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Apr 19, 2021

Q1 2021 Outlook Commentary

Though recent lockdown measures have come into effect across Canada, we view this as merely a detour on the gradual return to normal. Our Quarterly Outlook Commentary reflects this sense of optimism as we gain a greater understanding of what the new normal will look like — and when it may arrive.

In this commentary: 

Delayed Take-Off | Canada | U.S. |  International | Fixed Income 



Delayed Take-Off

Scott Blair, CFA
Chief Investment Officer


We’re usually excited to get to our destination, and the last thing we want to hear is that takeoff has been pushed back by a few hours. This kind of anticipation is analogous to our current situation in Canada. 

Vaccines are being distributed, the weather is getting nicer, we’re excited to get out of the house and back to our regular activities – but we’re now being told to wait little bit longer! At the time of writing this, Ontario is signaling a return to lockdown and BC is once again restricting indoor dining. Other jurisdictions, both here and abroad, are again looking to tighten up amid rising COVID-19 variant cases.

Although disappointing, we view this as a detour on the return to normal road – not something that’s taking us off course. 

We now have a template for what return to normal looks like, and that is Israel.

Well over half of the population of Israel is vaccinated. Once vaccination levels neared 40%, Israel saw a lasting drop in cases. That doesn’t mean the virus is gone today, but the waves and surges have stopped. 

During the recent Passover holiday, Israelis were permitted to gather in groups of 20 indoors and 50 outside. The UK is the only other major country with over 40% of the population to have received at least one dose of the COVID-19 vaccine. They too relaxed restrictions recently with groups of six allowed to meet outside, sports facilities reopening and the stay-at-home rule ending.

The U.S. should come close to a 40% vaccination rate in April. Most other developed nations have 10-15% of their population vaccinated (including Canada). For these countries, June is a reasonable goal for meaningful relief of restrictions. However, by increasing lockdowns now and targeting the most vulnerable populations for vaccinations, we could see significantly better days in May.

So what does all this mean for our economic recovery? We still see very strong economic growth ahead. In fact, we think this year’s growth will likely surprise to the upside. There’s enormous pent up demand, low interest rates and extremely high savings levels. It’s a powerful combination, with reopening being the catalyst to unleash the growth. We’re already seeing businesses anticipate the recovery, with Canada’s major airlines announcing a more normal summer schedule for instance.

Strong growth often brings talk of inflation and, of course, that’s a realistic fear and is getting a lot of media coverage. Undoubtedly, we’ll see pockets of inflation. Just as we saw shortages of some goods over the past year because we all demanded the same  stay-at-home products, we’ll likely see shortages again as our demands shift to the re-opening products and services.

Of course, businesses that were hurt the most from being locked down will also benefit the most from re-opening, and there should be strong demand for workers in these spaces which could lead to wage inflation. Although we don’t see runaway inflation anytime soon, we do think it will rise to more normal levels and could overshoot to the high side.

The past twelve months have been fantastic for major stock markets - many of which are up 40 or 50%. Though it’s highly unlikely that we’ll see 50% returns in the next twelve months, we are positive on the markets and see continued movement towards more economically-sensitive stocks like financials and industrials.

Over the past year, growth (stay-at-home tech names) performed well early in the pandemic. The spread between the S&P Growth and Value indices peaked in August, and began to narrow in November once the vaccines became a reality. The spread has continued to narrow in Value’s (more economically sensitive stocks) favour ever since (Figure 1). 


Figure 1: Growth of $100 – S&P Value vs. S&P Growth

Growth of $100 – S&P Value vs. S&P Growth


The second quarter of 2021 should be a transition quarter for Canada. Hopefully, one that sees easing of many restrictions as we move towards the summer. Think of it like the plane on the tarmac, starting to move slowly forward at first before accelerating into take-off.



Edward Friedman, CFA, MBA
Portfolio Manager


The first quarter brought about a level of mergers and acquisitions (M&A) activity that we have not seen in years. Among the activity announced were five major proposed deals that involve companies we hold in our portfolio.


What led to such a flurry of mergers? We believe that a confluence of several developments led to this:

  1. Low interest rates: All the deals involved significant amounts of debt or debt recycling.
  2. Post-COVID reality: The economic crisis led companies to focus on their core operations, or join forces with stronger players in order to adapt.
  3. Matching interests: Some of the deals have been contemplated for years, however interests of all parties eventually aligned.


A summary of the announced mergers follows: 

Alimentation Couche-Tard (ATD) and Carrefour

ATD agreed to acquire Carrefour for US$20 billion. The stock dropped 10% on the day of the announcement since this merger was to be fully financed with debt, and this would be the first time that ATD acquired a grocery business – which is an entirely new segment for the company. The deal was met with strong opposition from the French government due to concerns about food supply and employment. ATD consequently abandoned the merger talks.

