Blog

By Kevin Miskin, Hottinger Investment Management

The UK experienced is sunniest spring since records began in 1929, according to the Met Office. Investors certainly saw few dark clouds in May as optimism spread over the nascent opening of economies and the potential for fiscal unity in Europe. But are there dark clouds of rising Sino-US tensions, negative interest rates, opaque company earnings guidance and a potential second wave of coronavirus looming on the horizon?

With China back at work for two months, much of Europe for two weeks and restrictions being eased in the US and UK, there have been almost no reports of a second wave of Covid. One exception could be South Korea where a spike in infections resulted in Seoul re-implementing lockdown measures at the end of the month. At the time of writing, markets have not reacted to this recent setback, but we watch with interest.

The economic backdrop remained mixed. Gross Domestic Product reports for Q1 painted a picture of the major economies heading towards recession; the US contract by 5%, the UK by 2% and China by 6.8%. The virus continued to take its toll on labour markets; 40 million American have filed for unemployment since the pandemic broke and the jobless count in the UK rose above 2 million for the first time in 1996. The unemployment figure would have been far worse in the UK without the furlough scheme which has helped protect over 8 million jobs but comes to an end in October.

Yet, there were signs of recovery. The Purchasing Managers Indices, which measure the prevailing direction of economic trends, started to recover globally in May, albeit from multi-year lows. Further, according to Neuberger Berman, on the ground credit card spending has picked up, as have contacts with estate agents, while some airlines have seen new bookings outnumber cancellations[i].

In terms of policy, central banks and governments continued to demonstrate that they have further firepower to deploy. In what could prove to be a milestone for the EU, the French and German governments proposed creating a €500bn recovery fund that would make fiscal transfers to the hardest-hit European countries without adding to their debt burden. For its part, the European Central Bank indicated that it stands ready to expand its €750bn pandemic stimulus programme of bond purchases should the need arise.

In the US and UK there was much talk about joining Europe in the introduction of negative interest rates. Central bankers, for the most part, have voiced their skepticism but the extent to which they have ruled them out has varied.  Bank of England governor Andrew Bailey said he was not contemplating negative rates in mid-May, only to say he was not excluding the idea a week later. His change of heart happened to coincide with a 3-year Gilt being issued with an average yield below zero for the first time. Meanwhile, the Fed has remained resolute that it does not intend to take rates below zero, despite repeated protestations from President Trump.

TwentyFour Asset Management noted that the minutes from the latest Fed meeting stated that it was prepared to use its balance sheet to keep “Treasury yields at short-to medium-term maturities capped at specified levels for a period of time”[ii]. Therefore, they believe, the US yield curve should remain relatively well anchored at around current levels until a recovery takes hold. Further, the Fed would like to keep a heathy level of steepness in the yield curve to assist the bank’s level of profitability while not allowing longer-dated yields rise too far to protect consumer mortgage rates. In such a scenario where duration risk is limited, medium dated high-quality corporate bonds should offer better value than shorter-dated high yield bonds where default risk remains uncertain.

In the equity market, US banks rallied strongly during the second half of May as investors clearly backed the prospect of a positive yield curve over negative rates. Other value sectors including industrials and materials also started to outperform towards the end of the month as investors bought into the prospect of an economic recovery. The broadening of the rally helped drive the S&P500 through the 3,000 level for the first time since early March. Elsewhere, European markets started to pick-up, buoyed by their bias towards economically sensitive sectors, the prospect of fiscal unity and government intervention; France will provide its car manufacturers with about €8bn of assistance and Germany will bail out Lufthansa to the tune of €9bn in exchange for a 20% stake in the company.

For the month as a whole, the technology and consumer discretionary sectors remained dominant, outpacing the banks and industrial stocks. The Oil & Gas sector remained under pressure despite a sharp recovery in the oil price.

By geography, Japan was the stand-out performer with the Topix index gaining 7%, followed by the US and Europe (+4%) and the UK (+3%). In contrast to western markets, stocks in Hong Kong and China ended the month at a loss. Beijing’s decision to pass a law curbing freedom in Hong Kong drew the ire of the US in particular. The Trump administration said that it no longer considers Hong Kong politically autonomous from China, a move that may jeopardize the city’s special trading status with America.

It is fair to say that there was encouraging news during May and we appear to have cleared the first hurdle of coming to terms with Covid-19 in China, Europe and the U.S.  Yet, risks remain. During the past month, UK chancellor Rishi Sunak warned the UK faces a “severe recession, the likes of which we have not seen”[iii], and US Federal Reserve chair Jay Powell told CBS news that US unemployment could rise as high as 20-25% over the next two months and a full recovery may take until the end of next year. Meanwhile in Europe, whilst the Franco-German fiscal plan marks a positive step forward, it has yet to be agreed by the so-called Frugal Four of Austria, Denmark, the Netherlands and Sweden. At least Britain is now a former member and not able to block it!

At a company level, 45% of S&P500 companies either revised or suspended guidance during the Q1 earnings season and analysts expect profits to fall by 20% this year, according to The Economist[iv]. ASR believe that corporate earnings will take longer to recover than markets expect having seen earnings take two years to recover after the global financial crisis in 2008 and, therefore, 2021 earnings estimates remain unrealistic[v]. Yet, global equities have rallied by more than 25% from their March lows and are just 8% from an all-time high.

In terms of asset allocation, we continue to believe we are seeing a strong bear market rally with insufficient fundamental information to establish a growth or earnings trajectory. Therefore, we remained defensively position during May, mindful of a second equity drawdown. We are, however, considering increasing our exposure to investment grade corporate bonds with medium duration as they offer a pick-up in yield and the opportunity for capital appreciation combined with relatively low risk.

 

[i] Neuberger Berman – Not Out of the Wood; May 24, 2020

[ii] TwentyFour Asset Management – Yield Curve Boosts Case for Longer Dated Credit; May 21, 2020

[iii] Bloomberg – Sunak Sees U.K. Recession on Scale ‘We Have Not Seen’; May 19, 2020

[iv] The Economist – An earnings season to forget; May 14, 2020

[v] ASR’s Ian Hartnett, CNBC’s Squawk Box Europe; May 14, 2020

 

 

 

By Tom Wickers, Hottinger Investment Management

In the wake of the Covid-19 crisis, very few companies have flourished. Those that had infrastructures tailored towards the lifestyles of homebound consumers, such as Amazon and Netflix, have been the main success stories. As such, Big Tech led the charge in the US April stock market rally, leaving the NASDAQ in the green for 2020[i] at the time of writing. The other main sector that has had a strong influence over market movements, albeit with scattered success, is the pharmaceutical industry. Global interest in pharma may never have been higher as a result of its potential to free up economies with new tools to battle the spread of the virus. While encouraging results for one pharma company do little to directly affect index values, the sentiment swings and resultant market movements can be compelling, demonstrated by Moderna’s vaccine news last week. Sentiment turns on a dime in these markets and pharmaceuticals have had a pocket full of them.

The pharma products that are being developed to combat the coronavirus can broadly be split into three categories: diagnostic instruments, treatments and vaccines. Progress in any of these areas bode well for the recovery of the economy. Diagnosis allows governments to implement more precision in their policies to stem the viral spread. Effective treatments lessen the load on emergency care facilities and should reduce the death rate, providing more capacity for higher infection rates. A vaccine is the holy grail and maps the route back to normality, provided it is scalable.

As Figure 1 shows, since the start of the pandemic, the global pharmaceutical sector has performed extremely well in comparison to the S&P 500 market, galvanised mostly by the momentous performance of a small number of companies. In particular, the biotechnology sector has outperformed even the FANG+ stocks which have shocked the world with their rapid recovery. Biotechnology focuses on medicines derived from living organisms, which is naturally more geared towards vaccine creation, suggesting a significant amount of the sectoral value creation has been developed in vaccine candidates and testing. The heft of the 10 FANG+ stocks should not be discounted, as the combined market value currently stands at $5.5T[ii] while the whole of the MSCI World Pharma, Biotech & Life Sciences index weighs in at $3.6T[iii]. Regardless, the contributions that pharmaceuticals and biotech have made to the recent stock market rally are notable, even before economic implications and sentiment shifts are accounted for.

