Market Outlook and Investment Strategy

It has been about six weeks since much of the world went into lockdown to stop the spread of COVID-19. While things are certainly not normal, it would seem like we have adapted to the new reality and are doing as much as we can to slow the spread. From an investment perspective, it also gives us the opportunity to shift from managing the immediate crisis to looking forward and gaining some perspective on how this new reality will affect Alitis’ investments.

It is only in the last few weeks that estimates of the economic impact of COVID-19 have started to appear. Regardless of the source, all these analyses are trying to make some estimates around the three main drivers of economic impact:

  1. How deep is the disruption?
  2. How long will the disruption last?
  3. How fast will the economy recover?

We simply do not know the answers to these questions, nor will we until after the fact. However, the one thing that must happen to get back to normal is for the COVID-19 virus to stop spreading, and that will require a vaccine, a good proportion of the population to be immune, or proof that another approach works. Most likely, we will need to wait until a vaccine is developed and that appears to be at least a year away.

We will not know what the right course of action would be until this is all behind us, but the rest of this report is a very high-level view of our expectations, the implications for investments, and our likely strategy in navigating this situation.

Likely Scenarios Regarding the Spread of COVID-19

The one nice thing about living in British Columbia is that the government and health officers appear to have been ahead of most others in North America in preparing for COVID-19; controlling its spread through active measures and preparing for the lifting of some of the restrictions that we have all had to endure. As well, they have been forthcoming with information based on reasonable assumptions, estimates, and models. On April 17, an excellent report entitled “COVID 19: Where we are. Considerations for next steps”1 was released. The report gave many of the usual statistics, but the most useful information started on slide 30 which outlined their next steps and scenarios going forward.

In slide 32 of this document, the stated goal for the government is to “control transmission and growth in new cases while monitoring and minimizing unintended consequences of necessary public health measures.”  There are many unintended consequences, but the most obvious one being referred to are the economic consequences. Slide 34 shows one model that relates the expected number of patients in critical care to the strictness of social distancing measures in place as time progresses. As we have heard repeatedly in the news, there is a limited supply of critical care beds available, so keeping well below this limit is a primary consideration. The chart below shows some of the expected outcomes (I have annotated the lines to the right with my interpretation, so it is easier to understand):

According to this chart, we are presently at about 30% of our normal contacts due to all the social distancing requirements that are presently in effect. If we returned to normal, or even 80% of normal, the number of critical care patients would soar and soon overwhelm the health care system. Obviously, this is not a reasonable option. However, their model does seem to indicate that 60% of normal contacts is likely sustainable. Given a chart of this nature, it would appear that the BC government is in the process of reducing social distancing restrictions, but it is also clear that it will not be a return to normal or close to normal. Restrictions of some sort will likely remain in place until a vaccine has been developed and we will have to wait a few more weeks to see what restrictions will be lifted by BC’s health officers and the provincial government.

Economic Impact

If we assume that the BC model, or something similar, will be used in other areas of the world, it is reasonable to assume that the largest impact to the economy is occurring now in the second quarter of 2020 (Q2F) and that the situation will improve as restrictions are eased. Given that some restrictions are going to be in place until a vaccine is ready for use in (hopefully) a year, it is also reasonable to assume that the economy will take somewhat longer to return to its previous high that occurred at the beginning of 2020. Perhaps two years from now, in the second quarter of 2022, the economy will have fully recovered, and this appears to be the expectation of some of the big banks in Canada who have recently released their GDP growth forecasts:

Canada – Expected Change in GDP (%)2

Q1F Q2F Q3F Q4F 2020F 2021F
Royal Bank -4.0 -32.0 20.0 8.0 -4.9 3.4
Scotiabank -10.1 -43.9 21.3 17.8 -9.1 6.5
TD -9.7 -42.0 32.6 15.8 -7.5 7.3
CIBC -10.2 -40.5 33.4 18.5 -6.9 6.8
Average -8.5 -39.6 26.8 15.0 -7.1 6.0

United States – Expected Change in GDP (%)

