Where do we even begin? A global pandemic shocked financial markets in the first three months of 2020. Fast-forward to the end of June, and risk assets have sharply rebounded, buttressed by investor optimism over economic reopening prospects and the tailwind of unprecedented central bank support. In truth, the second quarter saw an equity market rally among the sharpest in history exist in conjunction with global economic data resembling levels not seen since the Great Depression. A strong global economy simply does not involve near-zero interest rates or a record-breaking number of the population collecting government paychecks.
Investors are clearly counting on a sharp V-shaped recovery as they look beyond current collapses in profit and economic growth. Fiscal and monetary rescue efforts continued to be the largest support to the global economy in the second quarter. The relative resilience of consumer confidence levels despite surging unemployment is a testament to the extraordinary actions taken by governments and central banks. It also suggests that the recovery could pick up speed as fear of the virus fades. With policymakers in “whatever it takes” mode since the onset of the pandemic, there is no reason to believe they will change course in the second half of 2020.
With lockdowns around the world beginning to ease, many pundits expect the global economy to reflect a reacceleration in the latter half of the year. Nevertheless, labour market scarring and weak demand could temper the pace of the rebound. We expect individuals and businesses to tread carefully as lockdown measures slowly lift in the third and fourth quarters of 2020. We highlight the word slowly as we believe the reopening process and subsequent recovery will be choppier and more gradual than many anticipate. We simply do not know how successful the reopening stages will be, nor what the right pace is to balance economic recovery with containment of the virus. There are still many unknowns when considering what the next stage of COVID-19 will mean for the economy, despite investor willingness to ignore the risks.
Renewed virus outbreaks in recent weeks, particularly in the southern and western United States, support our belief that the global economy will witness a markedly slower recovery than originally anticipated. Even with fiscal and monetary policies remaining highly supportive, continued social distancing measures will likely keep unemployment rates elevated and world GDP beneath pre-virus levels over the coming months and quarters.
With investor optimism persisting throughout the quarter, credit and liquidity spreads narrowed, and all bond sectors appreciated in price. Supported by the Bank of Canada’s accommodative monetary policies, a sharp rally in risk assets caused corporate bonds to generate the strongest gains. Long-term bonds also considerably outperformed their short-term counterparts, which is a typical feature of a risk-on environment. The Canadian long-term bond universe advanced 11.4% over the quarter, significantly ahead of the short-term market which gained 2.1%. Overall, the Canadian bond universe posted a return of 5.9% in the second quarter of 2020, and has gained 7.5% year-to-date.
Throughout the second quarter, numerous central banks emphasized their continuous commitment to counteract the COVID-19 pandemic via a range of monetary policy tools. The U.S. Federal Reserve reiterated that its toolbox will specifically exclude negative interest rates. While it is characteristic for central banks to ease monetary conditions during a recession, the massive response from the U.S. Federal Reserve, Bank of Canada, and other central banks around the world has been unlike anything witnessed in history. Arguably, these actions alone have resulted in the sharpest but shortest recession of all time.
With the objective of improving market stability, the Fed began investing in household bonds at the end of the quarter, purchasing $428 million in Walmart, AT&T, Ford Motors and Gilead Sciences, to name a few. Given the highly uncertain environment, the Fed is following in the footsteps of other central banks around the world, such as the European Central Bank and Bank of Japan, who have developed corporate bond purchase programs. With these programs, central banks help ensure that companies can continue raising capital in an otherwise very challenging environment.
During the second quarter, Fitch Ratings downgraded Canada’s sovereign debt from AAA to AA, as government finances have suffered due to infection control measures. Nonetheless, we think the long-term public debt outlook for Canada is far less concerning than for many other countries. Unless a country’s bonds are devalued from investment-grade to junk, a downgrade tends to have little impact. That is especially true for sovereign debt as highly rated as Canada’s.
Although global measures taken to manage the health crisis have resulted in a material decrease in economic activity, equity markets rallied higher during the latest quarter. Investors seemed to gain confidence in bidding up the price of risk assets on the back of massive fiscal programs announced by governments globally. This was further supported by commitments made by several central banks to maintain interest rates at historically low levels, with plans to provide financial support to both private and public companies during the pandemic.
In contrast to the optimistic tone of equity markets, the outlook for corporate earnings took a meaningful turn for the worse. S&P 500 companies collectively reported a 15% decline in year-over-year earnings in Q1 2020. In addition, there is little confidence of a short-term bounce in results with many companies withdrawing guidance for 2020 given the uncertain economic environment. The situation has not fazed investors, who appear to be looking forward to 2021 and beyond, where the consensus believes activity levels will improve.
The U.S equity market rallied nicely in Q2 with the S&P 500 posting a 15.4% return, while international and emerging markets returned 10.1% and 13.1%, respectively. While there was a broad rally in equity prices across geographies and industry sectors, the largest gains were realized by technology companies that are experiencing a surge in demand for their services. Companies with e-commerce platforms, video conference applications and entertainment streaming services reaped the largest gains, while companies with lower growth prospects in the financial and consumer sectors posted modest returns. Investor preference for growth companies has further widened the performance gap between growth and value factors.
The Canadian stock market participated in the rebound with the TSX posting a 16% return in Q2. The rise in value in Canadian stocks was dominated both by technology companies and gold producers. The increase in market volatility earlier this year caused some investors to fall back in love with precious metals, most notably gold that has seen its price rise by 16% year to date. Symbolic of the growing influence of technology, Shopify displaced RBC as the nation’s largest public company. The Ottawa-based e-commerce platform continues to generate impressive revenue growth as a rising number of new and existing businesses look to Shopify to help execute online strategies.
While markets have turned surprisingly positive in the face of a pandemic that has weighed down heavily on economic activity, we recognize that there has been significant government and central bank intervention that has and will continue to be supportive of asset prices. Nonetheless, we believe markets are vulnerable to take a step back if the health crisis worsens and the timing of an economic recovery is delayed. We acknowledge that there are investment risks on the horizon that warrant our attention to remain well diversified across assets classes, geographies, industry sectors and investment factors.
Given the high level of uncertainty we reemphasize the need to maintain balanced portfolios with greater liquidity options for our clients with cash requirements. For our clients with longer investment horizons, we continue to believe that long-term return prospects favor equities over fixed income and cash. Our sub-managers continue to favor both bond and stock holdings with superior quality characteristics that can withstand a more challenging market environment. Given the low interest rate environment and current asset valuations, it is likely that future portfolio returns will be unable to match those of the last economic expansion.