Figure 2 exhibits the market performance for the business days surrounding big positive global pharma news since the start of the crisis. So far, these have all coincided with upward swings in momentum in the S&P 500, regardless of other news at play. While we only have a limited number of events to analyse, the sheer prevalence of pharmaceutical news in the financial press would support the conclusion that the effects on sentiment from news on coronavirus combatants are vast. The sentiment ties and strong industry performance together have meant that the correlation between global biotech and the S&P 500 has risen significantly since the start of the crisis, even on a relative basis, and what may come as a surprise is that it has risen even more than the correlation between the FANG+ stocks and the S&P 500[v].

The purpose of this article is not to encourage or discourage readers to invest in biotech. On the company level, finding treatments is an inherently risky business and on the sector level, it is difficult to say whether there is much more value to be extracted. However, what is clear is that if investors want to better understand and predict market movements in this crisis, then they should be keeping one eye fixed on the pharma industry and its developments as it currently has the power to move markets.

[i] The NASDAQ Composite Index was priced at 9,375.78 on May 20^th, 2020 according to Infront Finance data.

[ii] https://www.theice.com/fangplus, Market cap data as of close of business 21/05/2020 from Bloomberg

[iii] https://www.msci.com/documents/10199/ecd9bc5a-b100-4ff8-bfae-3e7340d04631

[iv] Hydroxychloroquine: On April 4^th, Donald Trump advocated for the drug and pressured health agencies to make it more available (https://www.reuters.com/article/us-health-coronavirus-usa-guidance-exclu/exclusive-pressed-by-trump-u-s-pushed-unproven-coronavirus-treatment-guidance-idUSKBN21M0R2)

Moderna vaccine: On May 18^th, Moderna announced that the phase 1 trials of their market-leading vaccine had shown positive results (https://investors.modernatx.com/news-releases/news-release-details/moderna-announces-positive-interim-phase-1-data-its-mrna-vaccine)

Remdesivir: On April 29^th, Gilead Sciences announced that they had received positive results from their drug that suggested it shortened the symptomatic period (https://www.gilead.com/news-and-press/press-room/press-releases/2020/4/gilead-announces-results-from-phase-3-trial-of-investigational-antiviral-remdesivir-in-patients-with-severe-covid-19)

Roche & Abbott antibody tests: Starting on May 3^rd,  Roche and Abbott Laboratories received a series of antibody test approvals from public health bodies, verifying the accuracy of the products (https://www.roche.com/media/releases/med-cor-2020-05-03.htm)

[v] The daily returns correlation coefficients (with the adjusted R squared values in brackets) between MSCI World Biotechnology & the S&P 500 from 3^rd February, 2020 to 21^st May, 2020 was 1.15 (R^2 = 0.83). The equivalent for the NYSE FANG+ index was 0.87 (R^2 = 0.78). The respective correlations for 1^st February, 2019 to 31^st January, 2020 were 0.51 (R^2 = 0.40) and 0.45 (R^2 = 0.65). Source: Bloomberg.

 

 

By Tim Sharp, Hottinger Investment Management

An extreme deterioration of fundamentals amid the COVID-19 pandemic would suggest that the global economy is currently in recession. A strong rally in equities over the course of the last 6 weeks has seen investors ignore the current environment and focus on the ability of companies to hit 2021 / 22 earnings projections. We remain defensive reflecting the on-going fundamental outlook for growth and earnings as well as the concentration in technology stocks once more leading the market. It may be true that these companies have benefitted from the lockdown environment and the take-up of cloud services has accelerated, but valuations are now looking stretched.

The difference between winners and losers is extended and although equity investors are eternally optimistic some of the comments in the financial media justifying the full valuations of technology companies is very reminiscent of the 1999 / 2000 technology rally in our opinion. It is true that growth stocks tend to have lower debt so are less likely to suffer from credit defaults and offer protection from a slow return to normality, however, it is going to be difficult for equity markets to push higher when many traditional sectors, most significantly financials, have not participated.

Many countries are focusing on the reduction in new cases and deaths due to Covid-19 and the move towards re-opening economies. As most European and Asian countries relax stay-at-home protocols and many US states re-open, some despite seeing no flattening of the infection curve, attention moves to tracking signs that lockdowns have been lifted too soon through a resurgence of the virus. Morgan Stanley make the point that once governments have lifted restrictions it is going to be very difficult to go back to full lockdown from both a country and individual perspective[i]. Therefore, many are looking at the Swedish experience to social distancing as perhaps the model for the future having remained partially open throughout the pandemic.

To us, this sounds like a gradual move forwards, containing virus hotspots as they appear, as well as increased testing, leading to a U-shaped recovery rather than the more optimistic V-shaped recovery that has fueled the equity rally. The strength and depth of government support has led many to believe in a shallower recession, but it may also make governments slow to react to a second wave.  There remains a risk that should there be a second wave of the virus caused by the early lifting of lockdowns, the global economy suffers a W- shaped, double dip recession. ASR further write that this bear market is a multi-factor crisis bringing together a biological shock, an oil shock, a credit shock and an economic shock and as such, may well see a multi-phase recovery with economic uncertainty that is currently underestimated[ii].

At the time of writing equity markets seem to have stalled as the realization that the economic recovery is going to be gradual and the risk to future earnings estimates is real. Market technicals also point to a major resistance level on the S&P500 at 2950-3020 and the index has backed away from that level over the last couple of days pointing to potential weakness in stock markets in the very short term. A potential catalyst to push markets higher may come from a rotation into deep value sectors such as Energy, Materials and Banks, but, many traditional sectors have not experienced such moves as investors continue to shy away from areas of the economy that have been substantially affected by the pandemic.

Major companies have been a significant support for stock markets through buybacks, and signs that programmes have been halted or scaled back, due to falling earnings, will remove a major buyer from the market. ASR believe that corporate earnings will take longer to recover than markets expect having seen earnings take two years to recover after the global financial crisis in 2008 and, therefore, 2021 earnings estimates remain unrealistic[iii].

In terms of asset allocation, we continue to believe we are seeing a strong bear market rally with insufficient fundamental information to establish a growth or earnings trajectory. Therefore, we remain mindful of a second equity drawdown that may re-test the lows depending on the signs that economies have opened too early. Positioning remains defensive with underweights in equities and corporate bonds in favour of cash. Finally, the poor starting point for government bonds, with yields so low, means investors do not receive a real return but this should not detract from the natural hedge that ten-year government bonds offer against equity weakness for multi-asset investors. Actively managing duration may be a better strategy than ignoring the negative correlation this relationship offers.

 

[i] Morgan Stanley Sunday Start – U is for Unicorn; May 10, 2020

[ii] ASR Investment Committee Briefing for May 2020.

[iii] ASR’s Ian Hartnett, CNBC’s Squawk Box Europe, May 14, 2020

By Tim Sharp, Hottinger Investment Management

The Covid-19 crisis has in many ways been unprecedented and aside from the human tragedy that has unfolded the effects have been very difficult for economists and investors to forecast with any degree of accuracy. As we have pointed out in previous articles, comparisons to previous crises have proven mixed because there has not been a global pandemic since the Spanish flu outbreak in 1918 and globalization and technology have changed society significantly since then.Many investors have decided that the 1st quarter reporting season is largely irrelevant because the fact that the world is in recession and companies are in lockdown is already known. The important issues are whether balance sheets are strong enough to withstand this cessation in activity in a manner that will allow them to meet 2021 and 2022 earnings estimates.

Many companies have turned to governments for help with emergency funding, others have gone to the corporate debt markets with new issuance and many bellwether companies are being questioned as to whether the disruption to operations poses a meaningful risk to balance sheet strength. Visibility over future profits has disappeared as companies suspend guidance for the year leaving investors to try and figure out what the global economy may look like in the medium term.