Q1F Q2F Q3F Q4F 2020F 2021F
Royal Bank -3.0 -35.0 10.0 20.0 -5.5 5.1
Scotiabank -7.5 -39.0 25.9 16.3 -6.3 7.0
TD -4.2 -41.4 25.1 16.1 -6.2 6.6
CIBC -5.8 -39.4 25.8 12.3 -6.2 7.0
Average -5.1 -38.7 21.7 16.2 -6.1 6.4

The numbers indicate that these banks, on average, expect the Canadian economy to shrink by 7.1% in 2020 while the US is expected to shrink by 6.1%. This is not going to spread out evenly, as the decline in this current quarter is expected to be almost 40% on an annualized basis. (Do note that all the quarterly results are presented on an annualized basis which makes for much larger numbers, particularly in extreme situations like we have right now.)

On a global scale, the International Monetary Fund released its forecast of GDP growth, which shows a similar pattern, although not as steep of a drop and not as fast of a recovery:

Global – Expected Change in GDP (%)3

2019 2020F 2021F
World 2.9 -3.0 5.8
Canada 1.6 -6.2 4.2
US 1.7 -5.9 4.7
Euro Area 1.2 -7.5 4.7
UK 1.4 -6.5 4.0
Japan 0.7 -5.2 3.0
China 6.1 1.2 9.2
India 4.2 1.9 7.4
Latin America 0.1 -5.2 3.4

It is not a pretty picture. Except for China and India, most economies around the world are expected to shrink in 2020. However, there is some good news contained in these numbers. As shown in the first two tables above, it is expected that the pain will end in the second quarter and then turn to improvement thereafter.

To minimize the economic downside and help to ensure a recovery, governments around the world are sending vast sums of money to their citizens and businesses. In conjunction, central banks are pumping money into the financial system by buying a variety of bonds, mortgages, and other types of fixed income assets. Governments and central banks are buying time to help their economies survive as well as possible until a vaccine is developed for the virus. The following table, from the International Monetary Fund, shows how government deficits are expected to explode this year which will result in government debt increasing:

Expected Government Deficits and Debt as a Percentage of GDP (%)4

Government Fiscal Deficit Government Net Debt
2019 2020F 2019 2020F
World -3.7 -9.9 69.4 85.3
Canada -0.4 -11.8 25.9 40.7
US -5.8 -15.4 84.1 107.0
Euro Area -0.7 -7.5 69.1 81.3
UK -2.1 -8.3 75.5 85.9
Japan -2.8 -7.1 154.3 168.9
China -6.4 -11.2
India -7.4 -7.4
Latin America -4.0 -6.7 45.3 51.7

Given the current unprecedented situation, governments have little option but to borrow and spend money to avoid an economic disaster. For Canada in 2020, government deficits are expected to approach 12% of GDP and increase Canada’s net debt by almost 15% of GDP. If this was a one-time event it would not be much of a concern, however, the longer-term issue is that deficits are likely to continue for some years which will result is even more debt being accumulated. If debt is used for productive uses within the economy then this course of action may be sustainable; if, however, it is simply paid out with no productive use – just to help people and companies survive – then the longer-term implication may be the return of inflation. Inflation is not an issue now, but it is a concern for the future and one that we will be keeping an eye on.

Eventually, debts need to be repaid and that will involve generating a fiscal surplus rather than a deficit. Two options are available – raise taxes or cut spending – and it is likely that a combination of the two will occur. Canada has been through this before when it had accumulated a significant debt through to the early 1990s that needed to be paid down. Much of this was accomplished by not indexing government payments to the rate of inflation. As such, revenues increased as taxpayers slowly moved up to higher tax brackets while expenses grew at a rate that was less than the rate of inflation. The net effect was that the budget deficit slowly turned into a surplus thanks to inflation. Expect this playbook to be dusted off and put to use once the economy has recovered.

Political Considerations

In times of crisis you get to see the true nature of our elected leaders and of our friends around the world. It has been quite comforting and reassuring that, for the most part, Canadian political leaders have followed the advice of health officers and acted fairly uniformly to contain COVID-19. The health of Canadians has come first, and political squabbling has been put aside for now. Mistakes will surely be made, and these mistakes may only come to light in hindsight, but I think it is fair to say that Canada’s response has been good.

