Market Comment 11/08/2020
Market Commentary - August 2020
Hector Kilpatrick gives our latest Market Commentary of last month and Investment Outlook for August.
The MSCI UK All Cap Net Return index returned +0.5% during the three months to the end of July, whilst the MSCI World ex UK (£) Net Return index returned +8.8% 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 past few months.
The Emerging Markets 'region' produced the strongest return, aided by more effective track and trace procedures.
In Sterling terms, most major regional equity markets performed strongly, the exceptions being the UK (see above) and Japanese markets (MSCI Japan NR (£) Index, +0.2%). The Emerging Markets ‘region’ produced the strongest return (MSCI Emerging Markets Net Return (£) Index, +13.3%), aided by more effective track and trace procedures which have boosted the pace of economic recovery relative to developed 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.
Following a period of strong performance, Gilts produced a marginally negative return over the three months to the end of July (iShares Core UK Gilts ETF, -0.1%). 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, +4.5%). ‘Riskier’ high yield debt produced a strong positive return (iShares Global High Yield GBP Hedged ETF, +8.1%) underlining the more constructive investment environment.
The Brent crude oil price ended July at $43.3/barrel, an increase of 71% since the end of April. 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 July the gold price rose 17.2% to $1976/oz 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 investors (+12.5%, to £1,508/oz).
Since the trough in the markets in March 2020 asset prices rallied strongly as policymakers were 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 initial tangible successes in suppressing the spread of the virus 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 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.
The question that needs to be answered, is whether the sugar rush of extraordinary policy measures, both fiscal and monetary, will give way to a more sombre assessment of the outlook for economies and thereby profits. We believe this is likely, albeit with caveats.
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 20212.
We are seeing evidence that the hoped for 'V' shaped recovery is beginning to disappoint as rolling localised lockdowns are introduced.
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). Already we are seeing evidence that the hoped for ‘V’ shaped recovery is beginning to disappoint as rolling localised lockdowns are introduced and the public’s need to continue to socially distance is reinforced. This may well drive higher levels of unemployment and result in consumers hoarding cash after the first flush of spending driven by pent up demand.
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 the Federal Reserve has stopped the net printing of money for more than two months, 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 sidelines 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.
Head of Risk Managed Funds