- COVID-19 pandemic threatens global recession
- Major indexes fall into bear territory; S&P 500 down nearly 20%
- Bank of Canada, U.S. Federal Reserve cut key interest rates to effectively zero
- U.S. launches $2 trillion stimulus package; Canada $200 billion
- To inject liquidity, Central banks deploy massive bond-buyback programs
- In a supply/demand shock, oil falls from US$61.06 a barrel to US$22.74
- Canadian dollar declines from US$0.77 to US$0.71
Markets turned down as COVID-19 spread
In early December, a number of people who had visited a seafood market in Wuhan came down with a mysterious illness, becoming the first victims in the coronavirus pandemic. In a little more than four months, the virus spread from Wuhan, a Chinese port city of 11 million, across the world, infecting over a million people. In its wake, large swaths of the global economy shut down. Corporate profits crumbled and central banks slashed interest rates to zero. In just 15 days, the virus turned the longest bull-run in stock-market history into a bear-market rout.
The markets were far different just three months ago. The S&P 500 entered the year on a roll, touching new record highs. The U.S. Federal Reserve Board took the pulse of the U.S. economy and declared it healthy with near-record employment. Corporate earnings were solid. There had even been a partial truce in the U.S./China trade war – the path for markets to move higher seemed set.
All that started to unravel on January 7 when Chinese health authorities confirmed that hundreds of people had been infected by the coronavirus (COVID-19), which is present in bats and other wild animals. The virus may have been transferred to people shopping at a seafood market where domestic and wild animals were also sold. By January 25, Wuhan and five neighbouring cities in China’s Hubei province were locked down, effectively quarantining 56 million people. China’s lock-down appears to have worked. The virus though continues to spread rapidly worldwide, with the United States, and Europe becoming the new epicentres of the pandemic. And along with Canada, they have all but shuttered their economies.
Managing through the market storm
As the year began, we were slightly overweight equities. However, in early February when it became clear that the virus was spreading rapidly to other countries, markets turned volatile. By the end of the month, we had brought down our equity weighting and shifted more into U.S. stocks. With bonds rallying as yields fell, we had reached a point where the risk/reward outlook was less positive, and started to sell bonds and raised cash.
At that point, we also believed the market was oversold and put some of the cash to work in the last two weeks of March when it rallied on institutional rebalancing and Congress’s ratification of a $2 trillion stimulus package. On the final day of quarter we moved to neutral, with a cautious outlook on equities.
The $2 trillion economic rescue plan could help stabilize the U.S. economy and financial markets. As well, the U.S. Federal Reserve Board effectively cut interest rates to zero and launched a massive quantitative-easing program. And we believe the U.S. economy and financial markets may ultimately hold up better than others. For now, we are slightly overweight the U.S. and are looking for opportunities to add to our position.
The virus has swept across Europe. And with so much of the European economy (and that of its major trading partners) now near a standstill, it is vulnerable to a potential recession. And we moved from an overweight to an underweight position in international equities.
As the Chinese economy shut down, emerging-market equities sold off. However, with people returning to work and production picking up, there are signs that China may be turning a corner, with positive implications for other emerging market countries. And we moved from a neutral to a slightly overweight position in emerging-market equities.
In addition to the COVID-19 pandemic, the Canadian economy was also hit by a collapse in oil prices after the Saudis and Russians failed to reach an agreement on production cuts. Demand for oil also fell by 30% as the global economy slowed as the virus spread. Prior to that, as we anticipated, the S&P/TSX Composite Index held up better than many other markets. However, we don’t see much upside in the short term. We are now increasingly selective in what we want to own in the Canadian market, and we are holding to our underweight position.
The virus ends the S&P 500’s record run
On January 7, when Chinese health authorities identified the coronavirus, the S&P 500 fell slightly. But no one foresaw how rapidly the virus would spread, and on February 19, the S&P 500 was still up on the year. A day later, however, with the number of cases surging worldwide and the threat of a global recession on the horizon, the index started a rapid descent into a bear market. At one point, it lost 14% of its value in single week – the biggest weekly drop since the 2008 global financial crisis. At its worst, the index was down 30.4% and finished the quarter down nearly 20% (Charts 1 and 2).
Chart 1: Major indexes fell as the virus spread
Source: Bloomberg. Data as of March 31, 2020.
With China’s economy shutting down, emerging markets from Russia to Brazil went into a tailspin. In one eight-day period in January, investors pulled US$50 billion out of emerging markets– almost twice as much as at any time during the 2008 Financial Crisis. The MSCI Emerging Market Index was off 23.6%.
