However, a coordinated response by central banks and politicians, the fact that past health scares while horrible and life changing have proven temporary, and the massive repricing of assets that has occurred over the last few weeks encourages us to maintain a moderately constructive outlook.

Economic growth disrupted by Covid-19

The recent decline in risk assets followed several quarters of financial-market gains amid stable economic growth, supported by improved financial conditions and central-bank stimulus. An assortment of geopolitical risks remain, but the sudden spread of the Covid-19 virus, closely followed by the collapse in oil prices are the main culprits disrupting economic growth and investor confidence. U.S. GDP recorded the steepest contraction since the last recession. The U.S. economy shrank in Q1 at its fastest pace since the last recession as the pandemic shut down large parts of the country, signaling the end of the longest economic expansion on record. Gross domestic product, the broadest measure of goods and services produced across the economy, contracted at a seasonally and inflation adjusted annual rate of 4.8% in the first three months, the Commerce Department said Wednesday. The GDP report reflected the early impact of widespread disruptions in the U.S. economy caused by business and school shutdowns, social distancing and other initiatives aimed at containing Covid-19 as reported by the Wall Street Journal. These responses to the pandemic started in the final weeks of the first quarter, and were an abrupt shift from steady economic activity before the virus arrived on U.S. shores. Forecasters expect a much larger contraction in Q2, producing the two consecutive quarters of decline that commonly define a recession. On a positive note, most economists expect a rebound in the second half of the year.

Where do we go from Here?

Macroeconomic risks escalate

Several geopolitical risks had faded near the end of 2019, including the U.S.-China trade dispute and Brexit uncertainty, creating a favourable environment for risk assets. However, a collection of new challenges has reversed this positive trend and increased uncertainty for economies and global financial markets. Most turbulent of all is the Covid-19 virus, whose negative impact continues to propagate through the economic system, disproportionately affecting the poorer emerging-market economies. The steep decline in the price of oil, while a near-term benefit to consumers, has directed investor’s attention to the vulnerability of energy and other sectors facing lower cash flows, especially where balance sheets have been significantly leveraged through the past decade. Tensions remain in relations between the U.S. and Iran, and the upcoming U.S. presidential election poses another potential source of volatility for markets. Overall, the macroeconomic risks facing investors are more severe than they were at any time since 2008.

Central banks provide additional stimulus

Central banks including those in Canada, the U.S. Australia and China have recently bolstered monetary accommodation by reducing interest rates on multiple occasions in a coordinated effort to combat the risks of Covid-19 to economic growth. While further monetary stimulus is expected, its implementation and effectiveness have become worrisome as policymakers continue to move rates toward zero. Some central banks have lowered rates into negative territory and the potential for unintended consequences from such unorthodox monetary policies is a concern. While fiscal spending is more cumbersome and takes longer to implement than rate cuts, governments may find that it is the next logical – and perhaps more effective – step for supporting economic growth.

The International Monetary Fund forecasts Canada’s economy to shrink by 6.2%. In the IMF’s world economic outlook (released April 14, 2020), it expects the global economy to contract by 3% this year, and suggests developed economies will decline by far more. Further, the IMF notes, if the pandemic worsens and lasts longer than expected, the economic damage will be even greater. While there is a 6.2% decline in the forecast for Canada in 2020, there is also a 4.2% rebound predicted in 2021- all based on the assumption that the pandemic does not get worse and fades away by the second half of this year. Similarly the report estimates a 5.8% rebound in 2021 for the world economy, after the initial decline this year. According to the Globe and Mail, the report also notes “there is extreme uncertainty around the global growth forecast” and “the economic fallout depends on the factors that interact in ways that are hard to predict.”

Expecting U.S.-dollar weakness ahead

Currency markets whipsawed on concerns that Covid-19 will have a detrimental impact on growth and push the global economy into a recession. Initial concerns led to a U.S. dollar rally in a safe haven scenario, but heavy flows into U.S. Treasuries changed the narrative for the dollar when it became obvious that the spread beyond China will lead the Fed to cut rates aggressively eroding the interest rate advantage the dollar held. This may be the last straw that was needed to resolve and accelerate the toppy dollar range to the downside. With these developments our confidence in calling the start of the new dollar cycle is increasing. When we consider valuations and the ability to benefit from global fiscal measures we expect the euro and Japanese yen to outperform the Canadian dollar and the pound.

Implications

Covid-19 outbreak shocks economy & markets, equity prices & bond yields plunge

• The COVID-19 virus outbreak represents a significant challenge to global economic activity. It impacts global supply chains, weighs on travel and deflates investor confidence. That said, as with past health scares (i.e. SARS, Swine Flu, Avian Flu, Ebola), we expect the economic shock to be short-lived. Importantly, daily new cases of the virus are in a declining trend in China and the local economy is gradually resuming full operation.
• Although the virus outbreak has likely taken centre stage in investors’ minds, other risks exist. The U.S. presidential election is now in full swing, Brexit is still evolving, and the U.S.-China trade negotiations continue, all presenting sources of potential uncertainty for the economy and financial markets.
• Sluggish growth and concerns of potential recession late last year caused most major central banks to deliver significant monetary stimulus. In particular, the Fed has now lowered interest rates 3 times in 2019 and 2 times in 2020 and has been buying treasuries at a pace last seen in 2008 financial crisis. In the fall of 2019, the ECB lowered interest rates further into negative territory and restarted its QE program buying 20 billion euros per month worth of bonds. Further interaction by the Bank of Canada & US FED is certainly around the corner.

