The world continues to reel from the COVID-19 coronavirus pandemic. The sheer speed in which a public health emergency has turned into a global one and subsequently into an economic crisis, is shocking. What initially appeared to be a Chinese problem has rapidly become something for the whole world to worry about. Consumers have been panic buying essentials in anticipation of an impending government-enforced lockdown and the death toll continues to rise across the Western world. Stock markets have finally taken notice.
Draconian measures previously thought untenable in Western democracy are being implemented. UK prime minister Boris Johnson has urged residents to refrain from unnecessary contact and advised 12 weeks of self-isolation for people over 70, which falls short of France, Germany and Spain which have largely shut down their entire economies, France even fining people who get caught outside their homes. There is a shortage of critical ventilation machines for hospital ICUs, and governments can’t act fast enough to support people and businesses impacted by the economic fallout.
Managing the spread of the virus seems the most important point of action for policymakers currently. Social distancing does not appear to be enough. The key is testing as many people as possible as quickly as possible. In the US, the FDA has dropped usually stringent rules and are allowing labs to certify their own test results without awaiting CDC approval, allowing for up to 26,000 people to be tested per day. Human trials for a COVID-19 vaccine have begun in record time, though a cure is still at least 12 months away, which puts the burden on containing the spread squarely onto governments.
Central banks globally have been scrambling to react to the market selloff, with the Federal Reserve cutting rates to a banding of 0-0.25% and announcing $700bn of asset purchases (otherwise known as quantitative easing), the Bank of England cutting to 0.25% and expected to go further to 0%, the Bank of Japan extending its quantitative easing programme of buying ETFs (Exchange Traded Funds) listed on the Japanese stock exchange and the ECB, which initially disappointed markets by not acting (rates are already negative) now expected to cut rates further into negative territory, and have recently announced a massive bond buying programme and a ‘whatever it takes’ approach.
Governments are enacting record levels of fiscal stimulus along side the global coordinated monetary efforts, but markets as yet appear unconvinced by any of it, continuing to selloff until we have a clearer picture of the lasting impact of the virus, which we analyse in this research note.
A&J would also like to reassure our clients that we are continuing operations and able to service client’s needs as normal. If you have any queries, then please do not hesitate to contact your adviser.
Looking at global stock markets year to date shows the extent of the continuing troubles. Most interesting is the performance of China, which is barely down on the year and a clear outperformer. Given the virus originated in China (something the Chinese authorities are now denying) this is quite astonishing. Perhaps this gives some indication as to the likely trajectory of global stocks once countries can start limiting the number of new coronavirus cases and we reach peak infection.
Stocks have for some time now been at a total disconnect with the fundamentals. Going into 2020 stocks did look expensive, with many indices trading at all time highs even as some signs of economic slowdown became apparent. Growth stocks (such as the FAANGs) were dragging the rest of the US market higher, whilst corporate profits were, at best, stagnant. Companies have been paying out huge dividends and management teams have been manipulating earnings per share numbers for several years now by buying back company stock (this lowers the number of shares in circulation and thus gives a higher EPS number, even if earnings stay the same), as CEOs are often compensated on higher EPS over a number of years.
What we see here is a repricing of stocks and a reversion to the mean. The larger the deviation away from normality, the bigger the fall back towards it.
From a UK investor’s point of view, currency movements have been remarkably consistent since the start of the crisis.
The pound has suffered heavily since the start of this crisis, particularly against the dollar which has staged a comeback since the start of the year.
The dollar gains its strength from being ‘the’ global reserve currency and a safe haven asset that investors rush to in times of distress to protect their money. Many foreign sovereigns’ price and sell their debt in US dollars, as this tends to give them more stability and certainty over the value of the repayments, and many countries around the world peg their currency to the dollar, meaning they must hold vast dollar reserves. This means the dollar has significant cash flow, and the supposed regulatory sophistication and strength of the US economy also means the USD keeps as a good store of value.
Sentiment to the pound seems to have taken a big swing to the downside after showing strength following the Conservatives landslide election win on December 12th of last year. Sterling is now the weakest it’s been since 1985. Brexit tensions began to weigh on the currency early in the year as investors realised Brexit was far from over, as far as ongoing negotiations with the EU and the uncertainty surrounding those talks, but the scale of the swing seems unreasonable given the underlying strength of the UK economy compared to many of its peers, particularly in the eurozone where many countries were on the brink of recession and a debt crisis before coronavirus started playing on investors’ minds.