The MSCI World Index, fell 21.4% in the quarter, and the MSCI EAFE Index ended down 23.5% as the virus spread across Europe. At home, the S&P/TSX Composite Index, fell 20.9%. The move lower, was led by health care and financial stocks (Chart4).
Chart 2: Equity market selloff was worldwide
Source: Bloomberg. Data as of March 31, 2020.
Tidal wave of stimulus unleashed
In March, the Group of 20 major economies agreed to spend $5 trillion to shore up the global economy. Many central banks also reduced their key interest rates to effectively zero. Among those, the U.S. Federal Reserve Board cut rates by 1.5%. The Bank of Canada (BoC), which had not cut rates in 2019, could no longer stay on the sidelines, and reduced its key rate by 1.5% to 0.25%.
The BoC also made its first move into the bond market, agreeing to purchase $5-billion-per-week in government of Canada bonds. For its part, the Fed plans to buy $500 billion in U.S. Treasuries and $200 billion in mortgage-backed securities – essentially to keep the fixed income market from freezing up.
To help keep businesses afloat and protect people being laid off, Ottawa also moved into unchartered territory, providing $200 billion in direct assistance to individuals along with tax deferrals, government-backed credit and wage subsidies for business. And, as noted, the U.S. government will spend $2 trillion supporting businesses and individuals with direct payments.
The promised $5 trillion injection into the global economy could help stabilize the markets. But the markets will still need to see a massive amount of fiscal stimulus coming from a large number of countries. Moreover, the virus has to be contained in Europe and the United States. If it isn’t, the markets could decline again as a deeper economic slide is priced in.
A lot of what happens from here could also depend on China. It was the first country hit by the virus, and it looks as though it’s starting to come out of it. If it continues to show signs of economic recovery, it would imply that once the virus is contained, and with economic stimulus helping the economy, recovery may not be too far behind. And that could provide a boost to the markets.
Fixed Income: flirted with negative yields
U.S. ten-year Treasuries started the year trading in the 1.9% range, before ending Q1 at 0.70%. As equity markets priced in a slowing economy, and the Fed slashed interest rates, the yield on U.S.10-year Treasuries tumbled as low as 0.35%. Similarly, the yield on ten-year Canadian government bonds fell from 1.70% in January to 0.71% at quarter end (Chart3).
We reduced our bond exposure as yields fell to levels so low that there was less confidence in the ability of bonds to offset equity risk. As well, we expected that the stimulus programs could push yields back up in the coming months.
We benefited in Q1 from being underweight high yield bonds when spreads blew out, causing returns to go negative. We are now watching the spread on high-yield bonds, which has been widening against comparable Treasuries. If the right risk/reward equation presents itself, we may add to our high-yield exposure.
Chart 3: Bonds threaten to go negative, recover on stimulus
Source: Bloomberg. Data as of March 31, 2020.
Canada: COVID-19, then the oil price shock
As we entered the year, Canada's economic growth was already weak, at just 0.3% in the fourth quarter of 2019. The BoC expected GDP to come in around 1.6 % in 2020. But to say the least, COVID-19 and the oil price shock, which could aggravate underlying weaknesses in the Canadian economy, have darkened the outlook.
Few areas of the economy have been untouched by the epidemic. Indeed, with 75% of Canada’s exports going to the U.S. a number of sectors could be hurt as the American economy slows. As well, household spending, a key driver of the Canadian economy, is also tightening with millions of consumers under lock down, buying only the essentials when they do go out.
When the Saudis flooded the oil market after they could not come to an agreement with Russia on production cuts, the price of benchmark West Texas Intermediate fell to US$22.74 a barrel. Western Canadian Select, which trades at a discount to the WTI price, tumbled at one point to around US$3.50 a barrel. To put that into perspective, it can cost $7 a barrel just to transport Alberta oil to market.
Once the dispute is resolved, oil prices could bounce higher but that will be very hard to time. In the meantime, low crude prices could continue to hurt the S&P/TSX Composite Index, which has a 17% weighting in energy. Financials, which make up 32% of the index, also face headwinds with low interest rates cutting into profit margins on loans.
Nearly one million Canadians applied for unemployment benefits in one week alone in March. And until the impact of stimulus spending and lower interest rates kick in, we see little to be positive about, and continue to underweight the Canadian market.
Chart 4: Energy and health care lead the S&P/TSX Composite lower
Source: Bloomberg. Data as of March 31, 2020.
The U.S.: now in a steep economic slowdown
Before the epidemic, the U.S. economy was doing relatively well. The U.S. and China had reached phase one of an agreement to end their trade war. Corporate earnings were solid and the consensus view called for 2% U.S. GDP growth in 2020.
