Knowledge Centre

The pandemic is not over but it does look like we have entered the final phase. The lockdowns and restrictions are having less severe economic effects now than they did during the first wave of the COVID-19 pandemic. Global growth prospects are being ratcheted way up albeit with ongoing unevenness across regions and sectors as fiscal support is stepped up sharply, economies adapt to social distancing protocols and vaccination rollout accelerates. The second wave’s economic impact has been more modest than during the initial shock, driven by larger than expected fiscal stimulus packages and rock bottom interest rates.

Canada’s economy surged at the start of 2021 after the economy fell by 5.4% in 2020, the biggest collapse since 1961. The economy is only down 2% from its peak and is expected to return to its pre-pandemic level during the third quarter. For many investors, the economic destruction is last year’s story. The Canadian economy has surprised on the upside despite the painfully slow vaccine rollout and frequent lockdowns. Strengthening global demand for Canadian oil, minerals, agricultural products and services has reinforced the improving outlook. Canada’s consumer confidence saw its largest increase since the onset of COVID-19 as about 80% of lost jobs have been recovered. With disposable income increasing 10% and savings rates surging to 15.1% of disposable income, Canadians continue to plow money into real estate, further lessening the economic pain of the recession.

The U.S. economy appears to be speeding up again after slowing toward the end of 2020. Investors had little problem putting the devastation brought on by the pandemic behind them as stock markets are at record highs. Expected robust growth could lay the groundwork for the U.S. economy’s best year since 1984. Vaccinations are rising, retail sales and industrial production have been surprisingly solid, and the government is pushing forward with a gargantuan $1.9 trillion stimulus plan. All these factors will make it easier for companies to boost sales and profits, which will help employment and enable consumers to spend more.

The European economy contracted by more than previously estimated in the last quarter of 2020 as household consumption plunged because of COVID-19 lockdowns. Still, while countries such as the U.K. and France were hard hit, some countries like Germany and Spain reported surprising increases. The picture started to turn this year as industrial output was much stronger than expected in January pointing to better results this year. The European Central Bank looks committed to do its part to keep borrowing costs ultra-low so as not to derail the recovery.

There was no financial meltdown. The bull market in stocks is now in its second year after last year’s first quarter drubbing. The principal takeaway from the first quarter of 2021, is that while the pandemic is still with us, investors are taking it in stride. In fact, the one year earnings estimates on the MSCI All-Country Stock Index are back to pre-pandemic levels. As such, the numbers tell the story: Canadian stocks gained 8.1% in the quarter and 44.2% over the past 12 months; U.S. stocks climbed 4.8% in Q1 and 45.4% in the last 12 months (all figures in Canadian dollar terms); International stock produced a quarterly return of 2.2% and 34.2% since last March; and bond yield have seen swift increases since bottoming in December 2020, such that bonds lost 5.0% in the first quarter and now have only gained 1.6% in the last 12 months.

Thanks to the flood of cheap money and a somewhat positive outlook for the virus’ control, many countries now appear ready to enjoy one of their most rapid recoveries in decades. This combined with the billions of dollars in savings stowed away by pandemic-restricted citizens could unleash a potential tidal wave of additional stimulation. Certainly, we are not out of the woods yet as there is still considerable economic slack and a great deal of uncertainty about the evolution of COVID-19; but the outlook has not been this bright in over a year.

The Canadian economy started 2021 with strong GDP growth after an unprecedented decline in 2020 that saw it plunge more than 5%, a 60-year low. The economy surprisingly grew at an impressive 0.7% in January, a continuation from the fourth quarter rebound and this was accomplished despite the shutdown of nonessential businesses in most provinces. Initially, the labour market did not keep pace with GDP growth as it shed more than 200,000 jobs in January; this was quickly recouped with a 259,000 jobs gain in February. That fluctuation was largely expected but there seems to be a lot of positive news in favour of a strong recovery to pre-pandemic levels on the backdrop of extended government support programs. Canadian markets continue to build on the strong momentum that started in the fourth quarter of 2020 and the main index, the S&P/TSX, hovered near record highs and closed the quarter with a 8.1% return.

