The MSCI UK All Cap NR index returned +9.4% during the three months to the end of June, whilst the MSCI World ex UK (£) NR index returned +20.4% 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 improve investor confidence during the period under review.
In Sterling terms, most major regional equity markets returned between +17% and +22%, the exceptions being the UK (see above) and Japanese markets (MSCI Japan NR (£) Index, +12.0%). The American equity market provided the strongest return (MSCI USA NR (£) Index, +22.0%), aided by the index’s significant exposure to technology and pharmaceutical stocks.
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.
Gilts continued to perform well producing a positive return as investors anticipated further policy announcements which would support government bond prices.
Despite the more positive investment environment, Gilts continued to perform well producing a positive return (iShares Core UK Gilts ETF, +2.4%) as investors anticipated further policy announcements which would support government bond prices. Investment grade debt rebounded strongly as credit spreads narrowed following the announcement that the Federal Reserve would support corporate debt markets (iShares Core £ Corporate Bond ETF, +9.6%). ‘Riskier’ high yield debt also produced a strong positive return but interestingly, given the seemingly more ‘risk on’ environment, marginally underperformed investment grade debt (iShares Global High Yield GBP Hedged ETF, +9.4%).
The Brent crude oil price ended the quarter at $41.2/barrel, an increase of 80.1% since the end of March. 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 June, the gold price rose 12.9% to $1781/oz. Sterling weakness versus the US Dollar boosted returns marginally such that the value of gold held by UK based investors rose by 13.5% (to £1,443/oz).
During the second quarter of the year asset prices rallied strongly following the sharp COVID-19 related declines witnessed during the first quarter. Policy makers have been impressively swift to announce innovative measures to support economies which have 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 tangible successes in suppressing the spread of the virus in developed economies have, in aggregate, improved the confidence of company management teams concerning the outlook for economic growth. They have also galvanised investors’ risk-taking appetite and have led to a strong bounce in regional equity market indices. News concerning the unprecedented drive to find successful treatments and vaccines has also helped improve sentiment.
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. Those 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 web-based propositions and those which have little sensitivity to the economic cycle.
The question that needs to be answered therefore, is whether the sugar rush of extraordinary policy measures, both fiscal and monetary, will give way to a more sober assessment of the outlook for economies, and thereby profits. We believe this is likely, albeit with caveats.
The real scale of ‘post COVID-19’ unemployment has yet to reveal itself.
The first thing to note that the real scale of ‘post COVID-19’ unemployment has yet to reveal itself. With companies embracing higher debt levels to remain in business in the short term, the hangover could be material, particularly as the unfettered release from lockdown will only be assured after a successful vaccine is found and manufactured at scale. Unfortunately, it doesn’t appear that this condition will be satisfied in 2020. In a realistic best-case scenario, we may receive increasingly positive news concerning the development of a vaccine through the rest of the year, however populations will still have to suppress the spread of the infection until vaccines can be deployed in early 2021.
Barring the possibilities that the virus may lose some of its potency, or that specific populations are able to eliminate the virus completely from their midst, one has to assume that the rate of virus spread will correlate with the pace that economies open up (notwithstanding any seasonal effects). If correct, this means that the ‘V’ shaped recovery that is hoped for may well disappoint as rolling localised lockdowns are introduced which will ensure heightened public awareness of the need to continue to socially distance, etc. This may well sustain higher levels of unemployment, and therefore result in consumers hoarding cash after the first flush of spending driven by pent up demand.
Companies are likely to continue to operate in an environment of reduced demand and increased costs for the rest of 2020.
This means that companies are likely to continue to operate in an environment of reduced demand and increased costs for the rest of 2020. Given these dynamics we expect the rate of company bankruptcies to accelerate, which may undermine banks’ confidence to lend to corporates. The withdrawal of this financial lubricant from the engine of economic activity will further exacerbate the issues described.
It is also worth noting that over the past month or so the Federal Reserve has stopped the net printing of money and this slowdown in the rate of monetary stimulus could become a headwind to further asset price appreciation.
Nonetheless, central banks around the world have continued to demonstrate a desire to manipulate asset prices higher during times of economic crisis which reduces the perception of downside risk. This doctrine has not only resulted in all-time low interest rates, but also threatens the adoption more widely of negative interest rates. Given the enormous amount of cash currently sitting on the side-lines waiting to be deployed in this low (or no) interest rate environment, the pressure to put this money ‘to work’ is high and only small incrementally positive developments could be enough to see this happen. Therefore, given these factors, it is prudent not to be positioned too defensively.
Senior Investment Director - Head of Risk Managed Funds
3 July 2020