Market Insights: First Quarter Wrap-up

Market Update

We want to express our sincere hopes that you and your family are healthy and managing well during this difficult period. The first quarter of 2020 was unlike any we have seen in a very long time. In response to the pandemic and the social distancing and lockdown measures that have affected over one-third of the world’s population, global capital markets declined sharply. Energy prices also weakened significantly as a result of a price war between Russia and Saudi Arabia, further affecting the shares of energy companies and adding to the general atmosphere of anxiety in the markets. This was a stark contrast to the gains that investors had experienced in 2019 and the relatively calm nature of markets for an extended period. In fact, North American stock markets had reached all-time highs in February, on the heels of their strongest year since 2013. Expectations for a global mid-cycle recovery were on track, with green shoots appearing in global manufacturing indicators and a Phase 1 deal had been agreed upon by the US and China.

Then a major exogenous shock, a so-called ‘Black Swan’ event, occurred and North American stock markets were down at least 20% by the end of the first quarter, their worst quarterly performance in a dozen years. The decline occurred in an extremely rapid amount of time, with little discrimination of sector or geography, and with much of the decline occurring in overnight non-trading hours. The end result was a peak to trough decline of 37% and 34% for Canada and the US respectively. Government bonds benefited from investors moving to safe havens, and yields moved lower to all-time lows as prices rose. However, credit spreads widened to extreme levels, where corporate bonds were hit hard, regardless of the issuer, with even the highest investment grade bonds suffering. The FTSE Canada HYBrid Corporate Bond Index, which is well over 80% investment grade quality, was down over 5% and high yield bonds were down closer to 15% in aggregate. The Canadian dollar declined strongly (close to 9%) in value over the quarter, helping to mitigate losses for Canadians invested in U.S. markets. Meanwhile, safe-haven gold performed well with a 7% increase.

As businesses were ordered closed to help stem the spread of the virus, central banks around the world moved quickly to respond to the downturn with policies aimed at stabilizing the financial system, while the G7 countries announced that they would be willing to use “all appropriate policy tools” to provide economic support during the COVID-19 outbreak. Amidst surging unemployment numbers in both Canada and the U.S., the U.S. unveiled a US$2-trillion stimulus package (the largest in US history), while the Canadian government’s commitment to fiscal support reached C$176 billion. The U.S. Federal Reserve (Fed) made two emergency cuts to its policy rate, bringing it to a range of 0-0.25%, while The Bank of Canada made three rate cuts to reduce its overnight lending rate to 0.25%.

Provided the virus is transitory - perhaps contained in the second quarter - the global economy should be poised to rebound strongly in the second half of 2020. In the U.S., the government’s virus containment measures mean a technical recession - negative GDP growth in Q1 and Q2 - seems likely. Therefore, fiscal policy will be important in helping to offset the recession. The combination of unprecedented monetary and fiscal stimulus on top of last year’s global central-bank easing, in addition to the reduction in China-U.S. trade tensions, argues for a solid recovery when the virus threat recedes.

Milestone strategy and outlook

Certainly, this has been a very difficult period, and you may be anxious about your investments as well as your own health and the health of your loved ones. There are still many unknowns about the virus and the economic impact of the measures being taken to control it. However, it is at these times of great uncertainty that discipline and the ability to remove emotion from one’s financial decisions becomes an investor’s most valuable asset. We believe that your trust in us to oversee your investments objectively will prove beneficial as we come out of this correction. As history has demonstrated, markets have ultimately recovered from setbacks, large and small, before moving higher in the long run.

We can take comfort in the fact that the portfolios we have built together are diversified and constructed to withstand the market shocks we are currently experiencing. A well-diversified portfolio geared toward your financial goals and risk tolerance remains the best approach to dealing with volatility and offers one of the best opportunities to participate in the inevitable market recovery.

We will no doubt hear from all the long-term ‘perma-bear’ prognosticators right now; however, those same folks have been wrong-footed for the better part of a decade, and thus their claim of victory right now is a very misplaced one, and one from which you should look the other way. This is not indicative of a long-term investment process, one that we have developed and refined over time. How did these ‘bears’ arrive at their bear market conclusion? Because the S&P 500 dropped more than 20%? Are investors supposed to sell after a 20% decline, and thus by reciprocation buy after a 20% rise? This is absurd in our view, and not a strategy within a long-term process, one with which we will continue to follow through market cycles and adjust risk management according to a measurable diverse set of objective indicators, including market-driven, fundamental, technical, sentiment and economic cycle factors and characteristics.