All sectors apart from Materials posted positive returns with Healthcare, Energy and Financial Services leading the pack respectively with 38.1%, 28.2% and 12.7%. As anticipated, value sectors contributed to the strong performance of the S&P/TSX after their steep collapse in 2020. The materials sector, though value biased, has not been on par with other value sectors as it saw a 7.1% decline primarily on the backdrop of Gold’s underperformance due to rising yields. The energy sector made headlines again in the last few months with the surprise move by OPEC+ to curb supply. Members appear to be abiding more diligently with the agreement which is a rare occurrence. The sector soared amid a wave of future price upgrades. Financials have also been a hot topic in the last few months. The housing market has seen huge inflows of cash with record home prices reaching 25% more than pre-pandemic levels; a situation which does not appear favourable for households already under the strain of elevated debts. However, banks seem to be well prepared as their enormous loan-loss provision in 2020 should provide adequate buffer in the case of massive defaults.

There is a clear revival of the global recovery recently with the decline of COVID-19 infections and importantly the improvement of testing protocols and vaccine rollouts. Canada’s efforts got off to a very slow start compared to global peers. There has been some ramp up over the last few weeks and a growing confidence of catching up by year end. The higher-than-expected GDP growth in January and vaccine rollout created more optimism across the board. The Bank of Canada, International Monetary Fund and the Conference Board of Canada revised their GDP growth expectations upward to around the 5-6% range for 2021. The Bank of Canada in its first quarter policy guidance has left its key rate unchanged and is expected to move slowly even with a surprisingly strong GDP growth for the foreseeable future, an environment that will favour the economy’s resilience.

The case continues to be firming up in favour of S&P/TSX continued performance as the valuation gap is expected to significantly narrow especially compared to the S&P 500. The S&P/TSX’s outlook has become positive much like it was during the last energy boom more than fifteen years ago. After decades of underperformance, there are good odds that home-biased Canadian investors might be in line to reap rewards from their investments as the rally in value stocks picks up steam.

The Canadian FTSE Universe Bond Index lost 5.0% in the first quarter of 2021. The Bank of Canada kept its key interest rate unchanged at 0.25% and the U.S. Federal Reserve also maintained its rate at between 0.0% and 0.25%, which is effectively zero. Yields on 10-year Government of Canada bonds had dropped below 0.5% last year but have since recovered to the 1.5% level. In the U.S., the yield on the 10-year began the year below 1% and has since climbed to 1.7%. Despite the increase, the absolute level of long rates is still very low.

Without a doubt the big story in the bond market in the first quarter was the huge selloff in U.S. Treasuries, which had their worst quarter in years. The size of the move was historic and at one point the situation had people questioning the Fed’s strategy. A review of economic forecasts helps understand what happened as the economic outlook saw its single biggest upward move in history. Think back to the beginning of the year. The virus situation was getting worse, the vaccine rollout got off to a horrible start, and it looked like the U.S. was done with stimulus because the Senate was expected to be divided. Fast forward to the end of the quarter and we have historic stimulus, the prospects of even more spending, and U.S. vaccine distribution among the fastest in the world. Naturally, growth expectations came way up over the three months so what happened was the outlook got dramatically brighter and the market pulled forward its expectations for when the Fed would hike rates, which lead to the Treasury selloff.

Canada’s debt-to-GDP ratio now stands at more than 100% and the federal government has set aside another $70 billion to $100 billion of additional stimulus to repair the economy. And these expenses will need to be paid for. Cue the rapid run up in the yields for the federal government’s 10-year Canada bonds. Since the start of the year the yield on the 10-year bond has more than doubled, rising from 0.7% to over 1.5%, as yields surged past the government’s forecast not just for this year, but also for 2022. That is potentially bad news for the federal deficit, but yields are still at historically low levels and Ottawa’s borrowing costs for its long-term debt are much lower than they had been in the past.

The Bank of Canada’s Governor Tiff Macklem said Canada’s economy is flush enough with stimulus to survive the current downturn and doesn’t need additional help from monetary policy. The bank is expecting a quick recovery from a first quarter contraction, a scenario that would eventually require it to pare back asset purchases. The central bank expressed optimism that the economy will remain on track to fully repair damage caused by the pandemic by 2023. Macklem also said that the stabilization of financial markets has made a small rate cut a viable option, if needed. To be sure, there’s no prospect of any quick withdrawal of stimulus either. The Bank of Canada pledged not to hike its policy rate until economic slack has been fully absorbed, something not expected to happen until 2023. There are other concerns. With inflation hovering below 1%, Macklem said the central bank is more worried about deflationary pressures than any temporary overshoot of its 2% target.