Enter the Bear
Global stock markets have continued to sell off, officially entering a bear market (a 20% drawdown from the peak) last week.
This is the fastest move into a bear market on record, taking just 16 days and ending the longest bull market in history. In 2019 the S&P 500 gained almost 29%. It took less than four weeks in 2020 to erase those gains entirely. On Monday 16th, the index experienced its steepest drop since 1987.
Several nations have now temporarily banned short selling of some stocks (this is where investors borrow assets, sell them into the market and buy them back later, hopefully at a lower price and thus pocketing the difference), in the hope that this will slow the market selloff. Spain has banned all short selling for a month. There is little evidence that short selling adds to market volatility and so it is unlikely these policies will make much difference to the continuing market volatility, discussed in more detail later.
The longer a bear market persists, the longer it takes to recover from, as the table (data goes to close of business on Thursday March 12th) shows.
The velocity of the selloff has been unprecedented in recorded history. The Chicago Board Options Exchange Volatility Index (CBOE VIX) closed Monday at record levels. The last time the VIX spiked as high as this was after over a year of an ever-worsening credit crisis. In this instance the spike has come less than a month after US stocks reached all-time highs.
As we described in our last update, the VIX (Volatility Index) is Wall Street’s ‘fear gauge’ and is an indicator of investor sentiment. The higher the VIX gets, the more fear is present in the markets and thus the lower prices tend to move. At these extremely elevated levels we should certainly expect to see continually high volatility in stocks, and the potential therefore for some sharp moves in either direction, though downwards is more likely given the fear the VIX generally shows from the market.
There is even now talk of closing stock markets. Western markets have been closed in the past e.g. 9/11, but it is an important function of western free market democracy that participants can express their views and access their capital freely. The BoE and FCA have indicated it would take something quite material to change even from here to bring about a total stock market closure in the UK.
With the VIX this high it is unlikely investor sentiment will turn in the immediate future. Looking further ahead though, returns in the 12 months preceding large volatility spikes are consistently strong, suggesting that if we can see out the worst of this over the coming weeks, and bring about peak-infection, we could be in for some strong market moves soon after.
In our last update on March 4th, we pointed to the fall in the price of oil as an indicator that we had not likely seen the bottom in stocks. Unfortunately, this was proven entirely correct. Oil has suffered both a supply side shock, with record levels of oil being pumped out, and a demand side shock, with record low demand due to the economic fallout of coronavirus. This double-whammy caused by the price war between Russia and Saudi Arabia has sent prices plummeting to near $20 per barrel.
Analysts are now saying we could see prices as low as $20 per barrel in the coming weeks as weak global demand weighs on price. Falling oil prices are positively correlated to stocks in the short-term, and so without a resolution from OPEC to the price war it is reasonable to assume we have still not reached a floor in the stock market.
In the longer-term, low oil prices tend to be inflationary, in that this eventually feeds through to lower fuel prices, people have more money in their pockets to spend (and usually do), pushing up prices and increasing economic output. This does tend to take time, however, as oil majors usually delay passing on any price falls to the end consumer.
Oil majors such as BP and Royal Dutch Shell, which will take a huge hit to earnings as a result of this oil shock, also make up a large part of the FTSE 100, which may go some way in explaining why the UK stock market has seen some of the largest declines in the past two weeks. These companies also pay a disproportionately high amount of the dividends received from the FTSE 100. We can expect that they will dig into their cash reserves and/or borrow money to continue paying dividends, however this cannot be assured given the current economic backdrop and ever-falling oil price. With the price of these stocks falling so far however, the dividend yield now looks incredibly attractive, and assuming they can continue to fund future dividends investors looking for income could do worse than looking here for opportunities.
With this in mind, let’s look at the performance of the A&J model portfolios over this time against the FTSE 100, year-to-date.
Whilst the fall in portfolio value is obviously displeasing, this is unavoidable when running long-only model portfolios. What is encouraging is the level of downside protection A&J’s investment process has provided so far throughout this crisis. Our highest risk model – presently an all-equity portfolio – is down -22.73% compared to a fall of over -31% for the FTSE 100.
