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Inflation or deflation? - Review 3rd quarter 2020

Quarterly review

Richard Morin

Update :
Update :
October 20, 2020

Inflation or deflation?

The balanced portfolio invested 60% in stocks and 40% in bonds did its job, up 3.1% (before fees) for thethird quarter and 3.4% since the beginning of the year, despite the stock market downturn in September. One could have expected worse in the current context.

Asset classes Returns in $C
3rd quarter. YTD
Bonds[1] 0,5% 8,0%
- Canadian women[2] 4,7% -3,1%
- Americans[3] 6,6% 8,5%
- International (EAEE)[4] 2,5% -4,5%
- Emerging markets[5] 7,7% 1,7%

However, the clouds have not lifted. (U.S.) stocks are currently trading at nearly 37X corporate earnings, not to mention the uncertainty surrounding the evolution of those earnings as we enter the second wave of Covid-19. That's expensive by historical standards.

On the other side of the portfolio, the rate on Government of Canada bonds maturing in 10 years is just 0.50%. In other words, bonds are expensive too.

Such high prices for stocks and bonds - not to mention real estate, which has risen sharply since last year - reflect in part the intervention of central banks, which, in addition to keeping interest rates very low, are literally printing money to buy bonds issued by governments to finance the record deficits resulting from the fight against the pandemic.

And then there is the risk that all this money injected into the system will eventually lead to runaway inflation. Those the industry likes to call gold bugs have already concluded: there will be a big inflationary push and we need to sell our bonds to buy gold to protect ourselves. However, as we have already seen, the perception that gold offers protection against inflation is more of a myth (well maintained by these same gold bugs) than reality.

In any case, the truth is that no one knows if an inflationary surge is about to hit the economic planet. It is true that in theory, injecting more money into a booming economy will sooner or later put upward pressure on prices. Except that, at the moment, the economy is far from being at full speed.

In fact, many investors believe that deflation (a generalized drop in prices) is on the horizon because of the aging population combined with the pandemic shock. These investors are buying long-term government bonds to protect themselves from possible deflation.

Inflation or deflation, nobody knows. So what do we do?

The good old 60-40 portfolio

The answer to this question is simple: you don't do anything - as long as your portfolio is well diversified and balanced and matches your investment horizon. Indeed, we must remember the role that stocks and bonds play in a portfolio.

Stocks are used to generate growth and income (over 3% dividends annually in Canada). In addition, since they do quite well in times of inflation, your equity portfolio will compensate for the decline in the value of your bonds caused by the rise in interest rates that would result from a possible inflationary surge. In addition, although they underperform over the long term, Canadian stocks tend to do better than U.S. stocks during periods of high inflation - because of their focus on resources and oil - including the high inflation of the 1970s (Chart 1). Your home will also provide you with a fairly good hedge against inflation (Chart 2).

Canadian vs. U.S. Equity Chart
Graph House United States average selling price

Bonds, on the other hand - especially longer-term government bonds - are first and foremost an insurance policy for your portfolio. If there is a prolonged recession or deflation, interest rates will continue to fall - probably into negative territory - which will increase the value of your bonds and partially offset the decline in value of your stocks and home. For example, a 1% drop in long-term interest rates would increase the value of your bonds by about 8%. Not a bad protection.

Of course, if rates were to rise rather than fall, your bonds would lose value, but in that case, your stocks would likely more than make up for the decline. That's what a balanced portfolio is all about!

Rolling stone doesn't gather moss

This old adage makes sense when managing your portfolio and financial plan. In his management, Archer is patient and lets time work for you, while active managers try to "beat the market" by actively trading the securities in the portfolio. The majority of these active managers fail miserably: the data in the following table speaks for itself.

Archer vs. active managers[6]
  6 months 1 year 2 years 3 years YTD
Archer 60-40 Portfolio 14,3% 4,2% 4,9% 4,6% 5,1%
Average of active managers[7] 13,4% 2,1% 3,2% 3,2% 3,5%

Market Review

Canadian equities: the rise slows down

TheQ2 rally continued intoQ3, until stocks pulled back in September. Canadian equities ended the quarter up 4.7%, including dividends.

The industrial, materials and consumer sectors led the rise. This makes sense: these sectors are the first to benefit from the economic recovery that the market seems to be anticipating. Among the heavyweights in these sectors that contributed to the rise were Nutrien (potash, +19.7% in the quarter), Teck Resources (basic materials, +30.4%), Agnico Eagle Mines (gold, +22.0%), Alimentation Couche-Tard (+8.9%) and Metro (+14.1%).

