Third Quarter 2020 – Quarterly Commentary

A Financial Market Fairy Tale

As we are now well into what seems like the endless year of 2020 and following two-quarters of economically heavy quarterly updates, we thought for the third quarter we would try to lighten things up a bit by telling a story. Hopefully, you will enjoy the story of Princess Jacinda (in honour of the New Zealand Prime Minister who to date has arguably had the most success in leading her country through the pandemic) and her seven healthcare workers.

A Princess out for a walk…

One day in mid-March our Princess went out for a walk to contemplate the state of the world as it battled a pandemic, the likes of which had not been known for 100 years. The global economy was collapsing as countries locked down. Financial markets were crashing, and the health crisis was spiraling out of control through Europe and beginning to carve a sharp trajectory through North America.

Rather than panic, our Princess began to take deep calming breaths, just as she was instructed during her meditation podcasts. Unfortunately for our Princess, in one of those deep breaths, she inhaled a small droplet tainted with the coronavirus and immediately fell into a deep sleep. (Note: we recognize this is an unlikely way to catch COVID-19, but please allow for a bit of creative license in our storytelling.)

When the Princess awoke, it was September. Leaping out of bed in a panic she began to ask questions of the seven healthcare workers in her room.

“Oh my, what has happened with the virus?” she asked her club-hopping caregiver, Sneezy.

Sneezy shrugged casually as she sneezed into her mask. “It looked for a little while like it was under control in Canada and Europe, but now the number of people infected is spiking again.  The U.S. never did get the virus under control and it is spreading like a California wildfire through South America.”

Princess Jacinda’s mind began to race. “Are the hospitals overwhelmed? Do we have enough ventilators? Are people panicking?”

Sneezy wheezed again. “Nah.  So far there have been very few hospitalizations and death rates have come down. Older people are staying at home. It is younger people that are getting sick now, as we are the frontline workers and some of my friends still like to go to a party occasionally.”

“So, people aren’t freaking out?” she asked again, confused.

Sneezy coughed and shook her head. “The politicians keep trying to get everyone to stay home. They refer to it as lockdown fatigue, as it doesn’t seem like anyone is listening.”

Princess Jacinda contemplated this information. Turning to her next health care worker, she addressed Doc. “When I went to sleep, research was beginning on a vaccine. Is there going to be a vaccine before winter?”

Doc scratched his head thoughtfully. “I’m not really sure,” he replied. “Donald Trump has promised Americans a vaccine before the U.S. election in November.”

Our savvy Princess rolled her eyes at the Doctor. “Trump also told everyone this was no worse than the regular flu.”

Doc sighed heavily. “Dr. Fauci says there may be a vaccine relatively soon, but the consensus is that there won’t be a broad rollout of a vaccine until later in 2021. We are hoping that by limiting large gatherings and with people wearing masks while indoors, we can mitigate the spread until a vaccine is available.”

“If the healthcare situation is under reasonable control, then what has happened with financial markets? Are equity markets down 50% yet?”

Before any of her devoted healthcare workers could answer, an aging prince galloped up to the window on a white steed. Dismounting carefully, he entered the room, bowing deeply before the Princess, clutching his lower back as he tried to straighten.

“Please, let me respond to this question,” the Prince stated with a flourish. “But before I enlighten you on the state of the financial system, let me introduce myself. I am Prince Jerome, from the land of the Federal Reserve. The decline in equity markets was brought to a quick end in March by the decisive action of myself and my troops. By flooding the system with money, we restored liquidity to the system and equity markets have recovered all of their losses.”

“You launched another round of Quantitative Easing?” the Princess asked.

“Not just another round of Quantitative Easing,” Prince Jerome boasted. “We promised the world we would do whatever was necessary to support the financial system. We promised to buy government bonds, corporate bonds – even junk bonds, if necessary. There is no limit to the power of my balance sheet!”

“Aren’t you worried that all of this monetary stimulus will lead to inflation?”

Before Prince Jerome could make a fresh pronouncement, healthcare worker Happy burst forward. “We don’t worry about money-supply and government deficits anymore. The U.S. Federal Reserve has dropped its 2% price inflation target and moved to a target of 2% average inflation. That means that after 10 years of inflation undershooting the target, inflation can be allowed to drift higher until the average gets back to 2%!”

