As time passes between Asset Allocation notes in 2020 the world seems to be changing at a remarkable pace, it has been no different since March. The tragic human and economic consequences of COVID 19 have continued to play out around the world and there is a hint of geopolitical déjà vu as Brexit, US-China hostilities and Hong Kong tensions have all re-emerged in recent weeks. On the other hand, lockdowns have started to ease around the world, with relatively few signs of any severe second waves, albeit many easing schedules are in their nascent stages.
The majority of the economic data that has been released since the last Asset Allocation commentary has reflected the impact of locking down economies. Government instructed curtailments on economic activity have had profound effects. In April PMIs around the world have almost all hit record lows or touched 2009 levels. Car sales were down 96% in Italy and Spain and new car registrations fell by more than 97% in the UK. Japanese machine tool orders were down 40% year-on-year in March and Goldman Sachs suggested that Indian GDP could fall at a quarterly annualised rate of -45% in Q2. However, whilst these numbers are significant in size, they have not been surprising as economic activity has essentially been shutdown intentionally, so markets had largely digested this news in March and instead have since been driven by the policy reaction and estimates of depth and breadth of the economic malaise, and most importantly the shape of the subsequent recovery.
In Asia, most of the countries hit earlier with the virus are now in the latter stages of lifting lockdowns (with the considerable exception of India), with any second waves so far contained to small breakouts. China is now widely accepted to be back to around 90% of manufacturing capacity, with the 10% still lacking attributed to falling demand from the West. Services however have been, as one would expect, slower to recover as it takes time for the public to have confidence that the risk posed by the virus has diminished sufficiently.
The Western world has lagged behind Asia but much of Europe and the US are now beginning to lift lockdowns. It is difficult to assess if easing restrictions has been a successful policy yet as it’s early stages but activity has started to pick up again in Europe (see below), although from very low levels. There is a fear that the US has eased restrictions too early; several states are loosening lockdown whilst still facing a rising number of new daily cases. The logic of this is difficult to comprehend but there are some more positive signs in some of the areas that were hit first, such as New York and New Jersey, where their new case charts look similar to that of Spain or Italy.
Chart 1. Euro area mobility and stringency index
Source: Apple, University of Oxford, J.P. Morgan
In terms of the policy reaction to the virus, both the speed and the scale have continued to be staggering. Fiscal stimulus enacted has been more than 6% of Global GDP, more than three times the 2% spent in the Great Financial Crisis. And there is still more to come! The US have a fiscal bill heading for the Senate that has virtually no chance of passing immediately but it is likely to lead to a compromise and further stimulus down the line. Japan is in the process of another $1trn stimulus package. In Europe, the first signs appeared of significant progress towards a coordinated COVID recovery fund as France and Germany united in support of a €500bn package. In typical fashion it is likely to take time to enact, but it is a step in the right direction. Finally, whilst the Chinese fiscal package announced is smaller (in terms of percentage of GDP) than comparative measures in the EU and US, the combination of budget deficit, local government special bonds and COVID-19 special bonds amounts to 8.4% of GDP – still a sizeable figure.
Central Banks have continued to support economies wholeheartedly in the past couple of months. Most Emerging Market nations have followed the lead of Developed Markets and cut interest rates. The ECB and the Fed have extended asset purchase programs to include fallen angels (bonds that are downgraded from Investment Grade) and the Bank of England has admitted that negative rates are now under “active review”. The Bank of Japan has also introduced a measure that is essentially paying banks to lend to SME businesses. The “whatever it takes” policy appears to now be a global phenomenon.
Up until last week most markets were up a modest amount since the last meeting on the 26th of March, with the US leading the way due to the outperformance of tech and healthcare. Progress towards a significant European fiscal bill and the easing of lockdowns has seen the German and Japanese markets in particular surge in the past few days. Fiscal and Monetary stimulus has been significant and this is further evidence that it will continue to support markets in the months, possibly even years, to come.
Volatility remains elevated as the market digests progress made towards creating a vaccine or treatment for COVID and the success of easing lockdown restrictions. Caution should be urged about overreacting to early medical trials but the coordinated global medical response does seem to be encouraging, in particular the alliance of large pharma companies Sanofi and GSK – the biggest global vaccine producers.
Government bonds continue to look expensive, the best example of such extremes during the period being the UK issuing its first ever negative yielding bond. £3.8bn worth of 3 year gilts were bought at a yield of -0.003%, reflecting sentiment that the BoE may be heading towards negative interest rates. Whilst there is limited evidence of the success of negative rates, it does seem probable that rates will stay low into 2021 at least.