For Equities Markets:

• Global equities sold off sharply in February/March, erasing earlier gains for the year as fear surrounding COVID-19 impacted investor confidence. Many major stock-market indices declined as much as 30%. Prior to the sell-off, investors were highly optimistic and valuations had become somewhat stretched based on certain measures. The latest correction has returned U.S. stocks an under valuation and equity markets elsewhere are at attractive levels.
• Valuation risk in equities has been reduced as a result of the latest sell off but the profit outlook is now highly uncertain. S&P 500 companies generate 30% of their sales and 40% of their earnings offshore. The damage to earnings will ultimately depend on how long the virus lingers and the breadth of its impact. Although a wider range of potential outcomes are possible in the near term, we believe the longer-term impact on corporate profits past pandemic look much brighter.

For Fixed Income Markets:

• Investors flocked to safe-haven assets as it became increasingly apparent the virus outbreak was causing real economic harm. The U.S. 10-year yield fell to a new record low and the yield curve, as measured by the spread between 3-month and 10-year maturities, has once again inverted, signaling the certainty of recession. In addition to near-term pressures from the virus outbreak, a number of structural factors (demographics, shifting savings versus spending preferences and slower economic growth) continue to depress real interest rates. Taking all of these into account, however, our models still suggest that bond yields are unsustainably low. Valuation risk in bonds is acute and, should economies avoid recession, the outlook for bond returns is especially unattractive.

For Asset Mix:

• We added back the one percentage point to our equity allocation and sourced the funds from fixed income. For a balanced, global investor, we currently recommend an asset mix of 59 percent equities (strategic neutral position: 55 percent) and 39 percent fixed income (strategic neutral position: 43 percent), with balance in cash.

How We Are Positioned To Take Advantage Of This Outlook:

Asset Class	BenchMark	Range	Last quarter	current recommendation
cash & Cash equivalents	5%	0-15%	1.0%	2.0%
Fixed income	40%	20-60%	40.0%	39.0%
total cash & fixed income	45%	30-60%	41.0%	41.0%
canadian equities	20%	10-30%	19.8%	19.6%
U.s. equities	20%	10-30%	20.9%	21.1%
international equities	15%	5-25%	18.3%	18.3%
total equities	55%	40-70%	59.0%	59.0%

Global Asset Mix:

Asset mix – capturing the equity risk premium

Our asset mix reflects the fact that economies are likely to continue growing over the longer term, though we recognize that the Covid-19 outbreak has delayed progress anywhere from two to four quarters. Prior to the outbreak, we had trimmed our equity allocation by one percentage point amid concerns of stretched valuations, excessive investor optimism and the fact that economies were stabilizing but not accelerating meaningfully. Since then, the valuation risk in stocks has diminished, especially outside of the U.S., and the plunge in bond yields has boosted the relative attractiveness of stocks versus bonds to its most appealing level in many years. As a result, we added back the one percentage point to our equity allocation and sourced the funds from fixed income. For a balanced, global investor, we currently recommend an asset mix of 59 percent equities (strategic neutral position: 55 percent) and 39 percent fixed income (strategic neutral position: 43 percent), with balance in cash.

Geographic allocations are as follows:

• Canada 19.6%
• United States 21.1%
• International 18.3%

Risk / Reward to our Strategy

Bond yields plunge to unsustainably low levels

In this environment of heightened uncertainty, investors have flocked to safe-haven government bonds, sending yields to historically low levels that are unlikely to be sustained. Even considering secular headwinds that are depressing real interest rates, our models suggest that the U.S. 10-year yield is well below our modeled estimate of equilibrium and represents significant valuation risk. While yields are being suppressed more recently due to the virus’s impact on investor confidence in a time of stress, we expect that investors will eventually demand a real, or after-inflation, return on their savings. For that to occur, yields would need to rise from current levels, leading to low or even negative returns for bonds.

Sharp sell-off in stocks reduces valuation risk

Global equities have declined sharply as the Covid-19 outbreak and the collapse in the oil price pose a new threat to corporate profits and damaged investor confidence. The S&P 500 Index has declined significantly from its record high, erasing solid gains from earlier in the year. Historically, market reaction to crisis events tend to be short-lived as long as the shock doesn’t cause sustained and meaningful harm to the economy. While the sell-off has lowered equity prices and alleviated valuation concerns, a lack of clarity surrounding corporate profits means a wide range of potential outcomes is possible. However, in the event that worst-case outcomes for the economy and highly leveraged companies are avoided, the recent sell-off in stocks could provide for attractive returns in equity markets.

