growth and earnings expectations remain too optimistic.
EM Equity Outlook: Strong, but peaking
Reopening efforts, rising vaccine uptake and U.S. fiscal stimulus (with attention shifting to Biden’s infrastructure plan) suggests that bond yields are likely to drift higher. Yet these factors also point to stronger growth and earnings, while concerns over inflation overheating risks may be overplayed. Rising rates coupled with stronger growth and a transitory pickup in inflation should not be a threat to EM, a region geared to global demand. That said, the pain threshold for EM equities is lower than that of the developed world, as some EM central banks are likely to be more reactive to inflation, while rising rates put greater pressure on fiscal balances, where interest payments absorb a larger share of revenue, particularly in Latin America and India (Source: Peterson Institute for International Economics). This can explain why EM earnings revisions have lagged since February. Between greater inflation uncertainty on the back or reopening and record stimulus as well as our more nuanced outlook for the dollar, we think EM equities are less likely to outperform after a strong streak since March 2020.
While tactically downgrading our EM equity exposure to neutral, we view EM as a strong strategic, long-term opportunity to capture strong growth fundamentals. China alongside the U.S. continue to drive growth in 2021, benefiting demand for EM exports. But what appears to be driving earnings revisions more is 2022 GDP expectations, helping to explain EM underperformance.
However, even accounting for growth revisions in 2022, growth expectations in the U.S., Canada and EM regions continue to outperform the structurally-growth impaired countries like Japan and the Euro Area. This suggests recent earnings revisions may not be the best signal for 2021 performance and beyond. Furthermore, structural trends associated with tech innovation will outlast reopening themes, and EM is a tech hub and home to a vast consumer base increasingly geared to digitization. For example, ecommerce in China is the fastest growing market at an expected 12.5% Compound Annual Growth Rate (CAGR) over the next four years (Source: Statista). Finally, we note that balance sheets are relatively sound in North Asia (80% of EM equities), assuaging fears over inflation and U.S. dollar strength.
Outlook and Positioning: Narrowing our focus to global equity overweight
As the global economy is widely expected to experience a period of strong, synchronized growth, global equity markets have largely risen in tandem in 2021. Although we continue to expect the U.S. economy to outperform the Euro area in 2021 as European economic activity remains severely restrained by COVID-19, the global reflation tide could continue to equally lift all markets. We maintain a moderate overweight to equities versus fixed income, but we are narrowing our regional tilts by upgrading Canadian equities to a small overweight against EAFE, while closing our U.S. and EM overweight. Our steady pro-risk stance maintains an overweight to Investment Grade (IG) corporate bonds to Federals. Finally, we reduced the duration of our equity-light portfolios while taking our duration to neutral in equity heavy portfolios to increase our pro-risk stance. For some portfolios, we also increased our exposures to U.S. small caps.
* The performance for (ZLB) for the period ended March 31st, 2021 is (as follows: 30.11% (1 Year); 9.01% (3 year); 8.54% (5 year); and 12.56% since inception (on October 21st, 2011).
**The performance for (ZCN) for the period ended March 31st, 2021 is (as follows: 44.22% (1 Year); 11.31% (3 year); 10.05% (5 year); 5.82% (10 year); and 7.50% since inception (on May 29th, 2009).
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