i-Wire: Market Update 27th April

Market Update: Searching for the new normal

• Equity markets have recovered strongly and are now trading with far less volatility.
• We are concerned that this recovery may be too optimistic and markets could retrace some of these gains as they are now pricing in a lot of good news. They are taking the visibility of a peak in virus infections and the size of the economic stimulus packages and assuming that the recovery in growth and earnings will be V-shaped.
• Equity markets are trading at more expensive P/E valuations than they were before the outbreak of the pandemic.
• The one day ‘negative’ oil price was a technical event resulting from the way oil futures trade but the oil price has fallen from US$60/bl to US$20/bl and looks set to remain at these low levels for many months.
• Government Bond Yields offer negligible yield and minimal value but we see opportunity in corporate bonds, especially investment grade where spreads have widened significantly but default risk should still be low.

In this note we will look at:

• How markets have performed during the crisis.
• The outlook for the global economy, and why you should handle forecasts with care.
• The longer term outlook for markets.
• A ‘Q&A’ of what clients have been asking us.
• Conclusion

We are deep into the lockdown; I’ve lost count of the weeks but it sure feels like plenty. Captain Tom brings a lump to my throat every time I see his quiet strength and dignity and Peter Kay’s new version of Amarillo is an uplifting tribute to the NHS and all those working so hard and unselfishly to get us through this.  As a society I think the pandemic, however tragic, has shown us at our best as we now begin to look forward and plan for the exit strategy.

Whatever one’s view as to whether the government is doing a ‘good’ or ‘bad’ job, the sadness of so many families and the heroic efforts we see all around us need to be recognised so that a better, kinder and safer society should emerge from this crisis. This golden opportunity must not be squandered in an orgy of finger pointing and recrimination by politicians and in the media.

Markets: Looking through the pain

Equity markets have been taking a glass three-quarter full approach and made a significant recovery from their lows of a month ago as the charts show, in local currency as well as sterling. They have taken the combination of visibility in the peak of virus infections together with  the size and commitment of the economic stimulus packages as a sign that the recovery in growth and earnings will be V-shaped.

This is quite a recovery by all markets, especially Wall Street which has regained well over a half of the lost ground, and even more so for UK investor in US equities as the dollar has gained 7% against sterling this year which is a currency translation gain for UK  investors. The weak sterling currency effect has helped all overseas funds, as the table illustrates.

Figures from Financial Express Analytics

Sector wise the winners have been ‘big quality growth’ notably technology, healthcare and consumer staples whilst the cyclical/recovery bad boys such as energy, industrials and financials have suffered particularly severe falls. The ‘shape’ of the market going forward is an interesting conjecture which I’ll return to later in the note. Also apparent is the strong performance of ‘super safe haven’ government bonds whilst corporate credit (both investment grade and high yield) have recovered over the last few weeks as credit spreads have tightened in line with the more ‘risk-on’ sentiment within the markets.

Macro: Too soon to tell

A number of clients have asked as to why I haven’t been including a lot more economic data and forecast in my previous notes, which is a fair question. Two of the great curses of portfolio management are paralysis by analysis and taking mis-placed comfort in forecasts which are almost certainly going to  be wrong. We are wary of anyone’s forecasts (and hence our own!) in the best of times and these, sadly, are the very worst.

We are devotee of US investment ‘guru’ Howard Marks from Oaktree Capital who writes…..’the rules of the investment profession seem to require that its members describe their views about the future using high-sounding terms like “analysis,” “assessment,” “projection,” “prediction” and “forecast.” Rarely do we see the word “guess.” He goes on to say… ‘These days everyone has the same data regarding the present and the same ignorance regarding the future.”

