Richard Morin
Update :
14
April
2020
Update :
April 14, 2020
A crisis in 3 phases
Over the past month, most of us have come to understand the magnitude of the pandemic that is currently hitting the planet and the impact it will have on our lives. This unprecedented crisis for most of us will unfold in 3 phases.
Health crisis
Most governments are doing everything they can to slow the spread of the Covid-19 virus and limit the loss of life. We all have a role to play in ensuring the success of these measures. Since mid-February, Archer employees have been telecommuting and observing strict containment rules, with no impact on our operations.
While not affecting Archer, the containment and social distancing measures are having a direct impact on the revenues and profits of many publicly traded companies. As is always the case, this anticipated decline in profits is immediately reflected in stock prices. The speed of the decline - one of the fastest in the history of the financial markets - is explained by the almost immediate halt in activity in several important economic sectors.
Uncertainty about the magnitude and duration of losses caused by the war on the pandemic is the source of the extreme volatility seen in the markets - daily swings of 5% or even 10% are currently commonplace. This volatility will diminish as more is learned about the economic impact of the virus.
That said, the drop of about 28% in stock prices since the peak in February and 21% to date in 2020 is only justifiable if we anticipate a permanent and irrecoverable decline in corporate profits, which is unlikely. Time will tell if this decline was overdone, but we know that the stock market always anticipates the worst in times of crisis, which bodes well for medium and long-term returns.
The balanced portfolio - which invests 60% in equities and 40% in fixed income - fared much better, falling 10.6% (after fees) over the quarter, helped by a 1.6% increase in bonds. The 8.3% appreciation of the U.S. dollar - a safe haven currency - against the Canadian dollar also dampened the decline in value of our foreign investments. It is easy to forget that the balanced portfolio suffered even larger losses in 2000-2002 and 2008 and recovered quickly each time.
Financial crisis?
The behavior of the financial markets during the week of March 16 had the characteristics of a financial crisis: a rush to the exit of investors who sold even the safest securities - government bonds - to take refuge in cash.
Fortunately, central banks - notably the U.S. Federal Reserve and more recently the Bank of Canada - quickly pulled out the big guns (they learned the lesson of the 2008 crisis: act fast and go big) and the government bond market recovered.
Governments have also acted decisively: the United States has adopted an emergency plan of over $2 trillion - equivalent to about 10% of the size of its economy. Canada and other countries have adopted similar measures. Further fiscal measures will likely be announced as needs are identified.
We are not out of the woods yet. Most developed economies are probably already in recession. Unfortunately, this recession is likely to be more severe and longer than average, with more business and personal bankruptcies. The housing and mortgage markets - especially in the U.S. - appear vulnerable.
After the storm
Unfortunately, the worst of the health crisis is yet to come, at least in Canada and the United States.
As for the stock market, no one knows if we have passed the bottom. Will the rally at the end of the quarter be sustainable or will it be a false start followed by a second downward movement, as we have seen in the past? It is impossible to predict.
What we do know is that, like all the storms that preceded it, this one will pass. Even if the recession caused by the fight against the pandemic turns out to be longer and more severe than average, it will be followed sooner or later by an economic recovery. The stock market will anticipate this recovery by a few months, as it usually does.
The following table provides an overview of the frequency and duration of declines in the U.S. stock market since 1948, as well as the performance following the period of decline.
Declines in the S&P500 Index since 1948[7]
Canadian equities: weighed down by oil
As if the pandemic wasn't enough, the Canadian stock market has been hit by the oil price war that Saudi Arabia and Russia have dragged us into. Those who still use their cars can be happy about it when they go to the pump, but for the oil companies, it is a calamity. The drop in the price of oil has also weakened the Canadian currency which is down sharply against the USD (-8.3%) and the EURO (-6.4%) over the quarter.
The Toronto Stock Exchange's flagship index is down 20.9% for the quarter, while oil stocks are down 53.1%.
Financial stocks also fell 21.9% over the quarter. Large bank stocks (-20.2%) suffered a decline similar to the market. Smaller mortgage lenders, however, suffered a much larger decline (-45.6%), with no impact on our returns given their negligible weight in the index.
Other sectors fared much better, such as consumer staples (since we have to keep eating) at -9.7%, utilities at -6.2% and tech at -3.8%.
U.S. equities: every cloud has a silver lining
With a 19.6% decline in USD, the U.S. stock market did marginally better than the Canadian stock market. However, as mentioned above, the appreciation (8.3%) of the USD against the Canadian dollar limited the decline in CAD to 12.4%.
Technology stocks - the main sector of the U.S. stock market - did not do too badly with a drop of 11.9%. These companies are less affected by closures and many have very healthy balance sheets, after years of growing profits.
The much more fragmented financial sector fared much worse than in Canada, down 31.9%. The mortgage sector seems particularly at risk, as years of low interest rates and an often complex financing chain have encouraged risk-taking.
International equities: currencies again
On average, international stock markets did neither better nor worse than the Canadian stock market. However, the international equity portfolio also benefited from the weakness of the Canadian dollar. The decline in international equities was 15.9% in CAD.
Japan and Switzerland - two other safe haven currencies - did relatively well, while the UK and the EURO zone countries dragged down the performance.
Emerging markets: long live China!
There are winners and losers in emerging markets. Overall, their performance was -17% in CAD.
China was the surprise performer with a -1.5% return in CAD, the result of a smaller decline in its stock market (-10.3% in local currency) and a 7.4% appreciation of its currency against the Canadian dollar.
Conversely, the other four BRICS countries - Brazil, Russia, India and South Africa - had worse returns than the Canadian stock market and saw their currencies depreciate. With an economic crisis and a populist government, Brazil was the top performer with a 45.4% decline in CAD.
Obligations: our insurance policy
Canadian government bonds - both Canadian and provincial - are safe havens during economic downturns and stock market declines. The current crisis is no exception: these bonds are up 3.1% for the quarter. They were up over 8% until March 9, before falling back to their current level. Why are they down? Because governments will have to issue bonds en masse in order to finance the emergency plans recently put in place, which will inevitably bring down their price. That said, despite the fact that they only pay about 1% interest annually, they remain an essential insurance policy, especially in the current context.
Corporate bonds (which make up about 30% of Archer's bond portfolio, the other 70% being government bonds) generated a negative return of -2.5% for the quarter and about -6% since the Canadian stock market peaked on February 20. Note that the companies issuing these bonds are all rated BBB or better (no high yield bonds). Moreover, the drop in their prices since February does not affect the interest payment of about 3% per year for the moment.
We published a post recently to explain the recent volatility in the bond market. We're staying the course, including on bonds!
Real estate investment trusts (REITs): sold
As we explained in ourQ4 2019 letter, we believe the environment will be significantly less favorable for REITs over the next decade. Indeed, it is unlikely that the secular decline in interest rates that began 4 decades ago now - which is a big reason why REITs have performed better than other sectors of the stock market - will continue over the next decade. At least, if rates continue to fall, it will be because central banks are fighting a major economic slowdown, which will put a lot of downward pressure on the real estate market.
In this context, we have reduced the proportion of the portfolios invested in REITs during the quarter, keeping only what we hold through the Canadian equity index fund (about 3.5% of the index). So far, the market is proving us right.