October 2020 Newsletter
Another Solid Quarter
Despite some increased volatility in September, the quarter finished solidly in the black for North American markets along with our Legacy portfolios. Throughout the period, headlines were dominated by uncertainties about the timing of economic reopening, rising COVID-19 case counts, flaring tensions between the US and China, US social unrest and inequalities, and policy uncertainty surrounding the extension of pandemic relief benefits. However, markets managed to look past these concerns and were driven by the usual suspects: monetary and fiscal stimulus, vaccine progress/hopes, better-than-expected corporate quarterly results and economic data that surprised to the upside. The Bank of Canada, like its US counterpart, pledged to maintain interest rates near current levels for the foreseeable future. On the fiscal side, the minority Liberal government delivered a throne speech promising to do “whatever it takes” to support Canadians through the pandemic. While much of the speech was focused on the current crisis, many of the Liberals’ policy initiatives that were announced during the 2019 election were also mentioned. The full cost of the fiscal spending will not be known until the budget, but regardless, we know it’ll be a big number that will be tacked onto Canada’s already swelling debt. Credit rating Fitch already downgraded our nation’s credit rating from AAA to AA+ stable in June and reiterated that Canada's current debt-to-GDP ratios are higher than AA+ rated peers. Recognizing the ballooning deficits, the throne speech did pledge the government to fiscal sustainability once we exit the crisis. Finance Minister, Christina Freeland, also vowed to preserve Canada's reputation of sound fiscal management as the government considers the next steps to drive the economic recovery. If there is a silver lining here it’s that interest rates are extremely low and many spending measures are temporary; unlike the 1990s when Canada’s deficits were structural and interest payments were a significant drag on spending.
With a few concessions, the NDP supported the Liberals during the confidence vote thus Canadians will not be returning to the polling stations anytime soon. The same cannot be said for the US as November’s general election is quickly approaching. National polling data has VP Biden in the lead, but the race for the White House will be closer than initially expected as Trump has picked up some ground in recent weeks. In our view, the best outcome for the market is a decisive win by either candidate, while a close election result on November 3 will create further uncertainty as ballots are recounted. If there is one thing markets dislike it is uncertainty.
The last US election that was too close to call, and ultimately was decided by the Supreme Court, was in 2000. Florida was the battle ground, a state where George W. Bush won by a slim margin over Al Gore. Given the margin, state law required a recount and resulted in a month-long legal battle which ended in a 5-4 Supreme Court ruling in favour of Bush.
As if 2020 hasn’t thrown us enough curveballs, the passing of Supreme Court Justice, Ruth Bader Ginsberg, and the nomination of Judge Amy Coney Barrett, presents a new twist to the election process. It is uncommon to fill a Supreme Court vacancy so close to an election; historically, it has taken ~55 days to approve a nominee. With less than 30 days to the election, it may prove to be difficult to get Barrett confirmed. The Republicans currently control the Senate but that may not be the case after Election Day as they are defending 23 seats, while the Democratic Party will be defending 12 seats. If the Democrats win a majority in the Senate, confirmation of Barrett is a very unlikely outcome. However, if Senate Republicans can confirm Barrett prior to the election, not only would it tip the balance of power towards conservatives, but could be a deciding factor in a contested election. There are seemingly so many moving parts and potential outcomes over the next few weeks that it will certainly provide market participants with a little more anxiety than normal ahead of the election. Bottom line: be weary of jumping to political or market conclusions.
In our Legacy portfolios, we have and will take a more cautious, but measured approach with our investment strategy over the coming weeks. We intend to add thoughtfully positions to the portfolios on inevitable volatility while trimming or selling positions that either are overbought or have hit our stop loss. Our focus is always to preserve capital first and if done right, returns will follow accordingly.
Reviewing the Case for Fixed Income
Back to Basics: Why do we hold fixed income in our Legacy portfolios?
A discussion of the merits of fixed income in a portfolio is best prefaced with a review of the fundamentals. When investors think of “fixed income,” the next word that often comes to mind is yield. However, that is just one characteristic of fixed income and, in most cases, should not be thought of as the most important. In our view, there are three primary reasons why investors hold fixed income securities: (i) capital preservation (ii) income and (iii) reduce portfolio volatility.
- Capital Preservation
In general, fixed income is thought of as a “safe” asset class. This is generally true relative to equities when considering senior securities from investment grade issuers, like quality corporations or governments. However, not all bonds are created equal; high-yield debt, or “junk bonds,” may entice investors with larger payouts, but have an increased chance of default – the inability of the issuer to return the principal when the bond matures. Furthermore, good companies can issue multiple bonds that rank differently in their capital structure, also affecting their safety in the case of an adverse event.
Though they can’t be relied on with certainty, credit ratings give an investor a general sense of the creditworthiness of a security, giving them more confidence in knowing their invested capital will be returned at the promised time.
