Monthly Partner Memo – March 2021

Mar 01, 2021 | Paul Chapman


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With a semblance of normalcy returning to daily life just on the horizon, and the blessing of a few warmer and sunnier days of late, there is a glimmer of hope for many of us to be able to put groundhog day behind us.

Friends & Partners,

The main subject on everyone’s mind is yields screaming higher and talk of inflation, and how this impacts the outlook here. With bonds and many equities going down together, the scenario we’ve feared and expected is starting to play out. On cue, Warren Buffett wrote in his letter this weekend that “fixed-income investors worldwide – whether pension funds, insurance companies or retirees – face a bleak future”. This has been a core pillar of our key messaging, and focus of my recent event with Andrew McCreath: your traditional 60/40 portfolio that has worked well for the last 40 years is now looking perilous. I have stated in recent monthly notes, the following:

“A continued upward drift in yields remain the biggest risk to equities in my view, because as yields rise, multiples should fall because investors aren’t as willing to pay as much for expensively valued stocks… yields have the potential to up-end a positive outlook for stocks. And we want to make sure we are not blindsided by a spike in yields or inflation, because in that environment both stocks and bonds will decline, which is essentially the worst-case scenario for investors. So we position our portfolios and utilize investments that can work through these potential scenarios.”

We positioned for this in our portfolios, they are performing extremely well through this noise, and we expect them to continue to do so.

What’s Driving Yields Higher? And Some Stocks Lower?

The rise in the 10 year Treasury yield that has occurred over the past two weeks is coinciding with inflation expectations that are hitting multi-year highs. It has been compared to the “Taper Tantrum” of 2013, but there’s a key difference: surging yields are being driven by rising economic growth expectations this time around, and the Fed promises to remain very accommodative unlike in 2013. Bond yields are not spiking because the Fed is getting less dovish, they are spiking because the markets are anticipating a looming explosion in economic growth (Q1 2021 GDP growth is estimated at 9%!) and inflation (both of which are negative for bonds). And, that’s before we get an additional ~$2 trillion in additional stimulus.

Positive economic growth is good for corporate earnings and for stocks – if bond yields are moving higher in response to improving economic conditions, equities should fare well as this should coincide with stronger GDP and earnings growth. This is as long as yields don’t rise too quickly – which is the problem currently. Goldman Sachs noted that a two standard deviation move in Treasury yields in a month has historically caused equity market volatility, and we got that volatility on cue, hitting high-valuation tech stocks the hardest as we would expect.

The Current Outlook – Are We Really in a Bubble?

Let’s assess if we are in a bubble – or if there is simply a bubble in those calling this a bubble… The definition of a bubble may be when people are making money all out of proportion to their intelligence or work ethic. We have seen some pockets of this, but I’m not sure it’s rampant quite yet.

Higher bond yields on their own are not necessarily negative for equities, unless they rise too quickly. Looking at previous periods of rising Treasury yields, RBC and BMO found that equity markets have fared reasonably well, on average. When the U.S. 10-year Treasury yield increased by at least 100 basis points since 1960, the average price return of the S&P 500 during these past periods of rising bond yields is ~12%, while the average price return for the TSX Composite is even better at ~20%.

Expect the Fed to begin to address the rise in yields in the next few weeks, and if they do (as the ECB is starting to do), then we should see the rise in yields begin to moderate. However, if the Fed continues to ignore yields and merely continues its dovish reiterations and we see expectations for growth and inflation continue to build, expect the 10 year yield to keep rising, and for equities (especially tech) to continue to be weak near-term.

Both CSFB and JPMorgan made the call this week that we are NOT in a general equity market bubble at this point (yet) – I would tend to agree with this assessment. As I noted last month, there are certainly pockets of speculation, but I don’t expect that we are setting up for a protracted bear market. JPM notes that “we do not see a broad equity market bubble but rather certain pockets of the market that are experiencing hyper growth such as electric vehicles and renewables. While there is a lot of talk about bubbles, it is hard to see one in the broad equity market, where a dominant group (FANGs) practically hasn’t moved for 6 months despite massive amount of stimulus and an expected economic recovery, Financials that have barely recovered 2020 losses, and Energy that is still down 25% from last year despite a commodity bull market."

A Potential Replay of the Roaring 20’s??

There is certainly an argument that this is one of the most equity-friendly setups many of us has seen. The bullish argument for equities here would be as follows:

  1. Washington is moving forward with passing a large fiscal relief package.
  2. Fed has been vocal in policy stance and has indicated it will remain patient with inflation and rates moving higher.
  3. US economy is re-opening and economic momentum is strong. JPMorgan's Chief Economist ever goes so far to call that the US V-shape recovery will soon surpass China. 
  4. Fake news? Or just selective reporting? There remains a substantial perception gap between policymakers/media and COVID-19 realized data, and a closing of this gap is positive for risk assets.
  5. Millennials are at a spending inflection, and are steadily allocating assets toward equities as we know. Believe it or not, equities are seeing positive inflows in 2021 for the first time in 12 years.  Remember my data point in last month’s note: since 2008, 96% of the $3T in household savings went into bonds!
  6. Bonds are becoming less attractive total return vehicles as inflationary expectation are increasing, boosting the attractiveness of equities.
  7. Volatility (VIX) is steadily declining, and periods of declining volatility historically led to big equity gains, particularly for cyclicals.
  8. High yield and investment grade spreads are still stable, which is constructive for market structure.
  9. High household liquidity with record cash reserves (savings of ~$11.3 trillion).
  10. Potential wealth effect (~$124 trillion net worth) from rising asset values across home equity, stock market holdings and lower consumption (declined by ~$300bn in 2020).
  11. Healthy consumer balance sheet with debt service ratio at 40yr low, consumer leverage relative to disposable income at only ~9%, and historically low delinquency rates for consumer loans.
  12. Healing labor market with declining unemployment rate, rising average workweek, and potentially higher minimum wage.