Conclusion:

The Path Forward

It has been a very difficult couple of months with the well-being of our loved ones foremost in everyone’s minds. Much more than usual, there remains great investor uncertainty. We are paying close attention to markets and the underlying factors affecting the economic and earnings outlook. The economic news directly ahead will be unsettling but our forecast has the effects of the pandemic waning in the second half of the year, permitting investors to focus their attention on the prospects for a resumption of stronger growth in 2021.

How did we get here?

COVID-19 virus pandemic in China, stock markets in North America kept climbing. In mid-February share prices turned lower as worries mounted that Chinese lockdowns would disrupt supply chains into North America.

In March, the market downturn accelerated as outbreaks in Italy and Iran raised the prospect of a North American pandemic that would slow the economy to a much greater degree than any collateral damage from China. Ironically this realization was arriving just as China was restarting its economy, having brought the infection rate down to a much less threatening level.

Markets swooned because the outlook for the economy and corporate earnings has worsened swiftly over the past two months, precipitated by the spread of the COVID-19 virus and the collapse of oil prices.

Oil toil

First, the oil price situation. In March, Russia declined to participate in a proposed OPEC+ production cutback designed to shore up crude prices under pressure from excess end-product inventories and falling global demand.

Russia argued that previous production cuts had done no more than keep crude prices high enough to enable U.S. shale producers to fill the gap. Better to let prices fall far enough to force the shale drillers, many financed by debt and very few generating positive free cash flow, off the stage for good.

In an attempt to bring Russia back to the table, Saudi Arabia boosted its production by 2.5 million barrels per day, sending prices from the weak $40s down into the catastrophic $20s. That would normally put more discretionary disposable income into the hands of U.S. and Canadian consumers while stimulating more demand for gasoline. However, both effects have been largely offset by the fact that kilometres driven and discretionary spending are both weakening in response to the COVID-19 virus pandemic.

Russia, with a much lower all-in breakeven cost and a floating currency, may have more staying power. The June OPEC meeting looks like the earliest opportunity to resolve this dispute but our commodities team believes that may stretch out into the fall. Massive crude inventories, slashed energy company development budgets, industry bankruptcies – will take an even longer time to resolve.

The oil price collapse made lenders unwilling to extend credit to the energy sector – at a time when they have been backing away from lending to travel-related businesses among others, raising the spectre of a more widespread tightening of credit conditions, damaging global growth prospects further. Massive policy shifts by central banks have been designed to alleviate this pressure. Proposed government-backed loan guarantees could help further.

COVID-19 response

Which gets us to the COVID-19 virus. “Shutdown” and “Social distancing” intended to “flatten the curve” comes at great economic cost. The fiscal responses of the Canadian and U.S. governments are designed to put a floor under the second quarter by keeping consumers and businesses financially viable through the period of maximum economic constriction.

Implicit is the idea that infection rates and the number of daily new cases should be in decline in both countries well before that quarter ends, raising a realistic prospect of social and commercial conditions improving in the third quarter with a more pronounced rebound evident in the fourth. That is our expectation.

China was able to restart its economy within a few weeks of its infection rate (i.e., how many people one person with the virus is likely to infect) falling below one. South Korea, surprised by an explosive outbreak in late February, has pulled its “new daily cases” from close to 1,000 down to less than 100 in just a few weeks.

Any sign of slowing in Italy’s runaway outbreak as well as indications that “social distancing” was having a positive effect would be welcome and that appears to be happening.

In flux

The trajectory we are looking for – the number of cases peak in April/May, then recede in May/June and throughout the summer, is only one out of many potential outcomes. The “wishing and hoping” scenario –peaks sooner, recedes faster – seems unlikely to materialize. The “slower to peak and to recede” version would deepen the economic impact and likely produce a further round of government rescue/stimulus.

Two up legs to the pandemic, with the second beginning this fall and carrying into next spring, would not be unusual from an historical perspective – the Spanish Flu had three waves – raising the possibility

2021 might experience another period of economic contraction.

None of these scenarios, including our preferred one, can be said to be the obvious, odds-on favourite, leaving the outlook for the economy and earnings very much in flux in the short term.

The “value” of the market is the present value of all future earnings. Looked at that way, even big unexpected changes in the near-term earnings outlook shouldn’t have a large impact on the market value of corporations. But they usually do because, for a while, investors come to believe that the performance of the economy and market today are pointing to an altered trajectory for economic and earnings growth in the future.

Looking for positives

Looking back at a century of pandemics, wars, nuclear disasters and more, that sort of conclusion has not been useful. Within a year or two, the forces of global population growth and rising prosperity would reassert themselves and much before that stock markets would go back to capitalizing future earnings appropriately.

We find ourselves in a period of near-term uncertainty. The path the pandemic takes from here, and the success of the fiscal and financial measures taken to mitigate the damage, are largely unknown. Some economic data will arrive over the next few months that could produce more investor concern.

However, we expect some combination of an easing in the progress of the pandemic, together with signs the policy response is having the desired effect, will allow the market to regain its composure by permitting investors to focus on improving prospects for 2021.