Gloom, Doom... and Zoom
Report by Adam & Company’s Investment Management Team.
We have just experienced a few weeks that I am sure we will never forget and it feels like there may be many more to come. It is a particularly stressful time for us all, including our families, friends and colleagues. We hope you are staying safe and healthy in your home.
I wanted to start out by reassuring you of our preparedness for this situation and for our absolute confidence in being able to continue to serve you during this difficult period. All Adam & Company offices have been closed for several weeks now to protect clients and colleagues and all our staff are working from home and have been since the second half of March. We are all able to carry out our jobs just as we would in the office thanks to clever software and hardware supported by our parent company, RBS Group. However we do of course miss meeting our clients and colleagues and can’t wait for this situation to pass.
We have also had to issue large numbers of letters warning of falls in portfolio values. This is a regulatory requirement. Whilst we cannot rule out further ones given market volatility, we would note that the regulator has begun to look at the effectiveness of these.
Moving on to market news, the quarter has thrown up some amazing statistics and almost every news article we read seems to start with the phrase ‘For the first time since World War 2…’ In a sign of how far things have changed in recent weeks, the American video conferencing company Zoom – which Adam & Company uses to conduct meetings – now has a market value higher than the entire US airline industry.
The first quarter will see a fall in GDP higher than ever seen, with current thoughts that the lockdown could see the UK economy tumble 15% from the December quarter to the one just ended. Stock markets saw their fastest ever 10%, 20% and 30% falls. And the number of Americans filing for new unemployment benefits rose from 217,000 in the last week of February to 6.6 million in a single week at the end of March.
Usually we would be looking at economic lead indicators for signs of recovery – such as increasing business confidence or new order data – but this time markets will be almost entirely focused on the data around infection rates for clues to when the lockdowns will ease.
The economic spring underway in China may provide useful pointers to what lies ahead for the rest of the world. An initial increase in activity can happen rapidly once lockdown measures are eased, however this may run into constraints resulting from subdued demand as consumers will likely remain nervous, not least due to rising unemployment. Although news on drug developments such as a vaccine would improve sentiment dramatically, equally lockdown measures may have to be tightened again if infections reappear.
Whilst stock markets saw their fastest ever falls, we should also remember that they also saw some of their largest ever jumps in the second half of March. We continue to try and look forward and to invest in good quality companies with products and services which will be in demand in order to meet your investment objectives.
New Benchmark Index
With effect from 1st January 2020 we have changed the benchmark index used to measure cash returns. The Libor 3 month index which we previously used is being phased out by the FCA and therefore, we have replaced this with the UK Cash 3 month index. The tables in our reports have been updated to use the new index historically.
Please remember that the value of investments and the income from them may go down as well as up and that you may not get back the amount originally invested. Past performance should not be seen as an indication of future performance. Where an investment involves exposure to a foreign currency, changes in rates of exchange may cause the value of the investment, and the income from it, to go up or down.
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Most analysts were optimistic coming into 2020 given the truce in the trade war between the US and China, and the recovery in government spending.
However, global growth has already taken a severe hit as a result of the lockdowns to combat the spread of the coronavirus, with Citi economics research team cutting almost 5 percentage points from their growth numbers for 2020, on the back of a steep recession in the first half.
On a quarterly basis, the falls could be like nothing seen before with some countries seeing economic output fall well over 10% year on year; however the hope and expectation at the moment is that the lockdowns will ease as we enter the summer months, with a strong rebound expected in the second half of the year. This has certainly been the pattern in China, were the outbreak peaked a couple of months ago and where several economic indicators have recovered to close to previous levels.
Most central banks are effectively running a Zero Interest Rate Policy (‘ZIRP’) as a way of coping with the crisis. They are also committed to buying almost limitless amounts of government and in some cases corporate bonds to supress market interest rates. Market rates could have been expected to rise given the huge amount of government and corporate bond issuance, which will pay for government promises and help companies cope with a gap in demand. Inflation was already below central bank targets in developed economies coming into 2020. This economic crisis – with disruptions to supply but especially demand – will likely see inflation turning negative in most regions. This will be exacerbated by higher unemployment levels in the short term which could push down demand further. Unemployment rates were at 50 year lows in the US and UK, but will likely spike up given the air pocket in demand facing many companies in the second quarter.
As to what happens to inflation thereafter, it is completely dependent on how quickly we recover from this. If restrictions are eased, we could see a jump in demand from people booking holidays, restaurants, buying cars and so on – everything which was delayed as a result of the lockdown. Supply may not be able to cope and this could see prices rise. The weakness in Sterling would usually push up inflation as we import more than we export. It is unlikely central banks would be quick to reverse rate cuts, and may be inclined to encourage inflation if anything to help cope with the large debts being accumulated now.
