Equity Commentary: As at March 31, 2020

Source: David Picton | Jeff Bradacs, CFA | Michael Kimmel, CFA | Michael Kuan, CFA

Publish Date: Apr 15, 2020

Read Time: 12 minutes

Market Comments

Q1 2020 is one for the history books. “Unprecedented” being the key word – the speed at which information traveled over social media networks; the speed at which a highly contagious virus traveled over international air routes to just about every country; and the corresponding speed at which markets reacted to price in new realities.

Investors initially started off the quarter looking forward to a recovery in manufacturing, then to a deep but transient hiccup in China, followed by a mild and technical recession and eventually to a full-blown global shutdown of economic activity the likes of which has not been seen in modern times. Global central banks and governments have likewise reacted with unprecedented levels of stimulus, immediately going back to the 2008 playbook and then some.

As we begin to peer into the economic abyss that the global shutdown has created in an effort to contain the coronavirus pandemic, the bottom is hard to see but early indications are beyond anything that we could have imagined, punctuated by unemployment claims and an all-time low in Canadian small business confidence.

Nonetheless, by the end of the quarter, the S&P 500 Index had its best three-day run since 1933, buoyed by a huge stimulus plan, and closed that week up 10.3%, the most since 2009. This is perhaps a sign of improving confidence (amongst other market divergences that are also emerging) that the stimulus will help hold things together for a while, and that the eventual recovery will be equally swift as well. For example, the recovery can be seen in the China Manufacturing PMI, which bounced back over 50 after hitting all-time lows the month before. Though this might be temporary given the hit to the external global economy that has happened since, it’s still encouraging as it shows that there can be a light at the end of the tunnel.

Canadian Equities

The S&P/TSX Composite Index performed well last week as markets cheered additional actions by the U.S. Federal Reserve (Fed) to expand their balance sheet. Sectors that led the S&P/TSX Composite Index were Consumer Discretionary, Real Estate, and Health Care.

From a factor perspective, both value and leverage outperformed. We do not expect this factor trend to persist as we believe it was more driven by oversold levels and seasonality, in which it is common to see short-term reversals in April.

Oil & Gas companies were up on the week as oil price rallied on anticipation of a coordinated global oil production cut by OPEC and non-OPEC countries. We continue to see most oil exposed companies challenged at current prices and are increasingly concerned on short-term storage issues that potentially could cause shut-ins for oil producers. Our preference in the Energy sector remains natural gas as we expect the natural gas market to tighten due to the fall in associated gas as oil drilling comes to a halt.

Within Canadian Financials, Bank of Montreal introduced a 2% discount on its dividend reinvestment plan (DRIP) as a capital tool. We continue to expect the earnings power of Canadian banks to be challenged and their balance sheets will be used as shock absorbers during the crisis. Our preference within financials continues to be diversified financials and property & casualty insurers.

U.S. Equities

We have now regained half of the decline that we saw in the S&P 500 Index in Q1. We will now find out if this was merely a rally off oversold conditions or if it relates to something else. We believe that the market is likely to remain range bound for a while, at best. We can certainly admit that unprecedented actions taken by the Fed has removed the scariest scenarios in terms of a disorderly meltdown of credit and illiquidity in the market and that is part of what the recent rally was all about. The rally has been premised off oversold conditions, negative sentiment and incrementally good news on case counts to get to this point. The next stretch will be harder without the economy giving us any real help in terms of real evidence. It is likely some advancements on a therapeutic solution are needed to get markets moving higher from here.

Our investment style was under pressure in the past week. As pointed out by Goldman Sachs, momentum saw its worst five day stretch in the last 10 years. Programs enacted by the Fed, particularly involvement in non-traditional asset classes such as junk bonds, fostered a belief that governments are now privatizing gains and socializing losses. This environment bodes well for highly levered, low quality companies, something our strategy does not partake in.

OPEC cuts are headline grabbing, however to us, demand destruction in this environment is far more significant than the supply cuts recently announced by OPEC+ and history suggests many of the players are likely to renege on their commitments to their fellow cartel members. We remain uninterested in the sector.

We enter earnings season this week and this is likely not a positive catalyst. That said, most deem 2020 a write-off from an earnings perspective. Our job is to evaluate recovery scenarios and companies that screen attractive as we hope to normalize in 2021. That said, it is tough to ignore the divergence between stock prices and economic fundamentals. Recent incoming data has been consistent with the U.S. potentially entering a depression. At the same time, if one assumes we are paying a 17x multiple on the S&P 500 Index which is consistent with the 3 and 5 year averages, then it implies forward S&P 500 Index earnings of $164. This compares to the alltime high of $163 in 2019. We are somewhat skeptical of these projections and thus have been reluctant to deploy our capital into last week’s rally.

Global Equities

Germany was the best performing European market last week. A few factors contributed to the relative outperformance. First, Germany had the highest economic activity going into the crisis and should recover the quickest in a rebound. Second, the benchmark is dominated by large global corporations that should benefit from the recent pick-up in economic activities out of China. Third, Germany is expected to announce a stimulus package that is supportive of their auto industry, a large constituent in the index.

Switzerland underperformed the global market during the recent market rebound. While the Japanese Yen has lost some of its safe haven status, Switzerland had not, and the Swiss Franc was the only major currency that appreciated against the U.S. dollar this year. This safe haven status can be applied to the Swiss equity market, which has declined by less than half the European market this year. Given this outperformance, Swiss stocks are now very expensive relative to their global peers. Outside of Swiss pharmaceutical stocks, we think there is room for continued underperformance if the market continues to rally and investors look to use their Swiss holdings as a source of funds.

A number of companies, mainly in the UK, raised capital through new stock issuance last week. In most cases, management was looking to improve the company’s liquidity situation in the event that current crisis lasts beyond the next few months. All of the stocks traded above their issuance prices as investors applauded their first movers and the market priced in lower risk premium on these names.

As the COVID-19 new case counts peak and near the plateau in cumulative cases, we are seeing some unwinding of the stay at home stocks in Europe. These stocks may have near term downside if we continue to see improving COVID-19 developments, however some of these stocks may see some stickiness to their business and the crisis has accelerated growth at minimal incremental business cost, improving their long-term business model.

One thing that is worth monitoring is the potential for COVID-19 to remerge as an issue in Asia. Over the past week, we have seen Japan announce a state of emergency, signs of raising cases in Singapore again, and news of out of Korea that a number of “cured patients” have re-tested positive. These developments raise some questions about how quickly economic activities can return to “normal”.

Over the past couple of weeks, a lot of people have been dusting off the 2008/09 playbook as a starting point for their portfolio. While the root of the crises are different, the relative sector performance and valuation are similar with the cyclical sectors and financials out of favour.

Many of these sectors are near 2009 multiple lows. At that time, financials, basic materials, and autos outperformed at the turn.

From a fundamental standpoint, there are not a lot of compelling stocks to own within those spaces. However, there are a number of companies that are improving their businesses on the margin which will enable them to compete better. Most of this has been through repairing their balance sheets and better cost control. We would highlight Volkswagen and Prudential Financial Inc., as two examples of companies that are doing the right thing and may give investors good exposure to a rebound in the economy.

There are also companies where a rebound may take longer due to changes in consumer/business behavior. For example, air travel may take longer to recover this time around given the nature of the current crisis.

We have a positive outlook in areas that should benefit from fiscal stimulus. For example, Germany is looking into a recovery plan that “contributes to building a climate-neutral economy.”