By Drummond Brodeur, Senior Vice-President and Global Strategist July 13, 2020
We are in full summertime mode, with temperatures soaring in many parts of the country, economic activity rebounding, the worst recession in a century behind us, businesses reopening post-COVID lockdown, and equity markets rallying with the Nasdaq up double-digits. Ahh, life is good! It’s summer and the living is easy. Everything is up and to the right. What could possibly be wrong with this picture?
Well for one, global COVID-19 infections continue to hit new records with way over a million new cases a week, led by the U.S. And while much excitement has been generated by the 7.5 million jobs created in the U.S. in May/June, that pales in comparison to the 20 million-plus jobs lost earlier in the pandemic. U.S. unemployment estimates range from the official 11.1% up to well north of 20% by other measures, with over 30 million individuals still receiving some form of unemployment insurance (UI).
That economies are improving should come as no surprise. We literally turned them off in March and began to reopen in May. As I wrote in my previous Quarterly Outlook amid the lockdown (see Investing in the eye of the COVID Storm):
“The economy has literally fallen off a cliff and is plunging to an unknown and unprecedented depth. It will bottom and rebound beginning on the day we start to reopen the economy. The initial bounce will be sharp and very much V-shaped, but there is no way we will see the overall level of GDP return to its pre-crisis level for quite some time.”
That forecast was not prescient; it was a pretty basic statement of the obvious. So I remain a tad perplexed at the degree of surprise and wonder expressed around the fact that as economies reopened activity has improved from the depths of the shutdown. It does not mean the economy is in good shape. The direction of the economy is improving, and the initial pace has been robust, so momentum looks good, but the absolute level of economic activity remains dire.
The best analogy I can think of for the recent and expected path of the economy is bungee jumping. You fall like a rock to an unprecedented depth, then as you reach the bottom the elastic pulls you sharply and initially rapidly upwards, creating V-shape trajectory. But after the initial surge, your momentum rolls over, the rise slows and comes to an end well below the
point from which you started. The economy has indeed bounced strongly out of a depressionary bottom, but we have landed in a recession. Without getting caught up in semantics, I would argue that rather than being in a recovery from a recession, we have just entered the recession and that the real pain of rising permanent layoffs, business closures and bankruptcies still lies ahead. The trajectory of the economy over the next 6-12 months remains highly uncertain.
Welcome to the recession The pandemic and economic lockdown were the catalysts that tipped the economy into recession. A pandemic is not part of an economic cycle, nor is a deliberate policy of shutting down the economy. The pandemic-induced downturn in the economy unfolded in literally a matter of days. For reference, the 2007/08 recession and subsequent crisis unfolded over a year and a half. That was a cyclical recession punctuated at the end by a financial crisis. Today we are dealing with a deliberate and sudden shutdown and reboot of the economy, not a cyclical downturn and recovery. Arguing this is just another economic cycle is a bit delusional. It is an exogenous shock, driven by a pandemic that has not yet run its course. It is by definition different this time and it is essential that we respect this elevated degree of uncertainty and focus as clearly as possible on both what we do, and what we do not know. From an investment perspective the known unknowns on the path forward are far more elevated than usual.
Key Word: UNCERTAINTY
One of the key words for investors to keep in mind today is uncertainty. The two key areas of elevated uncertainty that we need to pay attention to in deciphering the potential fundamental economic, business and market outcomes required to successfully navigate portfolios through the elevated macro uncertainty ahead are:
1) The virus 2) Policy responses.
Let’s look at each with a focus on identifying how various outcomes may alter investment decisions going forward. We will remain in a very volatile macroeconomic and investment environment. Active global investment management across asset allocation, sector allocation and security selection will be critical in both protecting capital and importantly, generating the income and required returns investors are looking for.
