Making sense of the market recovery
Many of our clients are probably feeling uneasy contemplating the extraordinary recovery in world financial markets, as are we. The global equity index climbed by almost 18% last quarter, with the Nasdaq index rising by nearly double that, but still global COVID infections remain at or close to their daily highs, with lockdowns in some cases intensifying. As the IMF announces another major downgrade to global growth it is difficult to recall a time when sentiment across financial markets feels so at odds with economic and social pressures on the ground.
It is not only short-term economic damage that concerns investors. COVID-19 has dealt the harshest blows to the weakest in society – the poorest countries, the lowest paid, many minority groupings and the elderly all have and will suffer disproportionately. African economies, for example, will feel the ‘heaviest hit since the 1970s’ according to the IMF, while, in the UK, a recent McKinsey study showed that the regions of the country with the lowest hourly pay-rates also face the worst economic impact from lockdown. A long-term agenda of ‘levelling up’ to try and mitigate this rising inequality implies higher regional subsidies, greater onshoring of supply chains and, at some point, higher taxes – all critical issues for financial markets.
The speed and scale of the policy response still dominates
So, in the face of these challenges, what does the fact that the US, and many global markets, just recorded their best quarter in 20 years tell us about the wisdom (if any) of markets?
First, of course, it reminds us just how awful the previous quarter was – in the darkest days of early March this year there were near breakdowns in the functioning of almost every financial asset. Illiquidity and extreme volatility simultaneously engulfed oil, commodity, credit and real estate markets and, for a few days, even threatened the liquidity of US treasuries and UK gilts.
Second, it reinforces the dramatic scale, speed and determination of today’s central bankers in their efforts to reverse this. Led by Jerome Powell at the Federal Reserve, they copied much of the 2008/9 playbook but this time acting faster and in greater size (bond purchases today are running at three times the rate of the financial crisis). But it was also sheer inventiveness that saved individual markets. Take just two examples: the Federal Reserve rapidly established swap lines with a wide range of foreign central banks, preventing the terrifying prospect of the dollar liquidity crunch seen a decade earlier. Meanwhile, the decision not only to buy corporate bonds directly but also in the primary market, was itself revolutionary. It helped restart bond issuance as early as mid-May, with companies soon raising funds and plugging balance sheets, in near record volumes, across all major markets. Together they helped turned the March sell-off from one of the sharpest in bear market history to one of shortest.
Third, after a shaky start, the politicians started spending, with the single-minded aim of protecting jobs and saving businesses – again they moved in size and at speed. Each deserves credit; in the UK Chancellor Sunak led the move to furlough jobs and to support the self-employed with effectively no limit. The US administration made direct income support payments to individuals in extraordinary size (it is estimated that 68% of recipients received payments in excess of lost income), while the Japanese, as so often, delivered the largest programme as a percentage of GDP. But, it was Europe that perhaps surprised the most – a revitalised German Chancellor (Angela Merkel), a newly appointed Commission Head (Ursula von der Leyen) and a lawyer turned central banker at the ECB (Christine Lagarde), together formed a remarkable team. Through their Next Generation EU Fund they promised that 750 billion euros, in addition to the EU Budget, would be distributed as loans and grants to needier countries. The details will be fiendishly complex and the pushback from frugal nations strong, but the common platform and the funding by EU bond issuance is a hugely positive step for the stability of the Euro, and one that would not likely have emerged, but for the crisis.
Finally, the global quest for a vaccine and for therapeutic treatment for COVID-19 are also happening at warp speed. News continues to rapidly accumulate; there are currently 194 vaccine candidates and over 300 other therapy candidates to tackle COVID, but the leading three candidates appear to be Moderna, Pfizer/BioNTech and the Oxford Jenner Institute, which are all pursuing RNA-based vaccines. The optimism in a complete cure could still be misplaced given there has never been a coronavirus vaccine, but there are good grounds to believe that there is likely to be a stream of incrementally helpful therapies that build on the early base of Remdesivir and Dexamethasone to better tackle the virus.
Monetary and fiscal policy will need to be synchronised for many years to come
These four events all go some way to explaining the contradictions we see today in the financial world and the real economy, and they underpin our decision to keep our equity weightings at neutral, despite the extent of the rally. Going forward though, if long-term economic and social scarring is to be mitigated, massive spending programmes and generous central banks will have to operate arm in arm, and in scale, for many years to come. What does this mean for our investment thinking?
- Governments will need to conduct extensive ‘financial repression’ (deliberately holding rates on government bonds below their natural levels) for years to come to make their huge national debts affordable. We need to recognise this and use today’s record low yields to start reducing Gilt positions by switching into investment grade corporate bonds (increasingly those supporting projects with a social or environmental purpose).
- We will keep adding to listed infrastructure and renewable energy projects (wind, solar, storage and potentially hydrogen) that offer long-term inflation plus returns. Importantly, a position in gold should be retained as a hedge against a failure in any single government’s borrowing programme.
- We still have very little idea of the extent of likely business failures, bankruptcies and personal defaults. Avoid lower-grade bonds, highly leveraged private equity, complex debt funds and the equity of fragile, recovery situations regardless of yield. In short, be prepared to pay a premium for financial robustness.
- Major crises ‘have a marked tendency to reveal, exacerbate and confirm existing trends’ writes Professor John Watts later in this report. This suggests to us that our core investment themes will remain robust – the climate change agenda will not be derailed, digital and automation solutions remain compelling, while investment in healthcare and an ageing population will be prioritised. We will keep these at the heart of our equity selection.
- Finally, keep three trends in mind as we emerge from the crisis. Firstly, start to look to a revitalised Europe for returns as political risks diminish and asset values re-rate. In technology, consider mid-sized companies that are nimbler than the traditional great tech giants, and can avoid the regulatory and trade spotlight. Lastly, don’t forget that consumer cash deposits are at record highs and savings have soared under lockdown – so spending might just rebound more strongly than thought… as we begin the slow journey back to normality.