Commentary April 2020

Reblogged from First Sovereign Investment Management

This winter was a wild ride to say the least.  Initially related to the US election and later gaining full steam due to the Covid19 coronavirus (the “virus”), the winter’s market pullback was anything but enjoyable.  A dispute in March between Russia and Saudi Arabia about maintaining crude oil price stability was the icing on the cake.  Investors are rightly asking how they fared and what they should do now.  As investors we usually don’t know when or from where future pullbacks will originate but history does tell us that they are have never stopped recurring since the birth of investing.  They are part of the package.

Bonds and Interest Rates

Normally when I talk about bonds I am focused on what the world’s central banks are doing to steer the economy (not too hot/not too cold) but this winter the fear related to non-government bonds took centre stage.

This winter corporate bonds, as shown by my proxy the XCB corporate bond ETF dropped significantly.  High yield corporate bonds, as shown by my proxy the XHY corporate bond ETF dropped even further.  A couple of the industries worst hit are the oil industry and retailing.  In the oil industry numerous US-based shale oil explorers and oilfield service companies supporting them borrowed in the high yield (high risk) bond market.  Many of these US-based shale oil producers were high cost operations that required oil prices in the $50s/barrel just to breakeven. With the Russian-Saudi spat pushing oil prices to the floor, many of these high yield bonds are not going to be repaid in full.  There will be bankruptcies.  On April 1, US shale producer Whiting Petroleum filed for bankruptcy and there will be others in the US oil patch to follow.  Around the world, US shale producers have among the highest cost per barrel and thus are the most vulnerable.

In our portfolios we have no direct ownership of US oil producers nor junior Canadian producers who may be at risk. Furthermore, back in 2018 I generally exited high yield bond positions because I felt they were starting to show too much volatility without sufficient return to reward us for that rough ride.  Now the timing looks prescient although I want to admit my crystal ball certainly did not see the corona virus on the horizon back in 2018.  The decline in XHY shares from a price of $19.48 in Dec 2019 to $14.80 in March 2020 amounted to a roughly 24% pullback.  Now, it is not as if we experienced no decline in our income-oriented securities.  In fact, we did experience a significant pullback in a preferred share we own.  The difference is that I think the preferred share decline was a knee-jerk reaction in a broad market sell off that will recover whereas I think a meaningful portion of that high yield fund’s impairment will be permanent.

Without getting too much into the inner workings of the fixed income market I will note that US central bankers had to intervene this winter at least three times to deal with markets that were seizing up: first and most urgently to backstop the overnight interbank lending market (the repo market), then to support the struggling commercial paper market (the money market) and most recently to work with the US municipal bond and mortgage security market.  We can breathe a sigh of relief that they got to the problems very fast, which brought private investors back into the market.  Furthermore, there was not a single new bond issuance in the high yield bond market for the longest in recent history.  Finally, two weeks ago Taco Bell broke the ice with the first new bond issue in a while.  Although you might think one would be tempted to get back into the high yield bond market now with prices so low, the truth is that I believe there is still not clarity on the extent of corporate bankruptcies during this broad-based economic shutdown and so I am not eagerly jumping in yet.

Fig. 1: Bond ETFs:  Governments (XGB), Corporates (XCB), High Yield (XHY) – 2 years

Without getting into the esoteric details of the US Federal Reserve tactics other than to say the Fed is pulling all the stops to keep this economy afloat.  I am comforted by the Fed’s actions.


The rise of the US Dollar this March has been dramatic, not only against a basket of world currencies (in green below) but most emphatically against the Canadian petrocurrency.  Capital returned to the relatively safe USA market from overseas at a torrid pace and the oil glut made that worse for oil exporting countries like Canada. On 15 March 2020 the USD rose to a peak of 1.4498 USD per CAD (or if you think in the reciprocal 68.98 US cents/CAD) before the Canadian Dollar recovered a little strength in the couple of weeks that followed.  Still, the CAD is just trading at around 71-71 cents right now. Ironically the virus may hit the US harder than any other major country and yet the US is considered a safe haven.  This is that same as what happened in 2008 when the US was at the epicentre of the sub-prime meltdown and yet skittish capital returned to the US from abroad!

As is often the case, currency volatility helped us.  In general, we have a disproportionate weighting in the US that helps stabilize us during times of trouble (but holds us back in the good times).  As stock and corporate bond markets both pulled back this winter, the US dollar’s strengthening helped reduce our losses, when converted back to CAD.

Fig. 2: US Dollar Index and Canadian Dollar versus the US Dollar – 2 years

Stock Markets

You will notice in Figure 3 below that even though the US economy (as indicated by the purple S&P 500 index, had outperformed other global economies over the past couple years, all major markets fell dramatically this winter.  On 19 February 2020 the US S&P500 index had closed at a peak of 3386.15 before plummeting to 2237.40 by late March, for a decline of 34%.  This makes it more than the average recessionary pullback; something almost on the scale of the 2008 decline. Meanwhile in Canada the TSX Composite Index fell to 11228.50 from 17944.10, for a decline of more than 37%.

Fig. 3: Equities: USA-purple, Canada-blue, Japan-red, UK-yellow, Germany-green – 2 years

When will we be out of this? In recent days (last week of March and first week of April) there has been some recovery from the deep lows but I am not personally convinced we are getting an all-clear signal yet.   Some call this a technical rally, driven by forced end-of-quarter rebalancing at institutional investors that artificially drove the market up, some call it a temporary “relief rally” that often comes after a big decline.  In any case the impact of the virus is so significant that it will take time for investors to really figure out the prospects for different companies and for solid confident stock prices to be established. This market pullback has happened more swiftly than any other decline I have witnessed or studied.  With that in mind you might wonder if the market is going to recover faster too.  Despite the pace of the decline, I still believe that the market will take time to stabilize.

It seems that many people in the US have been in denial about the risk of the virus and have not been taking necessary precautions.  The same thing is happening in other countries too but since the US is the world’s largest economy, the issue matters more there than anywhere else, from an economic perspective.  In the next couple of weeks we will get further clarity on how well (or poorly) the US is able to dampen the spread of the virus and we will also see shocking headlines about the widespread deaths this is going to cause across the USA.  I suspect that is when the gravity of the situation is really going to set in for a lot of people.  Although I never worry about precisely timing the botttoms of markets, that maximum fear will in my opinion tie in roughly to market bottoming.

With that in mind, you may wonder what I am doing now.  The main focus is two-fold.  First of all there may be securities that were right leading into the decline but not the right thing to hold exiting the decline.  I am actively looking at places where changes may be made to position the portfolio for the times ahead.  Second, there are some great businesses trading at prices cheaper than I have seen them in over a decade (let’s say since 2009 in many cases).  Some of those high quality businesses have always been out of reach for me because they have always looked too expensive.  Now there may be opportunities to upgrade the calibre of our portfolio holdings.

Lastly, I would congratulate all those of you who have added fresh cash to your portfolio now that prices are down and encourage others to do so, to the extent that it fits with your financial plans.  Although it takes nerves of steel to do it, bringing fresh cash to the table when prices are low has historically been a smart long-term move.

Respectfully submitted,

Paul Fettes, CFA, CFP
CEO, First Sovereign Investment Management Inc. and Efficertain Corp.
Portfolio Manager to RN Croft Financial Group

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