Yields remain incredibly low by historic and even relatively recent standards. Two years ago, the 10-year U.S. Treasury paid 2.5% and during the Clinton administration, yields on 10-year Treasuries rose to 8% from 5.2% between October 1993 and November 1994. The bond market is worried and saying that policymakers ought to pay more attention to those bond investors protesting policy decisions, also known as bond vigilantes. Yet evidence of inflation remains elusive. Consumer prices, excluding the volatile food and energy sectors, have been tame, as have wages. And even before the pandemic, unemployment plumbed lows not seen in decades without stoking inflation. Indeed, the bond vigilantes remain outliers. Even many economists at financial firms who expect faster growth because of the stimulus package are not ready to predict inflation’s return. The inflation dynamic is not the same as it was in the past as globalization, technology and e-commerce all make it harder for firms to increase prices.

The Standard & Poor’s 500 index skyrocketed 6.2% in U.S. dollar terms over the first quarter. In Canadian dollar terms the index was up a healthy 4.8%.

The pandemic’s blow to the U.S. economy last year ended the country’s longest economic expansion on record at nearly 11 years. The COVID-19 virus inflicted the worst economic freeze since the end of World War II as the economy contracted 3.5% in 2020. The nation’s Gross Domestic Product (GDP) grew at a 4% annual rate in the final three months of 2020; however, it slowed sharply in the fourth quarter from a record 33.4% surge in the third quarter. That gain had followed a record-shattering 31.4% annual plunge in the previous quarter, when the economy sank into a free fall. Even as the economy shrank last year, the stock market managed to rise sharply with the S&P 500 index gaining 18.4%. The disparity between the two reflected the fact that the stock market is forward looking rather than a reflection of the current state of the economy.

After last year’s false start, the prospects for a sustained reopening of the economy through the second half of 2021 are promising but investors are already concerned about rising interest rates. The vaccination rollout and the $1.8 trillion U.S. fiscal stimulus package have sparked fears that economic growth will accelerate too quickly, placing upward pressure on rates. Many investors are worried that if the economy rebounds too quickly, inflation pressures and interest rates will increase significantly over the next 12 months – but 24 to 36 months may be more realistic. It will take at least until the end of this year for the U.S. economy to recover the lost output from the lockdowns and even longer in other economies. Broad based inflation pressures are unlikely to emerge until 2023 so it may take until late 2023 or early 2024 before we see the first rate hike.

The Federal Reserve (Fed) is the U.S. central bank and it is projecting economic growth this year of 5%, up from its December estimate of 4.2%. Following on the 3.5% contraction in 2020, many analysts are more optimistic and forecasting growth of roughly 7% this year. That would be the fastest U.S. expansion since 1984. To allay concerns that rapid growth would propel an equally rapid increase in interest rates, the Fed’s chief Jerome Powell has openly discussed the financial tools the Fed could use if long term rates rose so quickly that they could threaten the economy’s health. The Fed could shift more of its monthly purchases of Treasuries to longer term securities, such as 10-year notes, while cutting back on its short term bond buys.

The Secretary of the Treasury, Janet Yellen, noted that the government’s ratio of debt to the size of the economy is much larger than it was before the global financial crisis but stressed that the cost of all that debt is relatively small as interest payments on the debt as a share of GDP are now below 2007 levels. In the meantime, the economy is recovering. Hotels and airlines will likely take longer to recover but these are a small share of the economy. The disruption also spurred new investment in digital technologies and the recovery will be faster in sectors such as retail, health care and education that pivoted to digital delivery during the pandemic. The labour force will need to re-skill for the new digital economy, which will take time, and the result will be a much different economy.

The growth in both government and corporate debt is likely to last for several years. In the short term though, the prospects for a return to pre-pandemic GDP levels this year look promising. The downturn has not stressed the financial sector, does not result from a burst credit or real estate bubble, and pandemic related supply disruptions will pass. Typically, the recovery following a financial crisis or a burst real estate bubble takes a long time because damage to banking system balance sheets keeps banks from providing credit to the economy for years. This time there is less need to repair corporate and household balance sheets so the prospects for recovery are very good.

