Unprecedented monetary and fiscal stimulus, combined with signs of an economic recovery as lockdowns eased, triggered a rapid rebound in risk assets.

Largest and most abrupt shock to growth in modern history

The easily transmitted virus spread rapidly around the globe, infecting more than 6 million people. Although deaths and illness are certainly a tragedy, the biggest impact to global economies came from government-imposed lockdowns that shuttered businesses and curtailed consumer activity. As a result, we have slashed our growth forecasts over the past quarter, and they are now mostly below-consensus. Our base case outlook for the U.S. is for a 7.1% decline in 2020 GDP, though we recognize a variety of scenarios are possible based on the depth and duration of the shutdowns and the speed of the subsequent recovery. Relative growth expectations between global regions vary based on the severity of lockdown measures in place, the sector makeup of their economies, and country-specific vulnerabilities such as older populations.

Where do we go from Here?

Numerous risks as economies begin reopening and beyond

As countries ease lockdown measures, the most prominent risk is that the virus regains traction and forces economies into a second closure. In attempting to gauge which countries are most at risk of suffering a second wave of infections, we focus on variables such as the number of infections per capita, the rate of change in new cases, the strictness of the lockdowns and the degree to which they are being loosened. The pandemic’s longer-term repercussions include elevated debt levels that could hinder growth and lifestyle changes that could lower productivity. Inflation could also emerge as a concern once economies eventually recover. While the virus has dominated our thinking, there are other risks that are worth keeping in mind. The U.S. election in November, an important Brexit deadline and the deterioration of U.S.-China relations could all serve as sources of volatility for economies and financial markets.

Policymakers deliver record stimulus

Mandated lockdowns required governments to support workers who could not work and companies that were not allowed to operate. The fiscal stimulus provided has been massive and broad-based, spanning many countries and sectors, with provisions for households as well as businesses. In the U.S., the federal government delivered nearly US$3 trillion in financial aid, almost double the US$1.6 trillion doled out during the financial crisis of 2008-2009.

The U.S. Federal Reserve also supplied substantial relief on the monetary side, slashing short-term interest rates by 150 basis points in early March, and expanding its balance sheet by trillions of dollars to ensure the proper functioning of financial markets. Together, the U.S. fiscal and monetary programs have so far amounted to more than 35% of GDP.

U.S. dollar reverses gains from initial crisis-driven surge

The U.S. dollar ended a nine-year stretch of gains after the liquidity shortage experienced during the early days of the COVID-19 crisis led to what we believe was one final rally in the greenback’s lengthy bull market. The dollar’s subsequent weakness in late May and early June signaled that investors have begun to factor in its overvaluation as well as the country’s fiscal and monetary excesses. Shorter-term considerations, such as lower U.S. interest rates and election uncertainty, may also be weighing on the currency. The euro and yen are likely to benefit most during this initial phase of the U.S.-dollar decline, while we expect the Canadian dollar and British pound to lag. In the months to come, the performance of individual emerging-market currencies will depend largely on the evolution of the pandemic.

Implications

• Covid-19 has dealt an historic blow to the global economy. Leading indicators collapsed and unemployment surged as mass quarantine and lockdowns pushed the world into deep recession. Activity is now picking up alongside the easing of controls in regions that appear to have moved past the worst of the pandemic, but conditions remain severely depressed as governments, businesses and consumers seek to balance the desire for normalization against the still-considerable global health threat. We look for real global growth to shrink by 4.6% in 2020, below the current consensus, but for a symmetrically solid rebound to 6.3% growth in 2021. Massive slack in the economy has crushed the threat of inflation through the forecast horizon.

• It goes without saying that there is an unusual degree of forecast risk in the current environment as critical variables could move in several directions. The degree to which the pandemic recedes with or without a treatment or vaccine, the speed that economies reopen, and businesses’ ability to adjust their operations to accommodate the new environment and achieve past levels of profitability all cloud the future. More common but still-significant macro risks include US-China relations, the US Presidential election this fall and finishing the process of Britain exiting the EU. Added to the mix is the dramatic resurfacing of racial tensions in the US since the death of George Floyd. For all the uncertainty, we can be sure that 2020 will be remembered for enormous and fast moving events, and for durable changes that result.

• Fiscal and monetary authorities drew on lessons learned through the global financial crisis, with the speed and size of response first among these. In the US, the Federal Reserve Board reduced short-term interest rates to near-zero while expanding its asset purchases in both size and scope, pushing into corporate debt and even passive securities to ensure liquidity challenges did not morph into a solvency crisis. Working almost as quickly, Congress poured in over US$3 trillion in various aid programs targeted at business, workers, families and health care which, together with the monetary stimulus, sum to something like 35% of GDP. Similar fiscal and monetary programs in Canada, Britain and Europe appear to have stabilized near-term threats.

