Heuristics, aliens and the 90% economy
Investment Commentary | Second Quarter 2020
7 min read
The human mind is set to look for patterns. Rules of thumb (‘heuristics’) allow us to analyse situations, solve problems and make decisions quickly when we don’t have the time or information to perform deep analysis.
These have unforeseen consequences. Mental short cuts can be influenced by in-built biases such as risk aversion – when we hear bad news, we may struggle to look to the long term. We may panic and lose our sense of proportion. We may believe the many theories which have flared in recent years, spurred on by the internet and its unruly offspring, Twitter and Facebook.
One example raised recently is the relationship between the metre and the Great Pyramid of Giza. The length of a metre is the distance travelled by the speed of light in a vacuum during 1/299792458ths of a second. This same number appears in the latitude of the Great Pyramid – 29.9792458 degrees north. Coincidence? For some this is evidence that aliens are responsible for pretty much everything.
This tale may be more evidence that correlation does not equal causation, but we can definitely say that some of this is really serious – we have seen a dramatic rise in fake news and a dramatic slump in vaccinations for example.
In another coincidence (perhaps), 8.5 is emerging as a key number to watch. $8.5bn is the amount pledged globally for the research into a vaccine against Covid-19 across 140 programs. Likewise, the best estimate we have seen for the lost economic output as a result of the coronavirus crisis is an amount exactly 100 times greater than this: the world economy will be $8.5 trillion dollars smaller than it would have been by 2021 if the virus had not hit.
As well as lots of large numbers, we are analysing several letters, such as U, V and W. These are possible shapes of the economic recovery, the best case being a V shaped one where we sharply return to normality. The worst is probably W where the recovery fades quickly and another recession emerges.
Without a vaccine, however, we may get a ‘reverse radical recovery’ as described in the Wall Street Journal. Think of the mathematical symbol for the square root, back to front – the economy jumps back up but to below previous levels and then flatlines as businesses are unable to return to normal, local lockdowns spring up, and consumers face rising unemployment.
The Economist had a similar take and has written about ‘the 90% economy’. 90% in most spheres is a good result, but in an economy it means higher unemployment and lower consumer confidence and business investment.
The last quarter was easy on investors as governments and central banks ensured economies didn’t fall away like the side of a pyramid, but the next few will be trickier as we start to understand what is actually going on. We will however continue to look through much of this noise and focus on the long term. A vaccine will emerge; the virus will pass; economies will recover; and we will meet again.
With lockdowns easing across the world, economic activity is recovering rapidly. This can be seen in the sentiment indicators such as ‘Purchasing Managers Indices’ which track the confidence of various industries around the world. Other indicators, everything from US gasoline consumption to UK holiday bookings, also suggest a rapid bounce back.
Despite this, there is a great deal of uncertainty about how quickly this rebound will continue. Pent up demand for holidays and eating out will see many activities return to normal quickly however these will surely be limited as long as
the virus is circulating. Local lockdowns may be necessary; many vulnerable people will continue to shield and other may be reluctant to circulate freely; intercontinental and business travel remains largely frozen; finally, despite the best efforts of the UK chancellor and similar schemes in other countries, many companies have been severely damaged and will have to slash employment or, in the worst case, cease trading.
Inflation and Interest Rates
Under normal circumstances the issuance of colossal amounts of bonds to cover deficits would result in market interest rates rising as markets worry about being repaid and the government might find it difficult to find buyers, so the price demanded in the form of yields would rise.
The complete opposite is now true. Market interest rates have collapsed across all durations, going out many decades as central banks are effectively financing the deficits. Their balance sheets are expanding dramatically as they buy almost unlimited amounts of government bonds.
The danger for bond investors of course is that inflation rises. Even based on today’s mild inflation expectations, buying a 5-year UK government bond yielding 0.02% p.a. will almost certainly result in you losing money after inflation. At the moment inflation has slumped due to the collapse in demand and will fall further due to expected VAT cuts. With central banks missing their 2% inflation targets on the downside for a decade, could they try to run inflation higher than this to compensate?
