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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.

By Tim Sharp, Hottinger Investment Management

Global monetary conditions remain tight and the risks for financial markets are weighted to the downside. We continue to believe that there is a tangible risk of global recession within the next 12 months and will maintain our cautious stance in the near term.

The coronavirus has started to affect supply chains, underlining our prediction that the next likely inflection point will be around the beginning of the second quarter. This will coincide with first quarter reporting, the selection of the Democratic candidate for the US Presidency and the forward-looking tendencies of equity markets to be focusing current economic forecasting on Q420.

There is now evidence, as reported by Apple Inc, that the coronavirus is affecting global supply chains and is predicted to have a significant effect on Chinese Q1 growth and the wider prospects of the Asia Region. Japan is now predicted to enter a technical recession in the middle of 2020 – this is based on the slowdown in activity with China, South Korean President Moon Jae-in’s call for “emergency steps” to support the economy and Singapore’s unveiling of a $6.4bn virus-related stimulus package.

We recently highlighted in our China / India article that a 1% drop in China’s GDP will affect global growth by 0.2%, so the fact that the outbreak is having a magnified effect should not be surprising. However, it may only suppress spending in the short term – causing a spike in demand once the worst of the outbreak has been overcome, instead of causing longer-term damage to global growth prospects. It could be argued that equity markets in particular are discounting a v-shaped recovery in trade, growth and earnings, however, equity valuations are looking over-extended, the buy-on-dip mentality seems to be firmly in place, sentiment remains positive and few look as though they are positioned for recession[i].

We feel that current forecast earnings in developed markets over the coming year are too high and open to significant revisions, and we remain sceptical about whether the current levels of central bank stimulus will be enough to boost the global economy, so we believe a threat of significant equity drawdown remains. A squeeze in profit margins has been the reason for the fall in corporate profits over the past year, as wage growth has strengthened across developed markets. The consensus expects 9% EPS growth over 2020, which looks optimistic to us. Absolute Strategy Research (ASR) expects global EPS to decline 4%, with declines of 6% and 9% in the eurozone and US respectively[ii]. EPS growth remains underpinned to an extent by share buybacks that have seen company balance sheets change exponentially as debt is raised to buy back shares. According to Julius Baer, S&P 500 buyback peaked in 2019 at approximately $1trn but is likely to stay high while the cost of equity remains substantially above the cost of debt and the economy continues to expand[iii]. However, fundamentals cannot be ignored indefinitely and a sustained squeeze on profits should be reflected in stock prices eventually.

A strong dollar is a symptom of tight global monetary conditions. There remains a reluctance of international banks to lend US dollars due to the interest differential and it is unlikely, in our opinion, that the recent weakness will last. A weaker dollar would be necessary to support a recovery in global growth outside of the US, and the continuation of a strong risk appetite would be a prerequisite for this depreciation to persist.

The early results in the Democratic candidacy race have been upset by the entry of Michael Bloomberg, who immediately polled in second place behind Bernie Sanders. We continue to believe that the Democratic choice of presidential candidate could have a material effect on investors, due to the strong socialist ideals of some candidates that will frighten markets.

The final risk not being priced in by financial markets concerns the inflation that could result from the squeeze in corporate margins further sustained by the supply-side disruption due to shutdown in China. US Housing Starts and PPI in January both surprised on the upside, and while the FOMC meeting agreed that current policy was appropriate, minutes revealed an active discussion around inflation and financial stability concerns in light of elevated equity valuations and corporate debt.

In the UK, Consumer Price Index inflation rose above expectation in January, at +1.8% vs.+1.3% in December. This was seen to justify the BOE’s decision to leave rates unchanged, although many economists expect inflation to move back down as early as February on the back of lower utility prices. The next potential inflection point in the UK is the March budget, where investors will be looking for commitments to fiscal spending designed to boost productivity. We agree that UK equities are relatively cheap among developed markets, but also recognize that there remains uncertainty as to the final shape of the UK-EU trade deal that may continue to hold back capital expenditure.

Turning to Europe, the euro is the worst performing G10 currency vs. the dollar and fell below 1.08 this month for the first time since April 2017[iv].