The shape of the recovery becomes key to the ability of society to return to normal or a new normal and companies to meet future earnings estimates. The ferocious sell-off in stock markets in February / March followed by an equally unbelievable recovery by certain sectors point to a belief by many in a V-shaped recovery. However, the economic forecasts suggest perhaps a U-shaped recovery or even worse an L-shaped recovery, not to mention a W-shaped or even theoretically a J-shaped (or Nike “whoosh”) recovery. But what does this mean and to what does it translate in real terms?

The shapes of recessions principally relate to the shape created by a basket of economic measures used by economists to measure a recession when plotted on a graph. The much talked about V-shape recession is characterized by a sharp economic decline followed by a quick and sustained recovery. In other words, the economy will quickly return to normal once the virus recedes with no lag or loss of momentum much the same as often seen following a natural disaster such as a hurricane or floods. If this crisis follows this path, then we would expect to see the unemployment rate that has spiked so strongly fall back just as quickly as economies re-open and people return to work. We would also expect economic activity to return immediately to pre-crisis levels as pent-up consumer demand is satisfied and pre-pandemic activity resumes.

Absolute Strategy Research (ASR) point out some differences between natural disasters and pandemics most notably that natural disasters tend to be geographically isolated events rather than having a synchronized global effect. Furthermore, natural disasters tend to provide an immediate stimulus to the economy as society physically rebuilds whereas pandemics tend to suffer a demand and supply shock through the quarantining of the population that depresses the possibility of output to recover its previous peak . We tend to agree that a V-shaped recovery looks unlikely and it will be a slow, cautious return of activity over a prolonged period.

The Global Financial Crisis (GFC) of 2008/09 caused a recession through damage inflicted on the financial sector through extended activities that were conducted “off-balance sheet” in what became known as the shadow banking sector. ASR reminds us of the rule that downturns which coincide with a financial crisis tend to be deeper and longer lasting than otherwise[i]. An L-shaped recovery is, therefore, characterized by a steep decline caused by plummeting economic growth followed by a shallower upward slope, indicating a long period of stagnant growth that can sometimes take several years to recover [ii]. We hope that the recovery from Covid-19 does not take 5 years or more to recapture its previous strength, but this may depend on the level of defaults seen within the corporate sector[i]. The levels of corporate debt have spiraled in recent years as companies have taken advantage of cheap finance to restructure their balance sheets and buy back shares. Therefore, the robustness of corporate balance sheets combined with the support provided by governments and central banks may hold the key to the strength of the recovery [ii].

ASR calculate that households appear to have significantly increased their savings since the start of the pandemic, which may be a sign that spending habits have permanently changed but is more likely to be the result of an inability to follow normal spending patterns due to the lock down. Although, consumption opportunities not taken will probably be lost to the economy it is likely that household spending could support a recovery[i].

The 1973 Oil shock caused rapidly increasing oil prices and led to the 1973-1974 stock market crash that affected most stock markets and economies in the developed world. Developed economies turned down in 1973 showing only slight signs of growth before recovering again in 1975 in what is often described as a U-shaped recover[ii] .

The current situation could also resemble a U-shaped recession if the steep decline into quarantine does not create a depression (L-Shape recession) with the return of a slow, cautious reappearance of economic activity over the next 18 months.

As governments start to formulate exit strategies and economies begin to re-open, should a V-shaped recovery take place then we fear that the acceleration to normal activity in the very short term could precipitate a second wave of the virus bringing us to a W-shaped recession.

A W-shaped recovery, often called a double-dip recession, is when an economy passes from recession to recovery and immediately turns back down into another recession which can be particularly painful for investors that are drawn in too early into financial markets by the swift recovery in activity.

The unprecedented relief offered by governments and central banks have underpinned the real economy in the short term and led many investors to bet on a V-shaped recovery in activity. For our part we favour a U-shaped recovery but as countries rush to re-open even though new outbreaks are still occurring, we fear a second wave of the virus in the autumn creating a W – double dip recession.

Policymakers may need to ensure that they follow up their initial support with additional relief measures once the economies have re-opened and the size of the challenge that lies ahead becomes more evident. The effectiveness of the economic and humanitarian policies in place for the next phase may well decide which shape the Covid-19 recession-recovery resembles.

 

[i] ASR – What shape will the recovery be? – Dominic White / Ben Blanchard – May 5, 2020

 

[ii] Investopedia – A Guide to Economic Recession – Jim Chappelow – April 20, 2020

By Kevin Miskin, Hottinger Investment Management

Ben Bernanke, former chairman of the US Federal Reserve (Fed) once said, “I’ve never been on Wall Street. And I care about Wall Street for one reason and one reason only because what happens on Wall Street matters to Main Street.”

During April, economic data confirmed that the US and Europe had entered recession and global activity was in freefall. This dismal scenario was corroborated by government bond markets where the benchmark US and UK 10-year yields posted their lowest monthly closes on record (0.64% and 0.23%, respectively) and the German bund yield slipped further into negative territory. Meanwhile, there was hiatus in the oil market where futures briefly turned negative for the first time in history due to the sharp fall in demand. Yet, in equity markets, April was the best month for the S&P 500 since January 1987, while FTSE All World index of global stocks recorded its best month since 2011. The question is, in this challenging climate, can Main Street take solace from the recent activity on Wall Street?

The International Monetary Fund (IMF) did not pull any punches mid-month with its view of the economic consequences of Covid-19 when it said the loss of output globally would “dwarf” the global financial crisis of 12 years ago, with most economies emerging 5% smaller than planned, even after a sharp recovery in 2021[i].

The economic data, thus far, would tend to support the IMF’s forecasts. In the US, gross domestic product fell by 4.8% in the first quarter and the virus has claimed 30 million jobs to date, which has resulted in a sharp decline in retail sales. Fed chair Jay Powell has warned of “considerable risks to the economic outlook over the medium term”.

It was a similar picture in Europe where the economy shrank by 3.8% over the last quarter, the fastest pace on record, with France posting its worst decline since 1949. Meanwhile, in the UK, the Purchasing Managers Index of service sector activity, which represents 80% of the economy, plunged to 12.3 in April having been comfortably above the expansionary watermark of 50 just two months prior.

Having been quick to respond to the onset of the economic downturn in March, central banks extended their list of policy actions further in April. The Bank of England started to finance the government directly, effectively increasing the latter’s account by an “unlimited amount”, thereby bypassing the process of quantitative easing whereby it buys gilts issued by the government.

Meanwhile, the US and European central banks made their first ever forays into the non-investment grade corporate bond market. They will allow themselves to buy the bonds of “fallen angel” companies, or companies that are downgraded from investment grade to junk. An immediate beneficiary was the Ford Motor Company, which having been downgraded to junk status in late March made the cut for the US programme by one day. More broadly, the pledges to buy riskier corporate bonds effectively placed a floor under the credit market and provided investors with a reason to buy, safe in the knowledge that the Fed and ECB had their back, without the banks themselves having to spend a cent.

For its part, the Bank of Japan (BoJ) removed the limits on its purchases of government bonds to allow it to exercise “yield curve control” by anchoring the 10-year yield at zero. TwentyFour Asset Management caution that the BoJ’s actions could be a prelude for other central bank actions. They believe the huge amount of issuance coming down the tracks to fund the enormous fiscal expansion could be inflationary and deter real money investors from buying longer-dated maturities given the paltry yields on offer[ii]. That would leave central banks as the dominant buyers with the long-end of the curve becoming not only risk-free, but return free, thereby pushing investors further towards the credit and equity markets.

April brought the first batch of US and Pan-European company earnings reports since the outbreak of coronavirus. By-and-large markets were primed for disappointing numbers as analysts had already been quick to cut estimates to 2008-09 levels, according to Barclays[iii]. With almost half of US and European companies having reported, earnings growth has been the lowest in a decade. Credit Suisse forecast that US companies’ earnings are on track to fall by 16% for the first quarter and may not fully recover for years[iv].

