Market View - 3rd Quarter 2020
“Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.” – Paul Samuelson, Nobel Laureate in Economic Sciences
“Calling someone who trades actively an investor is like calling someone who repeatedly engages in one night stands a romantic. The stock market is designed to transfer money from the active trader to the patient investor.” Warren Buffett of Berkshire Hathaway.
LAST QUARTER REVIEW
While most of the western world spent the second quarter in lockdown as governments, on scientific advice, sought to slow the spread of the coronavirus pandemic, global trade and economic activity slowed to a trickle causing the deepest recession since the thirties depression almost a century ago. Thankfully global equity and bond markets rebounded strongly following the sharp share price declines of March, led by tech and growth companies in the US with the Nasdaq technology index going through 10,000 in June for the first time ever, and other Wall Street indices also nearing all-time highs.
The reason the global equity and bond markets have proved so resilient and the severe bear market, forecast by many pundits, has not occurred is most likely due to the rapid and determined fiscal and monetary policies initiated globally, with more than $8 trillion being made available to support businesses and employees. The stimulus undertaken included the Federal Reserve (Fed) in the United States announcing on 9th April that it would provide up to $2.3 trillion in loans, aimed to support households and employers, and to bolster the ability of state and local governments to deliver critical services as part of the 2020 Cares Act, the largest economic relief package ever passed by Congress.
On the 8th June, just prior to its FOMC meeting, the Fed announced it would expand its Main Street Lending (Cares Act) Program to be able to support more small and medium-sized businesses by halving its minimum loan size to just $250,000, whilst also increasing the maximum, as well as the term of each loan option from four to five years. The Fed program intends to purchase 95% of each eligible loan that is submitted.
At the FOMC meeting, the Fed reinforced its commitment to support the US economy and US asset markets, by promising to keep rates between zero and a quarter percent for at least 2020, and quite probably some way beyond judging by Fed Chairman Jay Powell’s comments, “ We are not thinking about raising rates. We’re not even thinking about thinking about raising rates.” The Fed also pledged an additional $80 billion per month for the purchase of Tresuries and $40 billion per month for mortgage backed securities, with the former an essential part of the recovery program as the US government debt increased to $25.74 trillion in May from just under $25 trillion in April for an economy expected to shrink to $20.14 trillion this year from $21.12 trillion at end 2019.
Following the unprecedented rise in jobless Americans in April, there was much better news in the May as the US unemployment rate dropped from 14.7% the previous month (the largest in records back to 1939) to 13.3%, a huge improvement on Wall Street’s expectations of 19.8%, as the economy gradually began re-opening. Effectively, the number of unemployed people fell by 2.1 million to 21.0 million, and those on temporary layoff decreased by 2.7 million to 15.3 million.
In the UK, the unemployment data as reported by the BBC in June does not look anything like as severe as in the US thanks in large to some 8.9 million workers being covered by the government’s furlough scheme. This means more than a quarter of the UK workforce is now being supported by the scheme which so far has cost £19.6bn, whereby employees receive 80% of their monthly salary up to £2,500.
A similar programme for self-employed workers has resulted in 2.6 million claims made worth £7.5bn. The furlough scheme, officially called the Coronavirus Job Retention Scheme, was originally intended to last until the end of July, but has now been extended until the end of October.
Economic growth declined by 2.2% during the first quarter in the UK, the largest fall in GDP since the third quarter of 1979, while the drop of 2.9% in household consumption was the largest in more than four decades as spending on transport, bars, restaurants, hotels, clothing and footwear all fell. Due to declines in government and business expenditures, total fixed investment in the third quarter declined 1.1%, while government consumption fell 4.1% following decreased expenditure in health and education.
Meanwhile on the 18th June, the Bank of England (BOE) at its Monetary Policy Committee (MPC) meeting voted unanimously to maintain the key bank rate at a record low of 0.1%. The MPC also voted by 8 to 1 to increase the target stock of purchased UK government bonds, financed by the issuance of central bank reserves, by an additional £100 billion, to take the total stock of asset purchases to £745 billion.
The programme is expected to be completed around the end of 2020 and the BOE will continue with the existing programme of £200 billions of UK government bond and sterling non-financial investment-grade corporate bond purchases. A combination of concerns around a second wave of coronavirus, weak economic data and continuing uncertainty surrounding some of the terms of the UK’s Brexit exit helped keep the pound weak during the quarter in a range of between $1.20 and $1.28, while the yield on the benchmark 10-year gilt fell from 0.34% to just 0.17%.
