Market Comment 04/05/2020
Market Commentary - May 2020
Cornelian's Investment Team give their view of the previous month and outlook for May.
The MSCI UK All Cap NR index returned -19.3% during the three months to the end of April, underperforming the MSCI World ex UK (£) NR index materially, which returned -7.3% 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 evidence that the lockdowns were helping to reduce COVID-19 infection rates drove a recovery in asset prices in April.
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 -11.1% in local currencies).
In Sterling terms, Asia ex Japan was the strongest major regional equity index (MSCI Asia ex Japan £ NR index, -2.7%) helped by China’s (and the region’s) much reduced trend in new COVID-19 cases and the earlier opening up of their economies.
Gilts produced a positive return (iShares Core UK Gilts ETF, +5.8%) as investors grew concerned that COVID-19 could 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 as credit spreads widened in response to sharply slower economic growth (iShares Core £ Corporate Bond ETF, -1.9%). ‘Riskier’ high yield debt produced a sharply negative return (iShares Global High Yield GBP Hedged ETF, -9.6%).
The hard stop to global economic activity has seen a collapse in demand for oil products.
The Brent crude oil price ended April at $25.3/barrel, a decrease of 56.6% since the beginning of January. The hard stop to global economic activity has seen a collapse in demand for oil products. Announced supply side production cuts have yet to return the market into balance.
The gold price rose 6.1% to $1687/oz in the quarter to the end of April. Sterling weakness boosted returns such that the value of gold held by UK based investors rose by 11.3% (to £1,340/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.
Policymakers have clearly learnt the lessons of 2008 and have responded extraordinarily quickly.
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 in April.
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.
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, the implications for markets are likely to be profound and may include the anticipation of a return of inflation and all that that entails. Whilst this is not currently our central scenario, we remain very aware of the possibility of such an outcome.
Political pressure will be intense to continue to lend and we know that the crisis is probably time limited.
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 in 12-18 months’ time.
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 as the second quarter progresses. 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. This could knock confidence once again concerning the outlook for economic growth and company profits.
The early phase of the recovery is likely to be ‘credit friendly’.
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 been increasing 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, following the bounce in markets we have begun to reduce our exposure to UK and international equities somewhat, thereby locking in some of the near term gains in share prices.
Chief Investment Officer