Within the banking sector, the central theme was billions of dollars being set aside for loan loss provisions, USD50bn being the latest estimate across the US and Europe. Consumer stocks including Adidas, Coke and Unilever reported sharp, often double-digit, declines in sales. Dividends were cut or suspended; Royal Dutch Shell cut its dividend for the first time since the war and the largest UK banks suspended payouts for this year and next, although the decision had effectively been made for them by the Bank of England. There were bright spots within the technology sector where companies such as Netflix and Microsoft were beneficiaries of the transition to working and being entertained from home; Satya Nadella, CEO of Microsoft, noted that two years of digital transformation had occurred in two months[v].

Nevertheless, almost across the board, companies were unable to provide guidance for future earnings. It is often said that “markets hate uncertainty”, therefore it was somewhat surprising that global stocks rallied to the extent they did. Clearly investors are more concerned with companies remaining solvent in 2020 and are looking to a brighter 2021.

Benchmark equity indices gained between 4% and 6% in the UK, Europe, Japan and China. However, it was the performance of US stocks that stood out with the S&P500 gaining 13%. If ever there was a reminder that the S&P500 has five names (Microsoft, Apple, Amazon, Facebook, Alphabet) making up 20% of the index, rather than a clearer representation of the real economy, this was it.

Following the latest leg-up in equity markets, valuations look rather rich. The MSCI Europe index is trading on a 15.2x forward price-to-earnings multiple, which is higher than its pre-COVID-19 crisis level. Meanwhile, the S&P 500’s forward multiple has risen to 20.1, well above the previous peak in February and now the highest it has been since April 2002. In terms of style, Quality and Growth stocks have become almost the most expensive on record while the more economically sensitive Value stocks trade at historically cheap levels. This would suggest investors are assuming that government bond yields are going to remain at or around zero for the foreseeable future and earnings are going to recover later this year or next.

We remain cautious. Bear markets have a precedent for luring investors back in too early. The world is amid a sharp slowdown and the full drawdown on corporate earnings has yet to be established. Further, the equity market rally that started in late March has been driven by liquidity rather than fundamentals.

On a positive note, at the time of writing, lockdown measures are starting to be eased to varying degrees around the world, which is a first step towards recovery. Yet, it is too early to know whether the quarantine measures enacted thus far will prove sufficient to suppress the spread of the virus, or whether further periods of containment will be required until a vaccine becomes available.

Even once the lockdown has been eased, global growth could remain subdued for a while and we anticipate a more moderate return towards normality than the V-shaped recovery currently being priced-in by equity markets.

 

[i] Financial Times, “Global economy to suffer worst blow since the 1930s, warns IMF”, 14^th April 2020

[ii] TwentyFour Asset Management, “The Beginning of The End For Government Bonds, 27^th April 2020

[iii] Barclays, “Result Snapshot – Not bad enough”, 30^th April 2020

[iv] Financial Times, “US stocks close out best month since 1987 in global rebound”, 30^th April 2020

[v] Microsoft.com “2 years of digital transformation in 2 months”, 30^th April 2020

 

 

By Laura Catterson, Hottinger Investment Management

“The ballot is stronger than the bullet” ― Abraham Lincoln

If you are at all familiar with US presidential elections, you will understand that in attempting to outlay the hurdles a voter may encounter, one can never be terse; therein lies the rub.

2020 is particularly vulnerable. This election season is confronted by this generation’s global pandemic. COVID-19 is poised to upend US citizens ability to cast their ballot unless voting by mail can resurrect a far from auspicious system. Evidence from states who have already implemented this method suggests it works well if preparations are made early and potential obstacles are foreseen, the largest of which are logistics and time. Thus, in order to save democracy’s most sacred institution, officials at all levels of government must make hay while the sun shines, and sleeps for that matter.

If you are eighteen years old, a US citizen and resident in one of the fifty states, assuming you are not a felon; you are eligible to vote.[i] Today, the pool of eligible voters is far broader and more inclusive than ever before; yet imperfection remains. Gaining access to the ballot box has been made more difficult by active efforts to suppress some groups from voting. These tactics, wrapped in a veneer of law include: voter intimidation, criminalization of voter registration drives, disguised poll taxes, gerrymandered districts (where the boundaries of an electoral constituency are manipulated to favour one party), hackable voting machines, voter poll purges and squashing access to voting on college campuses.[ii] Voter ID laws are also an extremely effective way of voter suppression. Over twenty-one million US citizens do not have a government issued photo ID which as a result, reduces voter turnout by two to three percent.[iii]

This year’s election, however, is unlikely to look like any other. Should COVID-19 persist, the need to keep people separated will present an unprecedented challenge in holding a nationwide vote.[iv] The potential risk of contagion at polling stations means a reliable alternative is key. Now backed by two thirds of US voters, voting by mail could be the required remedy.[v]

The urgency of implementing this method en masse, however, is becoming ever greater. At the time of writing, COVID-19 has forced fifteen states to postpone their presidential primaries or switch to voting by mail with extended deadlines.[vi] The general election in November however, a date prescribed by law; cannot be postponed, followed shortly by the constitutionally mandated inauguration of the next president on 20th January 2021.[vii]

To ascertain whether voting by mail is a viable option nationwide, we must examine current state examples and assess the logistical framework required for November. Colorado, Hawaii, Oregon, Utah and Washington represent the five states where most or all votes are cast by mail. Their experiences have yielded the following key findings: voter turnout is significantly higher, it is safe and secure and lastly, voters of all political persuasions use it and like it which is a milestone in and of itself. [iv]

During the 2016 election, nearly one-quarter of all voters cast their ballot by mail and as figure 1 highlights, it is steadily growing in popularity.

These findings are encouraging however, expanding this method nationwide in a matter of months is a herculean task and one which needs to begin today.

At a minimum, the following is required: printing tens of millions of mail-in ballots and envelopes; ensuring registered voters automatically receive one; can request a replacement if they do not; and can return it by election day.iv Additionally, in states where voting by mail is relatively low, they are typically not equipped with machines that can scan mail-in ballots on mass. Thus, administrators currently compare signatures on mail-in ballots against those on file in the voter registration database. If these states are to expect a spike in mail voting this November, more staff need to be trained, voter registration simplified, and technology upgraded. The latter of which can only be implemented if the limited number of vendors who can perform such a task are not already constrained by a sharp increase in demand.[vii]

Further provisions that must be made include public education on handling and returning ballots, as well as nationwide early voting availability so that should a person be uncomfortable or unable to vote by mail, they can do so in person whilst social distancing policies are still adhered to.

Reassuringly, efforts are already being made to implement many of the above measures. Senator Amy Klobuchar and Senator Ron Wyden have designed a bill to combat the implications of COVID-19 and any future diseases or natural disasters which cause similar disruption. The bill specifies, should 25% of states declare a state of emergency, mail-in or drop-off paper ballot options must be made available and that requests for a ballot can be made electronically. The bill would also provide the necessary funding for states to implement such measures.

This is promising however, it would be foolish to suggest implementing every necessary measure, nationwide, without error and within a matter of months, is achievable. Nevertheless, the US government has responded to the threat COVID-19 has had on the economy and the health of the American people and it is crucial it responds to the threat on democracy in kind.

Looking ahead, it is likely voter suppression will remain for years to come however, it is evident that with the expansion of voter rights, predominantly voting by mail which once refined across all states, will do much to combat such draconian efforts. Additionally, the fact that this method of voting is liked by both sides of the political aisle suggests its popularity is only set to continue growing as well as the demand for a fairer and more just political system.

For this year however, all that can be done; must be. A country that suffers from some of the lowest voter turnout in the developed world[viii] clearly needs an injection of voter confidence and convenience. Voting by mail provides just that however, democracy has a deadline and the clock is ticking.