All that is now off the table. In fact, with nearly the entire U.S. population ordered to stay home, U.S. GDP growth could crater in the second quarter. Earnings could also look ugly for at least the next few quarters (and potentially longer if the virus isn’t contained).
Some economic forecasters believe the U.S. economy could bounce back quickly in a V-shaped rebound, while the consensus view sees a longer U-shaped recovery. However, nearly 10 million people filed unemployment claims in March. And because of the depth of the downturn, we believe a full recovery could take longer than many expect.
This raises the possibility of further economic stimulus, on top of the already announced $2 trillion program. In fact, U.S. President Donald Trump is again calling for a $2 trillion infrastructure-building program – a proposal he campaigned on in 2016, and one the democrats might support.
In the meantime, many leading U.S. companies (which could benefit as stimulus measures kick in) are trading at bear market prices. This represents a great opportunity for long-term investors, and we plan to add incrementally to our U.S. position, which is slightly overweight.
China: signs of an economic bounce back
China’s decision to fight the virus by locking down large parts of its population resulted in a sharp economic slowdown. February’s PMI numbers for manufacturing and services in China came in at 35.7 and 29.6, respectively, down from 50.0 and 54.1 in January – the worst performance since the financial crisis (Chart5).
However, significant parts of the economy are now coming back on line. In fact, the work resumption rate for large companies has climbed to over 90% in some parts of the country. As well, by early March, coal consumption (an indicator of industrial output) was running at close to 75% of last year’s levels.
To support the economic recovery, the central government has cut interest rates, and introduced a number of other incentives on the monetary side. As well, it is speeding up new infrastructure projects, including expanding 5G networks.
For now, we are positive on China and have a slightly overweight position in emerging market equities. While we think China is capable of reopening its economy, we are taking a more cautious approach on other emerging market countries, which could have difficulty rebooting their economies.
Chart 5: China’s PMI collapses and bounces back
Source: Markit. Data as of March 2020.
Europe: a struggling economy getting worse
Economic growth was almost at a standstill in the European Union as we entered 2020. With COVID-19 now taking an increasing toll on major EU economies, we believe the Eurozone may fall into a recession – if it is not already in one. Indeed, the European Purchasing Managers Index fell from 51.6 in February to 31.4 in March – an unprecedented drop.
EU growth is under pressure as economic output in the U.S. (it’s largest trading partner) - slows. European exports to China, another major customer for German cars and other European consumer products, has also dropped sharply. In February alone, car sales in China fell by 80%, and major auto manufacturers are closing factories in Europe. As well, tourism, a major contributor to the European economy, has all but dried up and could take a long time to bounce back.
On top of those concerns, Brexit has not gone away. Negotiations leading to a joint trade pact between Britain (Europe’s second largest economy) and the EU are moving slowly, and face significant obstacles. In the meantime, trade between the two has slowed.
As a result, with the health and economic crises continuing to unfold in Europe, we have moved from being overweight to underweight EAFE equities. In the process, we are using some of the cash that was freed up to invest in other areas.
Outlook: cautious on equities, deploying cash
Overall, we moved to a neutral position on the final day of Q1 with a cautious outlook on equities. In terms of fixed income, we expect to selectively add to our bond allocation. And we see some promise in high yield bonds, if the right risk/reward equation presents itself.
- Added to our slight overweight position in U.S. equities, and may increase it when investment opportunities arise.
- Increased underweight to Canada, with COVID-19 and low oil prices hurting the economy.
- With much of the Eurozone economy at a standstill, moved from an overweight, to underweight position in EAFE equities.
- With China’s economy possibly recovering, moved from an underweight to slight overweight position in emerging market equities
- Canadian dollar dropped significantly as the U.S. dollar strengthened against it. Until we see some resolution in the equity and oil markets, the dollar could remain in the US$0.70 range.
Overall, we will continue to manage risk in the short term while looking for longer-term opportunities. However, for now, we are comfortable with how the Sun Life Granite Managed Portfolios are positioned.
This commentary contains information in summary form for your convenience, published by Sun Life Global Investments (Canada) Inc. Although this commentary has been prepared from sources believed to be reliable, Sun Life Global Investments (Canada) Inc. cannot guarantee its accuracy or completeness and is intended to provide you with general information and should not be construed as providing specific individual financial, investment, tax, or legal advice. The views expressed are those of the author and not necessarily the opinions of Sun Life Global Investments (Canada) Inc. Please note, any future or forward looking statements contained in this commentary are speculative in nature and cannot be relied upon. There is no guarantee that these events will occur or in the manner speculated. Please speak with your professional advisors before acting on any information contained in this commentary.
© Sun Life Global Investments (Canada) Inc., 2020. Sun Life Global Investments (Canada) Inc. is a member of the Sun Life Financial group of companies.