Promising vaccine and coronavirus treatment news, coupled with the inauguration of U.S. President Joe Biden, has given markets a glimmer of certainty and optimism this year.
But, investors are keeping their eyes on simmering trade and anti-globalization trends that may return to the fore after being placed on the back burner during much of 2020. They’re also watching the looming spectre of prolonged low-interest rates and the potential for inflation, as well as the unusually positive correlation between equities and bonds that’s put the traditional 60/40 portfolio at risk.
“I’ve never experienced anything quite as challenging as what we’re experiencing now, in terms of interest rates [being] as low as they are,” says James Davis, chief financial officer of the OPSEU Pension Trust.
Trade, climate back on the agenda
The Biden administration could bring global trade back into focus, as it promises stronger relationships with trading partners than the previous administration and plans a more constructive approach to China. “Multilateral trade is generally beneficial for our economies and that environment there will be a little bit more constructive than it has been over the last couple of years,” says Ian Riach, senior vice-president and portfolio manager with Franklin Templeton Investment Solutions.
Marc Cevey, chief executive officer of HSBC Global Asset Management Canada Ltd., notes “irritants” are likely to remain, but stronger relations between the two countries that represent more than 40 per cent of global gross domestic product will be positive for markets.
“Anything that smacks of a slight improvement in tone in bilateral discussions and so on and so forth is going to be viewed constructively by markets and frankly would be very favourable,” says Cevey. “Something like the unwinding some of the tariffs, some of the sanctions, would only be viewed very positively. Small steps could make a big difference.”
Following the trade theme, while Brexit wrapped up when the United Kingdom and European Union inked a new trade deal on Dec. 24, 2020 — promising no taxes on goods or quotas on trade but no longer allowing U.K. service providers automatic access to EU markets — Davis says investors shouldn’t lose sight of the bigger picture that the saga represents.
“There are certain trends in place, of which de-globalization is one, and the extreme of that being nationalism . . . as [seen] with the U.S. election. Those [forces are] still there, that’s not going to change.”
Indeed, a question for the year ahead is whether globalization is gasping its last breath. “For a variety of reasons it was already losing momentum for several years prior to COVID, so is this likely to persist?” Cevey asks, noting that the coronavirus pandemic exposed the fragility of long-established, cross-border and global supply chains.
“We’ve certainly witnessed significant disruption in supply chains around the world as a result of COVID . . . and we shouldn’t be too surprised if, post-COVID, [leaders will] be re-thinking those supply chains.”
Climate change mitigation is also expected to see a fair amount of momentum, Cevey predicts, with the Canadian government targeting a green recovery, the European Union making a climate neutrality target legally binding and the Biden administration set to re-join the Paris Accord and re-implement environmental protections and fossil-fuel regulations through executive order.
A shot in the arm
Against this backdrop, central banks across the world are promising continued accommodative monetary policy for the foreseeable future to keep the economy chugging along as much as possible, with U.S. Federal Reserve Chairman Jerome Powell going so far as to say in June 2020 that the Fed was “not even thinking about thinking about” raising rates.
“Our view right now is interest rates are going to be lower for longer; every central bank has said so,” says Riach, though he adds that “if we get through the pandemic, get some economic growth, it means that longer-term rates will start rising.”
With rates as low as they are, Davis says the central banks don’t have as much firepower as they once did, and it’s necessary for governments’ fiscal policy to work in tandem with monetary policy to mitigate the risk of deflation. Substantial government stimulus, though, presents the opposite risk of unchecked inflation as previously tight-fisted consumers start to spend their cash during the economic recovery.
“The risk that is still out there . . . is unmitigated fiscal stimulus such that we have rapid, rising inflation. That risk is, I still think, there, and perhaps under-appreciated by the market,” Davis says.
William Yun, executive vice-president with Franklin Templeton’s multi-asset solutions, said during the firm’s 2021 outlook webinar in December 2020 that while it expects global growth to rebound next year as consumer demand picks up and jobs return, it anticipates “structural forces” including the unemployment rate and demographic, technology and geopolitical trends to keep inflation in check.
Positive vaccine news gave markets a shot in the arm in late 2020 and promised a likely return to normal at some point in 2021. Indeed, in December the Organization for Economic Co-operation and Development revised its projection for global gross-domestic-product growth to rise, saying it expected a growth of 4.2 per cent in 2021, after falling by that same percentage (4.2 per cent) in 2020. However, BMO Capital Markets warned in January 2021 that a so-far “sluggish” vaccine rollout could hamper Canada’s economic recovery in comparison to other countries.
Even as the first vaccine doses have started to hit arms, there’s still expected to be strong social dislocation throughout this year, as particularly pandemic-affected sectors such as service and travel struggle to recover.
“Some parts of the economy are suffering more from the pandemic — the service industry is one, but also areas such as women in the workplace,” says Cevey. “Today, it’s probably fair to say the marketplace and governments are not really emphasizing and focusing on those trends because the broad expectation is the world can go back to 90 to 95 per cent normal post-COVID, but that may be wishful thinking. At the end of the day, things may get better in 2021, but it’s fair to say a significant portion of the economy may not get back to the same level of employment that was previously the case.”
While facing these new challenges, pension plans were already grappling with the breakdown of the relationship between their bread-and-butter assets: public equities and bonds. “As a traditional investor your balancing act you’ve got is that if the equity market tumbles, then you’ve got the bond market there to support you. When both of them are at historically high valuations and are arguably being supported by the same policy lever of unconventional monetary policy, you can see that you have a big systemic risk that builds up,” says Calum Mackenzie, partner and head of investment for Canada at Aon.