[i] https://www.youtube.com/watch?v=P9VdyPbbzlI

 

[ii] https://www.theguardian.com/us-news/2019/nov/13/voter-suppression-2020-democracy-america

 

[iii] https://www.aclu.org/news/civil-liberties/block-the-vote-voter-suppression-in-2020/

 

[iv] https://www.nytimes.com/2020/03/21/opinion/sunday/coronavirus-vote-mail.html

 

[v] https://www.independent.co.uk/news/world/americas/us-mail-voting-november-election-trump-objection-a9479876.html

 

[vi] https://www.nytimes.com/article/2020-campaign-primary-calendar-coronavirus.html

 

Figure 1: eac.gov

 

[vii] https://bipartisanpolicy.org/blog/voting-by-mail-in-the-age-of-coronavirus-a-good-idea-but-not-a-total-solution/

 

[viii] https://www.pewresearch.org/fact-tank/2018/05/21/u-s-voter-turnout-trails-most-developed-countries/

 

By Tom Wickers, Hottinger Investment Management

“The inability to predict outliers implies the inability to predict the course of history” ― Nassim Nicholas Taleb

Over the last month, we watched from our windows as the world went quiet. Wuhan’s reality became ours, and social and economic systems have tumbled as a result. Very few economists had a global pandemic on their list of key economic risks, but the consensus has been out for some time now; the vast majority believe that we are already in a global recession[i]. The hotly-debated topic has become how long the downturn will last. Analysts’ forecasts of the recessionary damage and length are understandably wide-ranging as there are a plethora of unknowns still surrounding Covid-19 and we have limited economic data on the effects of the shutdown. While historic precedent should always be taken with a pinch of salt, it should help add some colour to these forecasts as well as our understanding of the current economic situation.

The current economic crisis is unique, like all that have come before it. However, what makes this downturn particularly extraordinary is that, purely from an economic perspective, it will be a recession that world powers entered entirely voluntarily. Governments have been attempting to press pause on the economy while supporting balance sheets and family wealth. Should the coronavirus pandemic pass as is currently forecast, the ability of the economy to return to the status quo will therefore depend on how well governments are able to execute this pause, to avoid structural losses, and how much damage is done to fiscal debt as a result. Regardless, a “pause” rather than a slip into recession means that economists are predicting a v-shaped bounce-back in earnings and GDP next year, similar to the 1974 Oil Crisis and other recessions caused by temporary shocks.

The most prominent economic forecast was released by the International Monetary Fund (IMF) this month, expecting US GDP to drop by 5.9% this year and recover by 4.7% in 2021. The Global Financial Crisis of 2008, the Oil Crisis Shock of 1974 and the Great Depression of 1930 are three recessions that put this new GDP forecast into perspective. Figure 1 demonstrates that while this US downturn is not expected to resonate on the same level as the infamous Great Depression, it is shaping up to be the sharpest we have seen in modern times. Furthermore, despite the IMF forecast being released only this month, Kristalina Georgieva, the managing director, has already clarified that it may be overly optimistic[ii]. Forecasts on unemployment paint a darker picture, with the Federal Reserve Bank of St. Louis estimating that it could reach 32.1%[iii] in Q2. This rate would likely be short-lived and requires certain levels of social distancing to be maintained, but it would represent the highest figure since records began.

Translating the economic data into what we would expect from markets from history, Figure 2 provides a clear depiction of one of the reasons why a lot of investment houses are predicting another leg down in stock prices after the recent rally we have experienced this month[v]. It would be unprecedented if the S&P 500 were to make sustained gains this early on in an economic crisis, before the extent of the initial damage has even been fully realised. The need to de-risk and preserve capital has meant that the previous recessions referenced below have required at least 10 months before the stock market has made gains relative to the industrial production index; an indicator of economic health. Therefore, even with the fact that this crisis is expected to be relatively brief, it is difficult to believe that the current rally will continue upwards after just two months, particularly as the economic data are looking dismal for at least the next year. Valuations are also currently poised on the optimistic side of Covid-19 forecasts; prices are reflecting a strong v-shaped recovery[vi] with no severe reoccurrences of the virus, no particular difficulties in vaccine creation and little in terms of economic structural shifts out the backend of the crisis. The counterargument in support of further upside is that once you ‘give investors confidence that the worst is behind them, history suggests they can put up with quite a bit of bad news’[vii]. If we truly have already turned a corner as some investors believe, with global self-isolation restrictions gradually easing, then markets may continue to tick up from here.

Given the freshness of the current economic crisis and the level of uncertainty that remains encompassing both its depth and longevity, to say we are out of the woods feels premature. Covid-19 has proved to be both pervasive and stubborn. As lockdowns have eased across Asia, cases have once again been on the rise[x], proving we do not yet have a clear route back to a functioning society. Equity investors tend to be intrinsically optimistic, which introduces substantial downside potential should news disappoint. However, optimism and foresight also mean that equity markets bounce well before economies recover, and the potential for substantial positive news in the form of a cure or excessive stimulus should not be discounted. Nevertheless, to chase a bear market rally is treacherous and currently caution mixed with occasional opportunism appears to be the sensible approach.

 

[i] https://markets.businessinsider.com/news/stocks/recession-coronavirus-bofa-says-record-number-fund-managers-expect-survey-2020-4-1029090262

https://www.ft.com/content/8ccae8d2-6eb0-11ea-89df-41bea055720b

[ii] https://www.bbc.co.uk/news/business-52326853

[iii] https://www.stlouisfed.org/on-the-economy/2020/march/back-envelope-estimates-next-quarters-unemployment-rate

[iv] https://www.imf.org/en/Publications/WEO/Issues/2020/04/14/weo-april-2020

https://fred.stlouisfed.org/series/GDPC1

[v] According to positioning in Business Insider’s Global Fund Manager Survey

https://markets.businessinsider.com/news/stocks/recession-coronavirus-bofa-says-record-number-fund-managers-expect-survey-2020-4-1029090262

https://www.cnbc.com/2020/04/08/data-from-investor-howard-marks-shows-why-there-may-be-another-drop-in-stocks.html

[vi] Absolute Strategy Research, ‘Equities Not at Trough Valuations’, 9^th April 2020

[vii] Morgan Stanley Sunday Start, ‘Short-Term Pain for Long-Term Gain’, 16^th April 2020

[viii] The start of the crisis is determined as the month when the Industrial Production Index started deteriorating.

[ix] https://fred.stlouisfed.org/series/INDPRO

[x] https://www.ft.com/content/2f55acf0-ca7b-4d7c-8ccb-971c96342ca9

By Kevin Miskin, Hottinger Investment Management

The coronavirus-related fall in global stocks that started in mid-February continued into March and spread to other asset classes. In the US, the S&P 500 suffered its fastest decline into bear market territory on record, bringing to end an 11-year bull market. In commodity markets, a surprise oil price war erupted during the first few days and by mid-month, near-panic had set in. Credit markets almost seized up, while US Treasury yields and currency markets experienced wild swings. In a nutshell, investors rushed for dollars and cash like some shoppers rushed for toilet paper.  

Sentiment improved in the second half of the month, following a swathe of policy initiatives from central banks and governments. The US Federal Reserve (Fed) cut rates to zero and adopted Mario Draghi’s famous mantra of “whatever it takes” to keep liquidity flowing through the banking system. Purchases of Treasuries and selected mortgage-backed securities will be unlimited and, critically, the Fed will purchase corporate bonds for the first time in its history. Within twenty-four hours of the Fed’s announcement, an unprecedented fiscal stimulus package of tax breaks and spending – worth more than $2 trillion – was agreed by the Republican and Democrat parties. 

The policy response was similarly substantial, swift and unprecedented in the UK and Europe. In the UK, the new chancellor Rishi Sunak introduced a fiscal stimulus programme that included loans and grants to businesses to help keep them afloat and wage subsidies for firms of 80% to encourage them to retain their workforce. Meanwhile, the Bank of England cut interest rates to 0.1%, the lowest level ever, and launched a £200bn money creation scheme. For its part, the European Central Bank launched a EUR750bn Pandemic Emergency Purchase Programme, which included the lifting of its self-imposed limit on the amount of eligible sovereign bonds that it can buy from any single member country. 

