On the below chart, we break out the Canadian bond universe into federal, provincial, and corporate components as well as slice by maturity. In each pane, the dashed red line is the Canada Bond Universe, which is the aggregate of these subsections.
During the quarter, there were two distinct periods. Initially in the quarter, the clear outperformer was long duration corporate credit. This outperformance was aided by central bank bond purchase programs bringing relief to the market, and causing corporate bond spreads to tighten. On the other end of the spectrum, federal bonds of all durations were underperformers in relation to the index. What this tells us is that risk was being rewarded during the initial part of the quarter, continuing the theme of the recovery in financial markets since the March bottom. Corporate credit is riskier then both federal and provincial bonds, and longer duration is also beneficiary of risk on behavior.
However, September brought some risk-off sentiment back into global financial markets. Within fixed income, this caused spreads to widen slightly, and led to longer duration bonds across the risk spectrum to weaken in response.
A similar story can be seen in the global fixed income space. Longer duration treasuries, high yield credit, and emerging market bonds were leading through August, and weakened during the risk-off phase of September.
Looking at the US yield curve and credit spreads, overall, the curve remained mostly unchanged over the quarter, but still lower across the board from the beginning of the year, due to the cuts by the US Fed in response to the COVID-19 pandemic and economic shutdown as a result. Aggregate US credit spreads continued their tightening trend (downtrend) during the quarter, although they did widen in September as global financial markets weakened, and some renewed volatility and concern came back into the market. As a reminder, tightening credit spreads imply lower yields, and higher bond prices, with the opposite being true when spreads widen.
Global equities were broadly positive through the third quarter, however gave back gains in September as concerns around increased COVID cases, the looming US election, and angst over whether a new relief bill will work its way through Congress weighted on US and global equities.
A major theme and takeaway that we have highlighted previously this year is the bifurcation coming out of the March selloff between winners and losers. This is depicted in the below chart. We break out the 11 sectors of the US equity market and classify into New Economy, Defensive, and Cyclical categories. As you can see, the sectors compromising the new economy have been the clear leaders. Many of the companies in these sectors are also the largest companies in the world by market capitalization, and this has had the effect where index returns are being dominated by a few companies.
This has resulted in topline index return numbers casting the overall health of the equity market in a far better light than the reality. The following table expands on this point. The median company, particularly in the S&P 500, is having a tough year and their share price performance is reflecting this reality, yet the headline number looks reasonable. We have had multiple clients ask this question as to how are equities faring so well given the way 2020 has unfolded, and the honest answer is that they aren’t faring well. The performance of these new economy businesses has masked the realities being faced by pretty much every other business during this pandemic induced recession.
This phenomenon is not unique to the US. When we look at Canada in a similar light, the results are equally bifurcated. In the below chart, you can see that Canadian technology and materials sectors have been clear outperformers, and are really the only two sectors that have seen significant positive total returns this year. In fact, Shopify has been on such a run that it is now the largest market cap in Canada. Much like the US, these sector moves in new economy technology companies and a renewed interest in gold mining companies due to the price of gold rising over the course of 2020 have masked the reality being faced by many of the bellweather large cap companies in Canada.
Further proof to this end is the performance of Canada high dividend (orange line), and Canada dividend growth (red line) baskets treading water for the year.
We do own a couple of these large technology companies in client portfolios, but certainly not in the weights they are held in the index, as to us that level of concentration would have high risk both absolutely and from a concentration standpoint. As it stands, the 5 FAANG (Facebook, Amazon, Apple, Netflix, and Google) companies account for roughly 22% weight in the S&P 500. As part of our portfolio construction and investment process, we are not inclined to chase growth at all costs, preferring to continue to build and hold a diversified portfolio of companies with the ability to protect capital in down markets and grow at a reasonable pace in periods of economic growth.
With respect to the portfolio allocation strategy, we continue to favour US equities within our global universe. This has continued to pay dividends, as 2020 has seen the trend of US outperformance continue as it has since coming out of the Financial Crisis. The following chart shows the MSCI World Index (Westside benchmark index), versus the MSCI World ex. US. You can see that in 2020 if you strip out the US equities from the MSCI World, the rest of the world is negative for the year.
Overall, within fixed income in the portfolio, we remain biased to underweight duration, as in our view there remains the risk for yields in the long end of the curve to back up. This would result in lower prices for bonds with longer maturities. This is particularly true coming out of this pandemic if we see inflationary pressures with pent up consumer demand and easy monetary policy providing the catalyst for such pressures to occur.
There is not enough yield pickup in the longer end of the bond market currently to justify taking on a market or overweight exposure to that risk. This is exemplified by the spread between the 2 year treasury and the 10 year treasury currently sitting around .3%. So for 8 years of duration you are being compensated an additional 30 bps in the federal market, and this characteristic persists through the provincial and corporate market as well. We will continue to harvest bonds at a premium as they trade closer to their maturity and roll out those proceeds into higher yielding quality names as we did during the quarter, while maintaining a careful eye to the duration risk in the fixed income sleeve of the portfolio.
September brought with it some risk-off sentiment, as equity markets began to digest the exceptional move experienced between April to August. This coupled with concerns over the US election, the lack of progress on a spending bill from US congress, and rising cases of COVID globally led to increased volatility and risk-off sentiment. We touched on many of the risks we are currently monitoring in our Fireside Conversation piece published in September, and encourage you to revisit that piece for more detail on these issues that are top of mind for us today.
With the US election set for November, we expect to see volatility remain elevated as market participants try to gauge the outcome, and weigh the prospect of a tight election that could result in a dispute over the outcome that could drag on past election night. We will continue to remain prudent in our overall asset allocation, and seek to use volatility to deploy additional capital at attractive prices.
If you believe in science and that there may be a functioning vaccine and improved testing coming throughout the year leading to economies recovering and re-opening, we would expect to see a rotation into some of the under performing sectors and businesses, and out of some of the high-flying technology and new economy names. We would expect there to be a large pent up demand by consumers that would be unleashed as economies re-open.
The major motivation around the moves in the equity sleeve of the portfolio over the quarter was to take advantage of the substantial recovery in equity markets to rebalance portfolio weightings and to lock in some profits on our technology names. We sought to redeploy some of those proceeds into other areas we feel have good upside from here, and were trading at more attractive valuations during some of the turbulence in September. These moves allow us to harvest some gains from areas such as technology, which has been a clear winner in 2020, and continually rebalance some of that equity exposure into sectors that we continue to favour but have not gotten as far ahead of themselves as others.
Within the alternative sleeve of portfolios, we continue to leverage strategies that can reduce overall portfolio volatility, or provide exposure to areas of the global economy that we currently lack. We feel that with volatility likely to remain elevated, yields remaining low, and equity markets fairly to over valued in aggregate, that alternative asset classes, strategies, and allocations will continue to provide strong benefits to the overall risk and return profile of portfolios.
All data and/or charts are sourced to Thompson Reuters Eikon unless otherwise noted.
The opinions expressed in this report are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson Wealth Limited or its affiliates. Assumptions, opinions and estimates constitute the author’s judgment as of the date of this material and are subject to change without notice. We do not warrant the completeness or accuracy of this material, and it should not be relied upon as such. Before acting on any recommendation, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Past performance is not indicative of future results. Richardson Wealth Limited, Member Canadian Investor Protection Fund. Richardson Wealth is a trademark of James Richardson & Sons, Limited used under license.