The outlook for equities is almost completely tied to the current crisis and how long it lasts – equity markets are inversely correlated to the levels of outbreaks with the outlier to this correlation being the USA where new cases continued to rise through June but equity markets recovered almost back to where they were in December. Other regions such as the UK and Europe have recovered sharply in Q2 but are still far below levels seen at the start of the year.
Much of this is logical – the UK has a high weighting to financials which have seen profitability damaged by lower interest rates and economic activity; European markets also have relatively high exposure to industrial companies which have been damaged by the fall in demand for consumer goods such as cars. And the 5 biggest companies in the US are the tech mega caps.
That said, from here we have been seeking to add names we think may benefit as recovery takes hold and can see value emerging in several area It will be bumpy but on an 18-month view many companies can take advantage of their strong balance sheets and emerge at least as strongly as they did before.
In absolute terms, the income offered by government bonds is extremely low.
Credit risk has undoubtedly risen as a concern in the mind 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, however, we feel highly indebted companies are to be avoided.
Whilst the UK market recorded is worst quarterly fall since 1987 in Q1, the second quarter has seen a welcome recovery. The MSCI UK rose 8.2% in the quarter, whilst the FTSE 250 recovery was stronger, up 17.5%.
The UK market was buoyed by significant levels of fiscal stimulus as the Government sought to limit the extent of the damage caused by the lockdown. The market also responded positively to the declining number of coronavirus cases and the gradual easing of lockdown measures. Increasing optimism over Covid-19 vaccine developments, with UK pharmaceutical companies at the heart of the global effort, was also received well by investors.
An abundance of miserable economic data releases did not dampen the recovery. GDP and retail sales reported record falls; however, these had largely been expected and baked into investor sentiment in the first quarter’s equity market sell-off.
Dividend cuts or complete cancellations were a frequent feature in the quarter, as companies sought to preserve cash and bolster their financial strength in light of the extreme lockdown measures. Royal Dutch Shell is one such example, cutting their dividend for the first time since the Second World War.
Uncertainty remains over the ability of the UK to ease lockdown measures whilst avoiding a resurgence in Covid-19 cases. The UK’s exit from the EU is also back on the agenda, and the Government has rejected calls to extend the Brexit transition period. This leaves UK companies with another challenge, a potential no-deal Brexit, whilst navigating through the already very challenging economic and social environment.
After their worst quarter on record in Q1, US equities mounted a spirited recovery in Q2, rising by 30.9%. Investors were encouraged by government and central bank actions to support economies and markets and moves to lift lockdowns added more optimism towards the end of the quarter. Technology stocks were among the biggest gainers, resulting in the tech-heavy Nasdaq index hit new all-time highs during the quarter.
Oil markets witnessed an unprecedented quarter with the contract for West Texas Intermediate oil, which is the main US oil benchmark, actually falling below $0 per barrel in April. With overstocked inventories and plunging demand, this meant that oil producers were paying traders to take barrels off their hands. However, as economic sentiment rebounded, so did oil prices to finish at $41 per barrel, up 75% from March-end levels. Oil equities mirrored this turnaround. The sector, having fallen by 51% in Q1, rebounded by 18.5% in Q2.
Traditionally defensive areas of the market, including utilities, consumer staples and healthcare, lagged the market’s advance in Q2. Meanwhile, the market’s recovery triggered speculative activity, particularly among retail investors. Online brokers saw surging trading volumes, leading to outages on online trading platforms in April.
European markets have strengthened in the second quarter of this year, buoyed by renewed central bank stimulus and hopes that the major European economies have got a grip on the coronavirus. The pan-European STOXX 600 index returned 12.6% in the quarter, unsurprisingly led by technology stocks, whilst the oil and gas sector was the weakest.
There are increasing signs of a modest recovery though the outlook remains very cautious. European consumer confidence, though still negative, continues to improve and is better than the levels seen in the global financial crisis and the Eurozone sovereign debt crisis. European economies have been able to start to reopen, and whilst there are stories of localised spikes in case numbers, there appears to be some degree of control over the virus at this stage.
