Resurgence and recovery have been the watchwords this year, as the global economy regained its footing after the downdraft of the COVID-19 pandemic. This unprecedented situation was compounded by subsequent fiscal and monetary policies. Although some uncertainty was expected, the outlook has become positive as pent-up consumer demand is being unleashed. As many economies advance toward a full reopening, there is a sharp upgrade in the economic outlook for the world’s wealthy countries and downgrades for poorer countries, which have struggled to vaccinate their populations.
Canada’s economy finished a sizzling summer by adding a third consecutive monthly increase in jobs that has brought the country close to pre-pandemic levels. Still, the economy is a long way from being fully healed. While the fiscal response to the pandemic has been massive, it should also be temporary with income and wage supports winding down. Given that borrowing costs also are low, debt servicing costs will remain quite affordable despite the increased debt.
Despite a brighter outlook for the U.S. economy, it is clouded by uncertainty over the Delta variant and the uneven progress of vaccination campaigns. However, improving pandemic management should reduce the need for more lockdowns. It is unlikely that the recovery can be assured until the pandemic is truly beaten back. Still, ambitious government spending plans are expected to fuel growth this year and next. Despite the alarming acceleration in inflation, the U.S. Federal Reserve might be winding down support and looking toward a rate hike as early as this year, since the economy does not need large amounts of liquidity anymore.
Europe emerged from a double-dip recession in the second quarter with stronger than expected growth. This occurred as pandemic restrictions eased, allowing major companies to produce stronger results and consumers to start spending built-up savings. Current trends continue to bode well for the European recovery, which has been sustained by heavy government spending on pandemic relief. The U.K economy continues to recover, although inflation is showing signs of being persistent which means the Bank of England could gradually unwind its quantitative easing program and raise interest rates.
Economic growth across Asia has slowed after being hit by the lingering impact of COVID-19 outbreaks and weak business investment. Japan is now starting to see stable growth above trend levels as COVID-19 cases decline. China’s factory and retail sectors faltered as growth hit a one year low due to supply disruptions, which threaten an impressive recovery. Problems in China’s property sector could have a wider impact on the broader economy. Other major emerging market economies are seeing accelerating growth as new cases have fallen sharply.
Investment results in the third quarter were muted by a late September return in volatility sapping impressive prior gains. Still, the year to date numbers remain very strong. Canadian equities have been one of the clear winners this year, climbing 0.2% in the quarter and 17.5% for 2021 so far (all figures in Canadian dollar terms). U.S. equities are almost as impressive, up 2.7% in the quarter and 15.3% YTD. International stocks gained 1.8% in the third quarter and are up 8.2% this year; while Emerging Markets have come under heavy pressure, down 5.8% in the quarter and returning -1.6% YTD. Bonds continued their negative spiral, falling a further 0.5% in the quarter and are down 3.9% so far this year.
Strong growth prospects following the complete economic shutdown last year are a very positive development although inflation concerns have surfaced. Investor optimism is certainly warranted given the exceptional speed of vaccine development and deployment. Sectors and markets that experienced a significant pullback due to the pandemic have bounced back nicely this year.
The Canadian economy, like most others, saw its GDP forecasts revised down in the third quarter on the backdrop of the new Delta variant, supply chain woes, and slower pace of vaccination in emerging economies. Though Canada has managed to catch up with its vaccination program, some of the initial assumptions about full reopening were quickly called into question due to new waves of infection among people already fully vaccinated. These concerns grew further as the economy posted an unexpected GDP decline in July, along with downward revisions for the end of 2021 and 2022. However, the jobs market was more in line with a gradual reopening as it posted three months of back-to-back gains as of August. Equity markets did not seem overly concerned with the negative GDP growth outlook as the TSX set a new record in early September at 20,821 points before losing ground to close the quarter at 20,070. However, increased volatility in late September flattened quarterly performance to 0.2%. On a year to date basis the index still stands as one of the best performing global markets with a 17.5% gain.
The rough ride at quarter end was broad based as all sectors but Energy were in the red for the month of September. For the third quarter overall, Consumer Staples led the pack with a 3.8% gain mostly because of higher food prices. Energy was second in line as benchmark prices in Canada and international markets rallied to three year highs amid tight supply versus fast rising demand. The sector benefited and gained 3.3%. On the flip side, Health Care declined the most with a 20.4% loss mainly due to Cannabis producers that fell short of earnings expectations. Consumer Discretionary posted the second worst return with a 6.3% loss. This sector has been under pressure recently as some individual players have experienced double digit declines caused by supply chain issues.