Looking at average calendar year performance over the past 17 years, corporate and government bonds have earned lower average total returns compared with equities, ranging from 3-7% depending on issuer and term, while the S&P/TSX has averaged a total return of ~8.5%. However, the path using fixed income is far more consistent, with fewer years of negative returns, and drawdowns that are less than a third of what equities have seen historically. What this translates into is a more reliable, less volatile trip for your investment.
- Reduce portfolio volatility
In recent years, the correlations between bonds and equities have increased. Massive quantitative easing programs have been a contributing factor in reducing the diversification benefits of fixed income products. However, government bonds still maintain attractive diversifying properties given their correlation with equities has remained low. Using federally-issue securities can thus help to reduce portfolio volatility, ultimately providing better risk-adjusted returns over the long run. In the following table, we can see the historical benefit of including fixed income with equities. Across different investor profiles, the higher the fixed income weight, the higher the Sharpe ratios and less volatile returns.
- Enjoy the beautiful colours and views as you take a hike along one of B.C.’s many beautiful trails.
- Visit animals and feed the ducks at Maplewood Farms.
- Enjoy a scream or two at Slayland: a night of a thousand screams.
- Visit a local pumpkin patch.
- Grab a slice of homemade pie.
- Take a whale-watching cruise across the Strait of Georgia and How Sound.
- Cosy up and a historic gastown walking tour at night.
- Get lost in corn maze.
- Soak up the colours and fall landscapes at VanDusen Botanical Garden.
- Take a Halloween flight with FlyOver Canada.
- Get nerdy and learn a thing or two at Science World.
- Get cultured at the Vancouver Art Gallery.
The current yield environment is challenged and is expected to remain that way for the near term. With central banks clearly signaling that interest rates will remain at accommodative levels for at least the foreseeable future, bond rates will also remain low across treasury and spread products. Investors searching for yield have done primarily two things: extended the term (investing for a longer period), and/or accepted a security with lower credit quality (decreasing the safety of capital). While we understand that at current rates, bonds may not provide the income stream that they once did, we caution investors against moving into non-investment grade securities just for the modest pickup they may provide unless additional research has been completed.
The yields on equities are higher than bonds across the spectrum; however, investors must consider the differences in the risk of different types of investments used to generate income. If an investor required $500,000 in late March of this year, in the equity market, they would have had to taken a haircut on the capital proceeds. If they had instead opted to purchase a high-quality bond that had a maturity to align with this date, they would have almost certainly received their principal back with no adverse effects.
The Bottom Line
In the face of record low interest rates, investors at times remain fixated on the low return potential of bonds, and therefore use that as a reason to reduce allocations to the asset class. However, this way of thinking is incomplete when capital preservation and portfolio volatility are investment objective considerations. In turbulent times such as now, investors should recognize the defensive nature of bonds within the context of the broader asset allocation framework. In our Legacy portfolios, we are presently tilted towards corporate over government bonds and are more focused on credit quality than simply chasing yield while keeping duration low (with a time to maturity less than 5 years, to avoid too much sensitivity to interest rates, should they begin to rise from the ultra-low levels they are now).
12 Must-Do Activities in Vancouver this Fall
As the leaves start changing colours, autumn is a great time to get outside and enjoy nature. Grab your mask and “social bubble” and enjoy some of these fall activities around Vancouver:
Charts of Interest
Demographics Hang Over Long-Term Growth
If you’re worried about the short-term economic outlook, the WSJ's Greg Ip has bad news: The long-term outlook is worse. The Congressional Budget Office has revised down its forecasts for both population and productivity and the results aren't pretty: The agency expects annual economic growth to average just 1.6% over the next three decades—down by about a quarter of a point from its forecast a year ago—and just 1.5% by the 2040s. The U.S. hasn’t had trend growth that low since the 1930s.
Only a bit of this is because of the pandemic. Most reflects longer-lasting forces, namely demographics and productivity. The CBO has had to revise down estimated population repeatedly in recent years and may have to again. Fewer births translate into fewer people entering the labor force 20 years later. And then they're expected to be less productive, in part because a smaller workforce by itself leads businesses to invest less.
The ABC’s of RESPs
An RESP, also known as a registered education savings plan, is a powerful savings tool for Canadian parents. Investments inside the account can grow tax free, with no tax on dividends, interest or capital gains. As well, the government offers the Canada Education Savings Grant, in which they will kick in up to $500 a year. Parents can contribute up to $2,500 per year, over 18 years, to maximize this credit.
Yet, if you have a good investment strategy in place, it may make sense to make a one-time contribution of $50,000 up front. Though you won’t reap the benefits of the government grants in future years, by investing a lump sum upfront you will be able to experience potentially higher returns through compound growth.
RESPs are highly marketed to new parents and if someone unsolicited contacts you shortly after your child is born, be wary to invest in their long-term “savings bond.” It will limit the flexibility of the RESP and take away the robustness of a good investment strategy.
Seth Allen Featured on City TV’s Breakfast Television
On Friday, September 18th, Seth was featured on City TV’s Breakfast Television; he discussed if there is a correction coming given the ongoing economic uncertainty.