Global Review (Q2 2020)
A burst of strong performance – but will it last?
The second quarter of 2020 saw strong performance in global risk assets, as markets and economies around the world responded to the easing of initial COVID-19 lockdowns and continuing stimulus and emergency support from central banks and governments.
The initial reopening phase led to a burst of consumer spending, which also raised expectations for economic growth to normalize. However, we remain cautious as a recent surge of new COVID-19 infections has led to new mobility restrictions, with more expected to come. This, along with lingering uncertainty about when an effective COVID-19 vaccine will be ready and deployed, has the potential to continue to drag on any economic recovery in the near term. At the same time, financial solvency risk persists for companies of all sizes despite government intervention in the markets. This, combined with slowing economic activity, creates a low-visibility environment for all investors.
Geopolitical risk is also elevated, with U.S. presidential elections later this year. Meanwhile, the trade relationship between the U.S. and China is already starting to deteriorate again, just months after the signing of the first phase of a trade deal between the two countries. Lastly, emergency fiscal policy responses globally are set to expire. If they are not renewed, their absence could create a significant threat to the recovery.
Developed market equities were up
Canadian equities gained
Markets hold their ground
As could be expected, consumer spending enabled by the reopening phase buoyed investor sentiment in the second quarter. The increased economic activity, along with continued emergency support, was supportive to global markets.
Developed market equities were up 19.4% (in local terms), and Canadian equities gained 17.0% as of June 30.Canadian benchmark 10-year government bond yields slipped nine basis points (bps) to 0.53%, while high yield and investment grade credit spreads tightened by 219 bps and 50 bps, respectively.The CBOE Volatility Index (VIX), which is used as a measure of the level of fear and projected volatility in the market, declined by 23 points to 30, indicating a significant easing of investor anxiety.The Canadian dollar rallied 3.6% vs. the U.S. dollar during the quarter to 0.737 from 0.711, and crude oil (WTI, near contract) rallied to US$39.27 from US$20.48 on March 31.
Long-term risks have not abated
While COVID-19 will continue to steal the show as the most high-profile and persistent risk facing investors in 2020, we also remain attuned to a number of other persistent factors with long-term implications.
First, structural economic headwinds – ranging from demographics and high debt to declining productivity and political paradigm shifts – could restrain real GDP growth and inflation, pressuring bond yields and earnings growth.
Second, since the global financial crisis more than a decade ago, markets have seen unprecedented monetary stimulus and low real interest rates, compounding the impact of other secular headwinds on risk premiums.
Third, it goes without saying that eventually, the bill will come due for all of the stimulus and support that governments have provided this year, which could likely lead to higher taxes and more borrowing. And when faced with high debt-to-GDP levels, countries use a combination of economic growth, higher taxation, debt restructuring and financial repression – a policy which includes the explicit or indirect capping of interest rates. We believe a mix of traditional tools and financial repression could lead to an abnormal distribution of impact across – and within – different asset classes.
And lastly, we continue to believe that as a result of a compression of the illiquidity premium in private markets, the skills of private investors will be tested in the future.
Lower return expectations call for caution
We continue to believe that investors face a challenging path ahead and that expectations should reflect lower investment returns in major asset classes going forward. While we expect investors will likely enjoy less reward for every additional unit of investment risk they take on, true diversification remains critically important. High-quality bonds, for example, while expensive at present, provide both diversification and liquidity benefits. We also continue to believe active management strategies can create value in the current climate, but their performance always has to be weighed against their usually higher cost.
The pandemic kicked off 2020 by creating unprecedented volatility and economic damage around the world. We believe the rest of the year will be just as difficult, or, at the very least, just as uncertain. It remains to be seen whether already strained governments can effectively respond to a second wave of infections, increasingly expected to hit just as fall and winter approach. With that in mind, caution should be top of mind in the months to come.