i-Wire: Market Update 14th April

• Equity markets have recovered strongly in the last two weeks
• We are concerned that this bounce may be too optimistic and do not think that a floor has yet been established by markets with any level of confidence
• Economic growth and corporate earnings estimates have been slashed with falls of up to 30% on an annualised basis in both growth and earnings now increasingly being ‘guesstimated’
• Government Bond Yields have collapsed and offer minimal value but we see opportunity in investment grade corporate bonds where spreads have widened significantly but default risk should still be low.
• UK dividends could be cut by up to 40% this year, though this should be seen in the context of very few alternative income sources with interest rates so low.
• We have been making/advising a number of changes to portfolios to improve their quality and robustness.

In this note we will look at

• How markets have performed during the crisis
• What next for the markets
• The longer term outlook for markets
• UK Dividend cuts
• What we are doing on portfolios
• Conclusion

These are the strangest days. I’m writing this note on Sunday afternoon, sitting in the sun, accompanied by an Easter Egg, ostensibly in a bubble of calm but knowing that we are now in the worst weeks. Many of you will have family and friends in the NHS and in the key industries who are working so hard and so selflessly to get us through this and to give us hope. Their dedication and sacrifice humbles me. Sadly, I know that by this stage of the pandemic many of you may have suffered the loss of a family member or friend, and if so the most sincere condolences of everyone in our firm go out to you.

Markets.

It isn’t usual to applaud Lenin for his foresight and well-chosen words in a stock market note but then he did say ‘there are decades when nothing happens and then weeks when decades happen’. Spot on Vlad. Markets crashed  at the steepest rate ever last month; the S&P 500  index breached the 20% barrier in just 11 trading days on its way to a 35% fall, even quicker than in 1929 which heralded the great depression. The response from Central Banks and Governments has been mightily impressive, raising hopes that we will see a savage, though short, recession with a strong recovery into the end of the year. This hope has led to a sharp recovery in share prices, as the year to date chart (in local currency) for the major indices clearly shows.

As I’ve done before, I’ll show this chart in sterling as it is a better representation of returns to the UK investor as the weakness of sterling has at least to some extent mitigated losses.

This points to Wall Street and the US dollar as the obvious ‘winners’ for now, though with markets so volatile, the course of the pandemic still unknown and with the US behind in the infection/mortality curve this differential could narrow both in the equity and currency markets.

For those who like tables as well as charts, here are  the sector returns table I included in the quarterly Investment Strategy (very grim reading) along with that of the first few trading days of April (happier)

Figures from Financial Express Analytics

Figures from Financial Express Analytics

As both the charts and the tables show, there has been a pretty strong bounce in risk assets with equity markets recouping between a quarter and a half of their losses and corporate credit making up a bit of lost ground on Gilts. At an individual fund level, those which produced the most distressing returns in the fall have in some instances seen the strongest bounce. To us this feels the action of a market flailing around trying to make sense of a situation it has never witnessed before and to which there are, at this stage, no answers. We are very pleased to see rising markets of course, but still see no sign of any equilibrium or calm returning as yet.

Market Outlook

The drivers of  the market going forward are simple enough to understand, the problem though is that there are no simple answers. The market is looking at three things

• When will infections peak?
• When will economies ‘re-open for business’?
• When will there be better visibility on earnings this year and in 2021?

The key debate, extensively covered in the media, is how and when we exit from our lockdown. This is a terribly difficult balancing act between the risk to life now against the very severe long term damage to the economy which worsens each extra week we remain locked down. This is not a straightforward and crass ‘health versus wealth’ argument but a very difficult moral choice, not least because a long-lasting recession will bring its own health risks from increasing levels of mass unemployment, poverty and neglect.

Global earnings estimates are increasingly dire with fears of an annualised fall of around 35% this quarter. As for growth, consensus forecasts are similarly awful; in the UK they seem to be pointing to a fall of around 7.5% in 2020, far worse than the 4.3% we saw in 2009 and with only 1921 and 1919 having worse falls in modern history. Against this background, we need to consider the reliability of the strong bounce in markets over the last two weeks. With prices rising but earnings estimates collapsing it can no longer be said that stock markets are cheap. They are ‘looking through’ these terrible times and pricing in more of a V than a U shaped recovery.