Expect inflation to also continue to dominate the narrative in concert with yields moving upward. On this theme, commodities may continue to have a bright outlook – Goldman Sachs commodity analysts are bullish in part because of what they see as “structural underinvestment” in commodities, particularly in energy, following a decade of poor returns. While the energy-heavy S&P GSCI commodity index has rallied 66% from its April 2020 low, its total return has been negative 60% over the past 10years against a 263% total return for the S&P 500 index.

We’ve noted in prior months that the case for being cyclically-tilted is strengthening, which has been playing out recently and should continue to do so. These points support the continued positive outlook on this front:

 

  1. Vaccine rollout set to accelerate.
  2. US cases dropping quickly.
  3. US economy set to re-open
  4. US corporates reset cost structures = strong operating leverage.
  5. US credit markets strong = cost of capital falling.

 

Thoughts on Trying to Time the Market

I’ve taken a number of calls from those who are hesitant about deploying funds and investing in this market. I certainly understand that tentativeness, and keeping dry powder is never a bad idea (and particularly attractive today). However, to remain allocated largely to cash longer term is never a good idea.

Following is an excellent chart on this from my colleagues at RBC GAM – it shows a theoretical client who deployed funds over the last 30 years in 10 deployments into the S&P/TSX equity index, each at the absolute worst time - on the brink of the largest market pullbacks. This client STILL ended up with double the amount had they kept it in cash.

Also note that all-time highs are fairly common occurrences. Since 1950, the S&P 500 has reached an all-time high over 1,190 times, which is an average of just under 17 times per annum.

On the other hand, should we try to pick bottoms? Trying to pick a bottom is a mug’s game – on any given day, there’s a 4.5% chance that the market is at an all-time low that won’t be seen again. Using those numbers, we can conclude that investors have less than a one in 22 chance of perfectly timing a market bottom even once. The odds of timing the market on a consistent basis are astronomically low.

Still think you can time the market consistently? Try this fun online game and see how it goes for you!

But Shouldn’t I Simply Buy the Index (or a Basket of ETFs)?

This is another question I get fairly consistently. Over time, this strategy will result in capital growth. And it has worked fantastically well in the last decade – we’ve all seen the studies showing how difficult it’s been for active managers to outperform. But, I’m a proponent that this will change moving forward. To boot, it’s been happening recently, and I expect selected active management outperformance to continue. As stocks climbed in recent months, US stock participation in the market rally has broadened, expanding the universe of opportunities for active investors. As well, performance breadth has increased, and the dispersion of individual stock returns has increased. So, rising performance dispersion and decreasing correlations means a good manager can create ‘alpha’ (i.e. outperform). You want exposure to the best-in-class portfolio managers moving forward.

Bottom Line: The Risks, Our Positioning and Preparedness

So, what could go wrong? There are the two possible events of 1) a COVID variant resisting the vaccine or 2) some sort of surprise geopolitical drama. Both are unlikely at this point, but we need to be conscious of their potential.

Valuations are arguably high (cool charts on this subject are here), but are still attractive versus alternatives like bonds. The famous Buffett indicator shows that US equities total market cap is becoming big compared to nation's GDP. Currently it stands at 244%.

At this point, the imminent threat is simply that we get too much of a good thing. As we have said in the past, there is a reason that governments of major developed economies haven’t pegged rates to 0% for years, openly welcomed an increase in inflation and exploded debt and deficits to open a fire hose of money on the economy. Because that type of policy could breed: 1) speculation, 2) substantial inflation and 3) a disorderly rise in bond yields. AKA ‘overheating’.

So, the bottom line is that we want our partners to be aware that while the outlook is positive, it’s not an outlook without risks, and we will be watching and positioning for indicators of risk (Treasury yields, inflation expectations, signs of froth) very closely in the coming months if too much of a good thing becomes a material negative.

We continue to position for a continued rotation into cyclical and value names from the highly valued growth sectors, which we expect to continue. This rotation could restrain the absolute gains in the S&P 500 (due to the tech overweight in that index). This plays into the inflationary theme as well, and bodes well for Canadian stocks overall.

Wealth Management Alpha

In the most recent instalment of my "you don't know what you don't know" series, I discuss the matter of Wills, which is something that many of us kick the can down the road on. In many instances, a secondary Will should be put in place as well, which isn't as bad as it sounds...

A multiple Will strategy can save you significant taxes upon our passing, and is a simple strategy that many of us need to consider. Read more about this in my article here .