However there remain large structural issues which should keep inflation subdued beyond the next couple of years, including globalisation and technology, and there doesn’t seem to be an end in sight to these.
The outlook for equities is almost completely tied to the current crisis and how long it lasts. If the pattern is the same as China, they should recover somewhat as the number of cases peaks out and as the market looks beyond to a period of relative stability. The announcement of a broad inoculation campaign on the back of a new vaccine for the coronavirus would also help. Equally, they may continue to be very volatile if the disease flares up again.
Valuation indicators for stocks are not very helpful at the moment as many are effectively seeing zero sales for as long as the lockdowns last. Balance sheet strength is becoming extremely important.
In absolute terms, the income offered by government bonds is extremely low.
Credit risk has undoubtedly risen as a concern in the minds of investors. Companies suffering from severe drops in sales may be at risk of defaulting on their bonds. However, government actions (various interest free loan schemes and the offer to pay staff directly) and the actions of the Bank of England (buying corporate bonds to push down yields and soak up supply) should mean this is largely avoided provided the lockdowns do not last beyond the summer. Generally speaking, highly indebted companies are to be avoided however.
Some inflation protection may be wise given the potential for this to rise later in the year if demand returns strongly.
Concerns over the Coronavirus initially concentrated on the supply shock impact to UK companies and the impact of a slowdown in Chinese economic activity on global growth. Nevertheless, as the growth in cases outside of China accelerated and governments took increasingly drastic measures to contain the spread and volatility across markets soared.
These fears were compounded as Saudi Arabia and Russia failed to agree on an appropriate response for the supply of oil and sent the oil price crashing. It was a further destabilising event in increasingly volatile markets, and shares in oil and gas companies which form a significant part of the FTSE 100 index tumbled.
As over a quarter of the world’s population found themselves in some form of ‘lockdown’, the associated negative impact on global economic activity sent markets into panic mode. Economically sensitive areas, such as travel and leisure, banks and oil and gas sectors were the hardest hit; however, there were few places to hide for both domestically exposed and internationally exposed UK companies in the rapid sell-off. Companies across sectors cut back or scrapped dividends entirely, notably in the banking sector.
These events drove the index from a peak to trough fall of 35%, before a rally in late March. As such the FTSE 100 recorded a 25% decline for the quarter, its largest quarterly fall since 1987.
Drastic action has been taken by the Government and the Bank of England in response. Interest rates were cut from 0.75% to 0.1% in the period, and sizeable fiscal stimulus has been announced in an effort to protect businesses across the UK as well as the public during these very challenging times.
Source: Thomson Reuters DataStream, 31 March, 2020.
US equities had their worst quarter ever – the S&P 500 fell by 22% in US dollar terms. The quarter started well, with equities rising by around 5% to peak on February 19th. However, the fear of a prolonged global economic shock from the coronavirus hit the markets in late February with heavy market falls continuing into March. The US equity market hit a low on March 23rd, down over 30% from the beginning of the year, before recovering. Bond yields fell to historic lows as investors fled to safe haven assets. The 10 year Treasury yield fell to a low of 54 basis points after starting the year at 1.91%.
Oil prices (on the WTI measure) fell by an astonishing 67% hit, not only by coronavirus fears, but also by a rift between Saudi Arabia and Russia. OPEC had provisionally agreed to cut output to support oil prices but this was conditional on Russia joining the pact. However, Russia refused to agree – leading to a 2 day drop in crude from $46 to $30 on March 9th.
Technology was relatively resilient during the quarter. The tech-heavy Nasdaq index was down just 14% over the quarter helped by “stay-at-home” beneficiaries including Amazon and Netflix. Traditionally defensive sectors of health care, consumer staples and utilities also outperformed, all falling by less than 15% in US dollar terms. Meanwhile, the Energy sector fell by 51% from its year-end starting point. Outside of energy, the worst performing industries included airlines, autos, banks and restaurants. Financials also suffered, falling by 32% during the quarter.
Source: Thomson Reuters DataStream, March, 2020.
Finishing strongly in 2019, European markets continued to track upwards into 2020. All-time market highs were posted in the first quarter before tumbling on the negative news flow surrounding COVID-19, with markets falling in excess of 35% peak to trough. Travel and leisure stocks were worst hit but few sectors were unscathed; pharmaceuticals companies like Sanofi and Roche proved more defensive. The crisis is causing significant challenges for governments and central bankers: extraordinary social restrictions have been combined with unprecedented monetary and fiscal policy to pull Europe through this incredibly difficult period.
Echoing her predecessor’s infamous “whatever it takes” speech during the depths of the Eurozone debt crisis, new European Central Bank (ECB) President Christine Lagarde affirmed that there were “no limits to our commitment to the euro”. This includes a significantly expanded quantitative easing programme, where the ECB will buy increased levels of government and corporate bonds. The ECB has also acted to bolster the resilience of European banks. These banks will be vital providers of credit and liquidity during this crisis to both households and corporates. The ECB has thus restricted European banks’ ability to pay dividends to shareholders and bonuses to senior staff. This will boost banks’ capital and support further lending, whilst unleashing “rainy day reserves” will provide yet more lending stimulus.
