We saw volatility jump meaningfully higher this past week. Stocks sold off in the worst week for global equity markets since the end of March, when the pandemic was in its infancy. The second wave of Covid continues to spread in a faster way than anticipated. The situation is particularly troublesome in Europe but is also concerning in the U.S., while Canada is faring a bit better. The market selloff is understandable as the global economy's trajectory and corporate earnings are now at greater risk of faltering over the next few months. However, we think today's situation is sufficiently different from what we were dealing with in early 2020.
Differences between now and the early days of the pandemic
The virus trends have understandably reignited the feelings of anxiety, exhaustion, stress, frustration, and concern that most people shared during the initial wave in late winter and early spring. On the other hand, investors remain preoccupied with the risk this wave poses to economic and earnings growth, both of which were expected to rebound in the not too distant future. That forecast is now in jeopardy as governments' restrictions in various parts of the world will weigh on growth. Nevertheless, we think the current situation is markedly different than the spring. We believe there are many reasons why.
More experience. While the pressure on health care systems is mounting in certain areas, the fatalities level remains below levels seen earlier this year despite the substantially higher number of current cases. A combination of better preparedness, experience, therapeutics, and the sheltering of vulnerable people has led to this improvement in hospitalization and fatality rates.
Range of containment measures. Governments are likely to employ less draconian measures than used earlier in the year unless the situation reaches an extreme, as it has in France. Even here, we expect to see progress over the next month. Israel serves as a good comparison. It went into a nationwide lockdown nearly five weeks ago and has seen its new daily infections decline by over 90%. Admittedly, it has come with a high economic cost.
Stability of the financial system. The financial system is much better prepared today, with central banks having aggressively lowered rates and employed various means to ensure the proper functioning of credit markets. Access to capital should present less of a challenge.
Government aid. Furlough programs, debt relief, rent deferrals, loans and guarantees, business subsidies, and income support are just a few of the various ways governments have stepped in to offer support to households and businesses impacted by the pandemic. We expect additional aid going forward, given the anticipated impact from renewed restrictions.
Vaccines. Hundreds of vaccines are being studied, and more than a handful are in clinical trials, with some expected to release data in the coming months. There is no guarantee, but given the global scientific community's coordinated efforts, we remain hopeful that a vaccine will be available for mass distribution in 2021.
The markets don't respond well to uncertainty
On numerous occasions, I have said that the markets are forward-looking (usually 9-12 months), and they tend to not perform well during periods of elevated uncertainty. The near-term has become more uncertain in the wake of the accelerating virus spread.
Compounding the challenge for investors is next week's U.S. election. Any clear and final outcome, whatever it may be, would be a welcome development for investors as it would remove one source of uncertainty. On the other hand, a contested outcome would likely add to the volatility. We do believe that a contested outcome is reflected in the market to some degree already. Additionally, the lack of a U.S. stimulus package has also added to the market's near-term volatility. Unfortunately, the passing of a stimulus bill became highly politicized (stop me if you heard this one before.) And a meaningful relief bill is likely going to have to wait until after the election. We view the passing of further stimulus as a "when, not if" moment, and one that would be a positive near-term catalyst.
Why we are constructive on the longer-term set up for the markets
Despite the near-term challenges facing the market, we are constructive on equities longer-term (2-3 year view.) In our opinion, the highly accommodative central bank policy is a meaningful tailwind for equities. Recall the investor adage – "never fight the Fed," which refers to when the Fed is accommodative, you want to give stocks the benefit of the doubt, and when the Fed is raising rates, you want to be more cautious. Today, central banks like the Bank of Canada and Federal Reserve suggest that we won't see interest rate hikes until possibly 2023. An easy monetary policy environment has historically been a big boon for equities for several reasons.
First, as global interest rates are suppressed, investors will seek out other means to increase yield in a portfolio. Anyone who has talked to their local banker about GIC rates in the last three months will understand this dynamic. For example, a one year Bank of Montreal GIC is paying 0.25%. Why tie your money up for a year at such a low rate? Investors seeking high returns will ultimately have to take on more risk to get them, which means we are likely to see additional fund flows into stocks over the next few years.
Second, a key benefit of a low rate environment to businesses is that their capital cost goes down. Many companies rely on some level of debt to finance their operations. As they refinance old debt at lower rates, there is a real improvement in these businesses' profitability as interest rate expense falls. We have seen this dynamic play out already with one of the companies we own in our portfolios – Restaurant Brands International, the parent company of Burger King and Tim Hortons, recently announced they would refinance $1 billion of debt at a rate saving of over 1%. That translates into over $10 million in cost savings immediately. Thus a low rate environment has positive implications on the profitability of businesses.
Third, the pandemic created a forced recession that was no one's fault. The low-interest rate environment allows Governments to fund record levels of stimulus (the crisis relief effort) at a minimal cost to society. This stimulus allows more money to flow into the pockets of the average Canadian and American. I do appreciate that this latter point can be a debated topic, as many worry about the accumulation of government debt. Still, I remain of the view that these are the exact measures the Government should be taking in the face of this pandemic. That we can fund a program like CERB at 0.5% interest cost and not 7% is a significant benefit to everyone.
Cash on the sidelines. One last long-term catalyst for stocks remains the elevated cash levels.
I have written before about roughly $4.5 trillion of cash still on the sidelines following the February/March selloff. The $4.5 trillion cash hoard is comprised of approximately $3T in institutional money and another $1.5T in retail investor money (investors like ourselves.) For comparison, there was $1.7T of cash on the sidelines in February of this year. We believe that the cash on the sidelines is likely to make its way back into the markets over time. In our view, this dynamic represents a potentially underappreciated long-term tailwind for equities. After the 2009 financial crisis, it took over three years for elevated cash levels to normalize. We expect a similar slow drip of cash back into the equity markets this time around.
On a final note, we can't help but remind ourselves of March 23rd, 2020. This date marked the low for global equity markets this year. A significant market recovery unfolded in the days and weeks after that. Yet, at that time, anxiety levels were high, and it seemed like there was no end in sight for the spread of the virus. It serves to remind us that timing a recovery, or a setback for that matter, is nearly impossible given human emotions that often get in the way. It is also too short-term sighted. We remain focused on the long-term and an investment plan that can help you accomplish your goals and objectives. We see the prospects for less uncertainty with the passage of time.