ECONOMIC UPDATE
I've been a financial advisor for 23 years. During this time, I have seen corporate titans fall, multiple market corrections, the dot.com crash, and the 2008 recession - all having both foreseen and unforeseen impacts on the global economy and many people's lives.
We now find ourselves in such a time. I know that many of you are concerned about the impact that COVID-19 has been having on the markets and will continue to have on the future of the global economy.
We are undoubtedly living in a stressful situation, but I hope this note will reassure you that our portfolios are well-situated to seek opportunities during these current economic times.
In the sections that follow, I would like to walk you through some of the unique occurrences we are living through, my thoughts on their impact, and, more importantly, how to move forward with our portfolios.
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EQUITIES
Year-to-date, the Canadian, U.S., and international markets have all fallen 30 per cent, while emerging markets have fallen almost 25 per cent.
As equities rise, it's common to see markets vary in performance. But, during a market crash, they often fall in tandem.
Commodities, however, typically act differently.
Gold, for the most part, has performed wonderfully. While to date, it is down two per cent on the year, the yellow metal is priced in U.S. dollars (which has soared against the loonie), lifting our gold positions 10 per cent on the year, and almost 25 per cent since the start of 2019.
One of the reasons for gold's fall is institutional and investor selling to raise funds. If it weren't for this, I believe gold would be at least 10 per cent higher than its current level.
Canadian energy stocks, on the other hand, have not enjoyed the same experience. Year-to-date, the Canadian energy index has fallen about 69 per cent - on the heels of a multi-year decline. Part of this fall is due to the global slowdown as fuel needs have fallen precipitously.
However, something completely unexpected occurred in concurrence: A global energy war.
Two weeks ago, OPEC+ (the OPEC countries plus Russia) met to discuss the aforementioned decline in global energy demand. Saudi Arabia strongly recommended OPEC+ curtail their production to support energy prices. Russia refused. They argued that U.S. producers have repeatedly taken advantage of their past cuts and had no interest in supporting energy prices while American companies increased their production.
Russia has a point. Three short years ago, the U.S. was the world's third largest oil producer, and pumped less than nine million barrels a day. In 2018, the U.S. became the world's largest oil producer, and, as of early 2020, were producing almost 13 million barrels a day - an increase of about 45 per cent in three years.
After Russia's refusal to lower production, OPEC also decided not to do so. But a few days later, the Saudis did the unthinkable. Likely in an attempt to teach Russia a lesson, they announced that starting April, they would increase their production from 9.7 million barrels a day to about 12.
To make matters worse, a few days later, they indicated their production would actually rise to 13 million barrels a day, and their ally the U.A.E., also committed to pump an additional million barrels, as well. As a result, global oil supplies are expected to exceed demand by at least seven million barrels per day, but possibly many more. As a result, prices fell from $62 per barrel to the low $20s in less than a month. Hence, the precipitous fall in energy stocks.
The good news is Russia and Saudi Arabia can't maintain this situation indefinitely. Both need prices to at least double in order to balance their budgets. Russia's goal is to punish the heavily indebted U.S. companies into bankruptcy and/or dramatically curtail their production. Saudi Arabia is likely also hoping for the same, while bullying Russia into future compliance. It is an expensive game of chicken, but prices should rise in the future.
Unfortunately we don't know how long the two will hold out. We hope not very!
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THE BOND MARKETS
Although bonds underperform equities as stock markets rise, they are a key part of a balanced portfolio. During bull markets, I'm sometimes asked, "Why do we own bonds?"
The answer is two-fold. First, fixed income provides stability to a portfolio when markets are shaky. Second, as bonds usually outperform in a bear market, they can be sold during these times in order to buy equities that have fallen.
With that in mind, I will discuss the recent happenings of the bond market.
As expected, bonds have outperformed equities by a significant margin. However, given the extreme volatility and uncertainty, they haven't performed as well as expected.
Up until March 10, the Canadian bond index was up over five per cent on the year. With equities 25 per cent lower at that time, this was a good result, especially as it increased five per cent last year as well. However, since then we have endured a number of historical trading days where markets have fallen, risen, then fallen again by about 10 per cent a day. When volatility like this occurs, the short-term rules of the game can change.
The price of a security is determined by the supply and demand (buying and selling) for that particular security. However, Exchange Traded Funds (ETFs) should closely reflect the value of the holdings held within them. This is referred to as their NAV, or net asset value. Last week, due to extreme liquidity issues, many of the Canadian bond index ETFs often traded at a three per cent discount to their NAV. This doesn't happen when the liquidity of capital is adequate.
This anomaly has carried over to this week. On Monday and Wednesday, when stock markets fell heavily, the Canadian bond index also fell by four per cent, or more. On Tuesday, however, both stocks and the bond index rose. This is notable because stocks and high quality bonds (which the index is composed of) are usually inversely correlated. When one rises, the other falls.
I mention this for two important reasons: First, the bond portion of your portfolios may be understated to some degree. Second, should equity markets continue to fall, it may be more challenging than usual to trim bond positions in order to raise funds to buy fallen equities.
This issue should dissipate when markets calm down somewhat.
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Making decisions with imperfect information is always difficult. The current environment is especially complicated because we haven't had a global pandemic in the modern era.
Currently, the following questions loom:
- How much worse will the health crisis become?
- How much longer will the health crisis continue?
- How long will it take to develop a vaccine?
- How will society change (culturally and economically) when the crisis ends?
- How much longer will the equity markets decline?
- What will the maximum equity decline be?
Although there is no way to be certain, I believe the following to be conservative assumptions to base our decisions upon:
- A vaccine is developed within 12 to 18 months
- Life will return to a semblance of normalcy within six to 12 months
- Governments will do everything they can to support the global economy during this period
- Global GDP should rebound to prior levels within 12 to 24 months
- Oil prices should rise to at least $45 per barrel (likely higher) within 12 to 18 months
Given the above unknowns and assumptions, historical examples, and my experience, I believe the following to be the most prudent path forward:
- Should markets (especially bonds) stabilize, we will rebalance portfolios. This will involve trimming bond and gold positions, while buying energy and global equities.
- Should markets fall 5 per cent to 15 per cent further, we will consider increasing the equity portion of our asset allocations and rebalance again.
- Should equity markets fall 50 per cent in total, we will treat it as a worst-case scenario and consider increasing equities once more. This scenario assumes the health crisis has not reached unforeseen levels.
I'd like to close by first wishing that you and your loved ones remain healthy. I also hope the upcoming period of social distancing will not be overly burdensome.
As I mentioned above, although these markets are stressful, we are well-situated to seek opportunities. Our portfolios may actually benefit from this crisis in the long run.
Take care,
Matthew
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The views of the author do not necessarily reflect those of Raymond James. This article is for information only. Raymond James Ltd. Member-Canadian Investor Protection Fund.
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