Last month we shared our Quarterly Outlook video series and addressed a number of questions from our clients. As promised, we are dedicating this blog to address one question in particular: “How are our investment pools positioned to perform if the recovery is long and slow”?
We do not try to predict the unpredictable. This is especially true when we consider the timing and pace of the economic recovery from COVID-19. Rather, we strive to best position our clients’ portfolios to endure over time. To get a sense of where we were and where we are today, Figure 1 shows early signs of an economic recovery already emerging.
Figure 1: Gross Domestic Product (GDP) vs Purchasers Manager Index (PMI)
The bars represent the quarter-over-quarter GDP growth of some of the world’s largest economies, namely the US, China and the EU. Overlaying that chart is the composite Purchaser Manager’s Index (or PMI) for each of those major economies.
The PMI is a monthly survey that polls senior executives on several factors that indicate their businesses’ overall health. This makes the index a leading indicator of future economic activity. After plummeting due to the pandemic in March, global PMIs have recovered and are beginning to signal better economic conditions ahead.
As world economies recover from the economic shock of COVID-19, we must remember that the US Federal Reserve (the Fed) is an enormous force and not one to be taken lightly. Therefore, when the Fed speaks, we must listen and interpret their words.
In the latest Federal Reserve meeting held on July 29th, Chairman Powell highlighted a few key points:
- Fed support is not going anywhere
First, Powell was definitive in his language and tone about his views on the Fed’s continuing support of the economy.
Our Take: “Not even thinking about thinking about raising rates” is the most aggressive forward guidance that the Fed can give markets. Simply, for investors it signals expansion of everything from liquidity, to credit, to earnings, to the economy and inevitably to risk assets.
- COVID-19 is a long-lasting disinflationary shock
Powell reiterated that the Fed views COVID-19 as a very large disinflationary shock to the global economy, leading to an inflation rate of close to just 1% for the foreseeable future. He further explained that the world was already experiencing disinflation prior to the pandemic, and that the demand destruction caused by this virus will make it even more difficult for the Fed to reach its 2% inflation target over the near term.
Our Take: Rates will be low and stimulus will continue indefinitely. For investors, this means a heavier tilt to risk assets (equities) as we continue this new economic cycle.
- Stimulus will not ease until full employment is back
Over the past three months, the US economy has seen the lowest unemployment rate in 50 years and the highest unemployment in 90 years (Figure 2). Powell noted that hardest hit by COVID-19 are workers in the service industry, with people making under $40k per year suffering the largest hits to their income. He also pointed out that minorities and women make up the bulk of the people in this workforce.
Figure 2: Unemployment Rate in the US (%)
Source: Trading Economics.
Powell reiterated that the Fed takes the issue of income disparity very seriously. He used this forum to remind us that throughout the decade-long economic expansion pre-COVID, it was only in the last two years (with the unemployment rate at 3.5%) that low-income and minority workers finally saw their wages increase and move towards some semblance of income equality. He also stated that even when at an unemployment rate of just 3.5%, the US had no wage or inflation pressures.
Our Take: In our estimation, there is a high probability that the Fed will not stop its continued economic support until the unemployment rate is back between 3 and 4% - a huge decline from its current levels and a movement which, as this past expansionary cycle has shown us, may take many years to achieve. The implication is that the economy will grow slower and lower but for longer and it means that we are probably just at the beginning of a new economic cycle where interest rates will remain low and monetary accommodation will remain high – prosperous conditions for the long-term investors.
We believe that in this environment, the best defense is a good offence. In other words, if the recovery is long and slow, we believe that investors should tilt their equity exposure to sectors that will benefit from a growing economy. In particular: Financials, Industrials, Consumer discretionary, and Technology.
Figure 3 highlights how our regional equity pools are positioned relative to their respective markets.
Figure 3: Equity Offense - Sector vs Benchmark Allocation (%)
Note: % allocation in gold represents an underweight position relative to the benchmark; % allocation in navy represents an overweight position.
On the fixed income side, the government bond market is looking extremely overbought, with 10-year bond yields just at 0.50% and 0.55% in Canada and the US, respectively.
We are seeing better value in corporate bonds and preferred shares, and have weighted our Diversified Fixed Income Pool (DFI) accordingly (Figure 4). The CWB M&P DFI Pool is generating a yield of 4.1% today – over six times the income of 10-year government bonds.
Figure 4: Fixed Offence – DFI Asset Allocation
This has been a year for the history books and we are only half-way through. We have witnessed the US unemployment rate fluctuate significantly, mirrored by the highs and lows of the market. As we make our way through the COVID-19 crisis and its effects on the markets, we will remain steadfast in our approach: exploiting inefficiencies in the market by uncovering and investing in quality companies that are currently mispriced, and being patient as we wait for their full value to be realized. While the ebb and flow of the economy and overall market are impossible to predict, adhering to a disciplined approach is the one constant we can control.