Summary
Overall, we are now seeing economies slowly starting to get back on their feet. This is looking to be a real positive as we head toward the end of H1, one we will not soon forget! Once certain key economies begin to recover, and with the continued support of central banks and government fiscal aid, we believe the recovery this year will likely be relatively quick albeit inevitably slower than the rapid descent. We are aware that the market is forward looking in its positioning, and it is currently pricing in a recovery much quicker than what was previously anticipated just a couple of months ago. How quick this recovery turns out to be really depends on how effective our return from lockdown can be and how quickly we can get back to a somewhat more “normal” pace of manufacturing activity and economic activity in general.
Heading into June we are cautiously optimistic: We have seen the rate of fatalities and ‘new daily cases’ steadily decline in Europe for some time now with no signs of any second wave on the continent as of yet. With February and March’s fall in global equities, followed by the sharp and robust bounce we have seen in April and May, we understand that all of this is potentially a lot to absorb for long-term investors.
If you are feeling confused, you are far from alone. It is totally understandable to feel like a deer caught in the headlights, but the challenge as a long-term investor is to approach your midyear check-up at the end of this month without letting fear and market volatility get the better of you. It is really important not to trade on emotions and also not to let uncertainty and overthinking affect your decision making. Sticking to your goals and staying invested may seem more challenging in times like these, but they are arguably more important than ever.
For existing long-term investors in well diversified multi asset / multi manager portfolios our core advice remains: Wash your hands. Ignore the current volatility in markets. Keep Social Distancing. And do not panic about your stocks! We will advise you if changes are needed.
Despite these uncertain times, we would like to remind clients that there are indeed some reasons for optimism in the near term. To some extent, the data for Q2 can only get so much worse. Enormous second quarter GDP contractions will form a relatively low base off of which to grow in Q3 and heading into year-end. Economic activity in China, though far from where it finished 2019, continues to steadily rebound as the country’s gradual re-opening remains largely intact and on course.
With the limited and sometimes mixed information that we have about this particular virus, one thing seems to be for sure: The medium to long-term path forward for the global economy remains an extension of the public health outlook. As Europe, the U.S. and other economies join Asia in re-opening, it remains to be seen whether they can do so without a major resurgence in COVID-19 cases. If further widespread outbreaks and lockdowns can be avoided, the April/May period should mark the low point of the year for economic activity. We see this as likely and currently have it as our base case scenario. We are well aware of the risks ahead, that things may not go that smoothly, and we may see the re-emergence of the virus in pockets. This would lead to an uneven start-and-stop kind of feeling around the world- we are currently positioned appropriately for such risks.
Much of the logic behind the recent risk-on tone is that in the past, quantitative easing and policy accommodation have pushed equity markets higher. But we believe that the spike of price/earnings ratios to new highs is exaggerated, and as a result we are not heavily chasing the rally of recent weeks. We are instead remaining cautiously optimistic with a view to tactically adding to our equity positions should we be presented with bouts of volatility and lower prices over the coming weeks and possibly months.
We see the possibility of some further virus-spreading, ever-increasing US-China tensions, the leadup to the US’ November election, and the looming December 31st Brexit deadline as a few potential causes of volatility over the coming months. Having said this, it seems very unlikely that we will have a massive March-like spike in volatility again soon.
Equities
We reiterate our short-term view on equity markets from our investment update last month: Equities will likely continue to be volatile and difficult to trade over the next few weeks and months, with sizable moves in both directions, but longer-term opportunities have been and are continuing to present themselves. History suggests market setbacks are likely in the path to recovery, and the two most recent significant bear markets, the Tech bear market in 2000 – 2003 and the Financial Crisis bear market in 2007 to 2009, both had a zigzag paths to recovery.
We expect the market consolidation that started in April to continue. In terms of convictions, we believe the winners will continue to win. Investors should avoid the sectors that are under extreme short-term pressure, which includes most airlines, challenged retailers, cruise lines, high fixed-cost and low-margin businesses, and commercial real estate, with the exception of certain individual names. Instead, we think investors should focus on sector leaders with sustainable businesses in an ESG integrated approach. This approach proved to be right during the correction and we recommend investors continue to follow this path. Sustainable companies with market-leading positions have been proven to win when market conditions are tough.
Fiscal
In summary, growth has collapsed, but the key question is not how bad it will be but for how long it will extend. Stimulus has been huge. Monetary authorities in 2008 did not even have the tools they have now have, so it took a long time to first create them, then deploy them – this time, the tools have been deployed very rapidly. All the ingredients for a significant recovery are there.
As the risk-on sentiment spread through markets, volatility naturally eased throughout May, with the Cboe Volatility Index (VIX, Purple line in chart below) sinking below 30 after having reached 80 at the height of the crisis in late March. As the VIX gave ground, WTI Crude oil prices (Green & red candlesticks in chart below) steadily climbed, hitting nearly three-month highs in the mid-$30s per barrel by late May. Crude prices are now higher than VIX—a pretty welcome situation if you are a bullish investor (see chart below). Higher crude can reflect increased demand for the commodity that arguably makes the world go around, while lower volatility indicates less concern about the market returning to the gut-churning ups and downs of March. The way we see things, that is a relationship worth watching as June continues.
At the Federal Reserve’s May meeting, Fed Chair Jerome Powell signalled a hesitance to using negative rates during this crisis, particularly given some of the downside effects they would have on the banking sector. Monetary policy comes into play in the US on June 10th when the Fed releases its next statement and interest rate decision. At that point, Fed officials might have to respond directly to questions about rates potentially going negative in the next few months, as the federal fund futures market began to indicate in May.
In Europe, much of the attention has been over an EU-wide recovery plan. The plan would allow the European Commission to borrow €750 billion in financial markets – equivalent to around 5.4% of EU GDP – to be funded by EU budgetary resources. The proposal is for €500 billion of spending to be made available, mostly as grants, and to make €250 billion of loans available to any EU country but focused on those most in need. This should help countries with already high debt levels, such as Italy, to access funding without having to issue more of their own debt. The European Central Bank, under the terms of its purchase programmes bought over €125 billion in government and corporate bonds over the past month.
In the years to come, we see the strong possibility that political and business leaders alike will begin to raise certain crucial questions such as: “If we can suddenly and drastically change our behaviour to fight a viral pandemic, can we also do so to avert what is currently a rapidly oncoming climate disaster?” In our opinion, the COVID pandemic has served as an accelerator of growing importance of Environmental, Social, and Governance investing (ESG): There will be an increasingly higher scrutiny of the ways in which companies act in the interest of all stakeholders and the community, and not just of their balance sheet. This will translate into a greater impact on stock prices of some ESG risk factors. Time will tell whether this virus proves a milestone and catalyst for ESG. From our research in this area so far, the answer would seem to be a resounding ‘yes’. Crisis conditions have boosted the importance placed on ESG metrics and served as a powerful illustration of why an integrated approach to investments and risk is important.
For further information on ESG, please contact one of our team members at Seaspray, or alternatively info@seasprayfs.ie
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