Quarterly Letter

True to its nature, the market continues to climb a wall of worry: layoffs, lockdowns, second wave of COVID-19, Trump vs Biden, China – US trade war. We can probably go on for another page of worries, but you get the drift.

As we move closer to the US election day (November 3rd, 2020), many clients are getting nervous for different reasons: some worry about the socialist biases of the Democrats, i.e. tax increases, more government and regulation; others worry about another four years of Donald Trump’s trade war and international bickering strategies.

To keep one’s perspective, we decided to look back 120 years, using the Dow Jones as a proxy and here are some statistics:

  • If you had invested $10,000 starting in 1900 and remained invested only when the President was a Republican, it would be worth $99,000 today;
  • On the other hand, if you had done the same thing but only when the President was a Democrat, it would be worth $430,000 today;
  • As obvious as it seems, you should know that if you had invested the same amount since 1900 and stayed in the entire time until today, it would be worth $4.2 million.


As usual, there are lies, damn lies and statistics.

Is the stock market strength disconnected with the harsh economic reality of layoffs and bankruptcies?

Lots of commentaries have been written regarding this conundrum. The fact is that the stock market and the economy are 2 distinct entities and there are times they actually move in opposite directions. On many occasions, especially near the end of a recession as layoffs continue and with corporate profits still on the decline, the stock market starts moving up anticipating the return of better economic times.

Furthermore, the pandemic lockdown has affected disproportionately certain sectors like hotels, restaurants, leisure and airlines – parts of the economy where layoffs and furloughing have been massive. These sectors hold much smaller weights in the major indices that most investors follow. As we mentioned in the last quarterly letter, if you take away Facebook, Amazon, Netflix, Microsoft, Apple and Google, the S&P 494 would have been down 11.3% in the first 6 months of 2020.

Do not underestimate the power of money printing and deficit spending, especially when it is global

For the first three months of the pandemic, the Federal Reserve of the US has printed $3 trillion USD and the US government has spent $3 trillion USD in relief packages for the economy and the US people. Canada has taken similar actions proportionate to the size of its economy. These newly minted dollars found their way into the financial markets and boosted asset prices. Surprisingly, even the hawkish German government is talking about the benefits of deficit spending. A dramatic policy pivot is underway, where bold monetary policy is combined with the massive European Recovery Fund.

Is there any precedent to where the Fed is heading in terms of monetary policy?

As outlandish as it may sound, this is exactly what the Fed did during the 1940s when the US entered World War II and ran up a massive debt in the process.

Despite the dire financial situation in the country following the Great Depression of the 1930s, in 1942 the US entered World War II following the attack on Pearl Harbor. The government went on a borrowing spree to finance the war efforts. Federal debt as a percentage of GDP increased from 39% to 116% by the end of the war in 1945. Guess who was buying the debt? The Federal Reserve, by increasing its balance sheet 10-fold. On top of that, it also capped interest rates at 0.375% for the short term and at 2.5% for the long term. During that time, as inflation ran up, real interest rates (nominal interest rate minus inflation) went from being positive to being negative. Effectively, the government was paying you back with devalued dollars. That is one way for the government to get out of debt!

For those of you who follow the events that have unfolded during this pandemic, the above scenario is quite illustrative of where we could go from here. The question has always been how much the government can borrow before it becomes problematic. We have no answer and looking at Japan would give you an idea why: in 1984, Japanese government debt as a percentage of GDP was around 65%. It is now at 236%. Yet, the Yen has appreciated against almost every major currency and Japan’s economy is anemic but not declining relative to other developed countries.

Market conditions and strategic alternatives

As we wrote in the first quarter of 2019, financial market performance is highly linked to the level of interest rates. As rates decline -- sometimes precipitously and sometimes gradually -- over the last 38 years (since 1982), equity and fixed income markets have performed very well thanks to:

  • Economic growth driven by lower interest rates which make buying a house or a car cheaper, leaving consumers more disposable income. Corporate interest expense has also declined, reducing the cost of new factories or production lines;
  • Increase in valuation on all asset classes (higher P/E in stocks thus higher stock prices, higher long-term bond prices, higher real estate prices, etc.)

Unfortunately, as rates are bound to a much lower level today, all prospective returns are also much lower in the absolute since asset classes are inherently interconnected. Investors move from one class to another in search of the best bargains and as such, reset the returns of everything relative to the interest rate levels of government bonds.

Since low interest rates are now a fact of life for the foreseeable future, this financial condition has created the lowest prospective returns in history for all asset classes. What are the strategic alternatives for investors under this new environment?

When uncertainty is high, asset prices should be lower, creating high prospective returns that compensate for the higher risk environment. However, the Fed’s action and policy have rendered valuation levels high (albeit not at extremes especially if interest rates stay low). Hence, markets could be vulnerable to negative surprises. Under such circumstances, we would lean toward a more defensive position -- i.e. we may have more cash than normal -- while using our fundamental analysis to look for special situation opportunities in areas that are less well followed by Wall Street and Bay Street.

The Claret Team