The oil sector, on the other hand, dragged the index down. Suncor Energy (-29%) and Enbridge (a pipeline that weighs 3.5% of the Canadian stock market, -5.8% for the quarter) contributed to the sector's underperformance.

While much has been made of Lightspeed's listing (+31.5%), in the technology sector it was still Shopify (+5.6%) that contributed the most to the rise because of its 6.5% weight in the index.

Sector Returns
S&P / TSX Composite S&P 500

(in USD)

Energy -9,4% -19,7%
Materials 8,8% 13,3%
Industrials 13,2% 12,5%
Consumer Discretionary 7,8% 15,1%
Consumer Staples 8,6% 10,4%
Healthcare (including cannabis) -14,4% 5,9%
Finance 2,8% 4,5%
Information Technology 3,6% 12,0%
Communication 0,8% 8,9%
Utilities 9,9% 6,1%

U.S. equities: the end of the playground?

The US stock markets ended the quarter strongly up (+8.9% for the S&P 500).

In addition to technology stocks, up 12% over the quarter, the same sectors as in Canada are responsible for the performance of the U.S. stock market: consumer staples and discretionary (+10.4% and +15.1% respectively), materials (+13.3%) and the industrial sector (+12.5%). Energy stocks are down 19.7% but, unlike in Canada, they do not weigh enough in the U.S. (only 2.1% of the S&P 500) to have a significant influence on the index's performance.

Tesla's shares are up 245% for the quarter, despite not being included in the S&P 500 index. Instead, it is stocks like Nvidia and AMD (technology, +76% and +71% respectively), as well as Fedex (+100%) that have driven the S&P 500 higher.

However, September seems to have been the end of the road for the US stock markets. Volatility returned with a vengeance, as the NASDAQ index (dominated by technology stocks) experienced daily declines of 3%, 4%, and even 5%, and made a foray into correction territory (down more than 10% since its peak) before recovering at the end of the month.

In addition to concerns about Covid-19's2nd wave and the impact it could have on the economy and corporate profits, it is the risks associated with the November 3 elections that are causing nervousness in the U.S. market. Trump has not only exposed and exacerbated the divisions within American society, he has also demonstrated that their democracy is vulnerable to populist attacks. Even if Joe Biden wins the presidential race, it will be difficult to put the lid back on the pot. Sooner or later, a Trump 2.0 will emerge, the first having shown the way.

International equities: Japan saves the day

The international equity portfolio generated a return of 2.5% in CAD for the quarter.

Japan alone contributed 1.3% to this return. Closer to home, the 4.6% decline in UK equities was partially offset by the rise of the British pound during the quarter, so the impact on the CAD portfolio was negligible.

Conversely, the Nordic countries (Sweden, Denmark and Finland), up 7 to 10%, saw their impact on the portfolio accentuated by the rise of their currency against the CAD. These three countries contributed approximately 0.9% of the asset class' return in the third quarter.

Emerging markets: Asia leads the way

Emerging markets performed very well inQ3, up 7.7% in CAD. However, this overall result masks huge differences between two distinct groups: the Asian countries (China, Taiwan, Korea and India), which were up by more than 10%, and the other countries, especially in Latin America, many of which experienced slight market declines.

Currency movements account for part of the difference in performance, with major Asian currencies appreciating by 2% against the CAD, while the currencies of Brazil, Russia and Saudi Arabia depreciated significantly.

Asian countries have also been more successful in fighting the Covid-19 pandemic, which improves their prospects. Another factor in their outperformance is that the technology and online business sectors are also weighing more heavily in their stock markets, much like in the U.S.

Bonds: rates are stable

Our bond portfolio generated a return of 0.5% for the quarter and 8.0% year-to-date. The rate on 10-year Government of Canada bonds remained very stable during the quarter, fluctuating between 0.43% and 0.66%. Given the relative optimism prevailing in the equity markets, one would have expected an upward trend in bond rates and therefore a decline in bond values.

This surprising stability on the bond side tends to be explained by the massive purchases made by central banks and their stated objective of keeping borrowing rates low. As they say: don't fight the fed. But central banks are not the only buyers. Investors, large and small, buy bonds as an insurance policy, even if they generate little current income. That's called being prudent and it's still the right thing to do!

1] FTSE TMX Canada UniverseXM Bond Index

2] S&P/TSX Capped Composite Index

3] S&P 500 Index

4] MSCI EAFE Index

5] MSCI Emerging Markets Investable Market Index

6] Data over 1 year annualized

7] Source: Fundata, Category: Canadian Neutral Balanced