Currency & Sector Liquidity Analysis Report: Q2 2020

September 1, 2020

The markets have enjoyed a strong recovery since the lows reached during the March market meltdown. The selloff was deeply overdone, as U.S. dollar holdings by investment funds reached a high of 1.70% in May, declining to 1.20% at the end of June only 20 basis points higher than in January before the market collapse.

The American markets have enjoyed stellar returns to date, with the Nasdaq Composite Index and S&P 500 Composite Index recently breaking all-time record highs. Canadian dollar weights seem to have stayed relatively stable all year, similar to the returns for the S&P/TSX Composite Index. It seems portfolio managers have correctly allocated capital in American markets to buoy fund returns while holding reinvestment in Canadian equities relatively stable.

Managers have also effectively deployed the Japanese yen, with the Nikkei 225 Stock Average riding significantly higher relative to pre-coronavirus outbreak levels. Some markets continue to perform relatively poorly, like London’s FTSE 100 Index and other European stock market indexes.

The flight to safety was very evident during these turbulent times, with the Canadian/U.S. dollar exchange rate spiking up to nearly 1.45 at the end of March. As markets shrugged off the pessimism associated with the pandemic, this exchange rate has dropped to roughly 1.31.

While the demand for money market instruments and Treasuries has skyrocketed, investors have also found other safe havens for their capital, such as gold. The yellow metal also recently rose to all-time highs at above US$2,000 per ounce.

Governments have deployed aggressive measures to help economies stabilize in these times. The U.S. Federal Reserve Board has gone as far as buying corporate debt and exchange-traded funds (ETFs) in the open market to prevent further market freefall. And with massive government relief efforts in Canada, the government announced that the Canadian federal deficit this year will hit nearly $343 billion.

As federal aid will eventually wind down in the coming months, it will become increasingly difficult for households to survive with sufficient income. There is, however, widespread criticism for some specific emergency response benefits. Some believe they are deterring individuals from returning to work or seeking employment, as these benefits exceed the income some made before the pandemic lockdowns. With federal governments pumping out benefits and payments, it is certain that Employment Insurance premiums and income taxes will trend higher in the coming years.

Many economists have expressed deep concern over the drop in permanent residency applications, a significant factor in helping create demand for housing and filling jobs that the baby boom generation will be vacating in the years ahead. Immigrants account for a vast majority of the economic growth in Canada, and with international travel bans, a rocky road to positive growth may be ahead.

With the November U.S. election scheduled for this rather wild economic year, overheated politicking is likely to increasingly influence markets as coronavirus woes seem to have plateaued.

Currency analysis

Our analysis focuses on the Canadian investment fund industry, and how portfolio managers are allocating capital in major currencies. The currency analysis excludes all cash equivalents, such as bonds with less than one year to maturity and collateral cash held to fulfill debt covenants. We believe by excluding these items, we can home in on the deployable cash in investment funds and assess the streets market sentiment. We then further analyze the liquidity of investment funds on a cash and cash-equivalents basis categorized by sector to help us understand which verticals portfolio managers are currently overweighting and underweighting.

Table 1 illustrates the month-over-month growth rates for the world’s major currencies.

Average portfolio weights for world currencies

Chart 1 illustrates the mean cash percentage in investment funds for nine major currencies in sequential order from January 2020 to June 2020.

US and Canadian cash on hand

Chart 2 illustrates the mean cash dollar value in sequential order from January 2020 to June 2020. The United States dollar had a net position of $3,205,739,041 for June 2020. The Canadian dollar had a net position of $6,377,079,365 for June 2020.

Investment Fund Liquidity Ratio

The Investment Fund Liquidity Ratio is calculated as the amount of cash in a fund relative to its total assets. It is important to assess this ratio when analyzing investments and allocating capital. It has the power to give deep insight into the overall flow of capital into specific verticals and the bullish or bearish sentiment in these investment categories. Table 2 lists the top and bottom 10 out of applicable sectors based on the mean ratio of over 3,000 investment funds with a mandate to invest in the corresponding sectors. The table lists the most bearish to most bullish sectors in descending order.

The red highlights the sectors with the highest ratio, which translates into underweighting their respective indexes. This could mean that portfolio managers are expecting negative performance in these categories.

The green highlights the sectors with the lowest ratio, which translates into overweighting their respective indexes. This could mean that portfolio managers are expecting positive returns in these categories, in the short term.

Review and outlook

As floating rates continue to be held low or move lower, there is no doubt that interest rates and fixed income will continue to face headwinds. In the course of this pandemic, ratings agencies downgraded the creditworthiness of companies and countries alike in almost every industry vertical globally. While oil prices have stabilized, energy-producing firms continue to downsize operations and shut down rigs in North America.

Looking at more of the promising sectors, small/mid-cap U.S. equity continues to be highlighted by portfolio managers as an opportunity. In volatile markets, small caps usually fall faster, but tend to outperform their larger peers after bottoming out, according to investment analytics company HCWE & Co. Geographic equity and emerging markets will also bear watching as economies reopening reopen and travel become more widespread.

Investors also have gained indirect exposure to surge in the price of gold by buying up mining companies, which are doing exceptionally well. Barrick Gold Corp. (TSX: ABX), for example, is trading at nearly an eight-year high. Preferred shares have also been an interesting investment class, as the conversion ratio from preferred to common is at its highest level, which may also help portfolio managers realize outsized returns for clients holding funds with a preferred-share mandate if the current market direction continues to exhibit positive momentum.

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