 

The second estimate for eurozone Q419 GDP remained unchanged at +0.1% quarter-on-quarter.  There is a growing realisation that growth in the eurozone is weakening again on the back of waning external trade and softening domestic demand, so that the expected pick up in domestic growth over 2020 is unlikely to materialise in the medium term.

In terms of asset allocation, we retain our view that there remains a heightened risk of equity drawdown and we believe that investors will need to become more vigilant around Easter, particularly if the coronavirus outbreak starts to have a material effect on global economic activity in the medium term. The expected support from emerging market economic growth, particularly in Asia, will be tested significantly by the spread of the virus. Greater risk aversion by investors could cause capital flight, leading to pressure on low interest rates.

 

[i] Absolute Strategy Research – Investment Committee Briefing 7^th February 2020.

[ii] Absolute Strategy Research – Profits downturn to persist 18^th February 2020

[iii] Julius Baer – Asset Allocation Perspectives 5^th February 2020

[iv] Capital Economics – Global Markets Update 19^th February 2020

 

By Jolette Persson, Hottinger Capital Partners

Q419 Chinese GDP growth of +6% year-on-year was in line with expectations. Industrial output at 6.9% and retail sales at 8% both surprised on the upside as the US and China came closer to their ‘phase one’ trade deal. Although it is encouraging to see that demand for spending and consumption has somewhat picked up alongside a steadily growing CPI – currently at 105.4 (though some of this is directly attributed to pork prices rising as a result of the African swine fever)[i] – property and infrastructure investments continue to slow. The fact that these are both key drivers of growth challenges the perception that China’s deceleration is coming to an end. China has historically built its economic growth on low-cost manufacturing, machinery and equipment and built its cities around factories to attract labour. As a result, close to a quarter of China’s economy is in real estate [ii].

India, another key driver of Asian growth, is expanding at its slowest pace for the last six years, down from close to 7% to 5% during 2019, followed by what has been a period of the weakest industrial production output in the last 8 years, high unemployment rates and slowing consumption. A decline in manufacturing might suggest that India’s economic issues are deeper rooted than initially thought, particularly as recent tax and interest rate cuts do not seem to have had a material effect on the economy. More concerningly, economists predict that India must grow in excess of 10% per annum to support the 12 million young workers entering the labour market every year [iii].

So what?

China being the world’s largest exporter by value (~$2.5trn) means that the magnitude of the effect of China’s growth on global growth is enormous. To put that into perspective, a 1% drop in China’s GDP shaves off 0.2% of global growth. This should not come as a surprise considering that China’s GDP represents approximately 19.24% of world GDP [iv]. In Europe, there is a clear relationship between the Chinese purchasing managers index and exports. Germany, with China as its largest trading partner, is likely to take the biggest hit from slowing Chinese growth of the European countries. For decades, China has provided a steady stream of income and contributed to growth in sectors such as automobile, machinery and engineering tools. German carmakers such as Volkswagen, Daimler and BMW all generate at least a third of their revenue from China, which has slowed significantly as a direct result of trade war tensions and their effect on Chinese demand for consumption, particularity on big-ticket items [v].

In the rest of the world, China’s largest trading partners – the US, Hong Kong, Japan and South Korea – have all suffered as a result of its slowing growth. Hong Kong’s economy contracted by 1.2% during 2019, pushing it into its first annual recession since the financial crisis in 2009, driven by trade conflicts and anti-government protests. Mainland Chinese travellers have since stopped going to Hong Kong (where they used to account for 70% of tourists), causing hotels, restaurants and the retail sector to plunge. Hong Kong’s exports, which mostly come from re-exported goods from China, have also reached an all-time low. Similarly, Japan’s manufacturing and exports to China have declined and the consumption tax hike in October 19 has further dampened demand and put off Chinese tourists, who are usually a major source of retail spend on luxury goods (~$16.4bn/year).

