Equity markets began the year with strong returns as the United States and China signed phase one of a new trade deal, global economic growth appeared to be stabilizing, and corporate earnings remained robust. However, toward the end of February, global equity markets sold off aggressively in response to COVID-19, the global pandemic that forced businesses around the world to shutter, schools to close, and unemployment rates to move significantly higher.
"The inability of central banks to normalize monetary policy after the financial crisis of 2008/2009 had, in our view, led to pockets of valuation risks in equity markets, making equities more susceptible to downside volatility."
The notable slowdown in economic activity was met with swift and decisive action from central banks around the world, including the U.S. Federal Reserve, which cut rates to close to zero. In addition, massive stimulus plans were announced globally to help backstop the economy and temper the massive economic disruption. As the quarter came to a close, equity markets recovered some of the losses from the sell-off, but investor sentiment remained decidedly negative as the virus continued to spread.
We’ve been concerned about global imbalances, high debt levels, low global economic growth rates, and persistently low inflation for some time. The inability of central banks to normalize monetary policy after the financial crisis of 2008/2009 had, in our view, led to pockets of valuation risks in equity markets, making equities more susceptible to downside volatility.
The Canadian equity market
The three pillars of Canada’s stock market—financials, energy, and materials—account for more than 55% of the S&P/TSX Composite Index.¹ All three sectors are influenced by macroeconomic factors and all three have faced challenges so far this year due to the slowdown in economic activity, the decline in commodity prices (with the exception of gold), and interest rates back to near zero.
We’ve become increasingly cautious about the banking sector since the beginning of the year due to concerns over rising provisions for credit losses, lower net interest margins, and an overleveraged Canadian consumer. While support announced by the Bank of Canada should help sustain liquidity levels within the sector, the lower interest-rate environment will put even more downward pressure on net interest margins.²
While some banks may have strong free cash flow at present, we expect this could decline due to their exposure to higher risk personal domestic lending, particularly if the economic outlook darkens further, which we believe has a high probability of occurring. We’re also concerned that banks with significant international operations could end up with disproportionately higher provisions for credit losses than their domestically focused peers.
Concerns about weak demand amid growing supply and increasing margin pressure from greenhouse gas-related expenses have tempered our views on the country’s energy sector since the beginning of the year. The COVID-19 outbreak hasn’t helped—fundamentals on the demand side have been deteriorating as stay-at-home policies are implemented and economic activity slowed to a trickle. Meanwhile, the supply side was disrupted by Saudi Arabia’s decision to ramp up oil production in response to Russia’s unwillingness to participate in further production cuts.³ Although OPEC+ did ultimately agree to production cuts, the damage was done—WTI oil prices fell from more than US$60/barrel at the beginning of the year to around US$25/barrel as of this writing, famously slipping into negative territory at one point.²
"We’ve always believed that it’s important to focus on companies with a history of strong free cash flow and cash returns within this space."
The materials sector is another cyclical area that’s prone to significant volatility. The sector consists of a number of subareas including base metals, precious metals, chemicals, forestry, and packaging. We’ve always believed that it’s important to focus on companies with a history of strong free cash flow and cash returns within this space. Currently, packaging and labeling companies are an example of an industry that meets that description, as these firms are less susceptible to commodity price changes. That said, we think there are interesting opportunities to be found, for example, in the gold space. Selectivity is key here—we managed to identify a firm within the space with an attractive risk/return profile and high free cash flow levels relative to its peers.
The road ahead
While there‘s little doubt that we’ve witnessed the end of the longest economic expansion cycle in U.S. history, coinciding with one of its longest equity bull markets, it’s important to remember that the starting point for both was the end of the last sharp correction in equity markets: the global financial crisis of 2008/2009. Then, as now, central banks responded with an unprecedented amount of monetary stimulus to keep financial markets operating. This time we’ve also seen supportive fiscal policy being introduced in North America, including the US$2 trillion stimulus bill passed by the U.S. Senate⁴ and the CAD$107 billion Economic Response Plan in Canada.⁵
Markets are forward-looking by nature and are attempting to discount a number of factors, not least of which is when the world will manage to slow the spread of COVID-19. The question at hand, as it was during the global financial crisis of 2008/2009, is when capital markets will move beyond discounting the economic damage brought about by the outbreak and begin to price in the eventual recovery.
It’s fair to say that the outlook for global markets—including Canadian equities—is uncertain at this juncture. As long as COVID-19 continues to disrupt the resumption of regular business activity, volatility will likely feature prominently in the financial markets. In periods like these, we believe it makes sense to continue to prioritize downside protection and focus on high-quality, well-run firms with strong free cash flow, particularly firms that can offer uncorrelated returns.
1 Bloomberg, April 2020. 2 Bank of Canada announces successful launch of standing term liquidity facility, Bank of Canada, March 30, 2020. 3 “OPEC and allies agree to historic oil production cut,” NBC News, April 13, 2020. 4 “Trump signs historic $2 trillion stimulus after Congress passes it Friday,” CNN, March 27, 2020. 5 “Parliament passes Ottawa’s $107 billion COVID-19 aid package,” CBC, March 25, 2020.
A widespread health crisis such as a global pandemic could cause substantial market volatility, exchange trading suspensions and closures, and affect portfolio performance. For example, the novel coronavirus disease (COVID-19) has resulted in significant disruptions to global business activity. The impact of a health crisis and other epidemics and pandemics that may arise in the future, could affect the global economy in ways that cannot necessarily be foreseen at the present time. A health crisis may exacerbate other preexisting political, social, and economic risks. Any such impact could adversely affect the portfolio’s performance, resulting in losses to your investment
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