These coordinated policy measures had the desired response, assuaging investors’ fears and bringing some kind of normalisation across asset classes. The dollar weakened, credit spreads tightened and equity markets posted double-digit gains from their lows, with the S&P 500 index recording its largest three-day advance since 1933. 

Yet, despite the rebound in the final week of the month, risk assets posted sharp declines for March as a whole. On aggregate, US, European and Japanese stocks fell between 10% and 12%. For a second consecutive month, China held-up relatively well, posting a decline of 4.5%. By contrast, UK stocks underperformed; the FTSE 100 fell by 14%, thereby closing-off its worst quarter since 1987.  

Part of the reason for the relative underperformance of the FTSE 100 was its high weighting in oil stocks. The price of Brent Crude almost halved to $25 during March, after Saudi Arabia and Russia engaged in the surprise price war mentioned above. The two countries have refused to scale back production despite demand falling by a quarter. Storage capacity has become scarce to the point where it might become cheaper to leave oil in the ground for some producers, including US shale companies, which are believed to have a break-even price of around $50 per barrel.  

With the oil sector under particular pressure, it is not surprising that the contagion effect has spread to credit markets, where the US energy sector – largely shale drillers and pipeline companies – accounts for 11% of the ICE High Yield Bond Index. The outlook for the broader corporate bond market is interesting. On the one hand, the level of support from the authorities is unprecedented and should limit an inevitable rise in defaults. In addition, yields have risen sharply at a time when equity dividends and buybacks are being cut. On the other hand, there will be a surge in downgrades and there has already been a sharp rise in ‘fallen angels’ (investment grade companies downgraded to high–yield), including Ford.  

Government bonds yet again helped to mitigate some of the losses incurred from risk assets. The Citigroup G7 Global Government Bond Index gained 4.4% in March. The 10-year US Treasury yield fell to 0.68% from 1.15% at the start of the month, while the 10-year Gilt yield ended the month at 0.36%. Whilst the vast amount of QE that is being implemented currently has suppressed government bond yields and flattened the curve, there may be a limit to how low yields can go once the vast amount of sovereign issuance commences in order to help fund fiscal spending. 

At the time of writing, there is still great uncertainty with regards to when the virus will reach peak levels in developed countries, thereby allowing economies and markets to look towards a sustained recovery. The recent economic data has been stark, reflecting the initial impact of the virus, with unemployment rising sharply, manufacturing in decline and inflation falling. In addition, companies have been cutting or suspending their earnings guidance due to lack of clarity. Capital Economics has forecast that US company earnings for this year could fall between 40% and 60%, in stark contrast to the 10% increase expected just three months ago. The Schiller cyclically-adjusted price-to-earnings ratio has already fallen from 32x on 19th February to 25x, but remains somewhat higher than at its trough during the financial crisis. Therefore, it is difficult to class equities as cheap, despite the dramatic falls seen over the past three months, and we would not be surprised if there was further weakness in prices. 

It may come down to the ‘haves and have nots’; those companies which have access to cash and those that do not. Companies that are able to take on debt are doing so in abundance and will survive, although they will likely suffer lower credit ratings and earnings. Those with no access to the debt market may face solvency issues or long-term capital impairment. Either way, valuations may face further downward revisions before markets can find a bottom. 

But there is cause for hope, largely due to the coordinated fiscal and monetary response. For example, it took the US authorities just one week to act, as opposed to two months during the Great Financial Crisis (GFC). In addition, the fiscal stimulus will be like nothing seen outside of wartime. The G4 plus China are preparing to raise their total fiscal deficit to 8.5% of GDP, compared to 6.5% during the GFC, according to Morgan Stanley. We also should look to China where, reportedly, activity is 85% back to normal. 

In terms of asset allocation, we have maintained a defensive stance and closed the month with higher levels of cash and lower equity than normal. We are compiling a shortlist of favoured equities and funds which we expect will be best–suited to a post-Covid-19 world. 

In this uncertain time, we wish all of our readers and their loved ones good health. Keep safe and stay connected!

 

By Jolette Persson, Hottinger Capital Partners

To ease the economic slowdown caused by the pandemic, governments around the world are announcing their versions of a stimulus package coupled with interest rate cuts as much as half or more. Despite this, markets have continued to sell off. We know that monetary policy operates with a lag (typically 6-12 months) so we were unlikely to see instant relief in markets or the economy, but coupled with fiscal measures, which have more of an immediate effect, this should help to ensure business continuity as navigation through difficult waters persists. We recognize, however, that neither type of measure will prevent a recession from happening, but it’s hoped they will support liquidity and provide a floor to the inevitable losses in the current climate.

The US +$1tn stimulus proposal plan recently announced is designed to cushion the impact of the slowdown on households and businesses and will include deferred IRS payments of $300bn and $1,000 cheques cut directly to Americans. The UK has issued a smaller – but nonetheless large – emergency rescue package of £350bn for businesses, which will include government grants for retailers, restaurants, and pubs in need. Further discussions are currently taking place around potential support packages for airlines – which at the current rate are widely forecasted to go bankrupt by May – and airports, to be announced in due course. In response, sterling has experienced what appears to be its worst sustained selling period in 35 years. The sell-off reflects the fact that investors are coalescing around the comparatively safer USD and showing a lack of confidence in the UK government to tackle the current crisis. It is also unclear how the UK plans to finance its emergency package, which will most likely require heavy borrowing. Even so, exactly how effective this will prove to be is yet to be determined, particularly as fiscal policy response to the coronavirus so far has been relatively benign. It will also come down to how successful the virus containment measures prove to be. [i]

At the time of writing, China has – for the first time since the start of the virus outbreak – reported no new local infections, showing that its actions to contain the virus have been effective. [ii] That said, this has been achieved at substantial liberal and economic cost, and furthermore the hiatus in new infections does not guarantee that there won’t be a resurgence as citizens return to work. The suspension period has pushed many businesses into bankruptcy, and as China sets off for a rebound in production, we do not expect this to happen at a fast pace, especially given the reliance on European business activity which seems to be decelerating by the hour. [iii]

In the UK alone, the hospitality, tourism, leisure and retail sectors have all suffered an unprecedented drop over the last week. Many businesses have decided to close their doors for the foreseeable future, which has to led thousands of workers losing their jobs overnight. As the government advises UK citizens to stay away from social gatherings, restaurants and pubs without officially forcing owners to close their premises, we will undoubtedly start to see more businesses file for bankruptcy in the absence of better fiscal support. One could describe the situation as catastrophic, and it leads us to expect a plunge in employment rates by the end of this quarter. The hospitality industry alone employs more than three million people across the country. Retail – already a struggling industry which saw a record number of store closures last year – is on pace to double that this year not just in the UK, but globally. [iv]

We are yet to see these drastic changes showing up in the official data, but it certainly feels inevitable that output across Europe will experience a sharp decline in the first quarter of 2020, triggering a linked recession in larger European economies. The severity of such a scenario will depend on the actions taken by policymakers next. So far, despite recent efforts, policy response does not nearly make up for the cost of the epidemic, which at this rate is estimated to exceed $3tn as it continues to shave off global GDP growth. [v]

Monetary stimulus continues to roll out. The European central bank (ECB) recently announced that it would buy €750bn worth of bonds to improve liquidity and decrease the cost of financing to make it easier for eurozone governments to support domestic businesses. Shortly afterwards, the Bank of England announced billions of pounds’ worth of its own bond purchases and proceeded to cut interest rates once more, which brought its benchmark rate to 0.1%, a record 325-year low. Though bond markets welcomed this news, we continue to see a lack of fiscal policy to follow. Businesses close to bankruptcy may not exactly be jumping at the opportunity to leverage up their balance sheets when business sentiment is at rock bottom. [vi]

Finance ministers need to provide liquidity support through fiscal policy to assist business owners in paying wages and keeping their employees on the payroll. Such efforts would include granting reduced working weeks (such as ‘Kurzarbeit’ in Germany), parental pay schemes as schools continues to close and deferring the collection of VAT and payroll taxes until the crisis is over. The aftermath of this crisis will be different from that of the financial crisis in 2008, as consumption then took longer to recover due to unsustainable debt levels. This time around, we expect manufacturing to pick up fairly swiftly in a “V-shaped” recovery. All social consumption, however, will first have make up for lost time, and as such is likely to experience a prolonged recovery period.