To state the obvious all current data, be it unemployment in the US or manufacturing and consumer spending data in the UK and Europe, is dreadful.  JPM forecasts an annualised fall in US Q2 GDP of 25% and Goldman 34% with similarly horrendous figures being thrown into the ring for the decimation of corporate profits.  But does this matter? These figures already feel historic and we’ve still got two months of the quarter to go. It’s going to be bad, very bad; everyone knows this and the markets have baked this in already. What matters is the exit strategy, the going forward, the shape of how quickly growth and earnings will rebound. V, U or L basically, or maybe a W if a secondary wave of infections occur post an easing of lockdown restrictions. The understanding needs to be not so much the numbers themselves but their shape and direction. The market is currently predicting a pretty positive outcome pricing in a V shaped recovery in growth and profits. FactSet, the bible on this as it combines all analysts’ earnings forecasts, is forecasting a 15% y/y fall in US earnings in Q1, 27% in Q2, 13% in Q3 and 5% in Q4. Notice the shape!

The support from Central Banks and Governments continues unabated. Since I last wrote the most notable measure has been the support for the US corporate debt market by the Federal Reserve who is buying not only investment grade (something it didn’t even contemplate in 2008) but also high yield (i.e. junk) debt. The ECB has also promised to accept as collateral the debt of ‘fallen angels’, investment grade companies that find themselves falling in to ‘junk’ status. This is moral hazard gone crazy but very positive for Main Street as well as Wall Street by preventing bankruptcies and even more unemployment. If its previous policy was throwing in the kitchen sink, the Fed is now throwing in cabinets, microwaves, dishwashers, chairs, tables, and that rather nice Lavazza coffee maker as well.

Market Outlook: Still in the Woods

Markets have rebounded strongly and appear to have found a floor but we remain less sanguine given that we have witnessed

• The greatest pandemic since the Spanish Flu in 1918
• The greatest economic contraction since the Great Depression in the 1930s
• The greatest ever fall in oil prices
• The greatest central bank/government intervention of all time.

That’s not only a lot of ‘greatests’ but also a lot to worry about, not least because post the bounce markets are trading on fully valued P/Es with no real sense of what future earnings are going to look like. The US forward P/E is now back to 19x for example, the FTSE 14x and even the MSCI Emerging Markets 12x. Not cheap at all.

Markets are now pricing in that we are approaching the peak in infections, that there won’t be a major secondary wave of infections and that the huge raft of support measures and almost guaranteed further large scale commitment from Central Banks and governments will lead to a V-shaped recovery in growth and earnings. Hopefully, this will be the case and we have been mightily relieved to see the strong rally of the last few weeks. However, our sense is that this is a pretty heroic assessment because it is still far too early to forecast with any conviction as to how both the pandemic and the economy will play out over the longer term. If there is renewed bad news flow  there could be a further series of large falls. It is not unusual for an initial rebound in markets following a significant crash to turn out to be a false dawn.

Q&A

We have a very wide client base from all walks of life who ask a lot of insightful and searching questions, which is exactly what we would expect. I’ve tried to group together answers for the most frequent

What are the main changes you have made/advised to client portfolios?

• Increased the ‘quality’ of the Fixed Income component with an increased weighting in investment grade credit where we considered spreads had widened too much and were overstating default risk.
• Increased the exposure to overseas equities/reduced the exposure to UK equities.
• Increased exposure to ‘growth’ funds, reduced exposure to cyclical/recovery ‘value’ funds.

Are you increasing/decreasing the amount of risk in the Model Portfolios?        

• The answer is no, the asset allocation of each of the Model Portfolios is broadly the same today as it was pre-the changes we have made. The objective of the changes is to increase the quality and robustness of portfolios at the fund level rather than the macro/asset allocation level. The equity markets are obviously much lower than pre-pandemic levels but then the fundamental outlook for profit growth is far worse and in valuation terms equity markets are around the same levels they were pre-pandemic.
• There has been some questioning of our increased exposure to corporate bond funds because of default risk but we see this asset class as offering attractive risk-adjusted returns. Spreads have widened significantly but bondholder positions are being strengthened by the significant level of dividend cuts whilst Central Banks, notably the US Fed, are underpinning credit markets with direct purchases of both investment grade and high yield bonds. In these challenging times we’d prefer to be in the right kind of fixed income than the wrong kind of equity.