“It’s not only that,” Happy bubbled with enthusiasm. “There is a new economic theory taking hold called Modern Monetary Theory that says governments can run as big of deficits as they want and the central bank can buy up the debt and it’s all okay – as long as you control your own currency. And, of course, if you do get inflation it can be a bit of a bummer.”

“Are the government running big deficits then?” Princess Jacinda asked with concern.

“HUGE!” Happy declared with glee. “The Canadian deficit will go from approximately $20 billion last year to $343 billion this year.  Think of all the great things we can do with that money! The United States started out spending trillions, but they are having second thoughts and most of their direct support programs for workers ran out at the end of July. Congress has been unable to agree on an extension.” Happy looked glum for a moment. “I am concerned the economy might not bounce back without more help.”

World: Government assistance increasingly costly

Source: NBF Economics and Strategy (Data: IMF) 1

A snort from the back of the room prevented Happy from lamenting the limitations on U.S. spending any further.  “You guys have it all wrong,” the voice grumbled.  “It isn’t about the economy, it’s about financial markets!  You keep thinking they are the same, but the evidence suggests they aren’t.”

Princess Jacinda rubbed her head as it was beginning to ache. “Grumpy, I assume that is you back there. Would you care to explain why financial markets don’t reflect the economy?”

Grumpy elbowed his way to the front of the room to address the Princess. “Just look at what is happening. Sure, unemployment is sitting at 8% – 10%, but who are those workers? So far, most of the unemployment is with young people and those in minimum wage jobs. They don’t invest in markets. Also, let’s look at which businesses have shut down. It isn’t the big businesses that are public companies, most of it has been small and medium-sized businesses. Big companies may benefit as they lose smaller competitors.”

Jacinda sighed, sinking into a nearby chair. “But if the economy continues to be weak, won’t the big companies lose customers and money too?”

Grumpy whacked his palm against his forehead. “You just don’t get it. No one is concerned about 2020 earnings; everyone is looking at 2021. Next year, the big companies will cut costs to protect their earnings and the markets will be happy. After all, it is all about the earnings.”

“It isn’t all about the earnings,” Princess Jacinda pointed out, feeling like she finally had some firm ground beneath her. “Valuations also matter – particularly over longer periods of time.”

Sleepy looked up rubbing her eyes. “Will someone wake me up when investors start to worry about the valuation levels?”

“How high are valuation levels?” Princess Jacinda asked, somewhat fearing the answer.

Six healthcare workers and Prince Jerome all looked at the ground, Sleepy let out a small snore, before rousing herself again. Reaching into her pocket she pulled out a crumpled piece of paper. “I prepared this chart for you. It looks at the trailing Price Earnings ratio for the S&P500 over the last 20 years. The black line is the average and the dotted lines plot out one standard deviation up or down from the average and the outer lines mark two standard deviations.”

Source: Refinitiv

Before Sleepy could continue, Prince Jerome interjected. “For any of you in the room that didn’t attend stats class, let me explain. Under statistical analysis, it is expected that the outcome (in this case the P/E ratio) will be within one standard deviation of its average approximately 2/3rds of the time and within two standard deviations 95% of the time.”

Sleepy cleared her throat and sighed wearily. “If I may continue. As you can see from the chart, most of the time, once equity valuations get outside the one standard deviation line, they have tended to revert towards the average line relatively quickly. Although in August the valuation level looked like it might approach the second standard deviation – it didn’t breach that barrier.”

Unable to contain himself, Happy burst in again. “The old metrics don’t matter. With interest rates hovering near zero, valuation levels should be higher than in the past. After all, it isn’t like people have any other choice on where to invest, bonds are returning near zero.”

Princess Jacinda began rubbing her temples. This felt like a migraine coming on. It was possible that she may not have fully recovered from her illness yet. She wondered if confusion and hallucinations were newly discovered symptoms of COVID-19, as none of this could be real.

Before she could speak, Bashful raised her hand tentatively. “I um, I ah, I would like to respond to some of Grumpy’s comments,” she stammered. “Perhaps the overall economy is not as bad as suggested and we forget that there are pockets of optimism.”

