News from the frontline – 22 May 2020

As the volatility in the market starts to ease, we are seeing the number of investor updates from fund houses slow. It does not necessarily mean the markets have tested the bottom, but rather there is not a great deal more to share at this stage.

What we know is that there will be unemployment, that businesses will fail, and that growth will be muted. But we should not forget that the amount of money put into the system to protect jobs and businesses is unprecedented, and we simply do not know what the impact of this will be. Banks such as Investec, who work alongside many smaller businesses in the UK, have commented that they see a sense of confidence from those they engage with. Small businesses make up a large proportion of the UK economy.

As countries exit lockdown there will be green shoots of recovery, which come from zero or a near zero base in many cases. The press tends to focus on the negative, it is important to see both sides.

We do not try to call the market but both First Trust and Clearbridge think we have reached the lowest point. First Trust are outspoken in their thoughts, and some (but not all) of them resonate with me. Clearbridge perhaps provides more analytical insight and it will be interesting to see how things change over the coming months.

We will continue to speak to fund managers and share those updates on the website. Our next updates will move to a fortnightly basis unless events turn. We have included useful website links at the end of this blog, and we would also recommend the links mentioned in the Invesco update.

As always, we hope you find these interesting.

First Trust (Chief Economist)

Many of the comments are focused on the US but what happens in the US tends to feed out globally.

Understanding an economy:

  • Everything has been driven by experts who do not understand how complicated an economy is; the scientists build a model about the virus which looks at how fast it spreads and how many it kills, if you placed the same model on an economy it would destroy it
  • There are trillions of factors which impact an economy daily, from how you make car manufacturing profitable to purchasing a cup of coffee
  • You need entrepreneurs who are willing to experiment and innovate; remember the microchip was made from sand
  • So, if you shut down an economy then the damage spreads across all aspects of the society and is greater than the experts understand. This is not just about the direct economic impact but also other health and financial implications which have the potential to further damage the economy

Coming out of lockdown in the US:

  • Pressure is building in the US to come out of lockdown (as we write this update every US state has eased lockdown restrictions). Elon Musk has been demanding California governors allow him to open his factory (remember his factory is running in China which has no cases)
  • Big advertisers in the US can now go back on 12-month advertising contracts which means that potentially networks could see revenue reduced if these companies decide to pull back on spend
  • People need to re-open their businesses, and pressure is coming from the ground up and forcing US states to act
  • Each US state understands that if one opens but they do not, then that impacts them. This creates pressure from state to state to act

Understanding the virus:

  • Flattening the curve does not stop the virus; deaths will still occur, but it does stop hospitals being overwhelmed
  • The risks lie within certain areas and age groups, and outside of this, risks are very low. The greatest risk consequentially from the virus lies in the impact on mental health, increased domestic abuse and suicide

Green shoots:

  • Everything is coming from a low base but over one week in the US, box office receipts are up 107%, rail car traffic up 1%, hotel occupancy up 7%, delivery to petrol stations up 14%, and month on month checkpoint traffic at airports is up 98%
  • When you put that level of money into the system you get a reaction. Commercial and industrial loans are up 159.5%
  • They are forecasting the S&P500 to reach 3,100 by the end of year, and for that to rise further in 2021. Currently they think it is undervalued because it is pricing in a 60% drop in corporate profits and 1.25% treasury yield (currently 0.7%)

Looking forward

  • Short term they think inflation will be low, perhaps even negative but they expect this to reverse because of restrictions through social distancing which will force some businesses to increase prices
  • They expect better GDP figures in Q3 and Q4. The recovery will be a U shape, corporate profits will be bad but not as poor as the market is pricing in
  • There will be a re-organisation of supply chains, but they cannot all come back to the US because there are not enough people
  • Negative interest rates in the US are unlikely
  • Real estate in the short term will be hit but it will recover
  • The markets will not test the lows and will go higher in the future unless corporate profits drop below 60% and / or treasury yields rise to 1.25%

Clearbridge Investments (Anatomy of recession)

We had an update with the team a few weeks back, so we checked back in to gauge their thoughts today:

Concerns coming into 2020:

  • They were cautionary coming into 2020 because of various economic signals
  • The main concerns centred on corporate profits outside of the S&P500. 59% of the US labour market is employed by companies with under 1000 workers, corporate profits across this area of the market has been flat for 5 years and many businesses have been struggling to combat higher costs
  • Job openings had been coming down since the early part of 2019

What factors should we look at:

  • The weaker economic data seen when entering the recession will likely mean weaker expansion when exiting
  • Expect that unemployment will settle around 10% after this crisis has been contained
  • Bear markets should not be feared, 20% of the time the S&P500 has been at levels of 39% below its previous peak
  • History shows it takes on average 16 months to climb to the peak, 6 months to sell down and 7 months to get to previous heights. This is the fastest decline in history, just 22 days
  • There have been 18 recessions since 1918, on average they last 13 months. The Spanish Flu recession was 7 months
  • The economy will improve, and markets will turn before the end of a recession
  • At the end of March, the only positive indicator they had on the recession dashboard was Fed Policy. So, they had 1 expansion and 8 recession indicators. This has now moved to 3 expansions and 6 recession indicators

Will markets test the lows:

  • There is a strong possibility that we have hit the lows of the markets but there are counter trend rallies; between 2007 and 2009 there were eight, and last one was in June 2009. Over 4 months between 1929 and 1930 markets were up 40% before they came back down so need to be cautious
  • They are cautious about the level of recovery as they think markets are pricing in a V shape recovery and much of the recovery is driven by a handful of companies
  • What could test the lows is a Democratic clean sweep which they think could happen, and low consumer confidence
  • Moving forward they believe we are in a ‘super bull cycle’ so once we exit this recession, the next ten years could be very good for equities, especially the US, with quality growth stocks and strong dividend payers

