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!
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