For Equities Markets:

• Equity markets crashed in late February/early March as the scale of the crisis became clear. At their troughs, the S&P 500 and the MSCI World Index had both tumbled 34% from their prior highs. As with credit markets, massive support programs and early signs that the crisis could be contained sparked a massive rally. Especially in the US where the tech-heavy index has recovered more than 2/3 of its losses, the V-shaped pattern has moved stocks well past valuation levels consistent with current and near-term corporate earnings prospects. Stock markets in most countries, though, remain below fair value and even in the US, should corporate profits approach normalized levels over the coming 12-24 months, further gains in equities are a possibility.

For Fixed Income Markets:

• In the US, T-bond yields plunged to only 31 basis points as safe haven buying came together with central bank yield suppression, pulling long-term interest rates to their lowest level in 150 years. Our models indicate significant valuation risk in US and developed world sovereign bonds, but near-term movement will likely be limited by central banks’ desire to sustain highly stimulative conditions as the economy seeks a solid footing. After initially convulsing as business conditions collapsed, credit markets rallied strongly on the back of government backstops put in place. Credit markets entered 2020 vulnerable to correction and the COVID-19 crisis sparked the event. After a massive widening followed by partial recovery, credit spreads now rest at attractive levels.

For Asset Mix:

• As with all crises that preceded COVID-19, we are confident that economies and corporate profits will eventually move beyond their prior peaks. In no way does that diminish the scale of suffering and disruption caused by the pandemic or its power to touch off significant and durable change in society and capital markets. As importantly, the crisis seems likely to reinforce trends already in place that will have major impacts on savers and investors. First among these is the massive reduction in the real rate of interest which now looks to stick near zero for a very long time into the future, likely bringing down nominal returns on all risk assets even if risk premiums do not change. Sovereign fixed income markets could be locked into low single digit coupons and returns for many years, reducing their utility as a risk modifier in multi asset portfolios and the income they provide. Investors will be challenged to find substitutes for the role played by fixed income through the past 40 years, although credit and private markets hold promise as a result of some combination of higher yields than sovereign fixed income, lower volatility than stocks and, frequently, correlations not perfectly tied to equity market indices. Modest additions to risk assets, including stocks, may make sense, especially for those with time horizons beyond a single business cycle.

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 – resetting strategic neutral asset mix in favour of stocks

The pandemic has reinforced many trends that were already in place before the virus, such as our world being stuck in an indefinite period of slow economic growth, low interest rates and highly accommodative central-bank policies. Other factors held constant, sustained low real interest rates suggest a long period of below long-term average returns lies ahead for the traditional asset classes. Our view is that stocks will provide superior returns, that results for sovereign bonds will be unappealing for an extended period and that sovereign bonds will not provide the income or risk-diversifying properties of the past 40 years. We are maintaining a modest overweight allocation to stocks given our view that stocks will outperform bonds over the longer term, but we have narrowed the degree of overweight given our modest return assumptions for equities and our below-consensus growth forecast. For a balanced, global investor, we currently recommend an asset mix of 59% equities and 39% fixed income, with the balance in cash.

Geographic allocations are as follows:

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

Risk / Reward to our Strategy

Sovereign-bond yields fall to record lows, held down by central banks

The U.S. 10-year Treasury yield fell to an all-time low of 31 basis points as investors sought safe havens and central banks ramped up bond buying. Government-bond yields are well below our modelled estimates of equilibrium indicating meaningful valuation risk in all major regions that we track. Over time, our models suggest that yields should ultimately rise from current levels, but large-scale quantitative-easing programs and highly accommodative central-bank policies will probably limit the extent to which that will happen in the near and intermediate terms. Nevertheless, the current low level of sovereign-bond yields is set to deliver unimpressive returns over our 1-year forecast horizon and possibly beyond. Corporate bonds offer higher yields and widening credit spreads caused by the crisis have boosted their return potential. We think exposure to credit, if properly managed, could serve as a useful avenue for enhancing portfolio yields.

Stock crash sent global equities into a bear market, but the panic was short-lived

Major market indexes fell more than 30% in a matter of weeks in February and March as volatility surged. The crash lowered our global equity composite to its largest discount to fair value since 2012, and a number of technical indicators reached values consistent with durable market bottoms. But the window of opportunity for outsized gains was brief. The S&P 500 Index has already recovered almost all of its losses, led by growth stocks and companies with highly predictable earnings. As a result, U.S. large-cap equities are back above our modelled estimate of fair value, suggesting investors should moderate their return expectations going forward. That said, non-U.S. markets remain attractively priced.