Inflation

  • Short term the impact of the virus is deflationary with a collapse in oil price, no wage inflation pressure etc
  • Long term inflation will come from re-orientation of supply chains, oil price spike, weaker dollar etc

Invesco (Economic Team)

Useful data insights:

  • The team discussed the stringency index (click here); this is based on 17 indicators of government responses which include containment and closure policies, economic policies, and health systems. They then aggregate the scores to provide the data for the index. So, you can see a measure of the number and strictness of Government policies – the UK has a score of nearly 80%, China has come down to 55%. If you look at China on 21 January, its score was 23% and by 26 January this had risen to nearly 70%. The main point is that as Governments act the level goes up and then as they come out the level goes down. This should provide an indication of when there will be potential rebounds in economic activity
  • The second piece of data is from McKinsey and Company (click here) and looks at consumer confidence. If you look at China this has gone from 43% to 57% in terms of optimism in the economy. In the UK, the data is shorter but currently optimism is at 18% and the US is 33%. This may reflect that China has relaxed lockdown measures and as the stringency measures go down, so optimism rises

Inflation:

  • In the short term, they believe we are in a disinflationary world
  • In the longer term, they can see reflation but not runaway inflation; the only thing that would put pressure on inflation is an error in central bank policies
  • With deflation this will be good for equities, but bond yields will fall, for reflation this is good for equities and bond yields will rise

US markets vs UK Markets:

  • The US and UK Markets are very different
  • US has a 40% exposure to Healthcare and IT, not including the likes of Amazon and Google (which are not classed as IT); if you include these types of companies then the exposure is over 50% of the market. The UK has 15% exposure to Healthcare and IT and most of that is Healthcare. The UK is massively exposed to financials and energy
  • Globally, expectations are for corporate earnings to decline by 17% and dividends around 5%. In the US, corporate earnings are expected to decline around 20% but dividends are set to rise. In the UK, corporate earnings are expected to fall over 30% and dividends by nearly 25%
    Additionally, UK will suffer a short term hit from Brexit if we leave with or without a deal on 31 December. There are also concerns about unemployment and house prices could fall in real terms by as much as 10% a year, over the next three years
    In summary, there are more negatives in the UK market vs the US market and this is reflected in the recovery from the low points. The US has less cyclical exposure and better, quality companies and it is likely to stay elevated because investors are prepared to pay for growth. That said, over the next 10 years the returns from the US might be lower

Market valuations:

  • Latest PMI data showing a recovery but still a massive contraction this year
  • Markets are looking to the green pastures of recovery based on the unwinding of lockdown and various support measures
  • They feel there is too much optimism within the markets, and any setback could potentially put equity markets at risk

Investec (Economic Team)

Away from the economic news, the team shared some thoughts from small companies they are engaging with.

There are two camps:

  • Some businesses have been fortunate to be resilient to COVID19 and have in fact been well placed to grow because of this crisis. Within this group of entrepreneurs, there is a sense of excitement and many with access to capital understand that this is a great environment to be bold
  • For others this has been difficult, and survival has been the key, with a focus on cash and liquidity. The different Government schemes have been important for these businesses and the general view is that although the schemes have had problems the Chancellor has been quick to act as they have arisen

Across all the groups they engaged with, there is an improved sense of confidence returning to the economy, with a feeling that we will get through and we can get back to ‘normal’ in the coming months.

Jupiter (Merlin and Economic Teams)

Thoughts on negative interest rates:

  • Sweden was the first European Country introduce negative rates; they have now said this is highly corrosive and dangerous
  • The UK indicated negative interest rates may be used, but the US has ruled this out
  • Normally a bank recycles deposits to lend out money, and they make money between the amount they charge on loans and the amount they pay on deposits. Negative interest rates reverse this
  • Effectively people are charged to deposit money, so they take money out which means money is drained out of banks just at a time that they are being encouraged to lend more
  • The EU followed Sweden, and this has damaged the banking system especially in Germany and Italy where the banks are being propped up by Central Banks. It has also damaged lending and savings within the EU
    However, if you have deflation then negative interest rates will help

Inflation:

  • There are two inflationary-based pressures – the first is longer term structural deflation which includes a weak recovery and over capacity. On the other side, increased inflation from fiscal spending, commodity prices and helicopter money (‘free money’ given to people particularly in the US). It is difficult to judge which will dominate

Snapshot of global events:

  • Positive news on vaccine trials especially from Roche and Astra, but still some way off
  • In the UK there is a battle between Unions and the Government on returning to work, especially schools and universities. Cambridge University announced they will not open in 2020/2021 and tuition has moved online
  • Australia has been vocal in calling for a review of China’s role in the COVID-19 outbreak, and China responded with tariffs of 80% on imported barley
  • A new funding scheme in the EU has been proposed by Germany and France, to be funded by successive budgets. Austria and Netherlands are opposed to the German and French approach as they believe any funds provided to member states should be in the form of loans
  • More stimulus packages being debated in the US
  • Brexit related gridlock rumbles on, especially around fishing rights, and at this stage it is difficult to know where we go. Currently, we are heading towards WTO rules effective New Year’s Day, and the Government is happy with this

And finally, we can expect higher taxes to pay for all this new debt, the question is where this comes from, and when.

Note: This is written in a personal capacity and reflects the view of the author. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.

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