With the COVID-19 pandemic still plaguing many countries, economies are in the worst shape they’ve been in decades. Hopes of a V-shaped recovery proved short-lived as infection rates began rising again during the third quarter.
Developed world countries, the US, UK and Europe, have had to tighten measures again to try and stem the rising tide of infections. India and Brazil remain in the grips of the pandemic, with no end yet in sight.
Employment numbers have been the first to reflect a slowdown in the impressive initial bounce back in jobs when economies began to reopen. In the US, 661,000 jobs were created in September, less than expected and well under the 1.5m added in August. More than 1m jobs were created every month between May and August. However, the number of jobs remains 10m below the pre-pandemic level in February.
Meanwhile, in Canada, the labour market seems to be recovering more swiftly, with 378,000 jobs created in September – an increase on August job numbers. The country is 720,000 jobs away from where it was in February. In Europe, the number of unemployed people rose by 251 000 in August to 13.2m. That meant the jobless rate increased to 8.1% from 8% the previous month.
Despite the poor economics fundamentals, equity indexes reached record highs during the quarter, which is perplexing. For the quarter, the S&P500 gained 9%, the FTSE 100 lost 4%, and the EuroStoxx eased 0.7%. The MSCI World Index rose 3.81%, and MSCI Emerging Market Index rallied 9.65%.
What’s keeping US indexes at such high levels? Well, for the first time in over 40 years, the five largest stocks have accounted over 20% of the S&P 500’s market capitalization, and they are all from the technology sector, which is another first.
Having returned almost 40% on average since the start of the year, the big five tech stocks have been the leading players, helping the S&P 500 to gain significant ground. If it were not for these stocks, the S&P 500 would be lower year to date.
While we are advocates of concentrated portfolios, we believe there is a substantial concentration risk in passive investment strategies that aim to mimic the performance of an index, like the S&P 500 or Nasdaq 100. These indices are heavily overweight the large technology companies, with no regard for the fact that these companies may be overvalued.
Irrespective of the potential risk stemming from overvaluation in the tech sector, equities have the potential to appreciate further given the accommodative monetary and fiscal policies that central bankers and governments around the globe have unleashed to fight the impact of the coronavirus pandemic. We are in an environment marked by the lowest yields in modern history. While there will be volatility ahead, we believe the best strategy is to focus on those situations where we can find quality companies that we can purchase at reasonable valuations for our investors.
Diversification Never Hurts
We continue to seek opportunities across a multitude of sectors, including those that have been severely depressed due to the closing of economies around the globe. One of the hardest-hit sectors had been the conventional energy sector, which has suffered as the demand for crude oil all but disappeared due to lockdowns and the slowdown in transportation, which accounts for a significant proportion of the fossil fuels use. Other uses, such as industrial use, have also waned.
Furthermore, the push for a clean economy has caused some headwinds for the energy sector. The reality is that currently, renewable energy will not fill the gap in demand for energy once the global economy starts to recover. The sector has also been impacted by supply-side issues that existed before the pandemic. Alongside the hunt for bargains in conventional energy, we are also assessing opportunities across the entire energy mix, including renewables, which we believe will eventually play a far more meaningful role than it does today.
Fixed interest assets continued to trade at record low yields and are likely to remain there for an extended period based on the US Federal Reserve’s lower for as long as it takes narrative. The central bank’s decision to shift to an average inflation targeting framework also served to give the Fed more flexibility. Now that interest rates do not have to be raised at the first sign of inflation reappearing, monetary policy can remain accommodative for longer.
During the third quarter, US bond yields remained largely unchanged from the previous quarter, with the 10-year US Treasury yield a percentage point lower than it was in October the previous year.
Gold was the primary beneficiary of risk-off investor sentiment as COVID cases resurged and concerns started to take hold that the huge stimulus packages may prove inflationary down the line. The price of gold hit a record high of just above $2,000 an ounce in the first week of August before easing off and consolidated just below that level for the rest of the quarter. For the three months, it gained almost 7% and remained more than 20% higher year to date by the end of September.
Volatility, accept it and manage it
Investors are craving returns and, more specifically, yields for generating income in portfolios. The issue is that it is becoming more challenging to generate stable cash flows in the form of dividends and interest without taking on more volatility. Hence, investors will have to learn how to deal with the volatility by positioning portfolios in such a way that the volatility does not lead to a long period of capital decline or even worse permanent loss of capital. The best way to accommodate for volatility is to have a measure of the intrinsic value of a security and to buy it at an adequate discount to its intrinsic value.
February and March of this year presented an excellent opportunity to deploy cash. It was a time when the markets and investors were riddled with fear, but also a period when assets where the cheapest they had been in a long time.
Stock markets experienced their shortest bear market in history after the March sell-off, with the S&P500 hitting a new record in August. Nasdaq also achieved new highs. All US indices were driven higher by the trillions of dollars pumped into the system as a result of the coronavirus pandemic, and a level of speculation in tech stocks.
Value investing has lagged growth
Growth stocks have been the clear winners this year, as investors bet on the companies that have stood to benefit the most from the pandemic, namely the tech stocks. In the US, by the end of the third quarter, the large-cap growth stocks had gained 40.1% from the previous year, while the large-cap value stocks had declined 7.1%, according to Morningstar.
Apple, the epitome of a large-cap growth stock, saw its market capitalization grow exponentially this year, becoming the first company to reach a market capitalization of more than $2 trillion in mid-August. The tech stock went on to reach a market cap of $2.3 trillion, bigger than the UK stock market’s FTSE100 Index when converted into pounds.
Stimulus continues to underpin the global economy
The trajectory of the global economy and financial markets for the rest of the year hinges on the pandemic, whether or not further fiscal stimulus is provided in the event of an ongoing rise in coronavirus cases and the US elections.
In the US, a second trillion-dollar stimulus package hasn’t yet made it out of the starting blocks. Thus, the US is bracing itself for a surge in bankruptcies from small businesses, as well as delinquent payments from households as the support from Federal subsidies taper off. The economy simply cannot continue to grow without these programs unless there is a meaningful upturn in real economic activity fuelled by spending from consumers and businesses getting back to pre-pandemic levels.
Elevated levels of volatility are expected in the lead up to the elections, with the results likely to have a material impact on the energy and the health sector given the divergent views held on these two critical industries by the two presidential candidates. A Biden win would be more favourable for the renewable energy sector than the traditional carbon-intensive energy sources. A Trump win would see the fossil fuel industry better supported. A Trump win would see the end of the Affordable Care Act, whereas a Biden administration would work towards ensuring access to free universal health care.
As always, there are opportunities in volatile markets. But it is essential to do your homework to avoid paying extremely high valuations for securities if you want to achieve meaningful long-term returns.
Garnet O. Powell, MBA, CFA is the President & CEO of Allvista Investment Management Inc., a firm with a dedicated team of investment professionals that manage investment portfolios on behalf of individuals, corporations, and trusts to help them reach their investment goals. He has more than 20 years of experience in the financial markets and investing. He is also the Editor-in-Chief of the Canadian Wealth Advisors Network (CWAN) magazine. He can be reached at gpowell@allvista.ca