Uncertainty # 1: The virus A key source of uncertainty surrounds the behaviour and path of SARS-CoV-2 itself. There is much we still do not know about the virus, yet we are learning more every day about how it spreads, who is vulnerable, and what treatments may be effective. Ultimately, we will also develop a vaccine. There are already a few conclusions we can make with a high degree of certainty, the first of which is that the virus is not about to disappear anytime soon. The likelihood of a vaccine being developed, produced and distributed to billions of people is not a story for this year. With luck we should see progress in 2021, but for at least the next year we must learn to live with and manage the virus. Any hope that it would fade away over the summer or that it was an over-hyped concern has been well and truly put to rest with the escalating infections occurring in many U.S. states including Florida, Texas and Arizona. States that tried to ignore or downplay the severity of the virus, reopened too quickly and/or refused to put any sound health policy into place have seen the virus return with a vengeance. The U.S. serves as a useful reminder, if needed, to the rest of the developed world of how not to handle a pandemic. It has been a truly tragic display of gross public policy and leadership incompetence. Elsewhere, we are also seeing exponential infection rates in many emerging markets, including Brazil, India, Indonesia and South Africa, where the public health infrastructure is not equipped to handle a pandemic. Globally we continue to see new record levels of more than a million new infections every week ‒ a tragedy likely to continue to unfold in the coming year.
Within Signature we continue to monitor the virus and vaccine-related developments and have been well served from the beginning by Dr. Jeff Elliot, head of our health care team. With a scientific background and a PhD in molecular biology and biochemistry, Jeff has from day one of the unfolding covid crisis given us a clear scientific-based perspective in trying to understand the virus and likely trajectories. His assessment and analysis of likely outcomes pertaining to the pandemic have been and continue to be remarkably accurate and have been critical in guiding the entire Signature team in our investment decisions and outlooks.
It is important to emphasize that the persistence of the virus does not mean we cannot continue to reopen economies and return to many pre-COVID activities. Quite the opposite, we cannot afford not to get our economies back up and running. But we have to be health smart about how we do so. Physical distancing, facemasks and handwashing all help to curtail the spread, so just do it! Aggressive testing and tracing programs tell us where the virus is present, when it starts to spread and when to target it aggressively. We know the more vulnerable populations are very skewed to age and pre-existing conditions, so we need to identify and protect them with extra caution. We are learning every day which treatments can be effective
in reducing the severity of the virus. Together, these approaches can provide a framework for setting sound public health policies to reopen economies and get more people back to work.
But as the outbreaks in the U.S. show, if you take your eye off the ball, the virus will come back fast, and this does have economic and behavioural implications. Many businesses will only be able to operate at reduced capacity and many will not be able to reopen at all. Economic activity will be directly impacted. There will be significant alterations in consumer behaviour as people adjust their actions to reduce their perceived levels of risk.
Having been under effective house arrest since mid-March, as activities re-opened during May/June many of us just wanted to get back to normal routines, the gym, out to dinner, a bar, a show, an event, etc. Hoping that the coast was clear, and with reasonable precautions, it seemed safe to do so. Activity tracking measures shows this is exactly what occurred. But the U.S. experience is causing a very sombre reflection on the notion that we will be back to anything close to the pre-COVID normal anytime soon. Across economies, cautious consumers will choose to avoid crowded situations, including public transit, planes, stadiums and office towers, regardless of public policy. As virus breakouts occur, targeted lockdown measures will be part of the tool kit.
How much, and how persistent the changes in consumer and business behaviour will be remains unknown, but there will be significant economic and investment implications. It will influence both levels and pace of economic activity and the relative winners and losers within the economy, dependent on the choices consumers make going forward.
Uncertainty # 2: Policy
Monetary policy swan song The second critical aspect to deciphering the path forward will be the direction taken by policy makers. As the pandemic unfolded through March and April, unleashing widespread panic and chaos across economies and markets, there was an extraordinary policy response from both central banks and governments around the globe. Monetary and fiscal policy supports were rolled out in spectacular fashion, unleashing literally trillion of dollars to offset the adverse effects of the pandemic.
The monetary policy response was twofold. First; unleash massive liquidity facilities (quantitative easing) to ensure the reopening and continued functioning of capital markets. Become the de facto lender of last resort in all key markets to prevent the unfolding liquidity
crisis from morphing into a massive solvency crisis and unleashing a depressionary economic outcome. Kudos to the central banks – being the lender of last resort was a primary reason for creating them a century ago and they delivered. Capital markets and price discovery are critical components of a functioning economy.
Second; take interest rates directly to zero. At least North America went to zero; Japan and Europe were already there. Interest rates have been on a downward trajectory for 40 years, and Signature has argued for some time that record low government bond yields are the biggest nightmare facing most investors (see Modern Portfolio Theory: RIP). We always acknowledged that in the next major downturn there would be one last gasp to the 40-year bond bull market as the Fed moved aggressively to zero to head off deflationary risks. While we did not foresee that downturn and crisis being in 2020, as the pandemic unfolded, the policy response moving rates to zero unfolded exactly as expected and in very rapid fashion. As a side note, with government bonds now at the zero bound, they pay investors nothing, and no longer offer the same defensive non-correlation in portfolio construction. For many investors, from a portfolio construction perspective, government bonds have effectively become useless pieces of paper. Within our broad multi-asset portfolios we own as few government bonds as possible.