In the European Union (EU), the European Central Bank (ECB) at its monetary policy meeting on the 4th June kept its Main Refinancing Operations interest rate at 0%, while the rate on overnight liquidity was fixed at 0.25%, and the bank’s Deposit Facility Rate was left at 0.5%. The ECB also announced that it was expanding its emergency pandemic purchase programme by €600 billion to a total of €1.35 trillion, until at least June 2021.
Additionally, the ECB launched a new backstop facility on June 25th to provide precautionary euro repo lines to central banks outside the euro area in response to the coronavirus crisis. The Euro-system repo facility for central banks (EUREP) will be available until June 2021 and will address possible euro liquidity needs in case of market dysfunction resulting from the COVID-19 shock that might adversely impact the smooth transmission of ECB monetary policy.
The price of oil was extremely volatile during the quarter with the cost of a barrel of Brent crude beginning the quarter at around $22 ending up at around $42. With demand for oil having collapsed globally, the doubling of the price over the quarter occurred largely thanks to the OPEC and Russian agreement to cut production, but (for now at least), the rally appears to have plateaued.
|Q1 GDP||Annual GDP||Base Interest Rate||Equities – Last Quarter||Equities – Last 12 Months||Bonds – Last 12 Months|
GDP Data shown are to the 31st March 2020; Interest Rate, Equity & Bond Index Data are to the 30st June 2020; Equity Indices used: US – S&P 500, UK – FTSE 100, Eurozone – Euro Stoxx 50, China – Shanghai Shenzen CSI 300, Japan – Nikkei 225, Germany – Xetra Dax; Sovereign Bond Indices used: S&P US T-Bond, S&P UK Gilt Bond, S&P Eurozone Sovereign Bond (Eur), S&P China Bond, S&P Japan Government Bond, S&P Germany Sovereign Bond.
Following the demise of the longest bull market in Wall Street history during the first quarter, prematurely slain like so many poor human souls across the globe by the coronavirus pandemic, it looks increasingly like the rapid fiscal and monetary stimulus response by the American authorities could result in the shortest bear market ever having ended last quarter! Of course only time will tell, but the signs are most encouraging as the benchmark S&P 500 index rose almost 20% last quarter and is up more than 37% since the 23rd March index low of 2237.4!
Naturally, few if any investors would have been fortunate enough to be setting up their investment portfolio in its entirety on that day although some may have committed small percentages that had been sitting in cash earning little interest. The key, of course, is that investing is a long term game of patience as our two famous quotes at outset reiterate, but the big question in this post coronavirus market has to be which asset classes and sectors now offer the best risk adjusted opportunities?
In our last Market View, one key consideration we identified was the likely significance of the US dollar’s behaviour during the economic recession, because determining its future direction and volatility is one of the most important components of investment portfolio construction. Three months ago, we nervously expected a continued dollar surge in value after the DXY (a US dollar index which is 58% Euro, 14% Yen, 12% £, 9% CAD & 4% Sw Fr) rose sharply almost 10% to 108 in mid-March due to a shortage of offshore greenbacks (eurodollars) as global trade collapsed.
The US dollar as the global reserve currency is, of course, what keeps the wheels of commerce running smoothly while enabling almost all commodities and international transactions to be exchanged seamlessly using greenbacks. The Fed, to its credit, acted immediately when the pandemic emerged to staunch the potential lack of supply and avert a potential worldwide crisis. The Economist newspaper in a recent article titled, “swapping panic for calm” explained how the liabilities of offshore shadow banks outside America exceed $10 trillion and that by providing dollar swap lines to the central banks of most of the other major G20 countries (except China), the Fed managed to restore an orderly foreign exchange market.
Some critics have suggested that during the Global Financial Crisis of 2008, the Fed was too slow in recognising the threat from a shortage of eurodollars, by taking a year to roll out swap lines to all its friendly counter-parties, whereas this time round it has seemingly managed to put them in place in just one week! Additionally, the Fed has ensured that it can also provide repo facilities to any central bank that wants them, which loosely means they can pledge US Treasuries they hold in return for dollars. Some countries, Indonesia for example, have reportedly been borrowing money on this basis to shore up their national champions like oil companies whom had previously borrowed dollars.”
In its Monetary Policy Report (MPR) published last month, the Fed advised that when markets began deteriorating in late February and throughout March, “the FOMC announced it would purchase Treasury securities and agency Mortgage Backed Securities in the amounts needed to ensure smooth market functioning and the effective transmission of monetary policy to broader financial conditions. The Open Market Desk began offering large-scale overnight and term repurchase agreement operations.”