Governments responded with enormous fiscal stimulus. Notably, Germany abandoned its “schwarze Null”, or black zero, approach to its normally balanced fiscal budget. Instead it unveiled a €750bn package to support the German economy. European political tensions returned to centre stage as the economically stronger Northern European countries dismissed the idea of issuing EU-wide “coronabonds” to raise money to tackle the crisis, something the Southern European nations were calling for.
Source: Thomson Reuters DataStream, 31 March, 2020.
The Japanese stock market did not fall as far as others during the recent market correction. The reason for this was that valuations were already pretty low compared to history, and whilst it is extremely difficult for the Bank of Japan to ease interest rate policy further, they do have huge firepower to buy assets, such as corporate bonds and shares. This hascushioned the worst of the financial market implications of the virus outbreak. For UK based investors, the weakness of the pound relative to the Yen has provided a further cushion.
That said, the economy will have dipped into a sharp recession and corporate earnings will fall sharply, especially in the big manufacturing companies such as the automakers. The decision to cancel the Tokyo Olympics will not have been taken lightly, as apart from anything it would provide a huge boost to the economy, but this was clearly unavoidable. As with most other things, 2020 is cancelled, roll on 2021.
Many of the Emerging Market economies will be hit hard from COVID-19. Not so much directly, as many have avoided it up until now, but rather as a consequence of a collapse in demand from their overseas markets. The exception to this may be India which saw the entire country locked down for weeks.
The epicentre of the virus outbreak was China. Despite this, Chinese equites held up better than other regions as the disease seems to have peaked in February and much of the economy is now back up and running. There will clearly be an impact on them due to the low level of exports they will sell, however the power of the Chinese government helped reduce the pain and stimulus is on the way.
Less robust economies such as Malaysia and Thailand will probably suffer more, and this is reflected in their poor stock market performance.
Source: Thomson Reuters DataStream, 31 March, 2020.
Concerns around the spread of the Covid-19 virus and the economic implications of actions taken by governments caused huge volatility in government and corporate bond markets during the quarter. Uncertainty about the economic outlook remains intense. However measures taken by the central banks have eased the fears within bond markets in recent weeks.
Government bonds provide a safe haven
When investor fears were at their most pronounced, there were few safe havens as investors sought cash and US dollars in particular. Gold and US Treasury stocks fell at the same time as equities. However, intervention by central banks did result in government bonds rallying by the quarter end. Emergency measures were taken to instil confidence and boost liquidity. In the US and UK, interest rates were cut to historically low levels. Quantitative easing (‘QE’) was deployed again with the aim of buying bonds to keep rates low and inject funds into the economies. The US Federal Reserve confirmed that there was no limit to the amount of Treasuries that it was prepared to purchase while the Bank of England is planning to buy £200bn of bonds (or more if necessary).
The European Central Bank (ECB) unveiled its own €750bn Pandemic Emergency Purchase Programme to run to the end of the year. Concerns focus on how Italy and Spain will cover the costs of tackling the virus. The concept of shared responsibility within the Eurozone through the issuance of ‘Coronabonds’ has had a mixed reception so far.
Actions by the central banks did tame the unexpected volatility seen in government bond markets with the result that UK ones produced a total return of around 7% in the quarter as investors sought the safe haven of long dated issues.
Corporate bonds reflect changing expectations
The rapid change in the economic outlook was reflected most clearly in corporate bonds. After performing well in 2019, fund flows into the asset class were strong at the start of the year as investors sought secure income. The difference or spread between the yields of government and corporate bonds were at low levels, reflecting investors’ willingness to take extra risk. The large fund outflows from the asset class saw these spreads widen sharply during the quarter to levels not seen, for example, in the US since the Global Financial Crisis of 2008. The move in the spreads of lower quality or ‘high yield’ corporate bonds was even greater. Fears focus on the strength of corporate balance sheets at a time of a sharp economic contraction as well as the liquidity of corporate bond markets when investors want to sell.
Again, the actions of the central banks have improved confidence. The US Federal Reserve has now joined the other major central banks in including investment grade corporate bond funds for the first time in its QE programme. Quality companies are now issuing bonds and attracting investors.
The duration of the economic contraction and the shape of recovery are still far from clear. A background of very low interest rates and bond buying programmes should be supportive for Government and investment grade bonds. However, concerns will focus on the extent to which corporate defaults will rise in a sustained downturn, and how governments will finance the costs of tackling the virus over the long term.
Source: Thomson Reuters DataStream, 31 March, 2020.
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