Global financial markets pushed higher late last year on the emergence of COVID-19 vaccines and ongoing stimulus policies. The return to more normalcy in the economy, markets, and society in 2021 is expected to propel financial markets to new highs for equities around the world. Even markets where the vaccine rollouts have significantly lagged are performing well. Of course, these gains and the global economic recovery, will still depend on the success of the continuing rollout of vaccines, future corporate earnings and central bank policies.

The European economy suffered through a rollercoaster year of freakish activity in 2020: plunging 11.7% in the second quarter; followed by a rebound of 12.4% in the third; and closing the last quarter only down 0.7%. Germany and Spain both posted surprise economic expansions in the final quarter. The near-term outlook remains challenging with a chaotic start to vaccinations which means that curbs will have to remain in place longer. To offset these problems the European Central Bank has unleased new stimulus measures and extended its emergency bond buying program to provide new ultra-cheap loans for banks. Europe’s economic sentiment indicators surged recently on strong demand for manufactured goods and exports; and is driving hopes for a return to some form of normality and optimism for the year ahead.

The U.K. economy has been ravaged by COVID-19 and suffered its biggest crash in more than 300 years when it slumped by 9.9%; but it now looks to be on course for a recovery, as growth in the fourth quarter turned slightly positive. Britain, reporting Europe’s highest death toll, reflects how its economy relies more on face-to-face consumer services than other countries. It is facing further government borrowing as it continues to focus on protecting jobs; as unemployment has risen quite dramatically, particularly in the service side of the economy. It will likely take until early 2022 before the economy regains its pre-COVID-19 levels. However, when restrictions are eased, the economy is expected to vigorously rebound outstripping the rest of Europe.

Japan’s economy will likely recover to pre-pandemic levels in the next year, despite ongoing headwinds from COVID-19. Difficulties last year were further exasperated by an increased consumption tax, natural disasters and trade troubles with China. Still, after suffering its biggest postwar slump, Japan’s economy has been recovering moderately from the pandemic thanks to a rebound in exports and manufacturing. A combination of expansionary fiscal and monetary policies have successfully stabilized Japan’s economy by preventing corporate failures and unemployment. While the health impact of COVID-19 has been mild so far, the key challenge will be to prevent the pandemic from leaving a lasting scar on the economy.

International stock markets continued to rise through the first quarter, although there was some consolidation in sectors that saw outsized performance last year. On March 23, 2021, the markets celebrated the one-year anniversary of the 2020 market trough and after a one year rally with few pullbacks the short and long terms gains are quite impressive: International stocks gained 3.6% in the first quarter and 45.2% for the last 12 months (all returns figures are in U.S. dollar terms); European stocks climbed 3.5% in Q1 and 42.0% over the 12 months; and Asian stocks jumped 4.5% in the quarter and 43.9% since March 2020.

Global growth contracted in 2020 but was still better than expected. Although vaccine approvals have raised hopes of a turnaround in 2021, renewed waves and new variants of the virus pose potential concerns. Despite a high degree of uncertainty, the global economy is expected to come roaring back. The strength of the recovery will vary significantly across countries, depending on medical care, fiscal and monetary policies, and economic strength entering the crisis. It seems as though the impact of COVID-19 is slowly slipping into the rear view mirror.

The near term outlook for Emerging Markets remains soft and directly tied to the COVID-19 pandemic’s trajectory and restrictions. Growth in most markets will accelerate as the year progresses when vaccinations accelerate and global demand strengthens. After better than expected performance late last year, the expectations have only increased such that most emerging market nations should fully recoup all the economic contraction from last year by the close of 2021. Further significant upward prospects could grow even higher depending on strength in two key sectors: manufacturing and commodities.

While other nations continue to struggle, China’s success in curbing the virus and its investment-driven stimulus has made it the best performing economy in the world. While it had its weakest growth since the 1990’s, it was the only major economy to grow in 2020. China’s share of global economic activity is expected to rise to about 19%. In some ways, the pandemic has actually escalated its rapid rise. China’s trade is now well above pre-pandemic levels, boosted by demand for Chinese-made masks and other medical goods. Consumer spending has been relatively subdued. To combat this the government has implemented tax relief and cuts in bank reserve requirements. The result of all measures taken is that China is expected to lead the world in economic growth this year.