The MPR also explained that the Fed, “coordinated with other central banks to enhance the provision of liquidity via the standing U.S. dollar liquidity swap line arrangements and announced the establishment of temporary U.S. dollar liquidity arrangements (swap lines) with additional central banks. The Federal Reserve also established a temporary repurchase agreement facility for foreign and international monetary authorities”
So a global crisis involving too few eurodollars has been averted, but the question now, in light of the ballooning US current account deficit following the issuance of trillions of additional Treasuries and the continuing deflationary forces pushing yields on American government debt ever closer to zero right along the yield curve, is whether the dollar has peaked and is about to begin a multi-year decline that will make overseas assets and especially equity and corporate debt increasingly attractive to American investors? Two additional considerations that suggest a declining dollar is an increasing possibility, are firstly the damage the economic recession has potentially dealt the US shale oil industry which had in the past decade propelled America from a thirsty crude net importer to being energy self-sufficient and a growing exporter which had consequently helped keep the current account deficit under control.
Secondly, (and partly due to the decimation of the shale oil industry by the pandemic), the US labour market, which historically has been renowned for its flexibility and mobility, will likely have a much greater percentage overhang of unemployment, creating an increasing relative current account deficit between the Eurozone and the US, and leading to a higher euro just on the basis of longer-term structural flows. Already in just a few months, we have seen massive spending in the US, causing the debt to GDP ratio to deteriorate, and we are likely to soon see another $1 trillion added irrespective of what happens between now and the election.
Come 2021, and probably regardless of who holds power in The White House and on Capitol Hill, we could easily see another $2 to $3 trillion spent on infrastructure, plus quite possibly more continued help for unemployment. Treasury issuance is therefore, likely to continue in earnest, and as we had been seeing even prior to the coronavirus pandemic, low yields have made buying the government debt at Treasury auctions less attractive for investors leaving primary dealers (historically investment banks and other specialist dealers) holding the stock on their books.
It was this scenario, namely the rise of private dealer Treasury holdings (which was then squeezing other bits of the big banks’ balance sheets), that caused the Fed to launch “not QE” or their repo operations in the fourth quarter of last year, and effectively take the issuance onto their books. Naturally, we have to wonder if as the US issues more and more paper to pay for the ballooning deficit, whether yields will be high enough to attract buyers because if not, then once more the primary dealers, or more likely as in recent months the Fed is going to have to hold them.”
The market tensions caused by all the increased Treasury issuance, and the likely eventual impact on the dollar’s value is reflected in the relative balance sheet of the Fed compared to the ECB and the Bank of Japan (BOJ). In 2015, the dollar strengthened as the Fed ended QE3, while the ECB and the BOJ kept expanding their balance sheets, and the strong $ trend accelerated when quantitative tightening (QT) began in 2018 as the Fed actually shrunk its balance sheet relative to its peers, but now this trend has begun to reverse.
The pendulum is now swinging the other way as the Fed has been forced to backstop all these assets and its balance sheet is exploding (from $4 trillions to $7 trillions), which suggests a potential inflection point for the dollar beginning a steady decline. This is the most likely scenario although if exceptionally the Fed has to adopt Yield Curve Control to stop the Treasury market falling apart, its balance sheet will grow ever faster putting more pressure on the dollar and potentially accelerating a decline.
From an investment perspective, a secular dollar decline will mean the market leadership in US stocks will gradually be rotated from growth to value and from tech and defensive sectors to cyclicals such as energy and commodities. Additionally, if the weaker dollar trend continues, it is likely that both institutional and retail investors on Wall Street will increasingly look to opportunities outside the US in the assets of currencies that are stronger relative to the greenback, such as the UK, EU, Japan and selectively emerging markets.
Reassuringly, the Fed has promised Congress that it will do everything in its powers to help ensure the American economy can recover as quickly as possible, after which it will put away its exceptional monetary tools until the next crisis. It has also guaranteed that it will continue its overnight repo operations to support the dollar funding markets as and when necessary which of course is an essential part of the recovery story to ensure an adequate supply of offshore greenbacks (or eurodollars).
While the unemployment numbers across the democratic West are a huge concern, the good news is that unlike the credit crisis twelve years ago (when people’s wealth in both their homes and financial securities declined by 40% to 50%), house prices in most countries continue to gently rise, while the value of financial assets over the past twelve months are still positive (e.g. the US) or are down between 5% -15%. Arguably therefore, having been in a period where it has not been possible to spend much money other than on essentials and with individual balance sheets in better shape than three months ago, the American, British and European consumer is well placed to help boost the economic recovery.
