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Quarterly Updates - April 2020

Diversification: key in Q1

Although down markets are never pleasant, balance across asset classes mitigated portfolio losses during a difficult first quarter of 2020. Cash, in particular, was king.

Volatility in global capital markets during February and March was so unprecedented that pundits are running out of superlatives to describe it appropriately: the worst single-day performance of the S&P 500 since 1987; the worst week for U.S. equity markets since the Great Depression; the worst month since 1931 and the highest levels of volatility since 1929. March of 2020 will thus go down in history with those famous dates… of that we can be sure, but the certainty ends there.

The reality is that we are in the midst of an unprecedented government-mandated shutdown of large parts of the global economy in order to slow the spread of a deadly virus, about which we still know very little. Although the news on the economic and public health front has been almost uniformly negative recently, they say even the darkest cloud has a silver lining, and later in the letter we will elaborate on the positives that we believe will emerge from these challenging few months.

By now most observers are aware that the spread of the COVID-19 virus and the associated economic shutdown has caused one of the larger asset market panics in history. At one point 35-40% from their highs.

in March, markets around the world had fallen 35 – 40% from their highs.

The extent of the losses has only been surpassed on a few rare occasions in history, as can be seen in Figure 1 below. In fact, the average bear market throughout history has coincidentally registered a similar 35% decline in the S&P500.

Has the market bottomed? Perhaps, but clearly there is potential for markets to go lower. However, the lower they do go, the more confidence one can have that the losses are in the rear-view mirror while attractive investment gains are increasingly likely in the future.

What happened?

As the month of March progressed and the virus continued its spread around the world, it became apparent that governments would have to shut down large parts of their economies in order to “flatten the curve” and slow the spread of COVID-19. What sounded like an orderly and sensible public health strategy collided with the hard reality of global markets, which have the ability to discount information almost overnight.

Due to persistently low interest rates, many investment strategies have used debt to “leverage up” and enhance returns. When asset prices started moving in the wrong direction in early March, these strategies became forced sellers into a market dominated by computerized trading strategies that accentuated moves to the downside.

An added challenge to markets during the quarter was the 50% collapse in the price of oil. In addition to the demand destruction from the virus-related slowdown, Saudi Arabia and Russia decided to start a price war in the midst of all the turmoil. The drop in energy prices hit Canada and emerging markets particularly hard.

In short, the panic and forced selling we witnessed in March was every bit as severe as October 2008, the height of the worst phase of the Global Financial Crisis when the survival of the entire financial system was at risk.

Unlike 2008 however, the open-ended shutdown of entire segments of the economy called into question the viability of countless businesses across multiple industries. Questions started to arise: Which retail stores survive? What about the airlines and the aerospace industry, hotels, cruise ships, the auto sector and restaurants?  The list is almost endless. The investment world was literally turned on its head overnight. Traditionally, investors make decisions with a three-to-five-year view. Suddenly, they were wondering if their investment would survive the next three-to-five months! Markets moved extremely quickly to reprice these news risks and unfortunately, trading liquidity evaporated. In short, there has not been anything like it in living memory.

Even safe assets such as US government bonds, which traditionally can be counted on as a hedge during periods of weakness, were adversely affected during the panic phase of the selloff. There were few places to hide with the exception of cash.

Some have likened the current situation to 2008.  Others have compared it to a war, namely World War II, when society and the economy were mobilized to fight a common enemy. The real pessimists make reference to the Great Depression. The good news is that even the most negative scenarios suggests this “sudden stop” of the economy will last no more than a few months, after which life should slowly return to at least a semblance of normal.

Further good news is that similar to 2008 (but unlike the Great Depression) the monetary and fiscal authorities have rushed to the rescue with impressive speed and vigor. On the monetary side, central banks worldwide have opened the floodgates of liquidity to calm markets and lower volatility. On the fiscal side, governments are stepping in to bridge the economy during the shutdown period by literally sending cheques to people in order to stave off a social calamity. The reaction on these two fronts has been nothing short of awe-inspiring.

Things may indeed get worse in the coming weeks on the health front but with respect to the economy and markets, it does give us significant comfort that unlike times of stress in the past, government and central bank authorities are of similar minds and are using every weapon in their arsenal to combat the problem.

Closing comments

It has been quite some time since the last major market downturn, so many people have forgotten how difficult they can be to endure. However, the current environment may feel worse than prior sell-offs because it combines market stress, business anxiety, and personal safety concerns all at the same time. It is a potent combination.

Where will the market go from here? No one knows. Perhaps we have seen the lows already. Often there is a “retest” of those lows after several weeks or months. Given the gravity of the situation, perhaps there is further risk that we will register a new market low. It is interesting to use 2008 as an example of the futility in trying to pick the absolute bottom. Figure 2 below shows, buying stocks within five months of either side of the ultimate low in March of 2009 proved to be extremely rewarding. Timing the bottom of the market is impossible. However, using a market that has declined significantly to one’s advantage in a methodical way has historically been a winning strategy.

On a related note, the following thoughts may be helpful and come from one of the most respected investors of all time: Howard Marks of Oaktree Capital, who had the following to say about the current selloff:

  • The “bottom” is the day before the recovery begins. We reject the notion of waiting for the bottom: we buy when we can access value cheap
  • Even though there’s no way to say the bottom is at hand, the conditions that make bargains available certainly are materializing
  • Given the price drops and selling we’ve seen so far, I believe this is a good time to invest, although of course it may not be the best time
  • No one can argue that you should spend all your money today…but equally, no one can argue that you shouldn’t spend any
  • The more you want to garner potential gains and don’t mind mark-to-market losses, the more you should invest
  • Is there really an argument for not investing at all? In my opinion, the fact that we’re not necessarily at “the bottom” negates the argument’

As is usual after market turmoil, there is no shortage of people predicting what the future will look like, notwithstanding their inability to predict recent events. We do not know what the future holds, what long- term effects all the fiscal and monetary stimulus will have on markets nor how the aftermath of COVID-19 will affect our lives in the future.  Undoubtedly things will change. However, we are fairly certain that in the future, many things will remain the same. People will likely continue to do their banking at TD, exercise in Nike shoes, wear Levi’s jeans, drink Tim Horton’s coffee, wear Alcon contact lenses and buy their home improvement materials from Home Depot. As for how society may or may not change, we’ll leave the predictions to others.

In the meantime, the government mandated economic shutdown is having a negative effect on the stock prices of countless companies while having a positive impact on others.

We believe the best investment opportunities lie within the former group, as opposed to the latter. Given the unprecedented environment, we encourage clients to take the three-to-five-year view as opposed to the three-to-five-month view.

We mentioned in our March email update that in the near-term, the news would likely get worse. However, we do believe that as the news eventually turns to decreasing infection rates from the virus, more stability and a path to recovery should emerge in markets.

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