In our year end commentary, we stated that in 2021 the “capital markets will be driven predominately by the offsetting effects of the Covid-19 induced economic weakness on one hand, and the extraordinary global monetary and fiscal stimulus on the other hand”. Given the rollout of the Covid-19 vaccine across the globe, the economic weakness is transitioning into one of economic resurgence. As a result, we’re removing Covid-19 from the phrase and replacing it with “the impact of rising yields”. While we recognized that yields would gradually begin to rise, we were surprised with how quickly it occurred. At the end of December, the yield on the 10-year US Treasury bond was 0.92%. As we write this, it is now just over 1.7%.
So, why have bond yields jumped dramatically in such a short period of time? Bond yields are highly correlated to inflation expectations. Given the massive amount of fiscal stimulus and ongoing monetary support, expectations are that the economic momentum will continue to gather strength over the next several years, leading to a rise in inflation. As inflation escalates, yields need to rise as well. Why? Who wants to hold a 10-year government bond yielding 0.9% when inflation is 2% or 3%? In terms of purchasing power, you will be losing money. When yields rise, the price of those bonds decline, resulting in a loss, unless the bonds are held to maturity. Anyone currently holding bonds in their portfolio has seen the effect of those rising yields, with the Canadian Bond Universe having declined ~5% since the beginning of the year. As a firm, we have been pessimistic on the outlook of bonds (Federal, provincial and corporates) for quite some time and had substantially reduced exposure to them at the end of 2020. While we expect to see a stabilization in yields over the short term, our longer-term outlook for bonds is negative.
The Kinsted Global Equity pool experienced volatility in Q1 that was higher than that of the S&P500 and the TSX. Due to the nature of many of the US companies that the Global Equity pool invests in, it was not unexpected. The focus is investing in growth companies that the manager (Morgan Stanley) believes have sustainable competitive advantages, where most of their profits are to be earned in the future. As a result of increasing inflation, those future earnings are not worth as much in today’s dollars, resulting in a revaluation in their stock prices. That said, the team focuses on long-term growth rather than short-term events with their stock selection, so we’re cognizant of the fact that this approach experiences occasional price volatility. To achieve outperformance, one must accept short term underperformance from time to time. One should not look at the volatility in their stock prices as a reflection of something fundamentally wrong with their businesses, but rather the market’s readjusting their valuations based upon rising yields. We’re very confident that many of the companies in the pool like Amazon, Spotify, Shopify, Airbnb, Doordash, and many others will continue to increase their market share over the long-term in their respective industries, resulting in strong price appreciation.
In summary, the capital markets in the first quarter of 2021 were driven by a significant revival in economic activity in some parts of the world (especially the US), and a resurgence in bond yields.
We’ve made our opinion on diversification abundantly clear in many of our commentaries over the past year and a half, and that has not changed. Traditional portfolio diversification which entails off-setting equity risk with traditional fixed income securities is dead for the time being (apologies to our colleagues in the industry who believe otherwise, or who are restricted to the public markets exclusively). The harsh reality is that while traditional fixed income may add some downside protection at various times over the next five years or so, they will struggle to provide any real returns (after inflation) over that same time frame. Asset mix changes made during the quarter reflect those thoughts on traditional fixed income, as we cut exposure and added proceeds to Kinsted’s Strategic Income, Real Asset and Strategic Growth Pools.
We are big advocates of private debt (institutional quality) and believe it will add significant value to the Strategic Income pool over the long term. This pool is well protected from rising yields caused by higher expected inflation, further complimenting any fixed income exposure. It is doing what it is supposed to be doing - providing a stable return of almost 2% during the first quarter.
The Kinsted Real Asset Pool received several capital calls for both Agriculture/Timberland and Private Infrastructure during the quarter. Within Agriculture and Timberland, one capital call was due to the acquisition of a 31,800-acre Eucalyptus plantation in Brazil. Another call was a result of an equity stake in a Chilean agribusiness which focuses on permanent crops including cherries, apples, blueberries, kiwis amongst others. The stable yields and inflation protection from these investments further compliment our client’s portfolios.
Within Infrastructure, one capital call was for investment in a company that operates and maintains the Elizabeth River tunnel; operational tolled tunnels in Norfolk and Portsmouth, Virginia. There is approximately fifty years remaining on the concession and the Fund is making the acquisition alongside a Spanish based firm that is a leading global operator of toll roads.
As you can hopefully discern from these comments, diversification is still attainable, but only if one is willing to look outside of the public markets and invest in areas such as agriculture, infrastructure, private debt and private equity.