The same assessment cannot be said for some of our friends around the world, with likely the biggest disappointment being the United States. There appears to be no national strategy or coordination, lots of finger-pointing, and little concern for the rest of the world. It appears that the current US administration has little regard for other countries including their friendly neighbours and this became clear when they invoked the US’ Defense Production Act to force 3M to stop shipping N95 respirator masks to Canada.5

The rational lesson to be learned from the actions of the various countries in the world is that you cannot rely on your supposed friends to help out in a global emergency and to ensure security, a country needs to be able to provide for itself. As a result, it is likely that the concept of globalization that has guided the world for the last 30 years will suffer a setback. If countries need to ensure they can look after themselves, it will require that the capability to do so is contained within each country. It would not be surprising to see more protectionist measures being deployed under the guise of being in a country’s “national interest.”  Canada, as a smaller trade-dependent nation, could face some challenges especially if our neighbours to the south continue on their current path.

Investment Impact

Now we get to the hard part! The impact on investments occurs where health, economic and political interests intersect. Each impact the others and, ultimately, will impact the investment options that are available for use in the Alitis Pools.

It is still very early to be able to determine the impact on investments.  Circumstances are changing by the day, but the following is our longer-term view on what we expect to happen:

Health Considerations

  • Most governments around the world will act rationally and try to balance health considerations with economic impact.
  • It will take a year before a vaccine is available that will protect against COVID-19.
  • Given the above, social distancing and other restrictions (60% of normal level identified by the BC government) will be in place for another year.

Political Considerations

  • Governments will have learned that in times of crisis, you cannot rely on your friends for help.
  • Certain industries and activities will be deemed to be in the “national interest” and be shielded from foreign competition.
  • There could be a rise in protectionism around the world.

Economic Considerations

  • It is going to be a very rough year globally and there will be new economic issues that have not even been considered yet.
  • It appears that most economies will not get back to where they were before the virus appeared until 2022.
  • Government deficits will be large this year and will likely take a few years to get back to where they were before COVID-19. Government debt will increase sharply over the next few years.
  • Inflation could return in a few years’ time.
  • To pay for all the government support, countries will eventually have to tighten their belts by raising taxes and lowering expenditures.

Investment Outcomes

With respect to the various asset classes we use at Alitis, here are our expectations:

  • Cash: Given the recent lowering of interest rates, cash makes very little return. Its value lies in its ability to be deployed when opportunities arise, and this is what we have been doing since the crisis started. We expect that cash levels will continue to go up and down in order to buy investments when prices are cheaper and sell when prices head higher.
  • Fixed Income: There was a very rough patch for fixed income investments in the third week of March but since the announced measures from central banks to backstop the credit markets, fixed income products have been excellent portfolio stabilizers and are doing their job as a place of safety in distressed times. We expect that this will continue to be the case over the next several months, but we will start to slowly move to fixed income products that offer better protection as inflation starts to appear in the years ahead. Concurrently, we expect that allocations to fixed income will be lowered as inflation will make fixed income less attractive relative to other asset classes.
  • Mortgages: We expect our portfolio of mortgage investments to continue to perform decently, even though the underlying managers are being cautious and holding back some earnings as a reserve against defaults. The reports coming from these managers are that the situation in mortgages is within expectations. We are finding that opportunities have really opened up with publicly traded mortgage investments. Prices dropped significantly in March and we have been buying as the expected returns are much greater than we can get on private mortgage investments. This is the same strategy we employed in 2014/2015 which led to the very nice returns we experienced in subsequent years.
  • Real Estate: We do not foresee any significant change to our real estate stance. We have almost exclusively focused on residential real estate with multifamily apartment buildings being the majority of this exposure. Of course, there will be some hiccups along the way, but no matter what happens in the economy, people need a place to live so the demand for residential real estate will continue. One area where we do see value is with publicly traded REITs which dropped significantly in March; we have been purchasing them when excess cash is available.
  • Stocks: Obviously, stocks have had a rough time so far this year and it is likely that this turbulence will continue. Luckily, we have kept a large part of the equity strategy allocated to cash which gives us the opportunity to buy when dips in the market come along. We expect that corporate earnings will be terrible in the second quarter of 2020. Now, if we look back to the financial crisis in 2008/2009, companies put as much bad news as they could into one quarter so it would make their recovery look that much better, and we expect a similar situation to occur this year. However, this bad news may lead to a good buying opportunity if the prices of stocks get pushed down in response to the overly compressed bad news. Looking out a bit further, we will be looking to shift more money into stocks since it is our view they will provide higher returns than fixed income especially in an inflationary environment.