Despite a challenging pandemic environment, the TSX has managed to reach one of its best earning cycles on record with many corporations sitting on comfortable balance sheets and cash flow positions. As anticipated at the beginning of the year, cyclical areas of the index such as Financials and Industrials have lived up to their expectations with strong earnings. That rebound propelled the value trade ahead of the growth trade with year to date gains of 19.52% and 11.59% respectively. In this environment of supply-demand imbalances leading to inflationary pressure, the value trade has some room to persist.
Over recent months, the slowing pace of economic growth in Canada and other global economies due primarily to the Delta variant, seems to indicate that the pandemic continues to be one of the key risks. One of Bank of Canada’s greatest fears is the threat of a fourth wave as another major outbreak could derail the rebound in the labor market. Thus, the Bank of Canada does not appear to be significantly scaling back monetary stimulus anytime soon. For governments at all levels, avoiding any future lockdown is the primary goal and they appear ready to continue their support programs. Finally, household finances (excluding government income) have considerably improved during the pandemic. With rising disposable income along with accumulated savings, Canadian consumers should have enough of a buffer to stand a further downturn, which puts Canada in a relatively strong position among its G7 peers.
During the third quarter of 2021 the FTSE Canada Universe Bond Index lost 0.5% and has fallen 3.9% so far in 2021. Yields on 10 year Government of Canada bonds closed the quarter at 1.5% as the Bank of Canada kept its key interest rate unchanged at 0.25%. The U.S. Federal Reserve also maintained its rate at between 0.0% and 0.25%, which is effectively zero.
The outlook for economic growth and budget deficits is basically unchanged after the federal election in Canada. According to economists, an election that changed little in terms of how Canadians are governed won’t have much impact on bond markets either as monetary policy is likely to follow a path toward tightening in mid 2022. The Liberal platform targeted smaller deficits and lower financing needs starting in 2022–23. Securing NDP support may lead to extra spending but the federal government is expected to move away from peak bond issuance. Bond supply should ease up soon after the Bank of Canada enters the reinvestment phase of its bond purchase program. The central bank is expected to continue tapering its bond purchases this year with a rate hike expected in the second half of 2022.
The extra federal government spending does not move the needle on most growth forecasts but it does suggest that inflation will continue to be a concern due to constraints on the supply side of the economy. The economy is already dealing with Canadians’ excess pandemic savings, a tight housing market and potential labour shortages. In the second quarter, Canada’s economy contracted by 1% thanks to fewer exports which the Bank has attributed in part to supply chain disruptions, notably in the auto industry. Meanwhile the housing market has eased somewhat from the record high levels seen earlier this year, while consumption, business investment, and government spending have all led to a 3% uptick in domestic demand. There were also more jobs in June and July, although the Bank notes that some sectors continue to lag, and low wage workers continue to be disproportionately impacted.
The U.S. central bank, the Federal Reserve (Fed), held its most recent meeting on September 21st and 22nd after which yields on long term Treasuries surged the most in 18 months. Investors have now brought forward their expectations for the first hike by the Fed to the end of 2022 following the hawkish policy meeting. Yields on 30 year Treasuries jumped the most since the onset of the COVID-induced crisis to 1.95% following the central bank’s meeting. The implied yield of the December 2022 fed fund futures contract has increased suggesting a quarter point rate increase by the end of next year was fully priced. Investors had previously expected the Fed to start liftoff in early 2023.
The Fed’s Chair, Jerome Powell said the central bank could begin scaling back asset purchases in November and complete the process by mid 2022. New quarterly projections in their so-called dot plot also favored that view with 9 of 18 officials now seeing a rate hike next year; up from 7 in June. The median dots suggest the federal funds rate may rise to 1% in 2023, and to 1.75% in 2024. The decline in Treasuries is part of a global bond selloff as central banks move to reduce pandemic stimulus. Meanwhile Norway has delivered the first post crisis rate hike among Group of 10 countries.
