OB Report
May 2021
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Cooperation Despite Dysfunction

Murray Leith By Murray Leith, CFAExecutive Vice President & Director, Investment Research
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In mid-April, the Vancouver Canucks shocked the hockey world by beating the Scotia North Division-leading Toronto Maple Leafs in their return from a team-wide COVID-19 outbreak. With 22 players and four staff having tested positive for the virus, and many requiring bed rest, there were many who questioned whether the team was fit to play after a 25-day pause and only one practice. But they did play, and they won! Go, Canucks, Go!

The players celebrated their win like they had won the Stanley Cup – and so they should have. Their victory, while small on the surface, is symbolic of humankind’s resolve and ability to rally together and adapt under pressure to make the best of a tough situation.

While the pandemic has caused much hardship and tragedy, it’s been remarkable how far the world has come in its fight against the deadly disease. Not only have vaccines been developed and rolled out in record time, but the global economy in general, and the stock and real estate markets in particular, are considerably stronger than anyone expected when the world went into lockdown last year.

Despite heightened social unrest and polarized politics around the world, individuals, corporations, institutions and governments have risen to the challenge and worked cooperatively, or at least more supportively than might have been expected, to put the world on a healthier path. It’s human nature to help each other in a crisis.

Indeed, politicians put their differences aside so that governments could provide the support that individuals and businesses needed. And they didn’t disappoint. In fact, the collective governmental response to the crisis has been so great that it has assuaged our biggest concern about the outlook – that social unrest and dysfunctional politics would render governments ineffective.  

Prior to the pandemic, we were cautious regarding the medium-term economic outlook because we worried that politicians wouldn’t be able to agree on the fiscal policies we’d need during the next inevitable economic downturn. Both fiscal and monetary policies can resuscitate economies during recessions, but for decades it has been central banks and their accommodative monetary policies that have fueled the recoveries. Governments have been too dysfunctional to be meaningfully helpful.

In the fall of 2019, with yields on government bonds negative in much of Europe and Japan, and otherwise extremely low in North America and elsewhere, we recommended reducing risk and raising cash in portfolios, as we reasoned that monetary policy would be much less effective during the next recession. Governments would necessarily have a much bigger role to play in the next downturn, and yet we wondered if that would be possible or popular.

Ideally, governments should take advantage of economic expansions to improve their finances, but most didn’t do that during the last cycle. Instead, they expanded deficits and increased debt, and therefore entered the downturn in a weakened state. Deficits naturally increase during recessions, as tax revenues decline and spending on benefits and services (i.e., unemployment insurance) increases. In addition to these natural cyclical pressures, there is ongoing secular pressure on government finances due to the rising cost of providing entitlements to an aging population. Consequently, we worried that governments would struggle to justify and finance discretionary deficits when we’d need them most.

Our concerns proved to be moot, as the magnitude of the COVID-19 crisis inspired cooperation despite dysfunction. Not only was the speed and scale of government and central bank responses unprecedented, but the support is ongoing.

It hasn’t been a typical recession. Aggregate personal income normally declines during a recession alongside employment, but this time it went up thanks to government relief payments. Moreover, credit usually tightens in a downturn, but this cycle it got cheaper and easier to secure due to extremely accommodative monetary policies. Rather than a credit contraction, we have had a credit bonanza.

More importantly, society’s attitude about government deficits and debt has shifted in the face of the pandemic. There is fairly widespread agreement that governments need to do whatever it takes to navigate us through the crisis, even if it means huge deficits and ballooning debt. There is also greater awareness regarding inequality and more support for policies that seek to address it.

While we still have longer-term concerns regarding the consequences of rising global debt, the important thing is that authorities did what was absolutely necessary in the face of the pandemic. Reassuringly, there is still tremendous stimulus in the economic pipeline and considerable pent-up demand that will be unleashed as the world opens up in the months ahead. It’s reasonable to expect a robust economic recovery well into 2022.

Nonetheless, it’s important to curb one’s enthusiasm for the stock market. Markets are forward looking, and it’s probably fair to say that they have already discounted a decent amount of the good economic news. Think about it in the context of the S&P 500 Index. This index recently reached a new high and is up almost 30% since the end of 2019, and yet earnings expectations haven’t recovered nearly as much. The one-year forward earnings expectation for S&P 500 constituent companies today is up less than 8% from where it was in December 2019.

The reason for this disconnect is that investors are willing to pay more today for a dollar of future earnings than they were before the pandemic. That may be perfectly reasonable given that interest rates are modestly lower and the economic outlook is brighter. Having more faith in the capacity of governments to do the right thing in the near term is another factor that may justify higher valuations. Still, higher valuations will make it more difficult to sustain high returns. Investors would be wise to ensure their portfolios are well diversified and not overly concentrated in popular and pricey securities.



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