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Market Update - The Uneasy Recovery

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The equity markets in much of the developed world continue their upward rally. Year to date, the TSX is up <green>+18.06%<green> while the S&P500 is up <green>+20.41%<green> [1].

Economic Recovery

As much as we would all like to put the pandemic behind us, Covid-19 remains a source of uncertainty for the global economy. The latest indicators point to a slowdown in the economic recovery we’ve witnessed earlier this year. Even as the world finds renewed optimism in Covid-19 vaccinations, the new Delta variant proves difficult to contain. Some parts of the world are back in lockdown. This is most notable in China, where new Covid-19 infections led to the closure of a major port, the Ningbao-Zhoushan port, for a period of two weeks. The Ningbao port was one of the world’s busiest by container volumes, connecting to over 600 ports in 100 counties, and its temporary closure provided yet another setback to the recovering global supply chain [2]. Similarly, lockdown measures have been re-introduced in places such as New Zealand and Australia [3].

There are signs that the Delta variant is having a tangible impact on the nascent business recovery. Numerous businesses warn of short term pain ahead. Southwest Airlines recently cautioned that it has experienced a deceleration in close-in bookings and an increase in close-in trip cancellations in August [4]. Meanwhile, Airbnb also warned about the potential adverse impact on its booking due to Covid-19 [5]. There are also indications of dampened momentum in high frequency data; traffic at restaurants, grocery stores, gas stations, and retail outlets all fell starting in late July, after initially surpassing 2019 levels earlier in the summer. Business confidence is also suffering as a result. A recent survey found that small-business confidence fell in August to its lowest levels since March, as only 39% of business owners expect U.S. economic conditions to improve over the next year, down from half in July and two-thirds in March [6].

Despite these negative developments, the uncertainty is much lower compared to last year. For one thing, the vaccine is drastically slowing the number of patients who develop severe symptoms, thus reducing people’s fears of going about their daily lives [7]. Vaccination rates in the developed world, such as in Canada and the US, are also climbing higher as one would expect [8]. Furthermore, although still highly uncertain and subject to fluctuations, there is hope that the Delta surge may have peaked in some of the outbreak’s original hotspots [9].

The labor market in the world’s largest economy also shows encouraging signs. Despite disappointing August numbers, the recent U.S unemployment and job growth numbers still point to a strong recovery [10]. The more optimistic statistics comes from the new U.S Census survey which finds that worker’s fear of Covid-19 is declining. The number of Americans who aren’t working for fear of Covid-19 keep falling, from a high of 5.5 million in January to 2.8 million in June and 2.5 million in late July and early August [6].

Finally, the market is optimistic about the excess savings consumers and businesses have accumulated during the pandemic. Oxford Economics estimates that, as of June, American households have saved an extra $2.5 trillion as a result of the pandemic. Consumers are eager to spend this cash, and when they do, it will help boost the recovery by unleashing pent up demand unto the economy [6].

Federal Reserve Tapering

Aside from Covid-19 related concerns, the market continues to monitor the Fed’s announcement of potentially winding down its $120B monthly asset purchases program, known as Quantitative Easing (QE), before year end.

The U.S Federal Reserve, along with other central banks, effected drastic measures to keep the economy afloat during the early days of the pandemic. The Fed took its benchmark interest rate down to near zero and implemented a quantitative easing program, which ended up swelling its balance sheet to nearly $8.4 trillion, almost double where it was in March 2020.

Nonetheless, now that the economy is showing more signs of life and the labor market is fast recovering, the Fed believes the economy no longer needs such radical policy supports. The U.S unemployment rate in August was 5.2%, drastically down from April 2020 highs of 14.8%, yet still hovering above its February 2020 rate of 3.5% [10] [11].

However, as the Fed considers the idea of removing QE, the market grows anxious about a repeat of the “taper tantrum” that occurred back in 2013, an episode that caused much pain for fixed income investors. This occurred as investors grew confused about the Fed’s messaging at that time; many investors incorrectly inferred that the central bank was prepared to raise its benchmark rates more aggressively. This caused long-term Treasury yields to rise sharply, by around 1 percentage point over several months (fixed income yield and price move in opposite directions, so a sharp rise in yield leads to a sharp decline in bond prices). Nonetheless, the Fed is learning from its past mistakes and is cautious about its signaling this time. The central bank is making it clear that its tapering decisions are mechanically unrelated to its interest rate policies. So far, there has been no panic as a result of the Fed’s announcement. Albeit, the market continues to watch for any changes in sentiment as the Fed moves to implement its decisions.

Market Positioning & Conclusion

The U.S stock market rally looks resilient, and investors remain bullish, despite the uncertainties in the economy. The S&P500 index has not seen a 5% pullback since last October while continuing to hit new highs. In the past 50 years, there have been only three years that the index ended without a 5% pullback: twice in the 1990s and then in 2017 [12].

We believe given where the U.S market is trading today, and given its general bullishness, there are fewer bargains to be found. Thus, we are patient with our capital deployment in this environment. However, this does not mean that we will try to time the market with exits and re-entries or try to guess what the market may do in the short term. We continue to view stocks as ownership in businesses, and we have bought many outstanding businesses, on your behalf, at very attractive prices, over the years. We believe as long as business fundamentals are solid, we will continue to hold them.

Although the U.S market looks expensive, we believe there are opportunities for bargain hunting in other markets. China, for example, just entered a bear market due to regulatory risks and investor psychology [13]. The Chinese government recently implemented new regulations and fines for businesses, which led many investors to conclude that Chinese shares are un-investable [14]. We believe this indiscriminate selling has created a chance for shrewd investors to pick good companies at attractive valuations. We have added a few of these companies with favorable long term prospects in our higher risked portfolios, and we will continue to monitor their development. We believe there is a high probability these businesses will perform well as long term investment holdings.

Overall, although covid-19 remains highly uncertain, we believe the current risks are manageable. We will keep monitoring its progress, along with movements in the market, and invest in attractive assets with the long term view in mind.

1 Factset August 31 2021 Price Return – End of Trading Day