From a long-term perspective, we want to reiterate our stance that we are still in the confines of a secular bull market that began in 2009, with recent times only challenging this view to some extent. As readers of our past commentaries, you will know that we believe we are in the middle innings of a secular bull market and this will be our view until the weight of evidence provided by markets, long-term economic data, market cycle characteristics, sentiment, and market internals prove otherwise. Until then, we remain in a more defensive posture for the time being. As we have been keeping clients informed through regular weekly market commentaries via email since early March, we have highlighted reasons to stay positive with an objective mindset. It is of the utmost importance to remember that one quarter is not how you measure wealth management, and that we must not make fear-based decisions during uncomfortable times during a long-term process. The result of those decisions is almost always a regrettable one.

The chart below demonstrates the importance of staying invested throughout downturns, and the risks of trying to time recoveries. While we may have shared this with you in the past, it illustrates the point so well that we believe it should be reiterated.

We would like to highlight one point we made in our recent weekly comments, that the correction we have experienced has been more likely an event-driven one, and less likely a secular or cyclical contraction. In all prior downturns going back to the 1800s, an extensive report done by Goldman Sachs demonstrates that event-driven downturns like present have on average been less severe in terms of drawdown, duration, and time to recover than structural or cyclical downturns. In addition, with the measures we have seen implemented globally from a fiscal and monetary perspective, more so than any point in history, we remain optimistic that we will get through this and perhaps even stronger on the other side. In addition, there were solid signs of recovery in global economic indicators prior to the virus situation escalating in China in February, and as you can see below, 2019 had seen the largest easing in monetary policy by global central banks since the 2008 financial crisis. This illustrates the diffusion index of over 32 countries’ central banks that calculates the percentage that raised rates over the last three months minus the percentage that have lowered rates, with the last observation being March 2020.

Source: Refinitiv Datastream, Russell Investments calculations.

That doesn’t mean that risk management through tactical shifts of asset allocation are not important - we believe they are - and our discretionary mandates made some of these adjustments even prior to the downturn helping to cushion the recent decline. In addition, a rebalancing process among companies within our mandates, those with strong balance sheets and a consistent history of growing dividends, is also an added benefit of active management.

However, we should make note that our proprietary Milestone Recession Risk™ Composite was built as a long-term leading indicator of recession risk, and thus not able to forecast shock (‘black swan’) events. With our indicator turning to a defensive stance in late March, our asset allocation will continue to maintain the same defensive posture when opportunities arise to raise cash and when deploying new cash into markets. When we begin to see incremental improvements in our long-term composite, as well as short-term market movements and underlying breadth indicators, we will then gradually deploy cash back into markets as we progress through the current bottoming sequence. For those with cash on hand now, we believe that highly volatile periods over the coming weeks and months could prove to be one of the most opportune times to invest in many years. However, as this quote describes well, waiting for the ‘all clear’ signal may be the easiest solution, but ultimately in the past the best times to invest have proven to be the most uncomfortable.

“When we have such a wide range of potential outcomes, volatility will be high amidst the uncertainty. But by the time certainty returns, the opportunity will be gone” - David Barr, PenderFunds

We do not believe we are likely in store for a quick V-shaped recovery, but we also don’t necessarily expect extensively further lows well past the low we have already experienced. After a substantial correction, we believe bottoms are developed through a process of time, and patience will be rewarded to those who stick with the long-term investment process.

We would like to end with an interesting chart showing a composite contrarian indicator from Russell Investments that has consistently shown to peak at or near long-term lows of the S&P 500 over the past fifteen years, especially when it has hit a level of 3 or higher which it recently well exceeded. Their composite is comprised of a range of indicators, such as technical market measures, positioning signals and surveys of investors. Although we have not overlaid the S&P 500 on this chart, we will note that levels above 3 in this indicator have matched up very closely with long-term lows of the stock market.

Source: Russell Investments. Last observation March 12th

In closing, we would like to wish you and your family well during this unique time in all our lives.

Here is our Milestone Market Report on economic data, capital markets, commodities and currencies through April 3rd, 2020: (click image for PDF version)

Sources: Russell Investments, Goldman Sachs, CI Investments.