06 Oct Guest Commentary, Gord Glagau – An Economist’s View – (Aug 24 2020)
I have been an avid and passionate follower of financial markets for decades…mostly to satisfy my own curiosity, but also to form opinions to share with others. My interests cover everything from equities to government and corporate debt, currencies, commodities, and other asset classes such as real estate and private equity/venture capital.
But first, I should give you a bit of my personal story. I grew up on a farm in Saskatchewan and learned early on how weather and politics in another part of the world could directly affect me, and my bank account. Selling product into a global market forces you to be aware of not just what’s happening locally, but around the world and to make decisions that involve calculated risks. I liked farm life, but felt there was more to be learned. So, I moved to Ottawa. Why Ottawa, you might ask? Well, I also had a fascination with politics and wanted to see first-hand how the political process worked…in addition to getting a degree in finance.
After Ottawa, I moved to Montreal and finished a graduate degree in economics…in international trade and finance. While going to university, my summers were spent either back home on the farm, touring through Europe or at a summer job on Bay Street (Toronto). After graduation, my summer job became full-time and I was officially no longer a farmer or a student, but a banker. Not long after graduation, I thought I needed a bit more street cred, so I got a CFA (Chartered Financial Analyst) designation. With a lot of the theory behind me, I really liked some of the practical elements of what the CFA designation had to offer…from portfolio construction to behavioral finance.
So, that’s a bit about me. Now I want to share some of the things that have been on my mind lately. I’ve always been fascinated with how global financial markets are interlinked. But I have to say the recent moves higher in both equity and bond markets are a bit puzzling, especially given the state of the economy.
The S&P 500 is setting new highs daily and the TSX Composite is only 8% below its all-time high in February of this year. In fact, the S&P 500 is now trading at 30x expected earnings…the highest valuation in over a decade. Compare that to the underlying economies, which are expected to contract. The International Monetary Fund (IMF) recently predicted that the global economy will shrink 4.9% this year which would be the worst annual contraction since WWII. Canada and the US will fare worse than the global average at -8.4% and -8.0% respectively. Given that the stock market reflects expectations of future earnings, it seems difficult to imagine how a company grows profit in an environment of joblessness and global economic contraction. On a more personal level, I feel for all those small business owners that have closed up shop in my neighborhood and I wonder who is going to replace those lost jobs.
The bond market is also telling an interesting story. Current yields on benchmark 10-yr bonds in the US are running at 0.65% and in Canada at 0.59%. In other words, the best that an investor can do by buying a 10-yr US Government bond today and holding it to maturity 10 years from now is an average of 0.65% per year. If you look at other government debt from around the world (Germany, France, Switzerland, Japan, etc.), the yields are actually negative…meaning bond investors are knowingly locking in a loss if they were to buy and hold. Among financial players, many say that bond investors are the “smart money”. So, why would a “smart” investor buy something that they know will lose money?
Well, the answer lies in how bond investors make money – bond prices rise when yields fall. A year ago (pre-COVID), the US 10-yr bond was yielding 1.50%. The move down in bond yields from 1.50% to 0.65% has benefited bond holders and many see this as a flight to safety. Typically, stocks and bonds are negatively correlated – in plain language, stocks usually fall when bond prices rise (driven by a desire to reduce risk). I’m sure I’m not the only market observer that wonders how long both stock and bond markets can rally at the same time.
This adds another chapter to the economic story, the economy is shrinking, bond yields are falling, yet equity prices are at all-time highs. It’s as if the stock market didn’t get the memo that there’s danger out there. If stocks are historically expensive, then the “buy-low, sell-high” equity investor should do just that…lighten up on equities, particularly those with stratospheric earnings multiples.
With cash in hand, market sectors (in addition to the bond market mentioned above) that do well in periods of falling interest rates are gold and real estate – more specifically, residential real estate. Everyone needs a place to live, and in a post-COVID world, we have spent more time at home than many of us would like. And for those living with a family in a condo tower, I’ll bet many are searching houses for sale well outside of the density in downtown urban settings.
However, I’m not as positive on commercial real estate, mostly because of the trend to on-line shopping and what is likely to be a permanent change in how much time we spend in the office. These well-established trends will only be further accelerated post-COVID. I am hopeful that mall owners will re-invent themselves, transforming a primarily shopping place to a multi-purpose entertainment space…but this transition will take time. As for office space, technology has shown that we can substitute in-office with online meetings from our kitchen table. It’s only a matter of time before companies will look to save money by downsizing their office spaces and further promote working from home.
And finally, there’s gold. While many view this as a quirky market that often has unexplainable price movements, gold does serve as a store of value in a low interest-rate world. A small allocation of gold (not necessarily gold stocks) can provide diversification in volatile markets.