Q2 2021 - Market Review
ECONOMIC COMMENTARY
Buoyed by the prospect of a broad post-pandemic economic revival and corporate earnings recovery, global equity markets posted another strong quarter. As such, the MSCI All Countries World Index[1], S&P 500 Index and S&P TSX Composite Index rose 7.09%, 8.55% and 8.54%, respectively.
From a stylistic standpoint, we note that leadership pivoted decisively in favor of growth and quality stocks for the first time since the Pfizer vaccine news back in November. In fact, the MSCI World Quality Index and MSCI World Growth Index respectively advanced 10.87% and 9.93% while the MSCI World Value Index advanced a more modest 4.71%. This 180-degree turn was provoked by the belief that the Federal Reserve might raise rates sooner than was previously anticipated as inflation continues to accelerate, putting into question the commonly held view that current pressures are transitory. As a result, financials and energy stocks, which comprise a large portion of value indices, started to lag while industrial metals and agricultural commodities which typically benefit from higher inflation, sold off precipitously.
Separately, global fixed income markets, which were down significantly earlier in the year, enjoyed a modest recovery during the second quarter. For instance, the ICE Bank of America Merrill Lynch Global Government Bond Index gained 0.84% while ICE Bank of America Merrill Lynch Global Corporate & High Yield Index gained 2.42%. In Canada, the ICE Bank of America Canada Broad Market Index was up 1.80%, recovering a little more than 1/3rd of the losses recorded during the first quarter. Interestingly, the ICE Bank of America 1-3 year Government Bond Index was down a modest -0.06% as expectations of higher short term rates negatively impacted bonds with near term maturities. Some commentators were perplexed to witness higher inflation expectations being detrimental to short term bonds while longer term bonds remained unaffected. We suspect that the flattening of the yield curve (higher short term yields but lower long term yields) is driven by the renewed fear that Central Banks might raise interest rates prematurely and that this would quash growth over the longer term. As such, we do not believe that the decline in longer term rates is attributable to reallocation decisions by pension funds and insurance companies as some have argued.
INFLATION EXPECTATIONS UNDER SCRUTINY
The Canadian Consumer Price Index (“CPI”) increased by 3.6% in May 2021[2] relative to the same month last year while the US CPI increased by 5.0%[3] over the same period. Both figures have been trending up and exceeding expectations consistently, which may suggest that the normalization of the US monetary policy might occur before 2023 after all, notwithstanding the Federal Reserve’s official stance.
At the time of writing this, we do not share those views for the following reasons:
Firstly, excluding food and energy items whose price may vary wildly over short periods, CPI measures are almost 1% lower.
Secondly, a significant source of inflation since the onset of the pandemic has come from used passenger vehicles. Used car vehicles are more expensive due to the lack of new car inventory at dealerships. This is caused by the forced shutdown of car manufacturing plants as semiconductor manufacturers adjusted their foundries to produce chips for home computers and peripherals; since many who adopted a work from home schedule needed their equipment upgraded. We trust that this phenomenon is largely over.
Thirdly, clothing, footwear and furniture prices are also up significantly. However, according to the Congressional Budget Office[4], these price increases are directly linked to the August 2019 round of trade barriers and tariffs that President Trump erected against China, some of which could even be reversed by the Biden administration.
With that in mind, our base scenario remains intact and we do not think that a year from now, headline inflation will materially exceed the upper end of the range that could prompt the Federal Reserve to act. In fact, we are confident that before raising rates, the Federal Reserve is more likely to start reducing its massive monthly purchase of treasury bonds and agency mortgage back securities. Ironically, this would likely pressure longer term bonds more than it does short term bonds, which could cause the yield curve to steepen again. It is also worth noting that during the last cycle, the Federal Reserve did not start raising rates until late 2015, nearly 3 years after Chairman Ben Bernanke had signaled that it might do so. To summarize, we believe that Central Bankers are acutely aware of the dangers associated with a pre-emptive action to curb inflationary pressures at a time where employment remains elevated and long term deflationary pressures – resulting from high consumer, government indebtment levels and demographic trends – remain.
INVESTMENT SOLUTIONS FOR A STRUCTURAL LOW INVESTMENT INCOME WORLD
While we do not believe that interest rates are bound materially higher, we do not believe that they can move materially lower either. Yet at the current levels, expected returns are not particularly enticing and are more likely to surprise negatively than positively. This creates challenges from an asset allocation standpoint.
For this reason, we have actively sought alternatives to fixed income investments which could provide a combination of higher after-tax returns and lower risk of material negative performance in a rising rates environment. Through our analysis, we believe that the introduction of highly specialized hedge funds, which are designed to work irrespective of the market environment, may be suitable complements in our clients’ portfolios.
Our preference goes for more established global managers with an established track record and a demonstrated ability to operate a strategy with scale. However, such managers seldom have an investment vehicle available on Canadian soil and when they do, the commercial terms are too onerous of the required minimum investment level disqualifies the majority of investors.
Consequently, we are currently working on establishing our own fund to serve as a conduit for Patrimonica clients to access these strategies. The launch date of this investment vehicle is slated for Q4-2021. We are confident that it will help address the critical challenges created by the low fixed income yields that prevail.
* Please note that the information contained in the “Annual Income” and “Yield %” columns in the Portfolio Valuation section of this report is not available for the securities that are not exchange traded.
As such, the data contained in these columns underestimate the annual income in dollars and percentage when non-exchange-traded assets are held.
However, the information on the income generated by the portfolio is available on the second row of the table of the Change in Market Value section. These numbers are provided for the last quarter as well as on a year-to-date basis.
[1] Index returns refer to the net total return series in local currency terms, unless specified otherwise.
[2] Source: Statistiques Canada
[3] Source: Bureau of Labor Statistics
[4] January 2020 Report.