Hello fiscal!! With central banks now all in with rates at zero and QE ongoing, monetary policy is effectively DONE as an effective tool for economic management! From the fading hands of central bankers, the baton of economic policy management has passed well and truly over to fiscal policy. Back to those very politicians whose responsibility for sound fiscal policy management has largely been abdicated over the past decades. From here, monetary policy will largely play a supporting role in enabling fiscal measures to be funded. I’m not sure I feel too comfortable with this but that is where the developed world finds itself today, and for the coming decade. Stay tuned ‒ this is going to be interesting!
Within the U.S., the initial fiscal response was spectacular. Through the Coronavirus Aid, Relief, and Economic Security (CARES), Paycheck Protection Program (PPP) and other programs, the U.S. government unleashed between $2.5-$3 trillion in fiscal support to help cushion the blow to businesses and households who saw their incomes decline and, in many cases, go to zero. As businesses shut down and employees were sent home, furloughed or laid off, the risk of sending the economy into a depression was very real. The aim of the fiscal spending was to keep businesses and households solvent until the economy could reopen. In this sense the extraordinary sums spent, far from being inflationary, were designed merely to fill the hole, to bridge lost income and prevent a further cascading economic collapse. For now, these income
replacement policies have been effective, and the economy and consumers are holding up well relative to the degree of devastation unleashed. With the CARES Act sending $1,200 to everyone and a $600 per week top-up in UI, many low-income workers and families are making more money today than when they were working. But these programs are temporary, and the stimulus will fade rapidly in coming months. That is when the pain will begin to escalate.
Best analogy I’ve come up with to frame the crisis and response is to imagine you have had a massive heart attack (the pandemic) and your life has been shut down. You are wheeled directly into the operating room with no time for niceties (lockdown). They bring out the circular saw and cut you wide open to reach your heart ASAP. Luckily, they are on time. They fix things up inside, then wire and stitch you back up with what looks a zipper right down your front. Not pretty, but at least you are alive. They know you will be in extreme pain when you come to in the ICU, so they pump you full of morphine (stimulus) and maybe they overdo it a touch! When you wake up you feel fantastic and happy to be alive! You are ready to jump up and waltz out of there, feeling no pain. You have never been so high in your life! Things are great until the drugs begin to wear off. That is when you feel the pain. It has been delayed by all the stimulus pumping through your veins. That is what lies ahead for the economy. As the stimulus fades, the true pain will begin. We have recovered from the shock of the surgery and now the real recession begins.
When the hotel closed in the shutdown you were sent home, furloughed or temporarily unemployed. The business was still there, just temporarily closed. When things reopen, you get your job back and go back to work, as does everyone else. In Canada, you collected Canada Emergency Response Benefits (CERB) so your income held up and you were able to pay the rent, the bills and have food on the table. The bridge worked. But if the hotel’s business doesn’t come back, or only partly does it will have to cut costs and now you get laid off permanently. Many small businesses will be forced to shut down or go bankrupt as they cannot operate profitably at only 60% or 70% or even 90% capacity, depending on the business. These will be the scars that emerge in the coming quarters as the pandemic-induced recession unfolds.
Bouncing into a recession Normally, the direction of the economy and level of economic activity go hand in hand as we decline into a recession. Today, given the nature of the economic shutdown, we are literally bouncing into a recession. The direction is positive, but make no mistake, the current and ongoing level of economic activity in coming quarters will be well below pre-COVID levels. Businesses are only beginning to adjust to their post-COVID demand reality, and while there are
clearly both winners (demand enhancement – e.g. e-commerce) and losers (demand destruction – e.g. retail), the net outcome will be a recession with lower economic activity and elevated unemployment.