[i] https://www2.deloitte.com/us/en/insights/economy/global-economic-outlook/weekly-update.html

[ii] https://www.nytimes.com/2020/03/18/world/asia/china-coronavirus-zero-infections.html

[iii] https://www2.deloitte.com/content/dam/Deloitte/dk/Documents/about-deloitte/Corona%20impact%20monitor%20-%20Mar%202020.pdf

[iv] https://www.bbc.co.uk/news/business-51923804

[v] https://www.bloomberg.com/graphics/2020-coronavirus-pandemic-global-economic-risk/

[vi] https://www.ecb.europa.eu/press/pr/date/2020/html/ecb.pr200318_1~3949d6f266.en.html

 

By Tim Sharp, Hottinger Investment Management

If we look back to the end of 2019, it was clear to us and our advisers then that the fundamentals underlying the financial markets were fragile and potentially vulnerable to an unknown shock that questioned the market’s expectation of future growth. We were advocating for caution due to the potential for a global recession as a result of tight monetary policy and a lack of the central bank stimulus necessary to maintain positive global growth.

The contagion of the coronavirus outbreak may have laid bare the over-valuation of financial markets and drastically altered the macroeconomic outlook for this year. As we see it at present, there are four main unknowns: [i]

It is unknown how far coronavirus cases will spread – both in terms of number and geography – before the global peak is reached. Statistics from 12^th March Absolute Strategy Research (ASR) would suggest that China is the only country, out of the 110 globally with registered cases, that has seen a levelling off of new cases. Asia (excluding China) is still seeing the number of cases increasing, as are Europe and North America, which means that the virus is not contained at this time. The best-case scenario based on the collated data is that the virus is brought under control during the month of April, when the economic fallout of the outbreak can be assessed.

At this time, the second unknown is consumer behavior, whether it is stockpiling during the epidemic or the willingness to return to normal consumption after the virus has been contained. Evidence would suggest that it took consumers 6 to 9 months to return to normal behavior after SARS, which calls into question the likelihood of a V-shaped recovery in the second half of the year.

The third unknown relates to the extent of the supply-side chain damage that is being sustained during the outbreak. For a company to change its parts supplier temporarily during a period of difficulty is one thing, but to have to implement such a supply chain adjustment permanently has more long-term consequences for the global economy. The impact could be similar to that of the US on-shoring that took place following the tax breaks in 2017.

The final unknown is the effectiveness of the central banks’ and governments’ policy response that has so far seen significant monetary policy easing from the US, Canada, UK and Australia, as well as an increase in QE from the European Central Bank (ECB). We have previously documented our belief that the strength of the dollar is fundamental to the growth of the global economy, and we feel that it may require a coordinated fiscal response outside of the US to stimulate the wider global economy. The strength of the Euro vs. USD, for example, will only be overcome in the long-run by employing a policy response that is wider-ranging than cutting rates and increasing TLTRO (targeted longer-term refinancing options) spending.  At this time, however, the countries of the eurozone are not in agreement as to the best way forward for policy coordination.

The breakdown of the OPEC+ discussions has laid the foundations for a possible oil price war instigated by Saudi Arabia and largely influenced by the actions of Russia. The immediate fallout of a 35% depreciation in the price of Brent Crude from $51.60 to $33.30 is an indication of the likely result of there being no supply quotas in place for the major oil producing countries. The result of a prolonged oversupply of oil, other than a potential $20 per barrel handle, could have a more significant effect on the global economy than even the coronavirus.[ii]

The fiscal breakeven Brent crude oil price for major oil suppliers provided by Absolute Strategy Research (ASR) makes for interesting reading and there is potential for two effects to unfold[iii]. Firstly, Saudi Arabia has a fiscal breakeven of $84, despite having one of the lowest costs of supply. In previous periods of low oil prices, markets have seen sovereign wealth funds selling down liquid assets such as equities in order to maintain the domestic agenda. We have seen no evidence that this type of action has happened as yet, but we remain alive to such a scenario of forced selling. Secondly, the figures show that Russia’s fiscal breakeven is $42, while alternative providers such as US shale and Canadian oil sands having breakeven prices of around $50. This clearly leaves Russia with a margin to put pressure on the new oil producers in countries that have been thriving on high oil prices arguably created due to the US policy of imposing sanctions on Russia and Iran. It will be interesting to see how this unfolds, particularly if the oil price stays at a low enough level to lead to the shuttering of US wells.[iv]

China is seeing the beginnings of a return to normal activities, with reports calculating that the economy has returned to 50% of its pre-lunar new year capacity when the rest of the world is yet to see the peak impact of the virus.i Assuming that other countries have to follow a similar or even longer timeline to China, it is likely that estimations that the outbreak will persist well into the second quarter may prove to be accurate.

Most developed market equity indices have moved into bear market territory (i.e. fallen more than 20% from the February 2020 record high) suggesting that the financial markets are beginning to price in the possibility of a global recession in 2020. The core view that we have seen is that the 1^st half of this year will see a technical recession and a peak in the epidemic, leaving the global economy to recover during the second half of the year. The downside risk to this scenario is that the virus containment is not as successful as currently expected and affects activity in the third quarter as well. This may then start to have a significant effect on the supply-side, impairing the ability of the global economy to bounce back quite so successfully and pushing the global economy into a deeper recession.i We are not so sure that this scenario is priced into equity markets, so we still remain cautious of calling the bottom of the market here.

The upside scenario is that the containment timeline could be correct and coordinated stimulus from major countries including China and the US may be effective enough to generate a strong recovery, however, at this time we do not have enough information to make informed decisions.

Any economic statistics that have been released recently relating to pre-virus contagion are largely irrelevant, so markets will remain volatile until fundamentals can be evaluated properly and we expect to see further earnings revisions.

[i] Absolute Strategy Research – Contagion Effects, 12 March 2020

[ii] Capital Economics – Oil price slump not a positive for global economy, 9 March 2020

[iii] Absolute Strategy Research – Investment Implications of possible Covid-19 Scenarios, 10 March 2020

[iv] Absolute Strategy Research – Oil shock adds to Coronavirus crisis, 10 March 2020

By Jolette Persson, Hottinger Capital Partners

There has been a clear spike in corporate profit warnings in the last three weeks. Apple was one the first of many US companies to publicly cut its revenue outlook driven by China’s slowing economy which in recent weeks has dampened further due to the spread of the coronavirus. The profit warning was narrowed down to an anticipated decline in iPhone sales in China and slowing pace in production. [i] Microsoft in parallel also issued a profit warning statement, particularly focused on its Windows and Surface businesses, due to supply chain disruption caused by the virus as the segment relies heavily on production operations in China. [ii] Similar to Apple and Microsoft, companies across geographies and industries are lowering their first-quarter forecasts, most notably in luxury goods, automobiles, leisure, airlines, technology and banks. Just in the UK, more than 100 UK-listed companies have now warned its investors about potential impacts of the coronavirus on their business. [iii]

Concerns over further escalation extends to global governments and central banks. Most recently in an attempt to soften the blow experienced in the US economy in the short-term, the Fed on the 3^rd of March decided to reduce rates by 50 basis points. [iv] Bank of England governor, Mark Carney, shortly after signalled that it was also prepared to cut interest rates in an attempt to keep current supply chain disruptions temporary as opposed to a permanent impairment in supply. [v] Economists are not ruling out the possibility of a global recession, especially if global growth in 2020 disappoints from what is already a relatively modest forecast. The recent decline in the oil price, which to a large extent reflects the deterioration in Chinese consumption, has aided our concerns about the global economy. Particularly, as we remain in a close to zero inflation environment. Though, it’s worth emphasising that there are yet clear signs of real economic damage, with unemployment rates left relatively unchanged since the beginning of the year, and consumption still in decent health outside that of mainland China. If a recession was to occur, it will likely hold little resemblance to our last seen financial crisis in 2008 (shockwave in demand) as banks went bankrupt, home prices plunged, and stock markets bottomed. This crisis would more likely evolve around a lack of supply, leading to a slowdown in economic activity.

