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Investment Commentary - First Quarter 2020

20/04/2020

Having started the year in relatively good shape the global economy was soon to be derailed by the emergence of a global pandemic, COVID-19. At the end of December, the World Health Organisation began receiving reports of a previously unknown virus behind a number of pneumonia cases in the Chinese city of Wuhan. What started as an epidemic mainly limited to China quickly became a global problem with the disease spreading to more than 200 countries and by the end of March infecting close to 1 million people around the world and claiming over 40,000 lives.

As the infection rates accelerated governments scrambled to mitigate the spread of the disease and began introducing forms of social distancing. Whilst this varied in form and severity from country to country, the common theme was to encourage people to stay at home. The result of which has been a sudden and dramatic slowdown in economic activity.

With both a global demand and global supply shock, equity markets quickly reacted. Having generally drifted higher throughout January and early February, markets quickly reversed their course and selling pressure prevailed. Some markets were harder hit than others but as the table above shows, no country was immune, reflecting the truly global nature of the crisis. It was the Chinese market that fared notably better than most, with the Shanghai Composite index down less than 10% over the quarter, however, to keep this in context, Chinese equities had lagged the global market considerably in recent times so it was starting from a much lower base. For the UK, the FTSE 100 index closed out the quarter with a loss of around 25%, having been down as much as 35% just a week earlier. These dramatic moves have become common place over the period with volatility at highs not seen since 2008.

Equities were not the only asset class to suffer, oil which had already been under pressure due to the ongoing disagreement between Russia and Saudi Arabia on production levels, lost over 65% in value, with Brent crude ending the quarter just below $23 per barrel. The broader commodity index also fell sharply losing 35%. Gold on the other hand, held up, gaining 3.5% over the quarter and once again proving its worth as a safe haven asset. Although in extreme times even safe haven assets can suffer selling pressure, as investors scramble to fund their obligations by selling whatever can be traded or is worth selling, which along with a strong dollar may have limited gains for the metal.

In the currency markets the U.S dollar has also proved resilient of late gaining against most major currencies, with the dollar index up close to 3% on the quarter. In contrast sterling has been under pressure declining by 7%, 6.3% and 4.9% against the yen, dollar and euro respectively.

In response to the pandemic, governments and central banks around the world have announced fiscal and monetary stimulus measures on an unprecedented scale.

The Federal Reserve cut interest rates by a total of 150 basis points in two emergency meetings, the first a 50 basis point reduction on 3 March 2020 which was then followed by a further 100 basis point cut on 15 March 2020, taking the target rate to between 0 and 0.25%.  The Fed also announced $700 billion in quantitative easing.

On 23 March 2020 the U.S. House of Representatives passed a $2.2 trillion aid package, the largest in history, including a $500 billion fund to help hard-hit industries and a comparable amount for direct payments of up to $3,000 each to US households.

In the UK, the Bank of England (BoE) also responded by cutting interest rates, 50 basis points on 11 March 2020 followed by a further 15 basis point cut on 19 March 2020, leaving the base rate at a record low of 0.1%. In addition, the bank announced a new programme of cheap credit and reduced capital buffers to aid banks in lending.

The UK Government also stepped in with a number of fiscal measures including a £30 billion stimulus plan, £330 billion pounds to provide loan guarantees to businesses, a scheme to pay 80% of wage bills for furloughed staff and allowing businesses to temporarily delay VAT payments.

The European Central Bank announced it would be adding 120 billion euros to its existing Asset Purchase Programme of 20 billion a month. It also added another 750 billion euros to its Quantitative Easing programme and for the first time included Greece in the list of eligible countries from which it can buy bonds. The ECB also removed the cap on the quantity of bonds it can buy from any single member state.

Germany, France, Italy and Spain each announced their own measures of fiscal response to support their economies, whilst other governments and central banks around the world similarly announced various support packages of their own.

Whilst this is a phenomenal level of support for the global economy on a scale never seen before, it cannot cure the lack of economic activity resulting from the removal of people from their daily work. The hope, however, is that business and households can remain solvent long enough to be able to resume their activities when restrictions are lifted. The cost of supporting businesses and individuals through this period is so high that it is clearly not sustainable for an extended period of time, which may mean the Government will have to find a delicate balance between allowing people back to work and controlling the spread of the disease. China has already started down this path, but it is too early to judge the success. There are also signs that infection rates may be levelling out in Italy, but again it is a little early to be confident that the worst is over for them.