This performance has been achieved via a heavy weighting withing the portfolios to ‘quality’ companies within our equity allocations. Quality companies exhibit strong balance sheets and cash flows, providing somewhat of a buffer during testing times such as these. Within our mixed asset allocations, which provide our more defensive positioning, managers have been largely positioned towards the same quality bias, with plenty of global fixed interest exposure giving uncorrelated returns to the equity holdings. Some of these funds also invest in alternative assets such as gold, property, absolute return strategies and infrastructure.
The A&J Investment Committee made a number of important changes in order to protect investor capital in these extremely uncertain times. We have allocated away from equities and towards UK government bonds (gilts) and cash. We have added exposure to UK government bonds across all portfolios up to High risk, as the volatility on these assets is lower than equities. We have also added cash in all portfolios to dampen volatility and protect capital. These changes have substantially reduced risk across the entire portfolio range.
We have also increased our exposure to the dollar (USD). As outlined previously it has performed exceptionally since the start of this crisis and will likely continue to do so as it worsens over the coming weeks.
The result of these changes is that our portfolios have been moved towards the lower end of the risk limits, aiming now for capital protection and low volatility over growth.
The above tables demonstrate the relative strength of A&J’s portfolios compared with the FTSE 100. All portfolios have significantly protected on the downside, achieved via effective portfolio diversification, which lowers the volatility profile of each portfolio. It is this that demonstrates the value in the A&J investment proposition, which is an actively managed, multi-asset approach to portfolio management. The flexibility afforded from our DFM (Discretionary Fund Management) abilities allows the Investment Committee to take decisive steps where we see necessary. When comparing to the returns one would experience if holding a passive investment fund such as a FTSE 100 tracker, it is evident the value that active investment management can bring.
This is a financial crisis too, not just a viral scare. Markets like certainty, and at present the only certainty participants can point to is that there will be a global recession, which is hardly reassuring. Uncertainty remains as to the human impact of the virus, the economic consequences, the length of time all this will take to play out, and subsequently what markets will look like at the end of it. With so much uncertainty it is no wonder investors are struggling to find an appropriate price for stocks. What will stop this becoming the next credit crunch will be central bankers’ willingness to ensure credit can continue to flow to companies and households seamlessly. Fortunately, it seems central bankers and governments have learnt their lessons from 2008.
The Bank of England announced Wednesday that it would print unlimited money to shore up the economy, with new governor Andrew Bailey saying the Bank will consider ‘radical’ measures such as printing money and giving it directly to households, a monetary stimulus known as helicopter money, which was previously seen as a method too extreme only a decade ago during the world’s worst financial crisis. Despite record central bank stimulus markets continue to shrug this off, finally acknowledging that monetary policy cannot cure a virus, and that it will take more than central bank action to curb the effects of this unprecedented global shock.
Fiscal policy response is now needed (and being implemented) to respond. The UK announced Tuesday a £330 billion rescue package to backstop struggling companies, the US is discussing over $1 trillion in aid. The biggest long-term consequence of this crisis will likely be much higher levels of government debt going forwards. With real and in many cases even nominal sovereign bond yields trading below zero (many still below inflation), higher levels of government borrowing should be manageable, and central banks will play a key role in keeping borrowing costs low for the foreseeable future.
A global recession, defined as global annualised growth of less than 2%, now appears to be a foregone conclusion. This is a deliberate recession. Governments have taken the decision that plunging the economy into contraction is preferable to the alternative, which is letting the virus do its worse, which is obviously unthinkable.
Whilst the effects of this pandemic are as yet unknown (hence the market panic) it is difficult to see much upside for the stock market. We believe that until we get some certainty around a possible vaccine and/or peak infection – neither of which can happen in a matter of weeks – financial markets will continue to struggle. Markets do not like uncertainty, and we are riddled with it right now. What we do know for sure, is that there will be a bottom and that stocks will recover. Bear markets and recessions tend to be short in comparison to bull markets and economic expansions, the sheer size and scale of government and central bank stimulus will ensure ample opportunity for the global economy to recover, and with that will come upside for investors. A&J’s portfolios are well-positioned for a continued downturn in economic activity, and we will be monitoring daily the markets and key data and prepare to reposition as things look more positive.
For now though, most important is that we all take care of ourselves and our loved ones at this time, stay safe, and get back to normality as soon as possible.