In India, IMF economists commented at the beginning of the year that India was the primary party responsible for the downgrade in forecasted global growth in 2020. Although we do not necessarily agree that India alone, more so than China, is a determining factor in global growth considering that it is a merely domestically-driven economy, India remains the fastest growing trillion-dollar and fifth largest economy in the world. As such, its output is not to be dismissed. The trade fallout between China and the US has hurt, but the decline in domestic consumption is the bigger problem. This has led to poor business sentiment, most evident in sectors such as automotive and manufacturing, as companies are refraining from capital expenditure.

Who stands to benefit?

Factors leading to today’s picture allows other countries to fill the gap and represent opportunities for some investors. We have already observed a change in dynamics whereby companies that normally extend their supply chains to China are now considering other countries such as Indonesia and Vietnam. Vietnam has already seen a huge increase in production and exports of smartphones and consumer electronics over the last 18 months. However, debates over local Vietnamese expertise in comparison to that of China still represent a hurdle despite the appeal of lower labour costs. Other countries, such as India and Indonesia, could eventually get to the point where they are regarded as exporters, provided that they continue to invest in infrastructure and policy reforms. Other direct beneficiaries of the US-China conflict include Latin American exports. Mexico, in particular, has been an unexpected winner as it has built out its manufacturing capability. In contrast to many countries in the Southeast Asia region, Mexico’s free trade agreements offer guaranteed access to more than 50 countries and it benefits from its geographical location being in close proximity to the US. Taiwan is the exception to the rest of Southeast Asia, whose additional exports to the US rose a whole 12.46% over the year totalling $85.48bn in 2019. This is reflective of its mature local tech industry that in turn has allowed its factories to ramp up capability and speed, with companies such as Taiwan Semiconductor Manufacturing Co. taking world-leading positions in their application. Taiwan also benefits from its geographical positioning with close trade links to mainland China [vi].

Bearing this in mind, 70% of surveyed European companies said that their supply chains had been disrupted to some extent and that holding off further action until real clarity is provided on trade is no longer considered a viable option. As such, we are forecasting additional haste for those companies looking to relocate production as well as more emphasis on supply chain diversification to avoid large and concentrated negative impacts in the future. We will continue to monitor the situation closely [vii].

[i] https://tradingeconomics.com/china/consumer-price-index-cpi

[ii] https://tradingeconomics.com/china

[iii] http://www.oecd.org/economy/india-economic-snapshot/

[iv] https://www.statista.com/statistics/270439/chinas-share-of-global-gross-domestic-product-gdp/

[v] https://think.ing.com/articles/germany-what-role-does-chinas-automotive-market-play-in-the-current-economic-slowdown/

[vi] https://www.ustradenumbers.com/country/taiwan/

[vii] https://www.china-briefing.com/news/eu-businesses-china-look-mitigate-trade-war-impact-eucham-2019-survey/

By Tom Wickers, Hottinger Investment Management 

The Alternative Investment Market (AIM) is a sub-market on the London Stock Exchange (LSE) which was introduced in 1995. The shares are unquoted (not listed on a recognised exchange) and provide a channel for companies to list and raise capital under lower regulatory requirements than in other developed equity markets. As such, AIM is largely used by smaller companies that do not meet the capital requirements of the main market or those that would find stricter compliance too costly, making it a hub for businesses with growth prospects rather than stable cash cows. The AIM market has grown substantially since its inception and is touted as being the world’s leading growth market[1]. By year end 2019, there were 851 companies listed on AIM with a total value of £103.9bn, in contrast to 121 companies listed at the end of 1995 with a value of just £2.4bn[2]. The companies listed on AIM are notably diverse, with the value in the AIM index relatively equally spread across the majority of sectors [Figure 1]. Investors can therefore allocate AIM portfolios according to forecast market trends as well as by individual stock-picking.

In 2013, AIM portfolios became more accessible to the general public as a law was passed making them permissible under an ISA wrapper. This allowed investors to mitigate capital gains and income tax via the ISA, as well as inheritance tax through the Business Property Relief (BPR) benefit of AIM investments (provided that certain criteria set by HMRC are met). The regulatory changes coincided with fundamental shifts in the characteristics of AIM stocks, leading to renewed interest from institutional investors in recent years.