Jacinda waited for the shy older woman to continue. “The Canadian housing market is booming as are all forms of home renovation. These are economic segments that have strong positive spin-offs to the rest of the economy. Due to the supply chain disruptions, inventory levels are low and only beginning to rebuild, which should help manufacturing recover further. Retail sales in the U.S. have fully recovered to pre-pandemic levels. Markets are forward-looking and perhaps they are looking at these factors. Travel and entertainment will likely continue to suffer, but anything related to e-commerce is expanding. I heard that UPS added almost 40,000 workers in a quarter to deal with the increase in volumes. I will admit it is easy to focus on bad news, but perhaps it is not all bad.”


* Seasonally adjusted by NBF
Source: NBF Economics and Strategy (data from Bloomberg) 1

Princess Jacinda sat quietly for a moment processing all the information she had gained. “If people aren’t worried about the virus anymore and they aren’t worried about markets anymore, what are they worried about?”

Once again silence filled the room. A commotion at the back caught Jacinda’s attention as Dopey tripped forward sprawling on the floor in front of her. Standing up to dust himself off, he answered her question. “The U.S. election. People are worried about the election.”

“What is the concern regarding the election?”

“People are worried that the results will be disputed. President Trump is already indicating that he won’t accept the results if he loses and is creating a case for voter fraud. With the higher than normal number of mail-in ballots, some states may not be able to determine the outcome for several days after election night. It is generally expected that the courts will need to make some decisions to determine the outcome of the election. The results could remain in dispute right up to inauguration day, undermining the legitimacy of the incoming president and risking upheaval as people take to the streets in protest.”

Princess Jacinda held up her hand. “Stop!  I don’t want to hear anymore.” The Princess paced the room for a few minutes trying to organize her thoughts given the conflicting data points.

“So, let me get this straight. Unemployment is high and despite some recovery, might go higher before it goes lower. Small businesses are shutting down at a rapid speed. But as in every crisis, there are winners and losers and some segments of the economy are doing well while others are devastated. Corporate earnings are expected to recover in 2021 and there is room for an upside surprise. However, if virus cases continue to move higher, the economic recovery that has begun could be completely derailed. In the meantime, equity markets move higher on positive expectations, low-interest rates, and a central bank willing to provide unlimited support. Government deficits don’t matter as the central banks hoover up all debt issuance. All this loose money has pushed valuations to levels rarely experienced in the past, but with no end to free money in sight, investors remain unconcerned. Then, to top this up, we may have the first U.S. election in which there is no president-elect far beyond Christmas – potentially destabilizing markets.”

The seven healthcare workers and Prince Jerome all nodded in agreement.

Uncertain how to proceed with such contradictory information, she approached her magic mirror. Staring into the reflective glass, she uttered the magic words, “Mirror, mirror on the wall, please tell me what’s going to happen this fall?”

The mirror began to change colours as the image in the glass spun like a mad kaleidoscope. Finally, a voice declared, “My dear princess seeking answers in the looking glass. Have you forgotten; I was purchased for your exercise class?”

Without the benefit of a clairvoyant mirror, Princess Jacinda began to make an investment plan, following the themes her personal trainer espoused.

  1. Consistency is important.  Just as regular exercise can improve your health. A steady flow of interest and dividends can improve portfolio returns.
  2. Don’t over-extend yourself – it will lead to injury. She reminded herself to assess the risk level in the portfolio and to ensure it remained in line with her risk tolerance. No matter how good markets have been, managing risk remains an important discipline as an injury can set you back a long way.
  3. Have reasonable goals and stay focused on those, even on the tough days. Just as you are unlikely to lose 50 pounds in a week, reaching your financial objectives is a marathon, not a sprint. Stay focused on the finish line, as there will be some rough spots along the way.

 

Logan Wealth Management
October 1, 2020

 

1 Note: Adapted from “World: Continuing recovery” by Matthieu Arseneau and Jocelyn Paquet, Monthly Economic Monitor, Economics and Strategy, September 2020. Copyright 2020 by National Bank Financial Inc. Adapted with permission.

 

Disclaimer:  Please note that the publication is designed to provide general information only.  It reflects the thoughts and opinions of Logan Wealth Management and should not be construed as financial advice, nor should the information be considered a substitute for personal advice.  Information used in this publication has been gathered from sources believed to be reliable. Logan Wealth Management is not responsible for and assumes no liabilities or responsibility for any loss or damages suffered as a result of the use or misuse of, or reliance on the information or content of this publication. Please consult your financial adviser to determine whether the information is applicable to your personal situation.