With equity markets representing the discounted value of future cash flows, the uncertainty of those cash flows in the current climate makes valuing businesses extremely difficult, even businesses that have thus far proved resilient can come under threat if other areas of the economy suffer extended hardship. Where businesses survive and come through this, there could be further obstacles for investors. We have already seen UK banks announcing that they will be suspending dividend payments following pressure from the regulator. It would not be unrealistic to see firms in other sectors be either reluctant too, or prevented from, rewarding shareholders for a period of time if they have been in receipt of government support. Of course, there will be businesses that have thrived in this period and others that will emerge with less competition than they had previously, as rivals fall by the wayside.

For the foreseeable future therefore, markets are likely to be highly correlated to the development of the COVID-19 pandemic and the expected timeframe for bringing the spread of the disease under control. Metrics to which we would normally rely upon to guide us in assessing the relative merits of equity markets being of less consequence at this time.

It will be of no surprise that the forward looking survey data in the form of the Purchasing Managers Indices (PMI) slumped in March. For the UK, the dominant Service Sector PMI dropped to 34.5, down from 53.2 in February (below 50 signals contraction). The Manufacturing PMI also dropped into contraction territory coming in at 47.8.

In the Eurozone, business activity also collapsed in March, IHS Markit’s final Composite PMI reading fell to a record low of 29.7 having been in expansion territory at 51.6 in February. The picture is similar across the world with the service sectors being particularly hard hit.

With all signs pointing to a significant slowdown in global growth it is not surprising to see markets reacting in the way they have. Despite the significant challenges that we now face, however, it is worth reflecting on the situation we were in at the start of the year. The global economy was growing at a modest but steady pace, corporates were in good shape having achieved significant levels of earnings growth over recent years and many having reasonably strong balance sheets. The consumer had been resilient, having enjoyed full employment and more recently above inflation levels of wage growth. The U.S and China were making progress on their ongoing trade disputes, and central banks were continuing to run accommodative monetary policies. All of which was a reasonably positive backdrop for equity markets. What has occurred since then is sudden and abrupt worldwide curtailment of business activity.  As markets are forward looking discount mechanisms, they have reacted accordingly, repricing in the expectation of lower future revenue streams. This has left markets that were trading above their long term averages in terms of earnings multiples, now on much reduced valuations. The great uncertainty that investors now face is to what extent current equity market prices reflect the reduced earnings potential of those underlying companies, and the answer to that lies in the extent and duration of the various forms of lockdown in place throughout the world. Any hint that infection rates are peaking could quickly send markets sharply higher and likewise any hint to the contrary quickly seeing them reverse direction. We would therefore expect high levels of volatility to persist for some time.

This is certainly a challenging time for investors in deciding how best to position portfolios during this downturn. There are clearly companies and sectors that have proved quite resilient in recent times, similarly there are those which have suffered significant damage and in some cases this will prove irreparable. For those companies which have been little affected or even prospered during this time, they offer some stability and possible protection against further downside. On the other hand, those companies that have been hardest hit and seen their share prices decimated in recent days, if they do come through, could offer significant upside from current levels. The same applies to asset classes that have held up relatively well, they may offer less potential return during a recovery, which is typical of defensive assets. We would conclude therefore, that this is not a time to be making radical adjustments to portfolios in an attempt to time the bottom of the market, but to maintain well diversified portfolios that are matched to client’s long term objectives and risk profiles.

As we have discussed, much depends on the duration and extent to which businesses remain closed. however, once they do start to operate again, albeit perhaps not immediately to the capacity they did previously, they may be operating in what could be a very favourable business climate, with support from their governments and central banks that would have previously been unimagined.

Equity Indices % Return
China (SSE Composite)  -9.8
Hong Kong (Hang Seng) -16.3
Russia (MOEX) -17.6
Japan (TOPIX) -18.5
US (S&P 500) -20.0
Europe (STOXX Europe 600) -23.0
UK (FTSE 100) -24.8
Germany (XETRA DAX) -25.0
France (CAC 40) -26.5
Italy (FTSE MIB) -27.5
Spain (IBEX 35) -28.9
India (S&P BSE 100) -29.2
Brazil (Bovespa) -36.9
Major Commodities  % Return 
Gold Spot Continuous  3.56
TR/CC CRB Commodity Index -34.45
Brent Crude  -65.55