Due to its venture capital slant, the AIM market holds higher intrinsic risk than more traditional indices such as the FTSE 100 Index. The companies have a lot of room for growth, but quick bankruptcies can also occur on the back of scandals or difficult market conditions. Financial news is littered with success and disaster stories; a prime example being Bidstack’s performance in 2019, climbing 526% in the first half of the year only to then lose 75% of its value in the second[3]. However, in aggregation, particularly in more recent years when the AIM market has become more established, AIM stocks have outperformed FTSE 100 stocks in returns with similar volatility levels[4] [Figure 2]. This is to be expected to compensate investors for the greater downside and liquidity risks involved. Drops in value are pronounced in the AIM market (as shown in Figure 2 at the end of 2018), the worst occurring following the financial crisis, where 65% losses were recorded[5]. Between 2015-20, the AIM All Share Index performed poorly, only marginally beating the FTSE 100 Index and underperforming the AIM 100 Index. In contrast, growth in the AIM 100 index was strong, outpacing the FTSE 100 by 31% over the time period shown. Should this trend continue, the opportunity would mostly lie in the largest AIM stocks, rather than the market as a whole.

Often nicknamed the ‘Wild West’ of markets, investors initially viewed the AIM market as a playing field for short-term, gung-ho punters because it had sparse research coverage and was prone to financial scandals and collapses[6]. Further, institutional investors did not need to get involved in the AIM market in order to access these successful companies as they were expected to move to a larger exchange once they had accumulated sufficient capital. Recently, however, larger companies have shown continued interest in staying on the AIM index, favouring the manoeuvrability that its softer regulation enables. Boohoo, currently the largest stock on AIM, has made no effort to move to the main market even though it is now large enough to list on the FTSE 100[7]. The result is that the AIM market has become more skewed towards relatively larger and more stable companies [Figure 3], providing a more investable environment for institutions.

The AIM market has materially shifted in the past ten years, still offering access to nascent companies but also to a plethora of established businesses that have thus far brought substantial returns at tolerable volatility levels. The shift from gamble to investment proposition means that institutional and individual investors alike should continue to watch this space. However, historical slumps provide ample warning of the palpable downside risks involved when investing both in individual companies and the index as a whole. Investors should take careful stock of their capacity to absorb losses before acquiring any significant holding in AIM shares.

[1] https://masterinvestor.co.uk/economics/aim-still-worlds-leading-growth-market/

https://www.londonstockexchange.com/companies-and-advisors/aim/for-companies/companies.htm

[2] https://www.londonstockexchange.com/statistics/markets/aim/aim.htm

[3] https://www.ii.co.uk/analysis-commentary/best-aim-stocks-2019-whos-1700-so-far-ii510030

[4] FTSE 100 weekly volatility was 1.79% in the time series, while AIM 100 volatility was 1.72%

[5] In reference to the AIM 100 Total Return Index (Gross Dividend) on Bloomberg from peak to trough.

[6] https://www.theguardian.com/business/2011/jun/24/langbar-international-fraud-history

[7] https://www.proactiveinvestors.co.uk/companies/news/278183/asos-seems-happy-to-be-aim-s-standard-bearer-28183.html

By Tim Sharp, Hottinger Investment Management 

Global monetary conditions remain tight and the risks for financial markets are that we may indeed be in late cycle, which could mean a global recession is likely within 12 months. This remains our base scenario and will be the reason we maintain our cautious stance in the near term, with the next likely inflection point around the beginning of the 2^nd quarter. This will coincide with 1^st quarter reporting, the selection of the Democratic candidate for the US presidency and also takes into account the fact that equity markets historically tend to try to predict economic outcomes 9 months ahead based on current economic forecasts.

