OB Report
September 2021
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An Unexpected Pandemic Silver Lining

Murray Leith By Murray Leith, CFA   Executive Vice President & Director, Investment Research


Who knew a global pandemic would be good for your portfolio? Despite the turbulence caused by economic lockdowns, and the inflationary pressures unleashed upon reopening, asset prices have soared. The broadly based U.S. S&P 500 Index is almost one-third higher than its pre-pandemic peak. The recovery in Canadian stocks has been impressive, too, although our main benchmark index is up a lesser 13% from its pre-crisis record. 

Not only did the extraordinary efforts of governments and central banks save the world from a deep and ugly recession, but their actions also greatly enhanced asset values. Aside from enormous government aid that directly supported the economy, asset valuations have been buoyed by two monetary policy levers: (1) ultra-low interest rates, which influenced prices like helium in a balloon; and (2) a huge increase in the money supply, which fuelled asset appreciation by creating demand for stocks, real estate and other assets.

We’re impressed and surprised by the speed and strength of the economic and stock market recoveries. According to the National Bureau of Economic Research, the official arbiters of U.S. recessions, the latest economic setback was the shortest on record. The recession was only two months long, bottoming in April 2020 after starting the month prior when the world locked down. The Great Recession that coincided with the 2008/09 Financial Crisis lasted a year and a half, and it took the S&P 500 Index more than five years to regain its prior peak. 

Prior to the pandemic, we were cautious regarding the outlook for several reasons. The economic expansion was already one of the longest on record; stocks were expensive, and we worried about the authorities’ ability to manage the next recession. The latter point was of most concern. 

At the time, interest rates were negative in Japan and much of Europe, and very low in the rest of the developed world. With limited scope to lower interest rates further, we feared monetary policy would be much less effective at reviving the global economy during the next inevitable downturn. We reasoned that fiscal policy would need to play a much greater role, and we were sceptical regarding that possibility given the level of social unrest and political polarization. 

The pandemic rendered these worries moot. The crisis was so monumental that there was broad support for a “whatever it takes” approach to save the economy, using multiple and coordinated fiscal and monetary policy levers. Indeed, the size and scope of the support and stimulus were unprecedented.

Most importantly, the crisis has likely ushered in a new era of coordinated fiscal and monetary policy. While we have long-term concerns about large government deficits being financed by central banks, the near-term benefit is that governments are better able to manage economic inequality via fiscal policy than central banks can through monetary policy. 

The social unrest that stems from economic inequality has long been our biggest concern. The lower and lower interest rates central banks have fostered in recent decades have benefited the wealthy, who disproportionately own the assets that get inflated. Now that there is mainstream support for greater government-led fiscal initiatives, financed by central banks, there is much larger scope to deal with this inequality. It’s a massive and difficult job, and governments will likely make errors at times, but there are policy possibilities on the table now that seemed unreachable before. That’s a big silver lining from the pandemic, and perhaps it’s a reason why investors are more confident about the future. 

We are certainly grateful that the authorities unleashed a firehose of support for individuals, businesses and governments. They did the right thing. However, we do wonder if they should be dialing back some of the stimulus now that the economy is back on its feet and inflationary pressures are evident. 

Central bank leaders argue that the recent surge in prices is a transitory phenomenon and that inflationary pressures will abate as businesses work through temporary supply bottlenecks. Interestingly, bond investors seem to agree with this benign outlook for inflation. After all, the yield on the 10-year U.S. Treasury bond recently dropped to 1.25% from 1.75% in March. One would expect bond yields to rise in the face of higher inflation, not fall. 

We hope the authorities and bond investors are right. If they are wrong, and inflation is persistently higher, interest rates will probably rise, which could put downward pressure on asset valuation multiples. 

Some believe stocks are already overpriced. Indeed, valuation multiples are near the high end of their historical range, but they are arguably justified by the fact that interest rates are well below average. Stocks can probably handle a modest increase in interest rates.

The challenge in the market today is finding stocks with a good margin of safety – a valuation that is discounted enough to limit downside risk and provide decent upside potential. In our view, most stocks are priced fairly relative to interest rates and to each other. In other words, there isn’t a lot of low-hanging fruit. 

Given the forgoing predicament, it’s fair to wonder if it’s a good time to take profits on stocks. Unfortunately, there isn’t an easy answer to that question because the alternative investments have risks as well. 

Bonds will do well and provide a ballast for investment portfolios if the economic recovery falters and interest rates go down. However, they will drop in price if interest rates rise in the face of persistent economic growth and inflationary pressures. Cash or short-term money market funds are not great alternatives either in an ultra-low interest rate world because the income from these instruments is insufficient to cover inflation. Wealth erodes from a purchasing power perspective when it’s invested in low-yielding fixed-income instruments.

It’s sometimes tempting to take money out of the stock market with the hopes of redeploying it after a correction or a crash, but we have long counselled against this approach, as it’s very difficult to successfully execute over an investing lifetime. Getting the timing right on both the sell and buy decisions is extremely difficult. In fact, we were recently humbled on this front. Having cash, gold and a generally defensive posture helped cushion the blow to the Odlum Brown Model Portfolio1 when stocks plummeted as COVID-19 spread and the world locked down. But our performance lagged in the early part of the recovery because we didn’t reinvest quickly enough. Stocks started pricing in the recovery much faster than we expected. 

We are currently fully invested within our all-equity Model because we feel stocks are still attractive relative to the alternatives, even though long-term return prospects are muted by elevated valuations. Still, cash and bonds have a place in the overall asset mix, as one can rely on them to lower portfolio volatility and provide reliable funds, if needed. Quality, diversification and balance remain paramount.

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 1The Odlum Brown Model Portfolio is an all-equity portfolio that was established by the Odlum Brown Equity Research Department on December 15, 1994, with a hypothetical investment of $250,000. It showcases how we believe individual security recommendations may be used within the context of a client portfolio. The Model also provides a basis with which to measure the quality of our advice and the effectiveness of our disciplined investment strategy. Trades are made using the closing price on the day a change is announced. Performance figures do not include any allowance for fees. Past performance is not indicative of future performance.

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