Arc Resources and Seven Generations (7Gen)

Arc agreed to acquire 7Gen in an all-share deal under which the shareholders of each company will own 50% of the combined company. Production of the merged company will be 340,000 barrel of oil equivalent (BOE)/day, of which 58% is gas, 22% condensate and 20% oil and natural gas liquids (NGLs). The merger is expected to generate synergies of $110 million and though the combined debt will be higher than Arc’s target of 1-1.5x net debt to Fund from Operations (FFO), Arc is projected to get to the bottom of that range by the end of 2022.


We liked that the management will focus on free cash flow generation and, for the first time in years, capital allocation will include both dividends and share buybacks.

TFI International and UPS Freight

TFI agreed to buy UPS Freight from UPS for US$800 million, financed by debt. The stock was up 32% on the announcement. We like this deal for several reasons:

  • UPS freight was sold with no debt and no liabilities. UPS will bear responsibility for all prior pension and accident liabilities.
  • TFI expects to generate significant synergies by raising UPS freight margin from 1% to TFI’s level of roughly 12%.
  • The acquisition will give TFI access to more markets in the U.S. and enhance its scale there.

Rogers and Shaw

Rogers agreed to acquire Shaw for $26 billion, financed mostly by debt and a small portion with shares. The deal made a lot of sense to us since Shaw will give Rogers broadband and cable operations in the West, which are operations that Rogers does not currently have. It also makes sense to Shaw shareholders, as they’re receiving a premium of 70% on the pre-announcement price, and it will take off the risk of large capital investment in 5G. Rogers expects to generate $1 billion in synergies over two years and get its leverage to ~3.5x within three years.


The most significant risk to this merger is regulatory approval, as it’s expected to reduce mobile competition in the West. Rogers tried to sweeten the deal for regulators by committing to invest $1 billion in rural and Indigenous communities to improve connectivity, and invest $2.5 billion in expanded 5G network that will create 3,000 jobs.


The market gives the deal only about 60% chance of approval. We believe a deal will be done but it is likely that some assets, such as Shaw’s Freedom mobile network, may have to be sold before approval due to competitive reasons.

Canadian Pacific Railway (CP) and Kansas City Southern (KSU)

CP agreed to buy KSU for US$29 billion in cash and stock, including assumption of US$3.8 billion in KSU’s debt. CP will finance the deal with US$8.6 billion in debt and 44.5 million shares. When concluded, CP’s shareholders will own 75% of the combined company and KSU’s shareholders will own 25%. Leverage will increase to 4x, but management expects it to be cut to 2.5x in 2023. Management targets US$800 million in cost and revenues synergies.


This merger makes a lot of sense. CP has been trying to replicate Canadian National Railway’s (CN) network access to three oceans for years. This merger will give it this access plus access to the growing trade hubs of Mexico. 


Regulatory approval is expected by mid-2022, which is why the market gives this merger only 60% chance of approval. However, unlike in the Rogers deal where competition is expected to decline, competition here will remain the same since CP and KSU have only one connection point, and the expanded network will give clients more options for single-line freight. Management is also convinced that the deal will be approved.



Though the ATD-Carrefour merger did not go through, ATD’s shares dropped over 10%. After reviewing the valuation and judging the chances of deal approval as small, we increased our weight in ATD by 30 bps from 1.2% to 1.5% as we viewed the stock as undervalued.


TFI’s shares reflected half the benefits management is targeting. However, like with other acquisitions, there is a significant risk of execution. As such, we reduced our weight from 2.2% to 1.8%, taking advantage of the 32% share price increase.


We strongly support the CP-KSU merger and believe that management’s synergies are conservative, as the expanded network will allow CP to better compete with CN. CP made a lot of progress in gaining market share over the past few years after it appointed a Chief Marketing Officer. This deal will help increase CP’s network utilization. As such, we increased our weight in CP by 25 bps and reduced CN’s weight by the same. We plan to increase our weight further as opportunities arise.



Liliana Tzvetkova, CFA
Portfolio Manager


Saket Mundra, CFA, MBA
Portfolio Manager


The U.S. economy outperformed most developed markets in Q1 thanks to aggressive vaccination campaigns and additional fiscal support. The U.S. is ahead of most countries on the vaccination front and its fiscal policy has been more generous than elsewhere. Many states saw some form of easing in lockdown measures, and the $1.9 billion relief package signed into law on March 11 has already resulted in an uptick in consumer spending and confidence. Retail, dining, and hospitality businesses that have recently reopened saw significant increase in demand with restaurant occupancy getting closer to pre-pandemic levels.