Fiscal taper Within the fiscal policy sphere, I mentioned the $2.5-$3 trillion already spent in the U.S., but as it fades there will be a severe economic hit this summer. The UI enhancement of $600/week that currently amounts to about $18 billion per week for more than 30 million individuals expires at the end of July and will be a big loss of support if not extended. We fully expect a fourth U.S. stimulus package will be passed to avert the current fiscal cliff, but critically do not expect it will amount to the same level of support as is currently available; we are entering a period of fiscal taper. The stimulus must be dialled back as the size of deficits are massive, but it will have implications. The size, timing and composition of further fiscal support measures will all have economic and market implications. So as with the virus, stay tuned to policy developments, (the U.S. election also ultimately falls under the policy umbrella, but we will leave that for discussion next quarter).
Key Word: ACCELERATION
Along with uncertainty, the second key word investors need pay attention to is acceleration. The global pandemic is having a significant impact across societies, economies, and markets. The post-COVID world we ultimately emerge into will be very different than the world we left behind in March. But for the most part, many of the key changes that I expect to be more permanent vs temporary will be those where existing or emerging trends see a significant acceleration as a result of the crisis. For investors and portfolio positioning there are four key trends that are likely to accelerate in the coming year and decade. They are:
1) The jump to ZERO 2) Slow growth 3) Geopolitical recession 4) Digital adoption/disruption
None of the four trends are new, but they all have significant implications for how you invest and build your portfolio going forward. Briefly on each:
Acceleration # 1: Jump to ZERO As I mentioned above, low interest rates have been the biggest headache for investors for many years and Signature has been at the forefront of both advocating for different approaches to constructing portfolios, particularly for investors looking to generate income, and in offering such solutions. Now, following 40 years of decline, interest rates are officially at ZERO in North America. The great bond bull market of the past four decades is well and truly over. It is Done! You simply cannot look at historical returns or patterns and expect a similar result going forward. A simple rule of thumb is that you can expect your 10-year return for investing in government bonds will be equal to the starting yield on the 10-year bond. Today that is roughly 50 basis points, or one half of one percent per year.
To put that in context, an investor looking to earn $30,000 a year by investing in a nice, safe Canadian government 10-year bond portfolio would need to have $6,000,000! If you are looking for income from your savings, that math does not work. Government bonds are no longer a suitable investment to generate income.
Simple rule of thumb: if you need/want income, invest in income-generating assets. It is not rocket science, but perversely does fly against just about everything we were taught about portfolio construction. Time for a rethink. There are no easy or perfectly safe options available, and this is the toughest investment environment in our lifetimes, but there are solutions. Income-generating assets can include credit (corporate bonds), real assets (real estate and infrastructure securities) and dividend-paying businesses with stable and growing cash flow generation. Signature has excelled at managing income solutions for two decades and both the Signature High Income Fund and Signature Diversified Yield Fund focus on generating income yields in the 5-6% range through investing in income-generating assets. Check them out. We also offer a full range of narrower asset class focused funds across both the credit and real assets markets.
Acceleration # 2: Geopolitical recession The second accelerating global trend is what I first wrote about a year ago (Winter is Coming: The Geopolitical Recession Begins Now). America First, U.S.-China trade, tech and capital wars, Brexit, China-India border war, defunding WTO, WHO, Paris Accord, TPP NAFTA etc. ‒ wherever you look, geopolitical tensions are on the rise. The post-World War hegemonic order established by the U.S. seven decades ago is being rapidly dismantled. At the core of the current geopolitical tensions is the rise of China as an economic, political, technology and military superpower to challenge the U.S. We have left the stability of a sole hegemonic superpower and entered a multi-polar world that will be dominated by great power
competition. How the U.S.-China relationship unfolds in the coming decade will be the most important geopolitical question of our time. Nothing is predetermined, but it will require great effort and skilled diplomacy beyond the recent random chaotic approach led by the U.S.
In a similar vein, the outcome of the upcoming U.S. election will be another step forward as the U.S. faces its most polarized society in decades and must ultimately choose how they wish their society and economy to evolve for the future. For way too many, the current status quo is not working. But that does not mean there are any better answers yet on the table. These are ultimately political choices that will unfold in the coming decade but have massive economic and investment implications. While all countries face varying degrees of similar challenges, as the global hegemonic power, choices made by the U.S. affect us all. Stay tuned.