Are you throwing the baby out with the bathwater selling ‘value’ funds here?

• Particularly good question, as one should always be fighting the next not the last battle and value funds have underperformed growth for ten years.
• Firstly we didn’t have a value bias in our equity fund composition, we look to run relatively balanced portfolios and had a number of ‘growth’ funds which have produced very good returns for many years.
• Value funds typically do well in rising interest rate environments and when an economy is picking up steam and ceteris paribus prior to the pandemic outbreak may well have had a decent 2020. Going forward we see super-low interest rates and challenged economies for next year as well as this. In this environment cyclical/recovery stocks will continue to struggle, whilst stocks and sectors which can generate growth and maintain pricing power over the longer term will continue to outperform. Despite in many cases lofty valuations this takes us back to the large, monopolistic growth/defensive sectors such as technology, consumer staples and healthcare
• Timing wise, we held off selling value funds during the initial few weeks of falls as they suffered most in the rout, as one would have expected. They have though to an extent led the recovery as risk appetite has improved, but this is not something we see as sustainable over the longer term. Thus, while these funds have produced some very heavy losses, we have at least sold them at better prices both in an absolute and relative sense than we would have done a few weeks ago.
• Financials, notably Banks, are likely to struggle. They make no money on their basic business of borrowing/lending with a flat yield curve, regulators are telling them not to pay dividends, customers are being given payment holidays and governments are urging them to give cheap loans to keep business solvent.
• The value to growth switch was one of the reasons for our decrease UK/increase overseas equities exposure positioning as the UK market is value biased (oils, banks, miners etc) with none of the big tech companies found elsewhere, notably the US.
• Whilst we have reduced exposure to value funds, we have not removed them entirely.

What are the likely winning and losing sectors/regions going forward?

• Winners are likely to be large monopolistic growth companies in sectors like technology, consumer sales and healthcare. Online shopping and remote working are obvious standouts.
• Losers are anything involving travel, recreation and consumer spending so airlines and high street retailers have suffered terribly.
• The market always shoots first and ask questions later; Zoom is up 150% this year and Amazon and Netflix 33% whilst EasyJet has fallen 65% and Marks and Spencer 50%.
• The composition of its stock market with a preponderance of growth sectors favours the US whilst Europe and the UK with a lot of ‘old’ industry stocks which will struggle unless global growth recovers quicker and more robustly than expected. The US economy traditionally bounces back from adversity quickest with its flexible labour markets, favourable insolvency rules, less bureaucracy and more dynamism.
• Asia and the Emerging Markets are harder to call, Asia is arguably ‘first in, first out’ out of the pandemic but China will likely suffer a major backlash and be trusted even less on the global stage following its questionable disclosure and self-serving behaviour during the pandemic. In a world that is likely to become more insular with less dependence on global supply chains is not an ideal environment for Asia.
• Emerging Markets are so diverse, just think about oil, India a big importer, Russia a big exporter. We fear for their populations that could suffer terribly; both from healthcare systems that are far less able to cope and the pressure that a strong US dollar places on their debt service costs.

Deflation or inflation?

• The case for Deflation; A complete collapse in global demand, rock bottom oil and commodity prices, a huge build up in debt, a strong dollar and bond yields on the floor.
• The case for Inflation: A printing of money and a fiscal expansion on a scale never, ever seen before.
• Two very strong cases M’lud, I think the jury may be out for some time.
• In the short and medium term deflation is the enemy and whilst you need to be ahead of the game in managing portfolios you don’t want to get too far ahead as you could be carried out even if you are eventually right, as all the ‘inflation is inevitable’ post 2008 theorists found to their cost.
• Longer term, inflation may be the only way the government can shrink their huge piles of debt. Inflation linked bonds in the US are pricing in only a 1% annual inflation rate in the US for the next ten years and are maybe fighting the last decade’s battle (monetary expansion but fiscal austerity) rather than the next decade’s  (monetary expansion and big government everywhere).

