August 6, 2020
- The capability of a strained body to recover its size and shape after deformation caused especially by compressive stress; or
- An ability to recover from or adjust easily to misfortune or change.
Source: Merriam-Webster Dictionary
In everyday language, resilience is typically defined as the capacity to recover from difficult life events. History contains many examples of tremendous human resilience during times of plague, persecution, war and famine. The COVID-19 pandemic serves as one current example.
The concept of resilience also extends to financial markets and portfolios. Financial markets have their own history with examples ranging from the stock market crash of 1929 to the Global Financial Crisis of 2008-09. Not all portfolios, however, are equally resilient.
Q2 2020 Financial Market Breakdown
So far this year, trying to make sense of equity markets’ performance has been exhausting. After experiencing the largest declines since the Global Financial Crisis during the first quarter, equity markets rebounded dramatically during the second quarter.
As mentioned in our previous newsletter (Mad, Mad, World), it’s important to be mindful that a notable percentage of equity market index returns in Canada and the U.S. were driven by a very small handful of stocks with extremely inflated valuation levels, meaning that the indices’ overall returns do not necessarily represent the majority of individual equities’ return experiences.
In the instance of the Canadian equity index return of +17.0% for the second quarter, this return is reduced to approximately 7.2% once the impact of the Materials and Information Technology sectors are excluded. These two sectors combined represent less than 23% of the index, but drove almost 58% of the quarterly return. Shopify, an information technology sector stock, contributed 3.8% towards the index return on its own. The positive performance of the Materials sector is largely due to gold.
A similar story holds true in the U.S., where five stocks in the S&P 500 (Apple, Microsoft, Amazon, Alphabet, and Facebook) represent over 20% of the index and almost 35% of the second quarter return of 20.5%.
As these instances demonstrate, equity markets’ performance has not been healthy from a long-term investment standpoint.
Where do we go from here?
Ultimately, the path of the pandemic will set the stage for the timing and speed of a sustained economic recovery. Actions to slow the spread of the virus, while necessary, are not a long term solution. The development of a vaccine or an effective treatment will be key. Regardless of when these events happen, there are lingering long term influences to consider when looking ahead:
- Lower interest rates for longer. The current level of near zero interest rates is expected to remain for foreseeable future. The effects of the pandemic have left world economies with notable spare capacity. Given this, low inflationary conditions are expected to persist. Central banks will not need to raise rates and will be reluctant to risk increasing interest rates too soon. Plus, the government may also have to increase taxes to pay for stimulus spending. This interest rate environment will limit fixed income returns but will be supportive to equity markets.
- Reduced globalization. The trend of reduced globalization began with the Trump administration. This was evident in the trade tensions between the U.S. and China. Brexit is another instance of reduced globalization. The pandemic has accelerated this trend. As an example, many countries have placed an increasing priority on domestically producing health safety and medical equipment to lessen reliance on other countries. Reduced globalization is likely to result in higher costs from a production standpoint which will also flow through to the end customer. Businesses and people may be paying more for products and services as global supply chains continue to reduce. This may also put pressure on companies’ profit margins unless the increased use of technology can serve as an offset in productivity improvements. Further down the road, this could have inflationary impacts.
- Government debt and its role in the economy. The massive amounts of fiscal stimulus are creating levels of government debt in the economy not seen since post World War II. Eventually, this debt will need to be addressed. There is also likely to be a continuation of political debate regarding the inequalities that the pandemic has created among people. A number of people were able to isolate and work from home while others were laid off as working remotely was not possible. The same will hold true for inequalities among businesses and the government may feel the need to provide additional support. In other words, government debt may become an even bigger part of the economy.
Based on the strong equity market performance of the past quarter, it appears that market participants are placing heavy reliance on the continuation of the government and central bank support that has been provided. However, should economic conditions deteriorate more than expected or should the pandemic situation unexpectedly worsen, market sentiment and conditions can be expected to change rapidly. Equity markets would be vulnerable to a downturn, as returns over the past quarter have been based on valuation increases and are not supported by improved earnings. In other words, the markets have gotten further ahead of the real economy. Based on the three themes above, there are a number of combinations of events which can be positive or negative for the financial markets. Uncertainty and volatility will remain high.
This is where the importance of portfolio resiliency comes into play as an insulator against uncertainty.
As implied by the Merriam-Webster definition of resilience, a resilient portfolio has “the ability to recover from or adjust easily to misfortune or change”. QPW views a resilient portfolio’s characteristics as follows:
- Diversification should be across and within asset classes to avoid concentration in any particular asset class or individual investment.
- The first level of diversification is at the asset mix level (e.g. stocks and bonds) which addresses broad asset classes and geographic exposures.
- The next level of diversification is within each asset class and should give consideration to aspects such as market capitalization for equities (i.e. large cap, medium cap, and small cap) and alternative investments which may be less correlated with core portfolio asset classes.
- Finally, there is diversification in the individual securities held within each asset class. QPW conducts rigorous, ongoing reviews of its managers to select best-in-class institutional managers. Understanding how they build resiliency at the individual holding level is paramount. Examples would include the selection of companies with competitive advantages regardless of industry or economic trends, and understanding the downside risk of companies in various scenarios.
- Risk – the key risk facing investors is the permanent loss of capital. This risk must be balanced against the investor’s individual need or desire for investment returns over their time horizon. Notwithstanding an investor’s time horizon, short term volatility of a portfolio can impact short term decision making, sometimes to the detriment of long term portfolio results. Diversification and asset mix are key to creating a portfolio that seeks adequate long term returns without a permanent loss of capital while managing volatility. A resilient portfolio can better weather volatility or the “shock” of market events.
- Detachment – a resilient portfolio is not influenced by behavioural biases such as greed and fear but rather is based on ensuring investment decisions are suitable to each client’s financial circumstances, investment objectives, time horizon and tolerance for risk.
- Long-term outlook – is implicit as resilience should stand the test of time. A longer time horizon increases the ability of a portfolio to recover.
At the end of the day portfolio resiliency is the product of a well-constructed portfolio. Here at QPW, we seek to create resiliency with comprehensive, well-constructed portfolios, focusing on asset allocation policy, manager selection and systematic rebalancing in light of each client’s individual financial circumstances.
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Quadrant Private Wealth is an independent, comprehensive, integrated wealth management firm committed to your financial well-being and peace of mind. We take the time to understand your complete financial picture. We tie all of your information together, including tax planning, to paint a picture of what your financial future could look like. And we aim to earn your complete confidence in the process.
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