Turning to the equity markets, the rally continued into 2021 with the S&P 500 up 5.8% (4.4% in CAD) in Q1. The rally that started a bit over a year ago has been extraordinary, and while stock participation was initially more focused in certain stocks and sectors (FANGs, Technology), we are now witnessing much broader equity participation. The rotation from defensives to cyclicals and from growth to value started last November, and continued throughout the first quarter. For the first time since 2016, we’ve seen a long stretch of value outperforming growth (to clarify, we’re only talking about six months).


All sectors finished in positive territory in Q1. Leading sectors were Energy, Financials, and Industrials – value sectors that underperformed for most of past year. The worst sectors were Defensives (Consumer Staples, Utilities and Health Care) and Technology. We saw a large increase in the U.S. 10-year government bond yields, and Energy and Commodities ex-Gold rallied.



We continue to expect a robust economic recovery throughout the year, barring any hiccups due to variant strains of COVID-19 or other external shocks. The Q4 earnings season was strong with earnings and sales both increasing 4% year over year (significantly higher than what was expected) with a large share of companies beating expectations.


Furthermore, comments from management teams were largely positive and supportive of strong growth. The market is expecting earnings per share (EPS) to grow 24% in 2021 and 15% in 2022. This bodes well for U.S. Equities and we expect stocks to do well, especially if the Fed stays put and does not increase interest rates, which is what they have telegraphed.


The rotation from defensives to cyclicals is not surprising considering these sectors will benefit the most as expansion advances. These sectors also lagged last year, and for some, even longer. 


We expect this rotation to continue with valuations remaining attractive. If the economic recovery proves to be stronger than anticipated, it will likely mean stronger earnings than expected for value/cyclical stocks which is positive for share prices. With a significant increase in long-term government yields, the yield curve has steepened, which is bullish for banks earnings and returns.


While we anticipate a strong 2021, there are always reasons for caution. We expect an inflation uptick in the near term due to strong pent-up demand, especially in certain areas such as services. Although our current expectation is that this will likely prove to be transient rather than a structural change, it might still have a short-term negative impact on equity markets.

On the vaccine front, if there’s anything we learned last year, it’s to not underestimate the virus. If more variants emerge and vaccines are less effective, growth might be less robust than forecasted.


The portfolio continues its gain against the benchmark as the rotation into value stocks strengthened. We also benefitted significantly as our thesis on a number of our holdings with idiosyncratic drivers came to fruition. We exited these idiosyncratic positions, such as GameStop, Coherent, and American Woodmark, as the price reached our estimate of fair value. Staying true to our process, we redeployed capital in a number of names where we found the risk/reward to be conducive.


We added to names such as Microsoft, Alphabet, Dollar General, Union Pacific, J.P. Morgan, Wells Fargo, Deere, CMC Materials, TJX and a few others. While different factors may work during different periods, we continue to follow our investment process by buying fundamentally strong businesses at lucrative prices and owning them over long periods. We believe this will lead to superior returns for the portfolio.



Ric Palombi, CFA
Director of Research


Monetary policy continues to impact market dynamics as it has over the past year and decade. Interest rates continue to hover around historically low levels. As global economies continue to recover from the COVID-19-induced recession, central bank monetary policies will continue to play a key role in the evolution of the overall and intra-market performance.


One of the biggest debates in the market right now relates to the relative outperformance of cyclical stocks compared to their defensive counterparts. Cyclical companies in Europe have outperformed defensive businesses by over 50%, from the lows in 2020 (Figure 2). This has handily outpaced the best relative performance for the cyclical group in most of recent history, which raises questions around the durability and sustainability of the rally.


Figure 2: European Cyclicals Outperforming Defensives

European Cyclicals Outperforming Defensives


Another topic that’s been prominent in the news is semiconductor shortages. Many different industries have been affected, with the most prominent being the Auto industry.

The unavailability of chips costing just tens of dollars each has held back the production of millions of vehicles costing tens of thousands
of dollars each.


The yield curve has steepened significantly in recent months as longer-term yields have risen, while short-term yields have remained low. Despite the steepening, yields are still below prior peaks. However, we believe there’s a real risk that yields will spike above previous levels as central banks have indicated a willingness to let inflation run hot as the economy heals. A steepening yield curve should be beneficial for cyclical companies and Europe, which is a pro-cyclical market (Figure 3).


Figure 3: Europe’s relative performance has tended to correlate with U.S. real yields

Europe’s relative performance has tended to correlate with U.S. real yields

In our view, an improving macro outlook and a higher inflationary regime should provide a material earnings boost for cyclical names, where earnings projections have not recovered to pre-pandemic levels.


Figure 4: European value stocks earnings estimates are 17% below pre-pandemic levels

European value stocks earnings estimates are 17% below pre-pandemic levels


To deal with the shortage of semiconductor manufacturing capacity, the market leader in the fabrication industry, Taiwan Semiconductor Manufacturing Company (TSMC), announced a massive US$28 billion capital expenditure plan. The scale surprised all industry observers. Similarly, Intel announced an upsizing of its capital expenditure for 2021 from $14 billion to $20 billion. The global shortage coupled with the dependency on just a handful of Asian manufacturers for critical semiconductors has also led to a push by U.S. and European governments to develop local manufacturing capacity.