Longer Term Outlook

The ‘exit’ from lockdown will bring different challenges both globally and in our own lives. We do not know what form this will take, or what the next year will hold for us, or whether our own values have been changed permanently.  Remote working is not the future it is here now, we know that, but will we still want to shop, travel and spend on the scale we did before. Will simpler pleasures replace grander ‘experiences’? On a wider scale, is ‘big government’ now the way forward as a permanent solution, not just an emergency stop-gap? Will collectivism become more important than individualism? Will countries continue seeing each other as inter-linked global partners or as individual and more closed entities? Will health, social welfare and security become all-important, with an adverse impact on civil liberties?

Markets are trying to work this out and can’t come up with answers because these are questions to which there is only conjecture. Instead, the market will for now trade on short-term newsflow from the daily pandemic numbers and from economic data and corporate earnings numbers as they begin to appear. Our sense is that markets will be higher in the long-term because global growth will eventually recover and history shows that the corporate world in aggregate always survives and eventually thrives even against the greatest setbacks. The road to this higher ground could though be long, arduous and particularly bumpy.

A World without Income.

The Banks have been told by the Bank of England that they cannot pay dividends to shareholders and companies accepting government help to pay their workers are in a similar position. Companies without this moral obligation are also retaining cash to support balance sheets as their revenue collapses rather than distributing it to shareholders. Two of the biggest dividend paying sectors in the UK are the Oil and the Miners and we’ve seen what has happened to commodity prices. Forecast are for a cut of at least 40% in UK dividends, which would take the trailing yield on the index down from 5.8% to more like 3.5%.

This is a particularly savage cut in an investor’s dividend income but some context is needed. UK 10 year Gilts yield 0.30%, 2 year Gilts yield zero, and UK Corporate Bonds yield around 2.4%. Many of you will no doubt recently have received a sobering letter from your Bank/Building Society/NS&I telling you that the interest rate on your savings account has fallen from derisory to almost zero. In a world of virtually no income, equity income funds maybe don’t look quite that bad after all.

What we are doing on Portfolios

Our initial stance was to wait a short time until some semblance of order returned to markets, warning against ‘cashing out’ at the bottom of the market. We are now making/advising significant changes to client portfolios in what is going to be a completely different economic and investing environment in the coming years.

Our main changes are

• We see opportunity in corporate credit as spreads have widened exponentially. We are increasing the quality of our fixed income component by increasing exposure to investment grade credit where we see the best ‘risk/reward’ opportunities with prices cheap (spreads wide) but risk of default still low
• We are making little change to the size of our cash or equity exposure across all portfolios i.e. we are neither increasing nor decreasing risk significantly at an overall portfolio level.
• We are reducing our weighting in UK equities. On the Balanced portfolios we have increased the weighting to conservative multi-asset funds, on the higher risk/reward portfolios Growth and Aggressive portfolios we will be increasing the weighting to overseas markets.
• We are selling some of our more value biased funds and increasing our exposure to quality/growth funds. In a world where the ‘lower for longer’ interest rate/inflation/growth narrative is set to be extended then cyclical/recovery/economically value sticks will continue to struggle.

On a housekeeping note, we are very pleased to have strengthened our investment team with the addition of Finlay Holland, a talented and experienced fund research analyst. Finlay is both a rugby player (fly half not prop, brain not brawn) and, at least so he tells us, a pretty good baker. Another reason to look forward to returning  to the office!

 Conclusion:  A long road still to travel

We have quickly adapted to our new lives, relishing our daily walk/run/cycle and zooming, skyping, facetiming or House Partying with family and friends. We were strengthened by the words of the Queen and continue to be uplifted by the ‘Clap for Carers’ on Thursdays and seeing the children’s rainbows in windows.  Kindness, community and inspiration is all around us and we know we’ll get through this, though in the tragic knowledge that many have lost family and friends.

In May or June our lives will change again as we leave lockdown into a world still very different to our old one. More than likely we may have different values both as individuals and as a society as a whole. This has huge implications for the financial markets in ways it is too early to understand with  clarity or conviction.

As a portfolio manager you never want to fight the last battle, it is the next battle you need to prepare for, though as yet we don’t know quite what sort of battle this will be.  Our sense though is that it will be a tough environment for investors in all asset classes so the changes we are making/advising to portfolios are aimed at improving the quality and robustness of the underlying funds we use.

Most importantly, as we continue to battle together through this dreadful pandemic everyone at HFMC continues to wish you and your families the sincerest of good health.