i-Wire: Market Update 23rd March

• The Covid-19 virus is spreading quicker and with more deadly effect than governments, and financial markets, had ever considered.
• The economic consequences are becoming ever more serious as ‘lock-down’ and ‘social distancing’ will result in a catastrophic fall in global demand never witnessed before.
• This is being met by a huge and totally unprecedented policy response by the authorities, the use of the term ‘war footing’ is for once not an exaggeration.
• There is going to be a very steep recession, the hope is that the policy response means this is V- shaped with a rapid recovery rather than become a long term depression.
• Markets continue to trade wildly with no floor yet in sight but we stick with our view that clients should avoid ‘cashing out’ at current distressed levels.
• In this chaotic market environment our first concern is to avoid making short-term ‘own goal’ errors when making changes to portfolios. We need to make considered changes when the market is less volatile to make sure we get it right for the ‘new’ and very different long term.

 We are experiencing a life we never thought we would be living. Our priorities have changed totally with our health and that of our families and friends now absolutely paramount. The incredible response from the NHS, the food distribution channels and other essential industries has been truly inspiring. Equally so is the kindness and community spirit in our own neighbourhoods, I’m sure many of you are contributing to and benefitting from this and the triumph of the human spirit is what will get us through these dark times.

As I wrote last time, it is our role to help safeguard and grow your wealth to the best of our abilities. A key part of this is to keep you informed as to how we see financial markets and what changes we think should be made to your portfolios. We will provide regular market updates for as long as this crisis continues in addition to the usual quarterly newsletter which will be produced as usual at the beginning of next month.

In this note we will look at

• How markets have performed during the crisis
• The collapse in sterling and its implications for your portfolios
• The policy response from Central Banks and Governments
• What next for the markets
• What we are planning to do with portfolios
• Conclusion

Market Returns

The year to date chart shows how the major equity indices have behaved during the crisis

I have run these charts in local currency (i.e. US stock market in US dollars, Japanese’s stock market in yen) and it shows two main features

• The UK, US and European markets are much of a muchness
• The Asian markets have done better (first in, first out of the virus?)

However if we run these charts in sterling, which is return they will produce for UK domiciled clients, then the effect is markedly different

In this context the UK stock market is a laggard, especially against the markets with ‘safe haven’ currencies such as the US dollar and yen. The HK dollar is pegged to the US dollar of course, hence its strength against sterling.

The next chart shows just how weak sterling has been since the onset of the crisis (sterling is the straight line!)

Only Norway, a petro-currency hammered by the collapse in the oil price, has done worse. So why has sterling done so badly?

• It lost any sort of safe haven currency years ago, that accolade remains with the US dollar, Japanese yen and Swiss franc
• The pre-emptive cut in UK interest rate may be the correct policy response but it has significantly reduced the yield and hence attractiveness of UK Gilts to overseas investors
• The financial markets consider that the UK Government response to the coronavirus has been dilatory, complacent and ill-conceived in relation to the swift ‘lockdown’ policies of everyone else.
• Our old friend Brexit; the FX markets were concerned before the crisis that we would be back into last-minute, cliff-edge, no-deal territory.

The weakness of sterling makes a big difference to the returns of UK funds because these returns are the return in local currency +/- the currency effect on translation back to sterling. Using my tried and tested ‘scores on the doors’ table shows the return of the sector average for each of the asset classes

Figures from Financial Express Analytics

There are a number of takeaways from the table

• Overseas funds have produced better returns than UK funds, due principally to the weakness of sterling as discussed
• UK Direct Property looks a safe haven but isn’t, as the fund closures of all the ‘bricks and mortar’ funds last week has shown, the commercial property market is in disarray and we expect some large mark downs in property values at some point
• Gold is not quite the safe haven it appears as it has fallen from a peak of US$1687/oz on March 6^th to a close on Friday of barely above US1500/oz. I have quoted the return in sterling and all of this positive return is due to the weakness of sterling against the dollar (in which gold is valued)
• Fixed Income, whilst obviously doing far better than equities, is also not quite the safe haven it has been assumed to be. Long dated bonds have done well but pulled back in the last couple of weeks as yields have shown they can go up as well as down.
• Corporate bonds have produced negative returns as spreads (a measure of how investors see the risk of corporate as opposed to government bonds) have widened significantly.

The chart shows the returns of the sector averages for UK fixed income funds and illustrate

• How Gilt prices have come off their highs
• How Corporate Bonds have fallen sharply as ‘risk off’ sentiment has worsened dramatically. Strategic Bond funds include ‘high yield’ companies with a lower credit quality and hence have fared the worse.
• Linkers have been all over the shop as they have a far longer duration than conventional Gilts.