Higher rates aren’t the only concern for bond investors. The debt crisis at developer China Evergrande Group has pushed losses on junk notes from China to 13% so far this year and dragged down emerging market bond returns as well. Gains for emerging market dollar notes were wiped out as markets convulsed. Until uncertainty surrounding Evergrande subsides, a pronounced bounce back in emerging market corporate credit is not expected. Current interest rate pricing looks reasonable and additional increases would require strong improvements in economic data.
The Standard & Poor’s 500 index closed the third quarter at its lowest level since July 2021 as the index lost almost 5% in September. The slide wiped out most of the index’s quarterly advance as it closed the quarter with a meager 0.6% gain in U.S. dollar terms. The S&P 500 index is up 15.9% year to date and has more than doubled since the pandemic induced low in March 2020. In Canadian dollar terms the respective change was a gain of 2.7% for the quarter and a year to date increase of 15.3%. The index has gone an incredible 317 trading days in a row above its 200 day moving average, one of the longest streaks ever. The recent drop was not unexpected as some investors have anticipated a 5% pullback could happen at any time given that we haven’t had one in so long.
Volatility continued to roil financial markets as U.S. equities closed the quarter with their biggest monthly selloff since March 2020. Stocks pushed lower even after confirmation on September 30th that Congress had passed a spending bill to avert a U.S. government shutdown. For many investors that was just one of a litany of risks as they also brace for the Federal Reserve to wind down its stimulus amid mounting fears of slowing economic growth, elevated inflation, supply chain bottlenecks, a global energy crunch and regulatory risks emanating from China. Political wrangling in Washington had threatened to push the U.S. into default and force President Joe Biden to scale back his spending agenda. Democratic Senator Joe Manchin wants the social-spending package cut by more than half to $1.5 trillion. House Speaker Nancy Pelosi was pressing ahead with a vote on a bipartisan infrastructure bill, even though progressive Democrats said they have the numbers to stall it until the Senate agrees on a more expansive tax and spending package.
U.S. economic activity slowed in July and August due to rising concerns about the Delta variant, as well as supply chain problems and labour shortages. The Federal Reserve noted particular weakness in auto sales attributed to low inventories caused by a shortage of computer chips. “Economic growth downshifted slightly to a moderate pace in early July through August” according to the Fed’s report known as the Beige Book. There had been an expectation that Fed officials would announce plans to start reducing the central bank’s $120 billion monthly bond purchases at their September meeting, however a disappointing jobs report for August showed the economy only created 235,000 jobs in August after gains averaging around 1 million per month in June and July. The jobs decline was also attributed to a sharp rise in COVID cases. Many economists believe the bond purchase announcement will now come at either the Fed’s November or December meetings.
Typically, periods of strong economic growth and record profits are also accompanied by high or rising interest rates, which tend to act as a headwind for stocks. But not this time. Many analysts are expecting an exceptional U.S. corporate earnings season which may lift the S&P 500 by another 8% through the end of the year. S&P 500 firms have so far seen their earnings per share forecasts raised by 21% and the trend shows no sign of abating. The second quarter U.S. reporting season saw almost 90% of the S&P 500 companies beating analysts’ profit expectations, the highest on record. The stunning rebound in corporate profits and a loose monetary policy by the Federal Reserve have helped Wall Street’s main indexes hit new highs following the COVID driven crash last year.
Over the last 31 years there have been nine instances where the S&P 500 rallied 10% in the first eight months of the year followed by an average 8.4% climb over the final four months. August and September have been the two weakest months of the year for equities over the last decade. Besides the sheer angle of the ascent, analysts have been struck by the smoothness of the rally. The S&P 500 hasn’t suffered a significant pullback since October 2020 so a drop in the market is expected but overall, the conditions remain in place for equity markets to continue climbing into 2022.
Despite concerns about the rapid spread of the Delta variant, many governments around the world are bowing to public frustration and pleas from businesses to move further away from the strict lockdowns of 2020. The waning impact of COVID-19 has boosted growth and should allow many major economies reach their pre-pandemic levels by the end of the year. Inflation may temporarily exceed target levels as forceful and persistent monetary support is still being used. Most central banks have slashed interest rates to record lows and launched stimulus programs to ensure there is only minimal slippage in growth.