One commodity that epitomised the volatility since the last Asset Allocation note is oil. There has been somewhat of a recovery in the prices of both Brent and WTI after WTI briefly fell into negative territory for the first time ever in April. This was mostly a technical short term issue but it was indicative of the extreme supply and demand imbalances caused by COVID-19. At the time of the last commentary both prices were in the $20s. Since then they have gone via the $10s and recovered back into the $30s. Supply has been cut off at a remarkable pace and, as lockdown restrictions are lifted, demand is coming back online after failing to suffer the vast demand destruction that was anticipated earlier in the crisis.
Figure 1. Percentage change in markets and currencies from 26/03/20 to 28/05/20
Activity & Positioning
In terms of positioning, we have done very little in terms of trading after the large volume of trades placed as the markets fell in March. We remain wary of any further downdraft in markets given the potential for volatility in the next few months as the world moves out of lockdown and other geopolitical events play out. On the other hand, as we have highlighted in previous commentaries, many of the fund managers we have spoken to recently have pointed to a multitude of stocks that are yet to recover from the market turbulence in March, as a result there could be significant upside for many of these names from here. Therefore, we want to remain invested to capture upside in these companies as things can turn very quickly – please see the Halfords example in Ian’s 18th May Coronavirus Commentary – however, we also want to be conscious of risk, so we do still have cash available to put to work if any correction in markets occurred.
Asia is somewhere that we also like given its handling of the virus, policy support, growing middle classes and lower debt levels (relative to the West). Vietnam is a prime example of this. After suffering from SARS in 2003, measures were enacted to contain a future outbreak and they have been remarkably successful, with only 324 cases as of 18th May and 32 days without a domestically transmitted case. The domestic economy has started to reopen, domestic flights are now at 76% of 2019 levels, and JP Morgan expects economic growth of 3.2% in 2020. Post-COVID Vietnam will also have the tailwinds of infrastructure investment, opening up of markets to foreign investors and could potentially be a beneficiary of any supply chain diversification given its cheap labour base. The stock market is cheap relative to the past at 10.5x PE ratio (according to Dragon Capital) with a history of strong earnings growth. We added to a Vietnamese fund earlier in the year and continue to like the space for the reasons listed above.
Changing tack to consider some of the short term risks to markets, Brexit has once again emerged as a potential source of volatility. Negotiations between the European Union and the UK resumed in April and May. Progress has so far appeared to be limited and there are fears that the UK will again attempt “hard-ball” tactics that could lead to a No Deal cliff edge at the end of this year. There is a deadline for requesting an extension to the negotiations approaching on June 30th and it is possible that there will be some volatility in Sterling leading up to that date.
I think that the most logical outcome (which does not necessarily mean it will happen) of the Brexit talks is that there will be some sort of vague deal signed between the EU and UK that broadly addresses most areas, leaving room for several years of further negotiations to thrash out the finer details. In this period of unprecedented uncertainty and economic damage caused by COVID it does not seem sensible to plunge businesses into a period of even greater uncertainty. Martin Wolf of the Financial Times summed it up quite well in his piece on the 22nd of May;
“The least wise thing to do of all would be to break its promises and cast the country loose into a dangerous world in the midst of the steepest downturn of the British economy in three centuries. Only lunatics or fanatics would consider doing something like this.”
Another potentially damaging side effect of the pandemic is the re-emergence of US-China tensions. With an election on the horizon, and historical precedent suggesting that it is rare for a President to be re-elected after overseeing a recession in the final two years of their first term, Trump is under pressure to find a fall guy for the downturn (see his bookmaker odds for a 2nd term below). Unsurprisingly, this appears to be China. Already Trump has restricted some US Pension funds from investing into Chinese equities and placed restrictions on US chips being used in Huawei products. This is likely to have wide ranging effects for the whole semiconductor industry. Taiwan Semiconductors (TSMC) for example boasts Huawei as its largest customer, but also supplies processors to Apple – relationships like this may be questioned from both sides. Perhaps it is no surprise that TSMC last week announced that they would build a new factory in the US.
My suspicion would be that the rhetoric against China will ramp up in the build up to the election, as Trump attempts to pass blame for the virus and win over the electorate. However, it should stay largely as rhetoric as Trump focusses on reigniting the economy, rather than starting another trade war that would damage American businesses at a time when they are already suffering.
Chart 2. Implied probability of Trump re-election based on betting odds
Source; JP Morgan, PredictIt
Linked to the aforementioned US-Chinese tensions has been a perceived show of strength by China which imposed a new security law upon Hong Kong. Gavekal Economics point out that this law could make Hong Kong more like Singapore and ultimately damage its status as an international financial centre – particularly if the US suspends the 1992 United States-Hong Kong Policy Act. However, the Chinese Finance Minister did insist over the weekend that there would be no affect on the autonomy of Hong Kong. Gavekal also suggested that rising pressure for Chinese companies to de-list from the US could mean an increase in Chinese firms listing on Hong Kong instead. The situation and the consequences are unclear but we should learn more in the coming months as the wording of the security law is revealed.
