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