Market Comment 03/06/2020
Market Commentary - June 2020
Cornelian's Investment Team give their view of the previous month and outlook for June.
The MSCI UK All Cap NR index returned -8.3% during the three months to the end of May, underperforming the MSCI World ex UK (£) NR index materially, which returned +4.9% in Sterling terms. Equity markets fell sharply during the period as countries responded to the COVID-19 outbreak by locking down their economies. Confidence was further impacted by a sharp fall in the oil price. Announcements of massive monetary and fiscal policy stimuli and a relaxation in lockdown rules in developed economies, alongside news of substantial cuts in oil production by the OPEC+ group, drove a significant recovery in asset prices by period end.
The outperformance of international markets was enhanced by Sterling weakness which increased international returns for UK based investors (MSCI World ex UK NR index returned +1.3% in local currencies).
In Sterling terms, the strongest regional equity market was the United States (MSCI USA NR (£) Index +7.1%), which performed strongly due to the index’s significant exposure to technology and pharmaceutical stocks.
Investment grade debt performed poorly initially as credit spreads widened in response to sharply slower economic growth.
Gilts produced a positive return (iShares Core UK Gilts ETF +4.5%) as investors became concerned that COVID-19 would negatively impact global economic growth significantly, and that central banks would manipulate government bond yields lower using quantitative easing, which then they duly announced. Investment grade debt performed poorly initially as credit spreads widened in response to sharply slower economic growth, however the Federal Reserve announced plans to buy credit, and this improved sentiment markedly (iShares Core £ Corporate Bond ETF -0.2%). ‘Riskier’ high yield debt produced a negative return (iShares Global High Yield GBP Hedged ETF -4.5%).
The Brent crude oil price ended May at $35.3/barrel, a decrease of 30.1% since the beginning of March. The hard stop to global economic activity has seen a collapse in demand for oil products, however announced supply side production cuts helped the oil price rise from mid-period lows.
The gold price rose 9.1% to $1730/oz in the three months to the end of May. Sterling weakness boosted returns such that the value of gold held by UK based investors rose by 13.1% (to £1,405/oz).
The rapid shutdown of numerous major economies due to the COVID-19 virus resulted in equities falling by roughly a third from their peak, and corporate debt also produced materially negative returns. The US economy alone is forecast by some to contract by circa 30% during the second quarter of 2020. Whilst the scale of the market falls are not unprecedented, the speed by which they sold off was. The previous record for ‘speed of sell-off’ was set in 1929 but has been beaten in 2020 by some margin (according to Goldman Sachs). The COVID-19 ‘cure’ induced recession is unlike any other economic shock observed before.
Importantly, the shutdowns are working in that they are bringing COVID-19 infection growth rates down. Policymakers have clearly learnt the lessons of 2008 and have responded extraordinarily quickly to provide massive fiscal and monetary support, designed to underpin confidence and a swift return to growth following the easing of restrictions. These actions have induced market participants to bid up asset prices materially.
Unfortunately, we know all too well that largesse today will need to be paid back tomorrow. This will mean that taxes will have to rise and austerity will need to be extended. This will impair the recovery which will also struggle with the effects of companies and individuals hoarding cash on concerns that there might be a COVID-19 rerun after lockdowns are lifted.
Lawmakers may move decisively towards the direct financing of infrastructure spend and subsidies for the electorate by authorising the printing of money.
In time, if the austerity playbook, which we have seen before, becomes politically unacceptable, lawmakers may move decisively towards the direct financing of infrastructure spend and subsidies for the electorate by authorising the printing of money specifically for these purposes. This is known as Modern Monetary Theory. Should this approach be enacted, market participants may begin to anticipate the return of inflationary pressures. If sustained, this could have profound implications for the valuations of certain asset classes.
Dividends are being withdrawn pre-emptively, share buybacks halted, capital expenditure reduced and working capital shrunk in order to help companies conserve cash during the uncertainty. If prolonged, this hoarding of cash will become self-defeating as it directly impacts economic activity. Critical will be how lenders react to companies which are at risk of defaulting on their loans. Will the banks put such companies out of business or will they (or policymakers) provide the necessary liquidity to allow companies to trade through this event? We think the latter, particularly as banks are relatively well capitalised. Political pressure will be intense to continue to lend and we know that the crisis is probably time limited in that a mass vaccination program is likely to be initiated at some stage in the future.
We are concerned that after the recent significant increase in asset prices, the release from economic lockdown may be more drawn out than is currently envisaged by market participants.
Our base case remains that the shutdowns work in western economies and developed Asian economies, and the number of new infections falls substantially in these geographies. However, we are concerned that after the recent significant increase in asset prices, the release from economic lockdown may be more drawn out than is currently envisaged by market participants and this could knock confidence once again concerning the outlook for economic growth and company profits.
Whilst companies act to shore up their balance sheets through equity issuance and the withdrawal of dividends and share buybacks, the early phase of the recovery is likely to be ‘credit friendly’. We have therefore increased portfolio exposure to fund managers that specialise in credit and convertible bonds in the first instance, as we are confident that these asset classes have return (versus risk) profiles which are both asymmetric and favourable.
In line with the narrative above, we have reduced our exposure to UK and international equities somewhat, thereby locking in some of the recent gains in share prices.
Cornelian Investment Team