“It’s very easy to see how you could have a situation where both the equity market and the bond market could potentially suffer and we’ve seen that — you expect correlation to be negative between asset classes, but we’ve seen in times of stress recently they’ve both gone in the same direction. That’s where you start to see pension funds have to look more closely at . . . diversifiers in the portfolio,” Mackenzie says.
“Maybe the hedge funds that have dragged their feet, maybe now’s the time for them to perform. Maybe [pension funds] do need that income from real estate, infrastructure, rather than from the fixed-income market. Maybe we need to look at something as esoteric and largely untouched by institutions as gold as a policy diversifier in these times because that traditional relationship is starting to really break down.”
While the OPTrust rode through the spring 2020 market meltdown with plenty of liquidity and performed well, which Davis attributes to the amount of bonds the fund had in hand, he notes that the ultra-low and potential for negative yields on bonds invite a serious question: “What role do bonds play in the portfolio? They no longer provide an adequate rate of return but we’ve always counted on them for diversification.
“The challenge is, when yields are really close to that zero bound or slightly below it, you can’t even count on bonds for diversification. Many investors are working through the different ways to achieve diversification in the portfolio, recognizing that bonds are not going to provide what they used to provide historically and we’re spending a lot of time on that.” But bonds do still have value as a volatility dampener in the portfolio, says Riach, suggesting taking a “dynamic” approach to the bond portfolio, looking outside of Canada and traditional sectors and favouring one- to five-year issues over longer-dated bonds that are far more sensitive to interest rate risk.
“[Shorter-term corporate bonds will] also benefit the same way we believe equities will if there’s some economic growth going forward. We’re underweight in bonds but not abandoning them by any means.”
Heading up the fixed-income risk curve, corporate bonds continue to provide enough of an incremental yield to merit continued exposure, says Cevey. But pension plans need to be willing to move on from corporate sectors they’re familiar with and experiment with other markets.
“In Asia, the yields are attractive [and the] corporates are very healthy. . . . Global or Asian high-yield or corporate bonds in general represent an opportunity. And in the private part of the market, the opportunity set is limited but incremental yield is definitely there, especially looking at infrastructure debt to the extent they can source the investments.”
On the equities side, investors are turning to global markets as Canada is expected to face cyclical and structural headwinds into 2021, with its continued reliance on resource exports and the concentrated nature of its economy and stock market.
“If we get more comfortable with the cyclical recovery, we may change our view of that, as resources should benefit in this scenario,” said Riach during Franklin Templeton’s 2021 outlook webinar. However, Canadian energy producers face higher break-even costs than competitors in other nations, and export transportation issues are poised to take centre stage with Biden cancelling the Keystone XL pipeline through executive order on his first day in office. The green energy movement, too, is expected to have longer-term impacts not only on the oil patch but supporting sectors, including Canadian banks that have been receptive to financing oil and gas projects. However, Cevey says Canadian companies are decently well-priced with attractive dividend yields that aren’t expected to be threatened and the country’s financial industry stands to do “reasonably well on the way to recovery.”
Looking abroad, he says developed Asian nations are recovering faster than the rest of the world, both due to their superior response to the pandemic and structural economic factors that bode well for their public markets. “Our economies in North America are way more service oriented, where Asia’s are more manufacturing oriented. It’s fair to say that in the long-term, the service sector is going to suffer more.”
Riach pointed to European and U.K. public equities as being undervalued. “In areas like Europe and the U.K., some bad news is already priced in pretty significantly, so we’re not adverse to leaning against the wind and adding to positions in areas that are maybe not as quick to get through the recovery as others,” he says.
Longer term, both Riach and Cevey are constructive on emerging markets, though note they haven’t handled the pandemic as well as developed countries and are prone to risk-off trades. “We would wait to get too aggressive there until we see some progress on the pandemic front,” Riach says.
Eyes on fundamentals
With a surfeit of noise in early 2021 — with the Georgia runoff results giving U.S. Democrats control of the Senate and a failed insurrection stunning the world — it’s easy to get lost in the cacophony. But Rob Almeida, global investment strategist at MFS Investment Management, says while political issues are important, investors should stay focused on the fundamentals. “The emphasis that investors have placed in 2020 on the credit facilities provided by central banks, on the potential fifth round of fiscal stimuli, election outcomes, et cetera, I think these things are important . . . but I think investors are over-emphasizing their importance as it pertains ultimately to what drives asset prices — which is cash flow.”
The global pandemic dragged the economy into a recession that was already coming, he says. Profit margins had reached all-time highs in 2019 against the weakest economic growth environment since the American Civil War, something that was only possible through “unsustainable” practices including underpaying employees, tax arbitrage and issuing debt to buy back stock, Almeida notes. Those issues haven’t yet been corrected.
“The market is telling you right now, under the expectations of huge fiscal stimuli, under a Democratic president and a Democratic-controlled Congress, that more debt will create GDP velocity, economic growth, that will solve all problems — and maybe it will, I just have my doubts,” he says. “The market’s expectation that you’re going to see a huge, V-shaped recovery . . . in margins [and it] could be dependent on politicians to get you that? That’s not investing, that’s hope. And hope
is not a strategy.”
Kelsey Rolfe is a freelance journalist.