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Return of volatility - 3rd quarter 2021 review

Richard Morin

Update :
Update :
October 15, 2021

The financial markets have gently reminded us that stocks don't always just go up. Down 5.3% since its September 2 peak, the U.S. stock market (S&P500 index) just experienced its first decline of more than 5% in nearly a year, while it averages 3 declines per year. For the entire quarter, however, the stock markets essentially stood still.

It is not surprising to see such a drop in September, historically the worst month of the year on average for the stock markets. Moreover, this volatility is likely to continue in October since the issues that are causing anxiety in the markets are for the most part far from being resolved:

  • Will the current surge in inflation be transitory or sustainable?
  • When and at what pace will central banks - including the US Federal Reserve - tighten their ultra-accommodative monetary policies?
  • Will the economic recovery succumb to the variant delta of the Covid-19?
  • Does the Chinese real estate bubble and the mountains of debt that support it constitute a systemic risk that could trigger a financial crisis?
  • Is the energy shortage - especially in Europe and China - a real threat to the global economy and corporate profits?

While we await the answers to these questions, balanced portfolios have generated good returns since the beginning of the year. Despite the September decline, global stock markets are up nearly 12% (in USD terms) this year.

Bonds, on the other hand, continue to defy the predictions of the "experts", with the rate on 10-year U.S. Treasury bonds remaining stubbornly low at around 1.5%. We will see in the Bonds section what factors may explain why rates remain low.

We are careful not to use overly optimistic return assumptions in our retirement projections, based on the results of the last 3 years. In the current environment of low bond rates and historically high price/earnings ratios for equities, we must be more conservative in our future return projections.

Market Review

Canadian stocks: oil again

The Canadian market was partially spared the September decline and ended the quarter with a slight increase of 0.2%.

What is now known as the energy crisis, which affects Europe and China among others, is driving the price of oil up. At $75 per barrel of WTI, it remains at its highest level since 2014. In the long term, efforts by several countries to reduce consumption should reduce demand, but in the meantime, oil companies have cut back on exploration and development spending so that the global market is very tight. While the energy sector only returned 1.6% in the quarter, the oil and gas exploration and production sub-sector is up 7.3% in the quarter and 67.8% year-to-date.

Gold stocks are down 9.5% for the quarter and nearly 18% year-to-date, reflecting the 7% decline in gold prices. Gold stocks generate profits and pay dividends over the economic cycle and therefore have a place in a diversified portfolio. Physical gold, however, generates no income and its price over the past year demonstrates once again that it does not offer the protection against inflation that some "experts" believe it does. It has no place in the portfolio.

Shopify, the largest stock on the Canadian stock market at nearly 7% of the index, is down about 17% from its high on July 23. This decline reflects the downward trend in technology stocks, which have a high price-to-earnings ratio; Shopify's is 70x. Despite this recent decline, the stock is still up nearly 20% year-to-date.

Cannabis stocks once again suffered a setback, falling 20.6% for the quarter and dragging the entire health care sector into the red. However, they do not weigh enough in the index to inflict damage on the portfolio.

Table Sector yields

U.S. stocks: waiting for the Fed

Despite a 4.7% decline in September, the S&P 500 index of large-cap U.S. stocks was essentially unchanged for the quarter. Adjusting for the currency effect, the return is 3.4% in CAD.

The market seems to be awaiting developments, particularly from the Federal Reserve, whose decisions in the coming weeks and months could be decisive for the direction of long-term interest rates and, consequently, for the evolution of the price/earnings ratio.

Growth stocks - and particularly technology stocks - would have the most to lose in a rate hike since they pay little or no dividends but rather reinvest their profits. We have already seen this trend emerge since mid-September, as the NASDAQ index (heavily concentrated in tech stocks) is performing significantly worse than the S&P 500.

International equities: Japan finally contributes

Japanese equities had a rare good quarter, which helped international equities generate a 2.4% return in CAD terms for the quarter.

The arrival of Fumio Kishida as Prime Minister will undoubtedly bring some stability in terms of economic policies. In addition, the global economic recovery has generated an increase in exports and profits for Japanese companies.

The strong performance of the Dutch stock market - which is a significant contributor to performance this quarter and for the year as a whole - is mainly due to the stock of ASML, an equipment supplier to microprocessor manufacturers.

International equities would have done better without the negative contribution of Hong Kong, whose stock market is being impacted by measures taken by the Chinese authorities to tighten controls, particularly in the technology and real estate sectors.

Emerging markets: China again

Emerging markets generated a return of -5.3% in CAD terms for the quarter. This represents a loss of almost all the return accumulated since the beginning of the year, which is now 0.2%.

The big culprit is China. Chinese stocks have fallen victim to the regulatory initiatives of the authorities under Xi Jinping's "common prosperity" policy. The Communist Party defends itself as trying to ungag certain Chinese companies and investors deemed too powerful, but in the meantime, hundreds of billions of dollars in market capitalization have evaporated for stocks like Alibaba, Tencent and Didi. More recently, fears of systemic risk from the mountains of debt supporting China's real estate sector have rattled global stock markets.

Elsewhere in the emerging markets, India continued its momentum (+15.2% for the quarter and +25.8% for the year in CAD) while Brazil suffered a setback (-18.3% and -12.2%).

Bonds: Where will rates go from here?

The Canadian bond portfolio had a slight negative return of 0.5% during the quarter.

The "experts" are puzzled by 10-year U.S. Treasury bond yields that are not responding to the resurgence of inflation in recent months and the expected end of the Federal Reserve's quantitative easing program. They believe that the inflationary push will continue and that rates should rise, which would lower the value of bonds. However, history shows that rates could remain low, even in an environment of sustained inflation, as we saw in the 1940s. Rates on 10-year Treasury bonds remained below 2.5% for an entire decade while average annual inflation was 5.6% (see chart).

Graph Interest rates on 10-year bonds

Several factors influence the direction of interest rates on 10-year bonds. While inflation and the end of the current Fed buying program tend to push rates higher, we can identify at least 3 factors exerting downward pressure. First, despite record deficits, new U.S. Treasury bond issuance is expected to drop substantially in 2022, reducing supply by the same amount, pushing prices up and, consequently, rates down.

Second, the exceptionally high returns of the past few years have generated actuarial surpluses for pension funds and insurance companies, which can now afford to "guarantee" the value of their portfolios over time by investing in Treasury bonds, even with rates as low as they are today.

Finally, we tend to forget that before the pandemic hit the planet, we did not fear inflation but rather deflation, caused in particular by demographic decline. Sooner or later, the pandemic will pass and these deflationary fears will resurface. We should not be surprised if rates not only do not rise, but fall even further. In such a context, we would be very happy to have kept a good proportion of bonds in the portfolio.