Market Comment 05/03/2020
Market Commentary March 2020
Cornelian's Investment Team give their commentary of the month past and Investment Outlook for March.
The MSCI UK All Cap NR index returned -9.2% during the three months to the end of February, underperforming the MSCI World ex UK (£) NR index which returned -4.8% in Sterling terms. The outperformance of international markets would have been reduced if it weren’t for Sterling weakness which increased international returns for UK based investors (MSCI World ex UK NR index returned -6.0% in local currencies).
Additional monetary policy easing allied with the announcement of a ‘phase one’ trade agreement between the USA and clarity on the Brexit issue, following the UK’s general election, helped equity markets perform strongly during the first part of the period, in local currency terms. However, concerns around the potential economic impact of the emergence of COVID-19 in China knocked investor confidence towards the end of January and more significantly in February.
In Sterling terms, Asia ex Japan was the strongest major regional equity index (MSCI Asia ex Japan £ NR index, +0.2%), helped in part by poor performance relative to other equity regions last year.
Gilts produced a positive return (iShares Core UK Gilts ETF, +3.4%) as investors grew concerned that the COVID-19 could impact global economic growth materially and that central banks may step in and manipulate government bond yields lower. Investment grade debt performed less well, albeit positively (iShares Core £ Corporate Bond ETF, +2.2%), whilst ‘riskier’ high yield debt (iShares Global High Yield GBP Hedged ETF, -0.7%) produced a negative return.
Concerns that demand would be reduced due to actions taken to reduce the spread of COVID-19 put downward pressure on the oil price in January and February.
The Brent crude oil price ended January at $50.5/barrel, a decrease of 19.1% since the end of November. The oil price rose initially as the view that global economic activity was stabilising gained ground and OPEC+ announced further supply restraint. However, concerns that demand would be reduced due to actions taken to reduce the spread of COVID-19 put downward pressure on the oil price in January and February.
The gold price rose 8.3% to $1586/oz in the quarter to the end of February. Sterling weakness boosted returns such that the value of gold held by UK based investors rose by 9.8% (to £1,243/oz).
Following a poor year in 2018, risk assets (such as equities and corporate credit) performed strongly in 2019. The first month of 2020 started off brightly but the news that COVID-19 had emerged in China impacted investor confidence as concerns increased that global economic growth could be impacted.
The major contributor to the positive change in investor sentiment during 2019 was the adjustment in stance by the Federal Reserve. In 2018, the central bank’s chairman made it clear that 2019 would herald a period of small but sustained interest rate rises. As economic growth slowed and risk asset prices fell in value, the Federal Reserve capitulated and in fact delivered three interest rate cuts during the year. This alongside the restart of quantitative easing in Europe, reduced the yield on government bonds materially and pushed investors into higher yielding ‘riskier’ assets. These central bank policies made it clear to investors that policymakers continue to believe that actively supporting asset prices remains a valid transmission mechanism for the delivery of sustained economic growth. Our belief that this is a perversion of the economic and investment cycle remains irrelevant for now.
At the tail end of the 2019, the US announced that a ‘phase one’ trade deal with the Chinese authorities had been agreed. Details are scant, but enough appears to have been agreed to postpone the insoluble strategic decisions that need to be taken until after the Presidential election in early November 2020. Furthermore, the progress to ratify the USMCA (United States, Mexico and Canada) free trade agreement helps diminish risk from this area as well. Both developments were rightly taken well by investors.
The breaking of the UK domestic Brexit impasse, and the avoidance of a socialist UK government via a decisive election victory for the pro-Brexit Conservative party, has also been supportive to asset prices.
Government bond yields had started to rise as the belief gained ground that the global economic slowdown was coming to an end.
Government bond yields had started to rise as the belief gained ground that the global economic slowdown was coming to an end. Whilst lower government bond yields supported risk asset prices earlier in 2019, it is interesting to note that share prices continued to appreciate despite the turn in government bond yields in the latter part of the 2019. The basis for this decoupling would appear to be that investors sensed that the profit warnings, so prevalent in economically sensitive stocks during 2019, may be replaced by positive trading updates in 2020.
However, there was a reversal of these trends during the first two months of 2020 as investors tried to assess the possible extent of the economic impact of COVID-19.
The reasons why investors were becoming more positive about economic growth going forward were several fold:
The belief was building that the Chinese have introduced enough stimulus to stabilise their economic growth rate, which has been slipping for some time. This view was supported by the strong performance of mid-sized mainland China property developers (listed on the Hong Kong stock exchange) which had in general, performed strongly in anticipation of better times ahead.
The US consumer remains in remarkably good shape.
In developed economies, labour markets, whilst strong, appeared to have become less tight which suggests that inflationary risks remain fairly muted despite real wage growth moving ahead at a healthy clip. In addition, the US consumer remains in remarkably good shape (good real wage growth, relatively low indebtedness and rising house prices) and they certainly have the wherewithal to prolong the economic upcycle given few signs of consumer overexuberance creeping into the domestic economy.
However, reasons for caution were being overlooked. US equity valuations were high relative to history and decent earnings growth was needed to return to justify observed market multiples, which now feels unlikely. In a slowing economic environment, the high levels of global indebtedness (both at the government and corporate levels) will become more of a focus.
One of the few justifications for holding government debt currently is that it will act as an insurance policy against an unexpected slump in global growth as quantitative easing will be fully deployed again, in this scenario, and this will support government bond prices.
Our working assumption is that the COVID-19 infection rate will fall away in the Northern hemisphere as summer approaches and this will be taken well by market participants.
As at the date of writing, our working assumption is that the COVID-19 infection rate will fall away in the Northern hemisphere as summer approaches and this will be taken well by market participants. However this is by no means a certainty and we will be continually reassessing this assumption in the coming days and weeks.
What is clear is that we can expect material stimulus (both monetary and fiscal). The G7 Finance Ministers and central bankers have pledged it, and the US Federal Reserve has followed through by cutting interest rates by 50 basis points. This will be supportive, but requires the COVID-19 infection rate to fall in the coming months to allow investors to push equity market levels back to previous highs.
Cornelian Investment Team