i-Wire: Market Update 6th August

Market Update: The Other Side of Summer

When it comes to my choice of Elvis I’ve always been in the Costello rather than Presley camp and the titular track could be written for these times, conjuring the sound of glorious summer sunshine but featuring  biting lyrics that paint a picture of ‘contradiction and confusion’ and a sense of great unease. We’ll  have to wait till the other side of summer and indeed many months beyond to get a clearer picture of how this dreadful pandemic will impact economies and financial markets. The crash and the rebound were just the beginning and we are now marking time in an uneasy truce balancing the conflicting needs of public health and economic welfare.

The current state of the pandemic is so well documented in every media format that there is no need for repetition, instead we need to  ponder as to what the market is discounting and be aware of the changes in market behaviour, of which there have been several, since I last wrote at the beginning of July. Equity markets are similar levels, the changes are elsewhere.

Investors have since April been taking a glass half full stance, in effect ‘looking through’ the dreadful growth and earnings numbers we will be seeing in coming months and focussing instead on the hoped-for recovery at the end of this year and into 2021. Equity markets have now paused for breath and have been range trading for several weeks now as the scale of the pandemic in the emerging world, fears over a ‘second wave’ in Europe, and in particular the inability of the US to control its rate of infection is causing concern. The bulls have pulled in their horns, but the scale of policy response and  ‘can do’ attitude of  the corporate world is sufficient for the bears to remain on the side-lines.

Market Returns

The chart shows the returns from markets in their own currency and illustrates how strong the rebound from the Q1 crash has been. Wall Street and rather surprisingly the Emerging Markets are  now in positive territory for the year, led by their large and buoyant technology sectors. The FTSE, with its high weighting in ‘old economy’ energy, industrials and financials and burdened by Brexit and the UK’s poor response to the pandemic remains a distance laggard.

The table shows the sector average returns from funds, broken down by asset class and geography. The overseas returns differ significantly from the chart in that they are the return when translated back into sterling rather than being shown in local currency. As sterling has been weak this year these returns are enhanced, though its strong pull-back against the dollar in recent weeks has blunted US returns somewhat. Whichever way you cut it though, UK equities has been the worst major asset class this year by a street.

Figures from Financial Express Analytics as at 6^th August

The following table, with data courtesy of the JPM Asset Management Weekly Brief of 3^rd August  shows the winners and losers in terms of industrial sector and style:

The winners continue to be the sectors in which the companies have visible, growing and consistent earnings streams, cash rather than debt on the balance sheet, resilient margins, and revenues that are less economically sensitive to changes to growth in GDP in the current environment of recession and radical change to business and social behaviour. Technology, strong consumer brand  and healthcare companies best demonstrate these attributes. The economically sensitive cyclical and recovery sectors have occasional flurries but value remains the most impecunious of poor relations.

What has changed since the rebound stalled?

• Equity markets continue to mark time, underpinned by the belief that Central Bank and Government policy support remain resolute in the commitment to generate economic activity and protect incomes and employment. Don’t Fight the Fed. But there has been a subtle shift in sentiment with a far less stridently bullish tone with markets understanding that the pandemic is going to be longer lasting than initially considered and that there is a trade-off between public health and economic welfare. The easing of lockdown restrictions is leading to an increase in infections, localised lockdowns are necessary and a second wave a possibility, and that while great strides are being made to develop a vaccine its eventual arrival will not be a ‘back to normal’ silver bullet.
• The other underpinning for equity markets has been the positive response from the business world illustrated by a surprisingly strong US corporate earnings season with blow-out numbers from tech companies in particular. Expectations were low but thus far around 80% of companies have beaten forecasts showing that corporate America remains dynamic, inventive and flexible
• If equities are still dreaming of economic recovery the Fixed Income markets remain resolutely downbeat and the last few weeks have seen even lower yields. The UK now has negative yields up to 8 years and the 10 year is only a miserly 0.1% and could well join the negative squad along with the rest of Europe which has German 10 years Bunds at -0.56%, the same as Switzerland. Even the likes of Spain, Italy, Portugal and Greece yield less than 1%. Forward markets don’t see the US 2-year yield above 1% for the next five years, currently the 10-year yield is 0.63% down from 2% earlier this year.
• Gold has surged from US$1750/oz. in June to crash through the mythical US$2000/oz. ceiling for the first time. This is partly a reflection of the recent weakness of the dollar (making gold cheaper for buyers in other currencies) and partly ever-lower bond yields which create a negative interest rate environment which is very bullish for gold. The chart of the Wisdom Tree Gold ETF in US$ shows the rocket taking off.

• The other startling move has been in the currency markets. The mighty dollar, the big dog, cock of the walk for years and the go-to safe haven currency in March has fallen by 10% over the last few months. The much-derided euro is now the currency of choice following the announcement of an EU fiscal package which for the first time involves debt mutualisation and the promise of a unified rather than single country fiscal policy in the future. The dollar is suffering from its loss of ‘carry ‘advantage following the huge fall in Treasury yields along with a sense that the US is losing its political and economic global leadership as the Trump administration blunders from one policy mistake to another, not least in its inept response to the pandemic. Whisper it gently but poor battered old sterling is making a bit of a comeback as the chart shows, the double figure losses at the height of the pandemic have been significantly pared, most notably against the greenback

Conclusion: ‘Doubt is not a pleasant condition but certainty is absurd’

Having opened with lyrics from an early 90s classic I thought I’d delve a little deeper into history for my ending and go old school philosophical by quoting Voltaire to ponder the folly of placing faith in forecasts, however scholarly and compelling they may appear at the time. We don’t know at this stage with any certainty how the pandemic and its economic impact are going to pan out, nor does anyone else, and nor will we be much wiser for many months to come. Volatility will remain high with markets very sensitive to pandemic and economic/corporate newsflow and we have a potentially incendiary US Presidential election in a couple of months just in case you’d forgotten. Oh, and the little local difficulty of Brexit.

The most likely longer-term outlook continues to be ‘lower for longer’ with interest rates and bond yields anchored near zero for several years and a low growth environment. The return of inflation is much discussed but remains an outlier with deflation the more immediate risk. Equities can grind higher in this environment, though you need to be in the right funds as the market is being led by a very narrow group of stocks with sector divergence about as wide as it has ever been as growth continues to trounce value. To illustrate this point several commentators, most notably our much admired Howard Marks from Oaktree Capital in the US, have pointed out that whilst the S&P 500 is broadly flat year to date the five heaviest weightings, Messrs Facebook, Apple, Amazon, Microsoft and Google, are up by an average of 36% for the year compared to a median change of -11% for the 500 as a whole.

You won’t make much money in bonds but you shouldn’t lose much either. Investment grade corporate credit continues to offer probably the best risk/reward balance in the Fixed Income world with a pickup over government bonds but low default risk.