Why is the fall in the oil price considered such bad news?

• Last week’s note explained that the complete collapse of the US WTI price deep into negative territory was a ‘one off’ technical fall due to the chronic shortage of storage space in the US and the expiration of the May oil price futures position. I say ‘one-off’ but we could well see the same again when the June future expires.
• Nevertheless, the price of both Brent and WTI oil has collapsed from US$60/bl to US$20/bl and looks like staying there through the summer months and beyond. The futures prices for many months ahead are still at rock bottom being only US$30/bl in May 2021 and US$35/bl in May 2022 but we know how quickly sentiment can change in commodity markets.
• Typically a fall in the oil price is considered a good thing, acting almost like a tax cut in that it lowers costs to industry and means a few extra pennies in the household pocket.
• This isn’t the case this time. Firstly it is reflecting rather than influencing the state of the economy along with the collapse in copper and the other base metals. Secondly, the collapse in the oil price is catastrophic for the US Oil Patch and will have a dreadful impact in the economies of a number of states, notably Texas, Louisiana and North Dakota. Globally it will have a similar impact on the big oil producers like Russia, Brazil, the Middle East and Norway.

Why have you started buying a Gold Fund…..you were always sniffy about Gold before!?

• Well, thank you for pointing that out, however politely. I’ve never been a big fan of the yellow metal deeming it a speculative asset as it has no valuation mechanism. With positive real interests rates since 2016 Gold languished and we didn’t sense much lost opportunity cost by continuing to ignore it
• As Keynes most famously said ‘when the facts change, I change my mind’ and with the pandemic being such a game-changer we are now in a totally different investing environment.
• Bond yields and savings rates are virtually zero (and below inflation) and in this environment there is no ‘lost income opportunity’ in holding gold. Gold can work as an inflation hedge, though somewhat erratically, and also as a geopolitical hedge. It can also be seen as a ‘hard currency’ at a time when all other ‘fiat’ paper currencies are seeing their Central Banks crank up the printing presses like there is no tomorrow, arguably devaluing them against gold.
• We are though respecting social distancing protocols to our new friend, so standing a little apart with only a relatively small weightings for now.

What are the prospects for sterling?

• Hmm, wished you hadn’t asked, always tricky but….
• At the moment the FX market is differentiating strongly between safe haven ‘risk-off’ currencies (dollar, yen, swiss franc) and ‘risk-on currencies (sterling, commodity currencies). The Euro sits between the two camps.
• Longer term, we feel sterling is undervalued, especially against the dollar.
• However, the short term is dominated by the ‘risk-on/risk off’ trade and for the next couple of months we see the risk for sterling as being asymmetric with less potential for a significant rise than for another significant fall.
• We are researching options to hedge out some of the currency risk from our increased overseas equity weightings, but are happy to hold unhedged exposure for now.

Conclusion: Still a long way to travel

I titled the conclusion in our last market update ‘a long way to travel’ and despite the optimism of the market since we see no reason to change our mind. Yes, the markets are still well down on where they were a couple of months ago but we are in unprecedented times which demand caution. Even in the depths of 2008, which at the time felt like as bad as it could get, daily life went on as normal with no thought that our lives could be changed for years ahead. Time needs to pass because judgements can be made with any conviction as to the effect of the pandemic on social behaviour and future economic growth. Until huge strides have been made in testing, tracking and tracing, in developing herd immunity and, fingers tightly crossed, in the production of an effective vaccine then we shouldn’t assume that the worst is behind us.

We are very aware that by this stage of the pandemic an increasing number of you may have suffered the tragic loss of a family member or friend. As we battle together through this dreadful pandemic everyone at HFMC continues to wish you and your families the sincerest of good health.