Many more billions will be spent over the coming decade to build up global capacity. The R&D budgets in the industry are also impressive: TSMC will spend over $4 billion on R&D in 2021 alone. Of course, TSMC, Intel, or Samsung would not be spending these billions if they did not believe they could make attractive returns on these projects. The strong end-market demand for semiconductors, along with the demand for leading edge technology, has led to a gold rush in the industry. And as the expression goes: it often pays to be a shovel maker in a gold rush.



As mentioned earlier, a steepening yield curve environment should be beneficial for the financial sector, while an improving economic outlook should continue to provide an earnings recovery and boost for cyclical companies. The portfolio continues to maintain healthy exposure to these themes, while at the same time we’ve trimmed some of our heaviest cyclical names such as Sony, Prada, Maersk and Antofagasta to reflect their changing risk/reward profile following their stock price rallies.


Our portfolio has a healthy exposure to the sole shovel maker in the semis industry: ASML. ASML makes the $200 million bus-sized machines that use lasers to etch out the incredibly tiny transistors and circuits on each chip. Many years ago, our analysis had shown that ASML’s technological edge was so strong that it would eventually be the only vendor for lithography equipment. That has come to pass. With 100% market share and an incredibly strong forecast for spending by customers, ASML is well placed to continue its strong earnings growth profile over the coming decade. Thus, while the shares appear somewhat expensive when viewed in the near-term, the strong earnings growth means that the shares will continue to compound upwards in value over time.


Fixed Income

Ric Palombi, CFA
Director of Research


Simply stated, too many market participants still think the Fed’s reaction function is like it was pre 2020. It really isn’t. The move by the Fed to adopt an Average Inflation Target has changed the game.


Consider the following from the Fed’s last meeting: Real GDP projections were revised up for 2021 and 2022; its inflation target for 2021/2022/2023 is now at or above 2%; and the unemployment rate for 2022 is now at 3.9% (below the long-run equilibrium rate of 4%).


The conventional response to stronger-than-expected growth, coupled with steep declines in headline unemployment, would have steered monetary policy towards tightening (such as increasing rates) in anticipation of higher inflation. In fact, the bond market is pricing in a 25 bps rate hike at the start of 2023, and two more hikes of that size by the end of 2023. The thesis is that trillions of dollars in stimulus coupled with an accelerating vaccination campaign means front-end rates cannot stay this low without inflation spiraling out of control. Yet, there’s still no change in the Fed’s expectations for 2023, which means the Fed does not forecast raising interests rates in 2023. So, as our colleague, Edward Friedman, likes to say, “What gives?”


Fed policy makers have doubled and even tripled down on their stridently dovish stance. They indicated that a rise in core inflation above 2% in 2023 is not grounds alone for a rate hike because maximum unemployment is a key goal. Chairman Powell was adamant that the Fed will react to data and not forecasts when it comes to inflation, and will specify what “overshoot” means once inflation is above 2%.


So, we think the playbook for the Fed looks something like this:

playbook for the Fed


In our estimation, the implications for investors are enormous. First, the yield curve has definitely steepened but the curve is no where near historical levels of steepness (Figure 5). Given the Fed’s new policies, we believe the steepening should at least be at prior peak levels, but may continue well beyond. This implies a normalization of interest rates higher than what is currently being discounted by the market.


10-2 year yield curve and recessions


As we stated, the conventional policy response reflected in the bond market stands in stark contrast to the Fed’s unequivocal message. Will the market move towards the Fed or will the Fed shift its reaction function towards the market’s conventional thinking?


We are firmly in the former camp.


While the probability of this scenario playing out is high, the risk is that the Fed will put on the brakes too quickly and cut the economic cycle short. This would take the form of premature or more aggressive tapering of asset purchases and/or increases in the Fed Funds Rate more quickly than the market anticipates. Even in this scenario, however, our thesis does not break. It just plays out much more quickly as the economic cycle burns hotter, but shorter, than anticipated.



Recognizing what’s different in this economic cycle is critical for how we think about positioning our Diversified Fixed Income Pool. As the thesis of reopening economies, reflation and interest rate normalization continues to play out, we believe the best risk/reward for fixed income investors continues to be in inflation hedges. We’ve continued to add to floating rate corporate bonds and preferred shares, which directly benefit from interest rate normalization. Our exposure to these has generally buffeted the rise in interest rates by being much less interest-rate sensitive. They also provide a better income stream than government bonds, and have appreciated in value as corporate bond spreads continue to contract and interest rates normalize.