So far corporate profit warnings have been concentrated around companies whose business is fed by a global supply chain. Companies without direct links to the disease have not experienced the same correction in revenue forecasts and/or share prices,  although, potentially, yet to be announced. We will continue to monitor this under the assumption that a global recession may not be as imminent a threat if this remains unchanged. In the meantime, there are some sectors with certain business models that might even stand to benefit from the current “quarantined” situation. With companies and governments encouraging people to avoid travel, work more from home, and self-isolate, companies catering to consumption through domestic internet services such as Amazon, Netflix, online education, online gaming and other home entertainment could be rewarded. These assets might serve as short-term stress reliefs in portfolios. What we as investors are more concerned with, however, is the long-term story.

There is a possibility that the market is overreacting, particularly in areas outside of Asia where the spread of the virus continues to remain relatively low and with stark measures in place for containment. Yet, major indices worldwide have lost trillions of dollars in value over the last few weeks. That said, however, we feel that perhaps markets may still be overvalued with some way to go before getting close to their intrinsic value.

When studying the effects of previous outbreaks of respiratory viruses like SARS and MERS (see figure 1), markets remained volatile in the short-term followed by a longer recovery period. With that in mind, although we do not think we have seen the bottom of the market yet, this could serve as an attractive inflection point, though it is still too early to tell. Markets will typically start to price risk correctly following a period of unchanged fundamentals. Potential positive catalysts  include the number of infected people outside of the mainly infected areas decreasing, suggesting that the virus is getting contained, workers returning to their regular schedule and production activity in China picking up. As we are yet to see any of this, the situation remains volatile and impossible to predict.

[i] https://www.ft.com/content/ab59aac6-51ce-11ea-8841-482eed0038b1

[ii] https://www.nytimes.com/2020/02/26/technology/microsoft-coronavirus-earnings.html

[iii] https://www.cityam.com/132-uk-companies-issue-coronavirus-warnings-as-ftse-100-spirals/

[iv] https://www.wsj.com/articles/federal-reserve-cuts-interest-rates-by-half-percentage-point-11583247606

[v] https://www.ft.com/content/2b0dfbc6-5d4d-11ea-b0ab-339c2307bcd4

 

By Kevin Miskin, Hottinger Investment Management

In last week’s blog, we noted that the global economy could enter recession within the next 12 months and urged caution as the risks to financial markets were weighted to the downside. At the time, however, we believed that markets would remain relatively benign until closer to Easter.  If, as Harold Wilson famously once said, “a week is a long time in politics” then it can seem an absolute eternity in investment markets.

During the first three weeks of February, the S&P 500 climbed to an all-time high and European stock markets reached levels not seen since the financial crisis as the broad consensus held that the global economy would avoid recession in 2020. Headline PMIs had troughed in October and PMI new orders were improving. US and European company earnings for Q4 2019 had exceeded expectations and high single-digit earnings growth was forecast for this year. There was a further assumption that as long as the coronavirus could be contained within China, the impact on global economic growth would not be too severe. However, with news of the virus spreading around the globe (notably in Japan, South Korea and Italy) towards the end of the month, this base case scenario was shattered.

The market reaction was both swift and severe as global equity indices fell into correction territory (a downward move of 10 per cent) in the shortest time period ever. For February as a whole, the MSCI World Equity index fell by 6.7%. The UK led the declines with the FTSE100 falling by 9.7%. Elsewhere, the major US, European and Japanese stock markets fell between 8% and 9%. Ironically, China became a port in a storm, with the Shanghai Composite index appreciating by almost 5% after markets returned from the Chinese New Year.

In the early stages of the coronavirus outbreak, Asian equity markets and cyclical sectors, such as transport, understandably bore the brunt of the selling. However, more recently it has been the ‘winners’ of last year that have come under pressure, including US Equities, technology, growth and quality.

The increasing chances of Bernie Sanders becoming the Democratic presidential candidate has also cast a pall over certain US sectors. His radical agenda includes breaking up banks by reinstating the Glass-Steagall Act, imposing a financial transaction tax, capping interest rates on consumer loans, increasing taxes for the super-rich and cancelling student debt.

In commodity markets, Brent Crude suffered a decline of 16.5% to $50, having traded at $70 in early January. Oil consumption in China has fallen by a quarter since the outbreak of the virus. Saudi Arabia is attempting to stem the price leakage by calling for a concerted cut in production of 1 million barrels per day, of which it has offered to bear the lion’s share. However, at the time of writing, Russia appears reluctant to fall in line. Gold initially fulfilled its role as a safe haven, rising to a 7-year high of $1,688, but ultimately gave up its gains to end the month in marginally negative territory.

The ultimate safe haven asset proved to be long-dated government bonds. Over the past two decades, the negative correlation between equities and bonds has hardly changed, despite ever-lower yields. The reason is that it is not the level of yield that provides the hedge, but the sensitivity to the change in yield, which comes from the length of duration. Therefore, even with today’s low/negative bond yields, having some duration in portfolios mitigated some of the losses from the equity market correction. The yield on the US 10-year Treasury closed the month at a record low of 1.15%, down from 1.51% at the end of January, representing a capital return of 3.3%. The UK 10-year gilt fell by 8 basis points to 0.44% and the German benchmark bund yield fell further into negative territory, ending the month at –0.61%.

At the short-end of the curve, the US 2-year Treasury yield has fallen below 1%, implying that the US Federal Reserve is expected to cut interest rates by 75 basis points by the end of the year. Meanwhile, the 30-year US Treasury has fallen to a record low of 1.7%, which suggests investors have become concerned about the sustainability of any longer-term recovery.

At the time of writing, the spread of the virus is accelerating outside of China and analysts are in the process of downgrading their predictions for global growth and company earnings. A Bloomberg poll of analysts has global growth predicted to fall to 2.8% this year, which would be the lowest rate since the financial crisis.

According to Absolute Strategy Research (ASR), we are at a crucial stage in the coronavirus narrative. During previous episodes when bond yields and equity markets have fallen to this extent, the relative valuation between the two asset classes has seen investors move back into equities. However, should risk assets fail to rebound during early March, ASR cautions that investors may start to focus on the potential for further supply chain disruptions with negative implications for global markets.

The disruption to global economic activity for Q1 may have now largely been discounted by markets. The question is whether the virus outbreak will be contained by the end of March or whether it will expand in terms of duration and geographic reach.

On the positive side, the slowdown in growth could yet prove to be short-term. In addition, recent political shifts towards anti-globalisation could ultimately prove to be beneficial; in Europe, companies have been stockpiling ahead of Brexit, while in the US companies have been forced to overhaul their supply chains as a result of the trade war with China. There is also hope that the spread of the virus could be curtailed as the weather turns warmer.

We believe a more likely scenario is that the disruption will continue into Q2 and result in a tightening in financial conditions. Central banks will likely respond with even easier monetary policy and governments may open the fiscal taps, which could provide short-term support for risk assets.

We were relatively cautious entering February and reduced equity allocations where appropriate as the virus spread beyond China. In the current environment, we will monitor developments while coronavirus fears continue to obscure the outlook for global markets until such a time as there is more clarity.