While Asia fared well overall, the divergence in performance of different geographies and sectors are quite extreme. North Asian countries (i.e., South Korea, Taiwan), had the greatest success in containing the pandemic and outperformed India and other southern countries. India also saw a recent spike in new infections but is expected to be very strong this year due to a faster than expected reopening of the economy and fiscal stimulus. Malaysia experienced a quarterly contraction in output because of pandemic-related restrictions on economic activity. Thailand could experience the largest positive spillovers from China’s growth and the return of international tourism which is an important source of employment and foreign currency revenues.

In Latin America, growth prospects are rising on the tailwinds of stronger global growth. However, structural weaknesses, especially in terms of investment, will still mean that the region will be among the last to return to pre-pandemic levels. The pandemic situation has worsened during Q1. For example, in Brazil, new daily cases are at new highs and hospitals in several regions of the country are at or near capacity. Generally, the expected vaccination progress in most of this region is expected to lag that in more advanced economies.

Despite the global turmoil caused by COVID-19, stock markets were generally strong around the world and Emerging Markets in particular climbing 2.3% in the first quarter and 58.9% over the past 12 months (all figures are in U.S. dollar terms); Asian stocks collectively gained 2.2% in Q1 and 60.6% since last March; Latin American stocks lost ground in the first quarter; falling 5.3%, but have gained 50.5% over the past 12 months.

The economic fortunes of Emerging Markets will vary across countries depending upon their resources for fiscal stimulus, vaccine investment, and labour factors flexibility. It is expected that between 60% to 70% of the population will have at least some immunity by the end of the year. Given the unusual nature of this crisis, it will be important to be flexible and open minded as the recovery plays out. The financial markets have not fully digested the extent of the economic damage that has occurred so while higher returns are likely they may be accompanied by volatility.

Real estate assets usually recover from weaker periods and 2021 is set for a rebound, especially after the incredibly strong year-end surge in REIT prices last year. Restrictions on travel, lockdowns and reduced physical interaction initially hit REITs very hard last year. Despite these challenges, investors appear to be betting on a recovery. Most of the REITs went into the pandemic with strong portfolios and healthy balance sheets so they should be more than capable of withstanding any negative investor sentiment. For example, the average Canadian REIT is now trading at a 9% discount to asset value, whereas the 20 year average is a 1% premium. Given the massive volume of equity raised globally, investors are eager to deploy pent-up capital and pursue opportunities this year.

With office buildings emptied, hotel vacancies through the roof and commercial tenants struggling to pay rent, it was no surprise that 2020 was a challenging year for the class of real estate investing. As the pandemic forced many staff to work from home, the office vacancy rate in Canada hit a 16 year high. As a result, new investments in properties plummeted in both number and value, with the total deal value declining 50% from 2019 levels. Still, office REITs are well placed to deal with the pandemic challenge, since not all leases expire in 2021 but over number of years; so REITS have time to adapt to a new office environment. Long term, as workers start coming back to the office, investors will see huge value and start to pile in with their large cash reserves.

Industrial REITs have thrived during the pandemic with the acceleration of e-commerce, creating demand closer to cities for faster and cheaper delivery. Conversely, commercial REITs were thrown into uncertainty as the pandemic undermined fundamental assumptions about the way people will work and shop in the future. Most tenants of industrial properties were able to continue operating through the pandemic, meaning they were able to pay rent.

The Canadian housing market has been one of the more resilient parts of the economy. Logistics, data centres, senior living and life science assets will draw the attention of investors. While the pandemic has decimated the retail and hospitality sectors, investors will also be focusing on discounted assets that can be easily repurposed. Retail and seniors’ housing have all lagged and are likely to create even more challenges ahead. Physical retail space has lost out to ecommerce, prompting a growth in warehousing and fulfillment centres.

From a performance perspective, the returns from REITs have rebounded well from the market lows of 2020: Canadian REITs are up 9.2% in the first quarter of 2021 and 29.3% over the past 12 months; international REITs did not do quite as well as they were negatively impacted by the increase in the Canadian dollar (all return figures are in Canadian dollar terms) over the past year as they climbed 4.8% in Q1 2021 and 21.4% over the past year.

As Canada and the rest of the world come back to life once the pandemic is over, so too will demand for tangible assets. Once COVID-19 fades into the background, the vibrancy of cities will return and so will the demand for real estate across the spectrum of available properties. Workers who think they will be allowed to work remotely forever may be making a bad bet. The bottom line is that while the market has focused on some of the perceived short term challenges, eventually longer term positives will take hold.