Corporate profits are being severely impacted by the COVID-19 crisis, but we think our measure of normalized earnings provides a better guidepost for what earnings could be under normal conditions, and it’s this measure that we use to determine fair value. The fact that investors are paying a high price for stocks today amid a recession may reflect confidence that a rebound in profits will accompany a recovery in the economy. Our scenario analysis suggests further upside for stocks is possible as long as investor confidence stays elevated, inflation and interest rates remain low, and earnings ultimately rebound to their long-term trend.

Conclusion:

The road to normal

Markets and the economy have both come a very long way in a short time. The year began with complacent expectations that 2020 would be another year of decent growth in GDP, corporate earnings and share prices. COVID-19 was thought to be a big problem for China but unlikely to produce a direct hit to North America and Europe.

Before February ended, the world had turned upside down: share prices had fallen massively, economies were shutting down and borders closing. Simultaneously, policy-makers undertook unbelievably huge monetary and fiscal stimulus efforts to head off a credit crunch and bridge finance the consumer and industrial economy.

By April, the number of new daily COVID-19 cases had peaked or was peaking and in some cases heading lower in the developed world. By May/June, the process of reopening many economies was under way.

Still a wildcard

Things are likely to go on changing quickly for some time yet. The virus itself continues to throw curveballs, any one of which might either reignite a surge in new cases or further stimulate the pace of economic recovery. Among the negative concerns:

Reopening of regional economies might reverse the downward trend in infections and send the number of new cases sharply higher once again. To some extent, that appears to have happened in places like Florida and Arizona, California, etc. If this proves a big enough threat, then closures and/or restrictions could be re-imposed, a blow to already-tentative consumer and business confidence.

On the science front, the eagerly awaited vaccine candidates already in trials might prove to be ineffective, dashing hopes for an early remedy. There are at least 135 vaccine candidates in development, of which seven are in Phase 1 trials, seven in Phase 2, and one in Phase 3. Phase 2 trials are where most vaccine candidates flounder. By one estimate, there is only a 30% chance that a prospective vaccine that makes it to Stage 2 will go on to be an approved, effective therapy.

There are also possibilities for COVID-19 virus developments to deliver upside volatility:

A vaccine or anti-viral therapy shown to kill the virus, and/or confer immunity, would likely deliver a big boost to equity prices.

The virus could weaken of its own accord. Health authorities first in Italy then more recently in New York City (both epicenters of huge outbreaks, since tamed) have recently reported that, in a matter of a few weeks, the virus in their locales has changed dramatically for the better. They report that many fewer infections require hospitalization, while a significantly smaller proportion of those hospitalized require ventilation or intensive care.

A big drop in the death rate could induce a meaningful decline in an individual’s assessment of their personal health risk or the liability risk facing a business. This, in turn, would boost consumer and business confidence and open the door to further normalisation of conditions.

There are many, largely unpredictable, potential outcomes, directly and indirectly flowing from the course of the pandemic that could either make the stock market surge higher or lurch lower from here.

Beyond the Crisis

In an environment where such volatility is clearly possible, maybe even widely expected, it makes it difficult for investors to focus on long-term values. We think it’s worth repeating a point we made in this space back in the last quarter:

“The ‘value’ of the market [or of an individual business] 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 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 before that stock markets would go back to capitalising future earnings appropriately.”

Arguably that is what has been happening since stock markets bottomed and turned higher in late

March. Investors have stopped focusing on what appeared in March to be open-ended downside for the economy and the stock market, and have begun to value businesses on their prospects beyond the pandemic – when the trajectory of the economy and earnings is likely to be positive and not too dissimilar to what it was in the years leading up to this crisis.

Focusing solely on the crisis-driven downside at the bottom in March, while ignoring the compelling market values then available and the prospects for a return to economic growth post-crisis, was the wrong thing for a portfolio investor to do. By the same token today, ignoring the considerable scope for nearer term volatility and disappointment, at a point when share values are much fuller and no longer mouthwateringly compelling, would seem to be repeating the same mistake in the opposite direction.

One foot in

In our view, the goal of a portfolio investor should be to own for as long as possible the high-quality businesses most likely to thrive and grow in the future, thereby allowing their usually high internal rates of return to compound on behalf of shareholders. At the same time, we think it’s advisable to lean against risks that arise in the economic and business environment when they become higher than normal.