In summary, the situation is still very fluid, and much depends upon when physical distancing restrictions are reduced and the economy can return to normal. It will likely be a year before restrictions are dropped and another year before a return to normal. In the meantime, we are being defensive but opportunistically investing in publicly traded real estate and mortgage investments as the valuations are good. Fixed income is a good place to be right now due to the choppy markets, but as the economic and investment situation becomes clearer, fixed income allocations will be reduced. With respect to stocks, we will use cash to selectively buy and sell when appropriate and later we’ll continue adding to our stock allocations by shifting away from fixed income. In the years ahead, when inflation starts to appear, we believe there will be better opportunities in stocks over fixed income.

My Own Investments

I have heard from the advisers that some clients are asking what we are doing with our own money. As Chief Investment Officer at Alitis I thought you might find it interesting what my family owns as of March 31, 2020:

Other than cash in our chequing account, all of my family’s financial assets are invested in the Alitis alongside every Alitis client because I am a firm believer in putting my money where my mouth is. I do have some excess cash in my chequing account which I expect to add to my Alitis portfolio in phases over the next six months or so. I am not the most aggressive investor and I prefer to diversify across all the asset classes we use in order to get a decent return while keeping risk under control. I am not planning to change this mix of investments since Alitis’ Investment Committee is making changes within each of the funds to adapt to the environment as just described. As such, there is no need to move things around. This mix suits my family’s circumstances which, obviously, will be different from other families’ circumstances. There is no perfect mix of investments for everyone. Focus on your risk tolerance and future goals and try to avoid getting caught up in all the daily news – it’s simply overwhelming!   When you meet with your adviser for your regular review, routine rebalancing may be appropriate; just keep in mind that rebalancing and reallocation of investments is already occurring within each fund which may make adjustments in your portfolio unnecessary.

If you have any questions or concerns, please contact your adviser and they would be happy to help you. Thank you for reading and I hope this report has conveyed our view of the situation and how we expect to manage your money over the next year.

Sincerely,

Kevin Kirkwood, CFA
President and Chief Investment Officer

References:

  1. https://news.gov.bc.ca/files/COVID19_Update_Modelling-DIGITAL.pdf
  2. Royal Bank: Financial Markets Monthly, April 9, 2020; TD: North American Forecast Update, April 20, 2020; Scotiabank: Forecast Tables, April 17, 2020; CIBC: Economic Insights, April 16, 2020
  3. IMF World Economic Outlook, April 2020
  4. IMF Fiscal Monitor, April 2020
  5. https://news.3m.com/press-release/company-english/3m-response-defense-production-act-order

General Disclaimer 

This report is provided, for informational purposes only, to customers of Alitis Investment Counsel Inc. (“Alitis”) and does not constitute an offer or solicitation to buy or sell any securities discussed herein to anyone in any jurisdiction where such offer or solicitation would be prohibited. Opinions expressed in this report should not be relied upon as investment advice. This report does not take into account the investment objectives, risk tolerance, financial situation or specific needs of any particular customer of Alitis. Each individual’s investment objectives, risk tolerance, financial situation and specific needs should be evaluated before making any investment decision.

Unless otherwise noted, the indicated rates of return are the historical annual compounded returns for the period indicated, including changes in security value and the reinvestment of all distributions and do not take into account income taxes payable by any securityholder that would have reduced returns. The investments are not guaranteed; their values change frequently and past performance may not be repeated.  Unless otherwise noted, risk refers to the annualized standard deviation of monthly returns for the period indicated.

The information contained in this report has been drawn from sources believed to be reliable, but is not guaranteed to be accurate or complete. Alitis assumes no duty to update any information or opinion contained in this report.  Neither Alitis nor any director, officer or employee of Alitis accepts any liability whatsoever for any errors or omissions in the information, analysis or opinions contained in this report, nor for any direct, indirect or consequential damages or losses arising from any use of this report or its contents.