Consequently, as the Western economies gradually re-open, we could in the short term be looking at demand shocks in certain sectors such as restaurants, airlines, tourism, and even motor vehicles, while there may also be supply shocks impacting western economies especially in light of the strained relationships between the US and China. Equally there has emerged a new work-at-home economy and as a result the revenues, cash flows and valuations (i.e., fundamentals) of some of the winners in this category will be soaring to new heights.
In the US, there are plenty of market analysts whom are confident that the underlying economy is sound, with few signs of systemic risks within the banking system. The markets are renowned as being discounting mechanisms and Wall Street’s response in the second quarter suggests the worst is over as investors have generally moved from worries about a protracted recession / depression and an L-shaped recovery to the likelihood of a U-shaped recovery into mid 2021, followed by consistently steady growth.
The big concern for investors of course will primarily be the threat of a second wave of the pandemic coming along, and paralysing the global economy once more. The good news is that while an effective vaccine, if at all achievable is probably years away, there appear to be several effective drugs (e.g. hydroxychloroquine, Remdesivir and dexamethasone) already in existence that should help reassure both policy makers and the public that a second wave need not be feared in the same way, and therefore hopefully next time, total lockdown can be averted.
This suggests investors can afford to be cautiously optimistic as we head into the second half of the year. Here in the UK, we envisage that just as in the US there will be ample opportunity to exploit value and also the popular trend of investing into companies that meet the criteria of being “environmental, social and governance” (ESG) friendly.
Historically companies paying high dividends would have automatically been associated with value but as a result of COVID-19, UK companies have cut or deferred £30bn in dividend payments, and even oil giant Shell has cut its pay-out for the first time since the Second World War. While the banks have been restricted paying dividends by the financial regulator, other industries such as hospitality, airlines and retail businesses have had no option as their cash flows have collapsed.
Hopefully the dividend famine will be temporary, but even now there are still plenty of companies that are paying attractive dividends (e.g. M&G 9%, Legal & General 9%, Vodafone 8%, BATS 7%, Admiral Group 5%, Tesco 4%). So, we shall be looking to as when opportunities present themselves to increase portfolio exposure to UK equity income funds that are looking to exploit the recovery story and identify the stocks of undervalued dividend paying companies.
We anticipate that these equity income funds will also be able to identify attractively valued companies that have embraced the ESG trend. We are mindful that this is an area that merits careful analysis as inevitably as with any evolving new investment idea, there will be many overvalued and under researched companies exploiting the euphoria.
Finally, it is worth observing that research by Professors Elroy Dimson and Paul Marsh of the London Business School has shown that since 1955, smaller companies in the UK (as represented predominantly by the FTSE Small Cap index as well as the smallest constituents of the FTSE 250 mid cap index) have outperformed larger companies (mainly FTSE 100 stocks) by an average of more than 3% per annum. To put that in perspective, an investment of £1,000 in the Numis Smaller Companies index (not dissimilar to the FTSE Small Cap index) in 1955 would (with all dividends reinvested) have grown to £7.8 million today while the same sum invested in the FT All-Share index would be worth just £1.2 million, which further emphasises the benefits of compound growth for the prudent and patient long term investor!
Interestingly, the Numis UK smaller companies index has more than 60% of its concentration in just three sectors, namely financials, industrials and consumer services, which we believe are undervalued on a long-term basis and should outperform appreciably once the recovery gathers momentum. Accordingly, we are always seeking to tilt client portfolios in the direction of small and mid-cap funds whenever relative valuations merit doing so, and we anticipate exploiting some of these opportunities during the second half of the year.
As always, investment risk is at the forefront of our advice and, whilst it is often necessary to undertake adjustments in portfolio allocation in order to maintain individual preferences, we are confident that our advised portfolios will remain well placed in meeting our clients’ needs. On behalf of all of us here at Ash-Ridge Asset Management, we hope that you and your loved ones will remain healthy and upbeat until we have seen the last of the dreadful COVID-19 pandemic!
Copyright © Ash-Ridge Asset Management 1st July 2020.
Data Sources: Bloomberg; Brookings Institute; Economic Cycle Research Institute: Financial Sense; Financial Times; German Federal Statistical Office; Hoisington Investment Management; National Bureau of Statistics China; Office for National Statistics; Real Vision; S&P Indices; The Cabinet Office Japan; The Economist; The Federal Reserve; The National Bureau of Economic Research; Trading Economics; UK Debt Management Office; US Debt Clock.org; Wall Street Journal; Zero Hedge.
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