The MSCI UK All Cap Net Return (NR) index returned -0.6% during the three months to the end of August, whilst the MSCI World ex UK (£) NR index returned +6.3% in Sterling terms. Equity markets recovered a significant amount of the ground lost during the precipitous decline in asset prices observed during the first quarter of the year. The collapse was triggered by a sudden realisation that the economic impacts of the policies enacted to restrain the COVID-19 virus outbreak would result in a deep recession, the scale of which could challenge the debt-based capitalist economic system. However, policy makers were swift to announce enormous economic support packages, both fiscal and monetary. These, alongside the easing of lockdown restrictions in many jurisdictions and positive incremental news concerning the extraordinary effort being applied to develop possible vaccines, helped to improve investor confidence.
In Sterling terms, most major regional equity markets performed strongly, the exceptions being the UK (see above) and Japanese markets (MSCI Japan NR (£) Index, -2.2%). The Asia ex Japan ‘region’ produced the strongest return (MSCI Asia ex Japan NR (£) Index, +12.4%) aided by more effective track and trace procedures which have boosted the pace of economic recovery relative to western economies and a weaker US Dollar.
The UK equity market return was impacted by the index’s significant exposure to energy and financial stocks (which, in share price terms, have lagged the recovery seen in other sectors), the persistence of COVID-19 within the population and concerns regarding the outcome of Brexit negotiations.
'Riskier' high yield debt produced a strong positive return, underlining the more constructive investment environment.
Following a period of strong performance, Gilts produced a negative return over the three months to the end of August (iShares Core UK Gilts ETF, -3.1%). Investment grade debt rebounded strongly as credit spreads narrowed following the announcement that the Federal Reserve would support corporate debt markets1 (iShares Core £ Corporate Bond ETF, +2.5%). ‘Riskier’ high yield debt produced a strong positive return (iShares Global High Yield GBP Hedged ETF, +5.2%) underlining the more constructive investment environment.
The Brent crude oil price ended August at $45.3/barrel, an increase of 28% since the end of May2. The hard stop to global economic activity has seen a collapse in demand for oil products, however production cuts and an incremental relaxation of economic lockdowns has helped the oil price recover somewhat.
In the three months to the end of August, the gold price rose 13.7% to $1968/oz3 as US Dollar weakness and the opportunity cost of holding the precious metal fell. Sterling strength versus the US Dollar reduced the gain for UK based investors4 (+4.7%, to £1,471/oz).
Since the trough in the markets in March 2020, asset prices have rallied as policymakers were swift to announce innovative measures to support economies which experienced a hard stop. Measures range from the fiscal (furlough schemes, top ups to unemployment benefits, emergency lending/grants to corporates, business rate reductions and the like) to the monetary (interest rate cuts, printing of money to finance the purchase of government debt and, to a lesser extent, corporate debt).
These measures (which have driven down the cost of government and corporate debt financing), allied with initial tangible successes in suppressing the spread of COVID-19 in many developed economies, have generally improved the confidence of company management teams concerning the outlook for economic growth. Recent trading updates have, in aggregate, been significantly better than feared. This has helped galvanise investors’ risk-taking appetite and has led to a strong bounce in regional equity market indices. News concerning the unprecedented drive to find successful COVID-19 treatments and vaccines has also helped improve sentiment.
The companies most exposed to the economic cycle have lagged index returns appreciably.
However, looking a little more deeply into the components of the market rally calls into question the improving confidence expressed by rising asset prices in general. The companies most exposed to the economic cycle have lagged index returns appreciably. Some sectors (such as banks, energy and travel) remain close to their lows relative to index returns.
The companies that have driven index levels higher include those which have seen a sharp acceleration in demand due to their internet-based propositions and those which have little sensitivity to the economic cycle but have seen their cost of capital fall appreciably.
The scale of the outperformance of these stocks is driving more investors to them and something of a feeding frenzy is apparent. It is, therefore, difficult not to conclude that these stocks are in the last 'gap up' euphoric stage of the market cycle, which ultimately always precedes a more sombre re-assessment.
The pertinent question, therefore, is what might turn sentiment the other way (i.e. towards value and away from growth). It is entirely plausible to construct a scenario whereby, over the next six months or so, investors start to focus upon the mass deployment of several successful vaccines such that herd immunity is achieved, economic growth continues to recover and inflation starts to show itself once again as we move through 2021 (given the low hurdle set in 2020).
The fear of missing out is a powerful driver and so writing off our central business districts altogether appears somewhat premature.
In such an environment, long bond yields would back up and discount rates rise. This move could be exacerbated by a greater appreciation that office work is not ‘dead’ and that there are disadvantages to web-based meetings when some participants are ringing in from home, whilst others are sitting around an office table. The fear of missing out is a powerful driver and so writing off our central business districts altogether appears somewhat premature. If correct, value could start to outperform as the old ecosystem starts to come alive again and the stellar growth rates seen in web-based propositions this year are not sustained.
The difficulty, today, is to determine whether positive news concerning vaccine deployment (and all that it will entail) will outweigh both the likelihood of a material rebound in COVID-19 cases this autumn and the material economic scarring which will be evident for years to come. This scarring will involve elevated and persistent unemployment (the level of which has yet to reveal itself), an extreme weight of debt (which will reduce the future long term sustainable economic growth rate) and increased levels of taxation (which will be required to get fiscal deficit and government debt levels under control).
We believe that the low growth, low inflation scenario is the most likely medium to long term outturn, given policy makers are hell bent on (i) propping up asset prices and (ii) preventing the economic cycle reasserting itself. However, in the near term it is entirely plausible that a dramatic change in momentum away from growth to value could manifest itself. Whilst we do not believe that such an outcome would mark a structural change in style leadership we have begun, at the margin, to increase our exposure to equity markets and UK stocks which have some value characteristics in order to protect against such a rotation.
1 Bloomberg, 13 July 2020 (https://www.bloomberg.com/news/articles/2020-07-13/fed-s-support-for-corporate-debt-has-been-a-wall-street-bonanza?sref=CZCP1vND)
2 Bloomberg, 31 August 2020 (https://www.bloomberg.com/quote/CO1:COM)
3 Bloomberg, 31 August 2020 (https://www.bloomberg.com/quote/XAUUSD:CUR)
4 Bloomberg, 31 August 2020 (https://www.bloomberg.com/quote/GBPUSD:CUR?sref=CZCP1vND)
Senior Investment Director - Head of Risk Managed Funds
2 September 2020