It’s 2020, but the outlook isn’t 20/20
It’s been four and a half months since the World Health Organization declared COVID-19 a global pandemic. It seems that the world has both stood still and evolved considerably during these past few months. As in the aftermath of a terrible storm, we are slowly emerging from our shelters, grateful that we were spared and have started to assess the damage. Depending on which metric one uses to assess damage, vastly different conclusions can be reached. With unemployment rates in Canada (12.3%) and the U.S. (11.1%) at multi-decade highs the economic damage appears deep and widespread. However, with S&P/TSX Composite Index down only 5.1% YTD as of July 20, and the S&P500 up 0.6% YTD, it wouldn’t be obvious that there even was a storm. This incongruous relationship between the real economy and equity markets has made us incrementally more defensive in the short-term as we see risks elevated while valuation gets stretched in some parts of the market.
Since our last Love Letter published in June, some notable risks are starting to come to fruition and don’t appear to be adequately discounted by markets:
- The containment of COVID-19 in the U.S. has reversed course and it now appears it will take longer than originally expected for many segments of the U.S. economy to bounce back. Consumer spending, which drives two-thirds of U.S. economic activity, is on a gradual road to recovery but consumer sentiment remains fragile as some U.S. regions weigh renewed shutdown measures.
- Economic deterioration since the beginning of the year, perceived mishandling of the pandemic response, and growing social unrest have dented Donald Trump’s reelection chances. Latest polls have Joe Biden maintaining a sizable lead over Trump in the presidential race, while the Democrats’ chance of wresting control of the Senate from the Republicans has become plausible. From a purely market perspective, we think a Democratic sweep on November 3 could be headwind to the U.S. equity market on concerns of higher taxes and increased regulation.
- China’s further encroachment into Hong Kong’s governance has further soured U.S.-China relations, essentially stalling further trade negotiations. Although much has changed due to the pandemic, investors may remember that progress on trade issues between China and the U.S. was a key driver of market performance in 2019.
On the positive side of the ledger, we note that massive and ongoing fiscal and monetary support has supported capital markets, while advancements in potential vaccines for COVID-19 has boosted confidence that a recovery could be in store for 2021. Given current market valuation (S&P500 trading at 22x forward earnings vs. 5-year average of 17x), we think these factors are dominating short-term investor sentiment.
The market’s pendulum may have swung too far
As we have highlighted in previous newsletters, performance has varied significantly among the various sectors within the equity market. Mandatory shutdowns, physical distancing, drop in consumer sentiment, and lower interest rates have created short-term winners and losers. Investors have flocked toward technology and healthcare companies, pushing valuation multiples to historical highs, while other sectors have been neglected and have seen valuation drop to multiyear lows. While some of this sorting makes sense, we think the market’s pendulum may have swung too far and may be too short-term focused.
Whether its growth vs. value, technology vs. financials, or Nasdaq vs. Dow Jones, the disparity in valuation has reached levels where a “reversion to the mean” trade has historically favoured the underdog. In the context of current market conditions, this means growth sectors like technology could underperform financials and industrials over the next 18-24 months. Even though we expect broad market gauges may remain range bound in the short-term, inter-sector and inter-region performance may vary. Our asset allocation and security selection process continue to reflect these shifting market conditions.