The Policy Response

I wrote in my last note about the necessity of a ‘shock and awe’ policy response and the Central Banks and Governments have stepped up to the plate. What the authorities have realised is that there will be a catastrophic collapse in global demand because we are all at home or in total lockdown. Schroders for example are this morning saying that global GDP will contract by 3% this year, making it the worst year since the 1930s, before rebounding by 7% net year. The challenge for Central Banks and Governments is to ensure that the post-virus economic path is V-shaped with a huge recovery bounce in (hopefully) the second half of the year rather than allowing whole industries to go to the wall, unemployment to rise disastrously and the onset of the sort of depression we haven’t seen for decades.

Have they done enough? I don’t think at this stage they could have done much more and it is clear that there is some properly thought out co-ordination with joined up monetary and fiscal policy. Central Banks have slashed interest rates and re-introduced quantitative easing to boost growth and maintain liquidity in the financial system and fiscal packages of eye-watering size are being launched with the UK paying the wages of those being laid off and the US to mail cheques straight to households. This is unprecedented; this is government policy on a war footing; this is right wing governments tearing up their beliefs with state intervention on the biggest scale ever. Governments are bypassing the banking system and going straight to businesses and households and are doing ‘all it takes’ and will continue to do so.

What next for the markets

The policy response has been phenomenal, and in time is going to make all the difference when the tide of coronavirus starts to turn for the better with slowing rates of infection and better rates of recovery.  At the moment though it is daily news flow that is the principal driver and in Europe and the US we are in the upward slope of the epidemic curve which is driving extremely negative market sentiment. China and Korea though are supposedly through the worst, which is something to give us hope, but better news is a necessity before the market finds any sort of floor, and this is of course some way off.

This is not to say the market will keep falling precipitously: it is a discounting mechanism after all. Valuations are optically very cheap but this is the reddest of herrings. Revenues and profits are disappearing into thin air and so too are dividends as companies shelve them to prop up their balance sheets, Marks and Spencer being the most notable so far. With savings rates at near zero this will be a harsh blow to so many of us expecting an income stream from our investments.

I stand by what I wrote last week, namely that markets do eventually recover however implausible this may feel at the time, and investor sentiment currently could not be more bearish given the underlying reasons for this market crash. Cash is King, but this will not always be the case and my greatest fear for long term investors is ‘cashing out’ near the bottom of bear markets and never getting back to reap the benefit of the ensuing recovery. Markets need to find a floor, and we are some way away from doing so, but the initial recovery from that level could be quick and steep.

What we are planning to do with portfolios

This is the most challenging time for managing money I’ve witnessed in the 40 years I’ve had that responsibility. The most important thing you want to know is what are we doing, and why.

• How were we positioned going into the virus outbreak?

With a truce in the US/China trade war, the global economic outlook was lacklustre but stable and the geopolitical background improved. Resolution on Brexit and the dismissal of the Corbyn threat finally improved the outlook for the UK stock market. We were though concerned that valuations in both equities and bonds were expensive and we were to some extent cautious, though by no means bearish, in our stance. So we had some cash on portfolios, a short duration positioning in bonds and an expectation that sterling and the UK would have a better year relative to overseas markets and currencies after three years in the doldrums.

• Are portfolios correctly positioned in an appropriate manner for their risk/reward profile?

Yes, they are behaving how we would expect them to in terms of the magnitude of their falls, using their relationship to the FTSE100 as a guide. Of course, we wish loss mitigation had been better.

• Why did we not act more decisively when the virus broke out in China?

Hindsight is a wonderful, and in this case, terrible thing. A saying in markets is ‘Never panic….but if you are going to panic then panic big’. We were not complacent, anything but, but we should in retrospect have acted absolutely straight away because the subsequent fall has been the most precipitous (over 30% in just a couple of weeks) in stock market history. We did not want to sell during this very steep and very rapid fall and run the risk of ‘cashing out’ in what may subsequently prove to be near the bottom of the eventual fall.

• Why have we not traded aggressively during the fall?

We never like to confuse activity with achievement and we have to get this right for you. We don’t like to make portfolio changes when markets are moving up and down nearly 10% on a daily basis and the investing environment so chaotic. What looks like a good trade on a one day or one week basis may prove to be the very worst thing to do on a one month or one year basis.

The coronavirus is a lifechanging event of such significance that while we can speculate, we do not yet know which companies and even industries will survive or thrive in the next bull market. When we feel we can re-enter the market with better visibility and clarity, and when volatility subsides somewhat, then we expect to be making/advising significant changes to client portfolios.

Conclusion

We are at the beginning of several months which are going to fundamentally change our lives in ways we cannot yet foresee. We have entered a bear market in equities of unknown magnitude and duration though one from which we do expect to recover, as we have always done in the past, no matter how bleak it feels in the eye of the storm.

Most importantly, and as we said last week, we wish you and your families the sincerest of good health.