Acceleration # 3: Slow growth The third global trend we expect to pick up pace is the ongoing deceleration of both global and developed economic growth. Global GDP growth has been sluggish for the past decade and we expect that to continue. Given demographic and structural issues, both Europe and Japan have growth potentials between 0 and 1%. Neither geography can be a driver for global growth. In the U.S., growth potential has been slowing and was already below 2% prior to the pandemic. I expect it will be closer to 1.5% going forward ‒ still positive, but not exciting and also weighed down by an aging population, exacerbated by recent anti-immigration policies and excess debt piling up to the sky. China has been the single largest engine of global growth for the past two decades and will continue to be so. But at a slower pace. They recently abandoned their 6% growth target and continue to shift toward focusing ongoing economic stimulus toward the quality, not quantity of economic growth. With no population growth China’s economic growth trajectory will continue to slow in the years ahead. As for the rest of the EM world, my fear is that the combination of rising global protectionism and the accelerating spread of COVID in many countries have set the stage for several economic collapses across the EM world in the next few years.
The net result will be slower global growth as countries wrestle with aging demographics and elevated debt burdens in the wake of the pandemic. For investors, finding growth opportunities will be more challenging with no broad global growth impulse lifting all boats. It will be akin to a zero-sum world with winners and losers. Companies that are well positioned for growth and demand enhancement (e.g. tech), will source their growth at the expense of other losing, or demand destruction, industries (e.g. retail).
Simple rule of thumb: If you want growth, invest in structurally growing industries and companies, and avoid those in structural decline or stagnation.
Acceleration # 4: Digital adoption/disruption Looking for growth brings me to the fourth acceleration trend and the one that will truly capture many of the exciting investment opportunities in the coming decade. That is the accelerated adoption and acceptance of technologically led behaviors and business practices. In effect, technology and software are disrupting traditional business models at an accelerating pace and will continue to do so in the coming decade. The roll out of 5G communications coupled with increasingly powerful artificial intelligence applications heralds the beginning of ubiquitous connectivity and the internet of everything. While those trends were already in progress, the pandemic and lockdown has illustrated the potential for disruptive bursts of acceleration. Two clear examples are in ecommerce and work from home (WFH) technology. As the pandemic forced the closure of bricks and mortar retail stores, consumers flocked online, accelerating the adoption of ecommerce by even the slowest of digital luddites. Instead of going to the liquor store, I can now press a few buttons on my phone and voila, a case of wine shows up at my door! This is fantastic. Indeed, investors in ecommerce platforms and ecosystems have seen spectacular returns of late as their businesses boomed. The offset, of course, has been an acceleration of traditional retailers shutting their doors. Once again, this trend was already well established but I expect we will see the adoption and disruption curve jump ahead by three years. For investors, tilting your portfolio toward the winners and getting out of the way of the acceleration in foreclosures by the disrupted is essential.
Conclusions We are in the most uncertain of times. The global pandemic is still accelerating, and unprecedented policy stimulus, funded by unimaginable debt burdens, has been unleashed. Tens of millions have lost their jobs with many only just learning how permanent the losses will be as business shutdowns begin to ramp in coming quarters. There has been a very significant disconnect between the fundamental economic outlook, its implications for corporate earnings and the strength of equity markets. To some degree this is supported by the collapse in interest rates to zero. Further digging into market behaviour also reveals a significant bifurcation, both in credit and equity markets. The winners and survivors are attracting rich valuations while the losers and the weakened are priced accordingly. While markets seem to be well ahead of themselves, they are also behaving in a rational manner, rewarding winners and punishing losers. Winners may prove to be too expensive and the losers too cheap, but market behaviour following the bounce in late March/April has not been indiscriminate.
As economic momentum fades, as dire Q2 earnings and outlooks roll in, and as people begin to contemplate potential election scenarios, I expect equity markets to pause and consolidate as they digest the extreme uncertainty ahead. The stability of the retail momentum-driven investor, who has been a part of the recent rally, remains untested in the face of a market correction and could drive elevated volatility.
My base case today would be for the S&P 500 to trade in a range between say the recent high around 3200 down to 2800 as the sugar highs from the exhilarating bounce off the bottom fade. Within Signature we remain defensive in our asset allocation, with a modest equity underweight and a maximum underweight in government bonds. In a zero rate, low growth world we want to take a barbell approach with our portfolios by increasing exposures to both structural income generators (credit and real assets) and to structural growth industries and companies, particularly around the broad technology and health care themes. We also believe in remaining active in our asset allocation and portfolio construction and being nimble in the face of both elevated uncertainty and acceleration. The near future will not look like the recent past. New thinking and common sense will be required!
Source: Bloomberg Finance L.P. and Signature Global Asset Management, as at July 10, 2020.
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