It's all about inflation - 1st Quarter 2021 Review

If we could predict the evolution of only one economic data, we would probably choose inflation.

Why? First, inflation - or at least the expectation of inflation - determines interest rates and therefore the yield on government bonds, which make up about one-third of a balanced portfolio.

Moreover, since investors are interested in the real return of their portfolio (i.e., after inflation), inflation also has a great influence on stock prices. On the other hand, a little inflation is good for corporate profits, as companies can increase their prices at the rate of inflation while controlling their costs. Too much inflation is not good for anyone.

Inflation also influences leadership in the stock market. For example, low interest rates that accompany low inflation favour growth companies, especially technology. Rising inflation and interest rates will generally benefit the major sectors of the Canadian stock market: banking, energy and resources.

This is the backdrop against which to analyze the portfolio's performance in the first quarter of 2021. Stocks and bonds have fluctuated with inflation expectations. And as mentioned in an earlier letter, there are two diametrically opposed schools of thought regarding the evolution of the inflation rate. One predicts that the billions in liquidity injected into the economy by central banks and governments will sooner or later lead to runaway inflation. The other school of thought - including Modern Monetary Theory - maintains that there is no risk of a sustained inflationary surge as long as we are not at full employment.

During the quarter, several economic data points seemed to support the former, including retail sales and employment. Investors reacted by demanding a higher interest rate: the rate on 10-year U.S. Treasury bonds rose from about 0.92% to nearly 1.75% (it is 1.55% in Canada). This rapid increase in rates explains why the bond portfolio generated a negative return of -5.0% in the first quarter.

Speaking of inflation, one cannot help but notice that the price of gold is down 10% over the quarter, despite the rise in inflationary expectations. So much for protection against inflation!

Long live Canadian equities

The good news for Canadian investors is that this rise in inflation expectations has helped the Canadian stock market, which has generated a return of 8.1%, compared to 4.7% for U.S. stocks (in C$).

Overall, balanced portfolios fared well during this relatively volatile quarter. However, caution remains the order of the day as equities - particularly new economy stocks - are trading at historically high levels, which will sooner or later lead to a correction.

Market Review

Canadian Equities: Banks and Energy

Until recently, investors were only interested in new economy stocks: technology and Tesla. That's why the U.S. stock market has generated better returns.

This trend was reversed in the first quarter of the year. The two main sectors of the Canadian stock market explain this good result: energy at +19% and the financial sector - which alone accounts for 31% of the Canadian stock market index - which rose by 13%. The former benefited from the 22% jump in oil prices and the latter from the rise in long-term interest rates.

As is often the case with energy, the reversal is particularly notable, with the sector suffering a decline of almost 31% in 2020. The cycle is well known: lower oil prices lead to lower production - especially in the oil sands where production costs are high. When the economy improves, demand for oil increases and the price rises again...until the next time. Like everything else, this cycle is completely unpredictable.

In both Canada and the U.S., technology stocks have treaded water. As mentioned earlier, these stocks do not like rising interest rates. It's mathematical: when rates rise, the present value of future profits - which forms the basis of stock prices - tends to fall. This is in addition to the fact that many consider technology and new economy stocks to be significantly overvalued.

The 37% performance of the health sector should be mentioned. This is mainly due to the resurgence of the cannabis industry - yes, the cannabis industry is classified in the health sector! - Unfortunately, it does not have enough weight to have a significant impact on the performance of the overall index.

U.S. equities: new records

Nothing seems to stop the U.S. stock market, which is going from record to record. Successes in the vaccination program point to an end to containment measures and a surge in economic growth. After the adoption of a relief plan of nearly 1.9 trillion, the Biden administration is back with an infrastructure plan that could exceed 2 trillion.

This was all it took to convince investors that U.S. equities continue to offer good return prospects, despite an annualized increase of nearly 14% over the past 10 years.

The gain was 4.7% in the first quarter. As in Canada - and as predicted in our last letter - rising long-term interest rates caused a shift in leadership from technology stocks (+2.0% for the quarter) to energy (+30.9%) and financials (+16.0%).

While the rate hike was sufficient to bring about a change in sector leadership, it remains insufficient to bring down the price/earnings ratio. Based on estimated earnings over the next 12 months, the price/earnings ratio of the S&P500 index is indeed at a historically very high level of about 22x. U.S. stocks are undeniably expensive, but it is only in retrospect that we will know if they were too expensive.

International equities: the currency effect

The major currencies have depreciated against the C$: the Euro is down about 5% and the Yen about 8%. This is a return of the pendulum following the reverse movement in the last quarter of 2020. The British pound is the only one to have resisted the decline, perhaps because of the success of its vaccination program. Nearly 50% of Britons are vaccinated compared to less than 20% of Europeans.

In this context, international equities only offered a return of 2.0% in C$. However, most international stock markets performed well in local currency terms. The Japanese stock market returned 8.7%, Holland 15.7% and Sweden 18.1%.

Emerging markets: weighed down by rising rates

Apart from the Chinese stock market, which has treaded water, and Brazil, whose management of the pandemic (among other things) ranks it among the dunces, most emerging markets performed fairly well in the first quarter: nearly 13% in Taiwan and South Africa and 6% in South Korea.

As in other international markets, however, the rise in the C$ has offset much of these gains, leaving the return to the Canadian investor at 1.5%.

On the other hand, emerging markets do not like rising interest rates and the prospect of an appreciating US dollar because their debt is denominated in that currency.

Bonds: rates are rising

The rise in long-term interest rates that began in the wake of the U.S. election accelerated in the first quarter. The market was right: the victory of the Democrats in the presidency and the House of Representatives opens the door to spending increases that will have to be financed by bond issues. From 0.92% at the end of 2020, the rate on 10-year U.S. Treasury bonds rose to 1.75% at the end of the quarter.

There was some concern that the Federal Reserve would have to buy all those bonds that the Treasury would have to issue. That certainly hasn't been the case so far, with investors making net purchases of $500 billion in U.S. bonds in the 12 months ending in February.

This increase in rates resulted in a -5.0% return on the bond portfolio in the first quarter. This was offset by the rise in equities. The other good news is that it will now be possible to invest in bonds at a higher interest rate.

The Federal Reserve is clearly more concerned about the risk of disinflation - or even deflation - than inflation. For this reason alone, it is important not to deviate from our strategic bond allocation.

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