The recovery in the European economy is on track and gathering steam but the pandemic continues to cast a shadow especially as the Delta variant becomes a growing source of uncertainty. Governments are pushing ahead with reopening; relying on a mix of vaccinations, hygiene guidelines and common sense in an effort to allow life to return to normal. The European Central Bank is forecasting accelerated inflation as a result of largely temporary factors (such as rising energy prices as the world recovers from the pandemic and people return to the office) which would not require changes to its policies.
The U.K. economy is now only the second worst performing group of seven economies after second quarter growth was higher, reflecting a big increase in consumer spending following the most recent lockdown. Unfortunately, there are growing concerns that the recovery will lose momentum due to consequences of Brexit. There is currently fuel rationing, and scarcity of milk, meat and other essential products which could make for a difficult winter. In truth, there is no actual scarcity in resources; just a shortage of people, specifically, truck drivers to move goods from Europe due to immigration restrictions. This is a self-made crisis that could come back to bite to U.K. on a number of fronts.
Japan is lifting its COVID-19 state of emergency after six months so the economy can be reactivated as infections slow and restrictions are eased. The government expects the economy to come roaring back as the vaccine rollout becomes more widespread (currently only 20% of the population is fully vaccinated) toward the end of this year. As a key global supplier of capital goods, Japan is poised to benefit from a strong global capital expenditure rebound in the wake of the pandemic. Meanwhile, Japanese consumers have built up excess savings and it is likely that a revival in consumer spending could occur.
Australia’s vaccination rate is fast heading toward the 70% to 80% range needed for the economy to begin opening up again. The Reserve Bank of Australia has largely stuck to its view that the economy has sufficient support to recover, although it has pushed ahead with a cautious winding back of its bond buying program, underlining its confidence in the economic outlook. This, combined with the strong rallies of many of the commodities Australia exports, should create strong underlying support for economic growth.
Over the course of the pandemic, global equity markets have moved like a pendulum. First generating one set of winners and losers; then flipping the results on their ear as losers become winners. Overall, in the third quarter, international stocks fell 1.4%, but were able to generate year to date returns of 8.8% (all return figures are in U.S. dollar terms). Asian stocks were very strong in the quarter, surging 6.0% (Japan rallied near to its all time high and was the best performing developed market); but is only up 6.7% for the year. Conversely, European equities fell 1.9% in the quarter and have gained 8.0% for the year.
EMERGING MARKET EQUITIES
The economic rebound from COVID-19 lockdowns across emerging markets has boosted demand from households and businesses. Strong economic growth is reason enough to have an optimistic view toward the remainder of this year and into 2022. Still, headwinds to growth are likely to intensify as countries adjust to no longer having record levels of fiscal and monetary support that provided the bridge to economic recovery. As well, the export boom that has propelled much of the recovery appears to have peaked and could unwind over the coming quarters as vaccine rollouts and reopenings help to normalize consumption. However, this could take quite some time as currently only 11% of the population in emerging market countries are vaccinated.
China’s debt-fuelled growth model is sputtering. During a brilliant 30 year run from 1978 to 2007, the country sprinted ahead growing by 10% per year. However, since the financial crisis of 2008, its pace has slowed considerably with more severe deceleration potentially looming ahead. Its three biggest headwinds: an economy that persistently misallocates capital; towering levels of debt; and slowing productivity gains. Also, the country’s obsession with real estate, which accounts for 30% of value added in the economy, is starting to become dangerously extended. Supply has been running well ahead of demand for years. China now has enough empty houses and apartments to accommodate more than 90 million people. Recent government crackdowns also signal that it is no longer interested in boosting economic growth at all costs. New COVID-19 outbreaks have also kept a lid on consumer spending even though 60% of the population is now vaccinated.
Every emerging market in the world has faced issues. Argentina’s notoriously shaky stock and bond markets, which have been hit by years of economic crises, are rocketing again. The outlook for investors in South America’s second largest economy is starting to improve as depleted foreign reserves have started to trickle back and COVID-19 cases are dropping. Brazil has been one of the weakest markets as higher inflation continued to rise and the central bank responded with further interest rate hikes. It was a significant laggard in the early rollout of the vaccine; now incredibly, it is among the world’s most vaccinated countries. Weaker industrial metals prices also weighed on performance of net exporter markets Peru and Chile. India performed well as the economy continues to recover while vaccinations have picked up.