Looking out further to the consequences of COVID-19, much has been made about the long lasting impacts of the pandemic and what the world will look like on the other side. Europe and the US have highlighted the role of the Chinese state in covering up the initial signs of a virus outbreak, and many companies have found that overreliance on supply chains largely situated on the other side of the world can hamper business continuity in the event of a shutdown in economic activity. Whilst I would imagine very few companies’ worst case scenario included pandemic planning in the past, it may well do in the future.
This has touted some to declare an end to Globalisation that will result in supply chains being re-shored and perhaps an increase in tariff implementation. If this were to be the case then it is likely that both of these measures will come at a cost, one that will probably be inflationary as it is passed onto the consumer. This is something to consider and could be one of several forces adding weight to the argument that inflation could rise in the medium to long term – others being the huge magnitude of fiscal expenditure, expansionary monetary policy and companies increasing prices to combat capacity cuts due to the effects of COVID-19.
There is also the fear that de-globalisation will be negative for growth of nations that have historically offered Western manufacturers cheap sources of labour. I do not necessarily think that this will be the case. HSBC point out that Globalisation as we know it started to reverse more than a decade ago. Exports peaked as a share of global GDP in 2008 and share of foreign value added has been falling since around 2008 as well, implying that international supply chains have been becoming less important for the last 12 years (see the charts below). As you can see from the final chart, there is no obvious impact on the economic growth of these changes since the GFC.
Chart 3. World exports in world GDP (Left) and Chart 4. Asian exports in world GDP (Right)
Source; CEPII, WTO, World Bank, HSBC (Left) and WTO, World Bank, HSBC (Right)
Chart 5. Foreign value added as a share of domestic value added exports (%)
Source: UNCTAD, HSBC
Chart 6. GDP growth (annual %) – East Asia & Pacific, South Asia, Europe & Central Asia
Source; World Bank
Figure 2. Portfolio changes since the March Asset Allocation meeting – RJIS
COVID-19 will clearly have some lingering effects on the world, there may well be more Government intervention affecting tax avoiding companies, stricter rules on mega cap M&A and manager compensation, diversified supply chains. It will also spark some social changes too such as more Zoom calls and working from home. We are working to ensure that our managers are investing in quality companies, with strong balance sheets that can emerge from the virus in a position of strength. We are confident that this is the case and we hope that the early signs from Europe and Asia show that we are past the worst of the first (and hopefully the largest) wave of the virus. The chart of restaurant bookings in Germany shows that although things are in the early stages, improvements can be made quickly.
Chart 7. Percentage year-on-year change in restaurant bookings on Opentable
Source; Opentable, Rupert Seggins (Twitter @Rupert_Seggins)
In addition, I think that society will be much better placed than it was the first time to cope with a second wave of the virus. In the UK for example, by mid-June we should have the capacity to test more than 200,000 people a day and have some sort of contact tracing app in place. These two things should enable the government to pinpoint clusters of outbreaks and hopefully suppress any wave without having to enforce widespread lockdowns. We also have the increased hospital capacity created by a number of Nightingale hospitals that fortunately have not had to be widely utilised thus far. This should help us cope with a more severe outbreak or even allow separate hospitals for COVID patients. Finally, we have the possibility of antibody tests (to give immunity passports), treatments or possibly even a vaccine by this point (although by all accounts this is a very ambitious timeframe). So I think that we will be considerably better placed to deal with any second wave and if managed correctly, the economic consequences should be much less severe second time around.
In terms of the markets, I have discussed some of the factors that could increase volatility in the short term; however, there are still widespread opportunities. The market recovery so far has been narrow and there are many stocks that perhaps need to see people returning to face-to-face commerce before they can rebound. As we have said, this can happen very quickly and we want to remain invested in order to participate for clients. It has also been reassuring to hear that European leaders are showing faith in the recovery as they have expressed their desire to meet in person again, rather than on Zoom. We will continue to assess risk/reward and we are well placed to take advantage of any short spells of volatility in the next few months.
Ian Brady Jack Byerley
Chief Investment Officer Trainee Investment Manager
28th May 2020
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Important Information/Risk Factors:
Past performance is not a guide to future performance and investment markets and conditions can change rapidly. Investments in equity markets will be more volatile than an investment in cash or fixed deposits. The value of your investment may go down as well as up. There is no guarantee you will get back the amount invested. If your fund invests in overseas markets, currents movements may affect both the income received and the capital value of your investment. If it invests in the shares of small companies, in emerging markets, or in a single country or sector, it may be less liquid and more volatile than a broadly diversified fund investing in developed equity markets.
The views expressed herein should not be relied upon when making investment decisions. The article is not intended as individual advice and if you require advice or further information you should contact us.