The market recovery in the second quarter of 2020 may go down as one of the most unexpected in the annals of history. Investor pessimism at the end of March was even worse than during the financial crisis, which was not surprising given how poor the economic prospects looked. Unemployment reached levels not seen since the Great Depression of over 20%, global economic activity was declining with Q2 GDP estimates of -10% in many developed economies, and with Covid-19 cases exploding daily, it was difficult to be anything but negative. With that as a backdrop, how was the S&P 500 able to deliver its best quarterly return in over two decades? First, never underestimate the market’s ability to cut through current turmoil, and trade based upon the future state of the economy. In other words, the markets had already priced in how poor the economic environment was at the time, but rallied on expectations of an improvement in the economic environment and corporate earnings at some point in the future.
One of the main reasons that expectations of the future economic environment are rosier today is due to the unprecedented monetary support from central banks and fiscal support from governments. Given low bank rates going into the current recession, Central Banks have had to resort to “unconventional” policy tools to support the economy. The most important of these was purchasing government debt to keep yields low. Offering to buy government debt in unlimited quantities (especially at today’s low rates), has allowed governments to run much larger budget deficits than they otherwise would have. Taking on these extremely large deficits has allowed governments to provide support to households and businesses in the form of direct cash payments and loan guarantees. Given much of the economy was on a mandated shut-down, this government support was/is required to prevent a complete economic collapse.
Economic data released in the last couple of weeks has in many cases shown double-digit month-over-month improvements, beating analysts’ expectations quite handily. The Citigroup Economic Surprise Index in the US has surged to all-time highs. Both manufacturing and services data in the US, have climbed meaningfully higher from their troughs just a couple of months back. The Global Leading Economic Indicator index showed that economic activity among 80% of the countries in the index has improved, while the overall global index seems to have bottomed. The bottom line is that the rapid recovery in global stock markets is not entirely due to monetary and fiscal stimulus, but rather an actual nascent recovery in economic activity.
Going forward, both the economic and capital market environment will continue to be influenced by Covid-19. Will we be forced to go into lock-down again? Will a vaccine be developed sooner than later? Nobody knows the answers. That said, some of the research we have read speculates that a vaccine will be available to the general public sometime in Q1 of 2021. While that may still be a ways away, the markets will trade based upon an anticipated acceleration in the global economy. While economic prospects are obviously very important for corporate profit growth, many of the assets we now invest in are not entirely dependent on economic growth. This will help provide some downside protection for our client’s portfolios in times of economic despair.
We continued to make great strides during the quarter in positioning our clients’ portfolios towards what we believe will provide long-term, superior risk adjusted returns. From a private asset perspective, we added exposure to private equities, agriculture, market neutral and infrastructure. Looking forward, we are continuing to focus on increasing exposure to private assets, in particular: infrastructure, private equity, agriculture and opportunistic credit.
Preferred shares were eliminated from most client portfolios, while small cap equities were trimmed significantly. Morgan Stanley, who we had hired at the end of 2019 to take over management of our global equity mandate (split between US and International mandates), finally took the reins during the quarter. To say that they’ve done a great job would be an understatement as they handily outperformed the global benchmark by close to 22% during the period. This was more difficult than you think. While the S&P 500 return year-to-date was -0.7% (weighted by market capitalization), the average return of all the stocks in this index (“equal weight”) was -11.7%! The group within Morgan Stanley employs a unique approach to stock selection that we believe will provide significant value in the years to come. The group predominately manages institutional mandates making access next to impossible for retail investors in Canada.
We are also consolidating our bond holdings into the new Kinsted Fixed Income Pool. To optimize tax benefits and overcome timing issues, we are temporarily holding a portion of our bonds within the Strategic Income Pool during this transition.
As many of you know, we’ve made some significant portfolio changes over the past year which we are extremely excited about. One portfolio addition we’d like to highlight is the single-largest energy infrastructure investment in the middle east, and the largest in the world in 2020. A consortium of six global investors entered into a $20.7B agreement with the Abu Dhabi National Oil Company to acquire a 49% stake in a newly-formed subsidiary, ADNOC Gas Pipeline Assets, with lease rights to 38 pipelines. Those involved are all large sovereign wealth funds or large institutional investors such as Brookfield Asset Management, Singapore's sovereign wealth fund and the Ontario Teachers’ Pension Plan. Core infrastructure assets like these pipeline assets are in highly developed markets, with predominately regulated or long-term contracted cash flows from mature cash-yielding assets. They are targeting cash yields in the range of 5-6%, plus expected capital appreciation.
Keeping with Infrastructure, we gained exposure to Seven Seas Water (SSW). SSW operates two separate businesses within the water infrastructure space: wastewater treatment plants for industrial and municipal customers in the United States and desalination plants for governmental and industrial customers in Latin America and the Caribbean. These assets tend to have long-term lease agreements and provide stable income streams.
Switching to agriculture, a couple of investments we have exposure to are quite interesting. One is a top 10 apple grower in the US. The investment has over 2,000 acres of apple producing trees in the state of Washington. They also produce cherries, which along with apples, are seeing their consumption growing globally, particularly amongst premium varieties and organic products. The state of Washington has prime growing conditions and has access to growing export markets such as Asia and core export markets like Mexico and Canada.
Another agriculture investment we have exposure to is the single largest producer of maple syrup in the world, located in Vermont. Maple syrup is a niche commodity with significant upside from a marketing perspective. The fundamentals in the U.S. are very positive with per capita consumption growing significantly. It’s also a highly fragmented sector that has been dominated by small family owned farms and has been slow to adopt new technologies. We think the sector is ripe for consolidation.
While both of these agriculture investments are completely different from each other, they do have several things in common: they produce solid cash flow; they are an excellent inflation hedge; and they have negative correlations to traditional assets like equities (thus providing diversification benefits). As an overall sector, agriculture has provided a better risk/return profile than any other asset class over the past 20 years.
An important attribute for our investments in infrastructure and agriculture is they are not correlated to short-term economic growth. These are essential services with secure stable cash flows backed by assets that should appreciate with inflation. All the conjecture about COVID, economic growth, Presidential elections, and quarterly corporate earnings are now much less relevant to your portfolio in the short-term.
We hope you find these insights helpful and recognize that investing one’s wealth does not mean your investment universe is restricted to only stocks and bonds. While many of these “non-traditional” assets are difficult to access as an individual, we are doing our best to provide you with exposure to institutional quality investments that we truly believe will enhance your investing experience over the long term.
Portfolio diversification is essential, but how can we achieve that in a world where bond yields are too low to offset volatility and a global diversification strategy is no longer as effective?