Many smaller Asian markets are taking a different approach to COVID-19 (including mass testing and travel restrictions) which has led to a slower recovery. The Asia-Pacific region has been more focused on eradicating COVID-19 so people have not been able to get out, thereby slowing the recovery. The COVID-19 policies in larger economies such South Korea, Hong Kong and Singapore are pressing forward with mass vaccinations. India was the best performing market as accommodative monetary policy and the easing of COVID-19 restrictions boosted investor sentiment.
Performance across emerging markets was quite varied and for the most part. It was very weak in the third quarter and down slightly for the year. As a whole, emerging market stocks were down 8.0% for the quarter and lost 1.0% for the year to date (all return figures are in U.S. dollar terms). Asian stocks fell 9.5% in Q3 and were down 3.9% year to date; Latin American stocks decreased 13.2% in the third quarter and dropped 5.4% YTD; and the lone bright spot amongst emerging market countries was Emerging Europe which gained 8.0% in the quarter and a world beating 24.0% year to date on the back of surging oil and commodities.
Emerging market consumers are the leaders of world growth and will be for some time to come. The reason is quite simple: emerging markets have 85% of the world’s population and almost 90% of its young people. The jump towards consumption levels similar to developed countries is still in its infancy and the punishing impact of COVID-19 represented but a hiccup in its trajectory. This journey will not be a straight line but over the long run will be extremely rewarding for investors.
GLOBAL REAL ESTATE
Since the start of the pandemic, the low interest rate environment has supported global economic activity and has left some real assets attractively valued compared to equities. The performance of Real Estate Income Trusts (REITs) also reflects different sensitivities to central bank policy, growth, and inflation. REITs, because they offer steady income, are seen increasingly as an inflation hedge. With interest rates at a generational low, property values are rising rapidly, making REIT holdings more valuable.
The Canadian housing sector is becoming more vulnerable to price acceleration and overvaluations as market activity remains strong. The key issue is supply, or rather not enough of it, as too few homes are being built to keep pace with population growth. Canada has the lowest number of housing units for every 1,000 residents of any Group of Seven country. REITs that focus on single and multi-family rentals have recovered meaningfully once it became clear that Federal governments support programs would help everyone pay their rent. However, supply will likely continue to fall behind demand given current immigration targets and current state of municipalities and provinces land-use policies.
Retail REITs are also seeing improving demand and better cash flows. Businesses are being allowed to reopen and are beginning to see revenue climb back towards more normal levels. Those REITs servicing the Retail sector are seeing stronger monthly cash flows and fewer delinquencies. And in some markets, they are also reaping the rewards of heightened demand for better locations. Deferred payments from tenants are being recovered as we continue to normalize. As well, increasing mall traffic (although some of the increased traffic is from pent-up demand) will help to make good quality real estate more attractive.
Office space is expected to continue to suffer as many employees choose to work from home in the post-pandemic era. Still, not all office REITs will be negatively impacted as multi-purpose office space, used for work and other activities such as events, will be remain attractive. Across Canada, the office vacancy rate hit 15.7% in the third quarter, the highest level since 1994. Large users of office space, such as banks and insurers, have said they will move to a more flexible work environment. It is still unclear if that strategy will result in those office tenants eventually needing less space. Investors are targeting prime location offices with strong tenant profiles and retail assets with grocery, drug store, financial services, and liquor store tenants especially in demand.
Commercial real estate leasing activity is picking up, driven especially by demand from the technology sector and on the industrial front; where vacancies are low and demand for distribution and logistics space remains at an all-time high. The amount of space for data centres has grown 30% annually over the past five years. As well, the accelerating trend to online retail has created a huge demand for personal warehouse space due to people moving or storing items to free up more space at home.
Real estate investment trusts (REITs) have not exactly generated a lot of enthusiasm among Canadian investors over the years, but 2021 might be changing all that. During the third quarter Canadian REITs gained 2.6% and for the year, the S&P/TSX REIT Index has returned 24.6% (all return figures in Canadian dollar terms). Internationally, REITs have not done nearly as well, but still vastly outperformed their equity counterparts; climbing 1.8% in the quarter and 16.2% year to date.
The impending resurgence in economic activity as the world emerges from the worst ofCOVID-19 will provide the REIT sector with a unique opportunity to generate enhanced returns. The return of normal economic behaviour, as well as ongoing fiscal and monetary stimulus, will be very beneficial to REITs.