Stock markets started the year strongly, buoyed by positive sentiment following agreement of a Phase 1 US-China trade deal and the strong majority of the Conservative party in the UK general election. US stock markets continue to lead the way, with technology stocks once more at the forefront of market movements. The S&P 500 is flat on the year while the tech-heavy NASDAQ was up 1.5% on the month despite anxiety at the outbreak and spread of the coronavirus in China, Asia and more widely, which has checked performance in other stock markets. European indices are down on average 2.5%, Japan 2.9% and the UK 3.0%.  The strength in UK equities seen towards the end of 2019 had largely played out by the start of the year, when the focus returned to the relatively short time period available for a new trade deal between the UK and Europe to be agreed. Our most recent investment strategy meeting took place on the last day of the UK’s membership of the EU, with withdrawal taking place at 11pm on January 31^st. This leaves the parties just 10 months in which to agree a deal within the existing timetable.

Government bonds have rallied since the outbreak of the coronavirus, which threatens to reduce Q1 GDP in China to 3.5% year-on-year from the 5.5% year-on-year predicted[i] with obvious knock-on effects to its largest trading partners including Asia Pacific, Japan and Europe. 10-year US Treasury yields have fallen from 1.92% to 1.51% and Gilt yields from 0.82% to 0.51%. The safe haven qualities of the US Dollar have also seen it strengthen 1.1%, once more painting a rather different scenario to that forecasted by many investment banks coming into 2020, albeit in the light of an unexpected epidemic. A strong dollar tends to reflect tight global monetary conditions and high funding costs will discourage foreign banks from lending dollars, meaning this position may persist.

The coronavirus is predicted to have a significant effect on Chinese Q1 growth, particularly due to the fact that it came to light just before the Lunar New Year celebrations. This will also affect the prospects of the Asia region as a whole, which many had predicted would be the catalyst for maintaining positive growth globally. However, this may only suppress spending in the short-term, with the possibility of a spike in demand once the worst of the outbreak has been overcome, rather than causing longer-term damage to global growth prospects, but which of these scenarios will materialise is currently an unknown. The reaction of financial markets indicates to us the vulnerability investors feel when faced with the potential of a worsening slowdown, leaving the risks firmly tilted to the downside.

The slowdown in corporate earnings over the last year has led to non-residential fixed investment falling in the US. Many forecasters predict that the 4^th quarter of 2019 will be a low point in earnings and economic momentum will turn positive this quarter. However, if earnings continue to fall then the capital expenditure recession will persist, putting further pressure on the benign economic scenario being painted. This is why we see 1^st quarter earnings as coming at an important time for markets.

European Q4 GDP came in weaker than expected, not just in Germany and Italy but also in France, which had been more robust in the past despite strikes and protests. The coronavirus is likely to weigh on January’s sentiment – surveys showed a small improvement in Eurozone activity, meaning that the expected economic recovery there will be slower than forecast and any sudden rebound is unlikely.

In the UK, November GDP was weaker than expected at -0.3% month-on-month, with both the services sector and industrial production faring poorly, resulting in many revising Q4 forecasts downwards. Furthermore, December inflation figures also came in below consensus and although January PMIs showed a bounce since the election, levels are still at or below long-term averages. The Bank of England’s Monetary Policy Committee will come under further pressure to cut rates over the coming months in order to support the economy.

At the FOMC meeting, the Fed left US rates unchanged and the statement following the meeting was much as before, suggesting that monetary policy remains appropriate despite the emergence of some new downside risks. Chair Powell did describe the coronavirus outbreak as a serious issue but it appears not to be serious enough to affect policy at this time. This reinforces our view that central bank reaction to a worsening economic scenario will be slow and too late to prevent recession.

In terms of asset allocation, we retain our view that a global economy in late cycle bears heightened risk of equity drawdown and we believe that investors will need to become more vigilant around Easter, particularly if the coronavirus outbreak starts to have a material effect on global economic activity in the medium term. The expected support from emerging market economic growth – particularly in Asia – will be significantly tested by the spread of the virus. Greater risk aversion by investors could cause capital flight, leading to pressure on low interest rates.

The remaining “known unknown” for investors is the US presidential race and reactions from the Trump administration to potential changes in economic performance that may affect chances of re-election. Furthermore, the Democratic choice of presidential candidate could have a material effect on investors as the current leading candidates have more socialist ideals that may frighten markets.

[i] Assessing the impact of coronavirus on the UK – Capital Economics 3 February 2020