The effect of COVID-19 on the stock market was swift and painful for investors: markets dropped by roughly a third in value between mid-February and mid-March 2020. Yet, stocks also staged a quick rally and markets have recovered a lot of the lost ground. By early June, Canada’s TSX was just about 10 per cent down from its peak in February. Considering that COVID-19 has done great damage to our economy, today’s valuation seems rather optimistic.
Markets reacted far from uniformly to the COVID-19 shock. The sudden impact on demand patterns had rather differential effects on different sectors. On top of COVID-19, oil markets were rattled by an oil price war between Saudi Arabia and Russia, where Saudi Arabia attempted to regain lost market share. The double shock thus hit the energy sector hardest, and the pain of this double shock was felt immensely all across the oil-producing regions of Canada.
When analyzing how sectors performed during COVID-19 so far (see chart), the patterns that emerge make a lot of economic sense. During COVID-19, consumer staples were the least affected. People still needed to eat. Likewise, utilities fared really well. People still consumed electricity, and only modestly less than before COVID-19. The sector that is noticeably absent from the Canadian list is what is generally referred to as “consumer discretionary”. The market for this is thin in Canada and generally includes leisure and travel companies, entertainment, and so on.
The energy sector was hit by far the hardest, with an initial price decline of over 60 per cent. Canada’s oil patch is particularly vulnerable because it has one of the highest production costs. Bitumen and other heavy crudes are costly to produce and refine, and thus oil prices well below USD 50 per barrel threaten the economic viability of production. The break-even cost for new mines is more in the USD 75-85 per barrel range, but to cover variable costs, prices need to be at least about 30 USD per barrel for the Western Canadian Select (WCS) blend. Lately, oil prices have been inching up again and WTI and Brent have now reached the 40 USD per barrel mark. The picture for the oil industry is improving, but threats remain (most of all from continuing price wrangling among OPEC+ countries).
Real estate has also been hit hard in Canada for several reasons. During COVID-19, there is no opportunity to visit homes, and increased uncertainty about the future may make many potential buyers jittery about future increases in home prices. Canada’s influx of overseas money into the real estate sector has also been abruptly halted in part due to the inability to travel. Consequently, the real estate sector has hardly moved since bottoming out in late March.
Canada’s stock market has also revealed two outperforming sectors: materials and information technology. The story for these two sectors is rather dissimilar. There has been a boom in everything IT related because so much work has gone online. In Canada, the star in this group is Shopify, whose stock price has about doubled. COVID-19 has invigorated the push towards online shopping, and Shopify is benefiting from this trend.
The materials sector has benefited from what is generally thought to be the “safe haven” effect of precious metals. Materials is usually a risky sector because adverse changes in the business cycle are usually felt rather quickly in materials that are at the beginning of the supply chain. COVID-19 would be considered damaging for materials in general, but Canada’s materials sector is heavily exposed to precious metals, which in turn explains the unusually strong performance.
Canada’s largest sector is financials, dominated by the big banks, insurance companies (Manulife, Sun Life) and Brookfield Asset Management. Royal Bank alone accounts for 21 per cent of the index. Unsurprisingly, the TSX overall tracks the financial sector closely. Banks have been exposed to COVID-19 through credit risk as insolvencies jeopardize their loans. Canadian banks passed a stress test by the Bank of Canada. Canada’s central bank has injected sufficient liquidity into the banking system, and the banks’ funding pressure has eased markedly in recent weeks.
So where do stocks go from here? The remarkable rebound is probably fragile. Markets seem to have shrugged off much of the economic effect of COVID-19 before most of the economic effect has fully percolated through the economy. Whether the economy will simply “snap back” into before-coronavirus gear is rather questionable. Jobs have been lost, and many small retail and food service businesses may not survive if they cannot operate above break-even capacity utilization. If there is a second wave of COVID-19 in the fall, the markets may take another dive as the outlook worsens. For now, the markets appear detached from the bleak economic data coming from our statistical agencies. Or, as Jeff Sommer explained in the New York Times article Why the Stock Market Just Doesn’t Care: traders are betting heavily on a rising market while the Federal Reserve is massively bolstering it.
All of this can teach wary investors three essential lessons:
- The first lesson is that even during a massive downturn, there are safe sectors. People always need to eat and power their homes and offices. Consumer staples and utilities are among the safer bets during such a crisis.
- The second lesson tells us that a crisis creates new winners and losers. Information technology got a boost… if only we had bought stock in Zoom last year! Consumer discretionary spending is probably the hardest hit, but the Canadian TSX is not exposed much.
- And the third lesson is that a crisis can come in pairs and triplets. This time, the oil price war and COVID-19 coincided to hit the energy sector doubly hard. This is why Canada’s TSX, which is energy heavy, has still not rebounded as much as the US S&P 500. Canadian investors should be mindful that Canada’s economy exhibits a strong industry sector bias, and thus investing outside Canada provides important balance to this bias.
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