It’s been an unnerving and confusing year, to say the least. We worry about all sorts of risks all the time, but not in our wildest dreams did we imagine we would be navigating the consequences of a global pandemic. The experience has been surreal, humbling and also surprising.
If asked a year ago how we thought the OB Model Portfolio* would withstand a worldwide pandemic and the worst economic contraction since the Great Depression, we would have predicted a major hit to the value of our portfolio. Although we owned high-quality businesses and were postured somewhat defensively with an unusual and meaningful level of cash, we would not have thought that would be enough to save us from significant and lasting economic pain.
The decline in the first quarter was alarmingly fast and deep, yet the value of our portfolio has bounced back astonishingly well. As of mid-August, we had recouped all that had been lost earlier in the year and achieved a year-to-date return of zero. Ordinarily, break-even status would be no reason for cheer, but it is remarkable considering the ongoing troubled state of the world.
The value of our Model has risen alongside the Canadian and U.S. equity benchmarks; including reinvested dividends, the S&P/TSX Composite Index is down just 1.2% for the year to date, while the S&P 500 Index is up almost 8%, in Canadian dollar terms.
It’s reasonable to wonder why the stock market is doing so well when the COVID-19 virus is still thriving and the economy is struggling. We can think of three reasons:
- Central banks are pumping enormous amounts of cash into the financial system with their bond-buying programs. Much of that cash gets redirected into the stock market, which puts upward pressure on stock prices.
- A small number of very large businesses, like Apple, Amazon and Microsoft, are thriving in a COVID-19 world. These businesses are disproportionately driving the indices higher because they are weighted by company size, which is masking the damage below the surface. Most stocks are still well below their highs. The U.S. Information Technology sector, for example, is up 28% year to date, while the Canadian Energy sector is down 24% over the same period.
- Business bankruptcies have been limited and personal incomes have held up well, despite record unemployment, thanks to generous support payments, loans and loan deferrals.
It’s the last point that makes us wonder and worry.
When the pandemic hit, there was a strong bipartisan consensus all over the world to act fast and powerfully. It was the right thing to do, and it’s the reason the recovery has been impressive. But now that governments have run up huge debts and economies are re-opening, society is less united on the role of government going forward. Some feel that governments should scale back fiscal support and slow the growth in debt, while others worry that the economic recovery will falter if financial aid is reduced or eliminated too quickly.
In America, Republicans and Democrats have been unable to come to an agreement regarding the size and scope of the next round of fiscal stimulus. President Trump seems intent on reducing financial support, seeking just $1 trillion in additional stimulus instead of the $3.4 trillion package the Democrat-controlled House of Representatives passed in May. The $600 per week federal supplement to state unemployment benefits expired at the end of August, leaving millions of workers wondering how they were going to make ends meet. Republicans don’t appear to have much appetite to provide additional aid to cash-strapped state and local governments. President Trump also seems reluctant to spend more on testing and contact tracing, which are critical to getting the economy back on its feet in the absence of a vaccine or better treatments. While we expect the two sides to ultimately compromise and provide additional stimulus, the delay and uncertainty could stall the economic recovery.
The potential for political gridlock on important fiscal policy matters during a recession is precisely what we worried about a year ago, and it was why we raised cash and subsequently bought gold in our Model Portfolio. The reason we haven’t yet seen devastating second- and third-order effects from business closures and high unemployment is because government support has been enormous, and we worry that some politicians don’t appreciate the risk of reducing aid prematurely.
We believe in capitalism and prefer free markets with limited government involvement, but we are also realists, and unfortunately we think the private sector is going to be licking its wounds for a while. That means more saving and less job creation from the private sector, such that society will need to rely on governments to a greater degree to create jobs.
Governments will have to be a lot smarter with economic support going forward. Speed and a one-size-fits-all approach were helpful out of the gate, but if we don’t transition to programs with a future return, we run the risk of bankrupting ourselves.
There is a great opportunity for governments to create jobs by building and enhancing infrastructure, restructuring our healthcare systems to be stronger and more resilient, investing in research and development, and advancing critical projects like clean energy. We need plans and policies that engage both the public and private sectors in these important endeavours. But, governments need to make sure their investments have a future payoff and that they are not throwing good money after bad. Keeping zombie companies alive in times of distress merely prolongs the pain.
Social unrest around inequality was our biggest long-term concern prior to the current crisis, and still is. Fortunately, one of the silver linings from the COVID-19 tragedy is that the issue of inequality has been brought to the forefront. Inequality has been a problem for a long time, and the pandemic has both exposed it and made it worse. COVID-19 is hitting lower-income people harder because they lack access to adequate healthcare and tend to live and work in over-crowded conditions. Worldwide protests on this matter are no surprise. Inequality is a global issue, and we believe change is in the air.
It often takes a crisis to precipitate meaningful change, and we are optimistic that, although the path may be bumpy, much good will come from this chaotic period and there will be more balance and fairness in the world. The human race has a history of emerging stronger from periods of crisis, and we don’t think this period will be any different. The world desperately needs better leadership, and we are hopeful that too is forthcoming. We are also optimistic that we will get a vaccine and/or better treatments. Our scientific and technological capabilities are unparalleled in this age, and never before has the world had so much money and so many people focused on solving the same problem.
Despite our optimism, there are bound to be plenty of good and bad surprises along the way, and that means stock market volatility. The next few months are critical with regard to the evolution of government policy and leadership, and we will be watching those developments closely. Quality remains paramount in the higher-risk, slow-growth world in which we live. But the best businesses are popular and pricey, and we have to moderate our return expectations and make sure we own less popular businesses too. It’s also important to be diversified with cash, fixed income securities and even some gold. It’s more essential than ever to hedge one’s investment posture and not be overly exposed to one economic outcome.
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*The Odlum Brown Model Portfolio is an all-equity portfolio that was established by the Odlum Brown Equity Research Department on December 15, 1994, with a hypothetical investment of $250,000. It showcases how we believe individual security recommendations may be used within the context of a client portfolio. The Model also provides a basis with which to measure the quality of our advice and the effectiveness of our disciplined investment strategy. Trades are made using the closing price on the day a change is announced. Performance figures do not include any allowance for fees. Past performance is not indicative of future performance.
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