Governments have taken extreme fiscal measures to support consumers and businesses during this crisis. Perhaps the most publicised example of this support has been the €9 billion package for Lufthansa, the German airline. At some point, however, the immense fiscal stimulus will have to be repaid, with budget deficits set to soar. European Central Bank President Christine Lagarde noted that given the extreme magnitude of the crisis, debt maturities to finance this crisis would be longer than normal. This is most clearly exemplified in Austria’s new 100-year bond, yielding a mere 0.88%. The ECB also announced further stimulus during the quarter taking the total support measures from its bond buying programme
to over €1.3 trillion.
japan and the far east/emerging markets
The Japanese stock market had a solid recovery between April and June. The type of shares and sectors doing well included technology and healthcare names. For tech, it became obvious that demand for products such as semiconductors would continue to rise and healthcare companies such as Chugai may provide some of the solutions to abate the current and future crises.
Whilst Japan had a relatively low level of deaths related to Covid-19, its economy will be severely hit due to much of its previous growth being related to exports. This is visible in the performance of the big car companies such as Toyota, Honda and Nissan which continue to underperform the stock market on fears of low demand for 'large ticket' items by Western and Asian consumers who worry about their jobs.
As we discussed last quarter, many of these economies will be hit hard by Covid-19 directly or as a consequence of a collapse in demand from their overseas markets however it is not always useful to lump such a disparate group of economies and cultures together with the simple label of ‘Emerging Markets’. Brazil has seen the virus affect it directly, but it is also suffering economic stress as an oil exporter following the collapse in the oil price. Many others are
still doing well.
The weakening Dollar should help borrowing costs (companies often issue bonds in Dollars and the repayments drop when that currency falls) but there are concerns going into the second half of the year that the trade and technology disputes between the US and China could flare up again as the US presidential fight gears up ahead of November’s election. Polls suggest ‘China bashing’ may appeal to both Republican and Democratic supporters, threatening the global economic recovery.
The action taken by governments and central banks to tackle the sharp contraction in global economic activity has brought stability to sovereign debt and credit markets. UK government bonds (or ‘gilts’) have continued to deliver positive returns this quarter while corporate bonds have recovered strongly after exceptional volatility in March.
Corporate bonds reflect changing expectations
The announcement on 23rd March by the US Federal Reserve that it would purchase investment grade corporate bonds marked a significant change in sentiment. The decision effectively underpinned the credit market at a time when there were concerns about companies gaining access to credit and a lack of liquidity in the asset class. The Federal Reserve also later extended its support to high yield bonds with its decision to buy Exchange Traded Funds that invest in them.
Government bonds provide a safe haven
Gilt yields have continued to fall (prices rise) with the 10-year yield now around 0.2% and issues up to 5 years showing negative yields to maturity. The economic background for gilts remains favourable. Growth forecasts for this year are still being downgraded, inflation is moderating and the path of recovery remains unclear. Also, the Bank of England will undertake a further £100bn of quantitative easing (QE) on top of the initial £200bn announced earlier in the crisis. The bond buying programme aims to keep rates low while boosting economic activity. While the level of debt is high and growing to cover the costs of the Covid-19 crisis, the Government is able to borrow at historically low levels of interest. New issues of gilts have been well received by investors.
In the US, the Federal Reserve restored calm to the Treasury market with its support measures including its open-ended bond buying programme. In the EU, concerns about the financial costs of the pandemic for certain countries, such as Italy, have eased with the announcement of a €500bn Recovery Fund of grants that could mark steps towards closer fiscal integration. Concerns raised by the German constitutional court about the scale and scope of the actions of the European Central Bank (ECB) have eased.
The level of new issuance of bonds by companies, which are seeking to raise funds to bolster their balance sheets, has been running at record levels. Inflows of investor funds into both investment grade and high yield bonds have been strong during the quarter. As a result, the yield differential or spread between government and corporate bonds has narrowed sharply during the quarter. While not falling to pre-pandemic levels, the level of spreads reflects improved confidence and a greater willingness to accept risk.
Fears about ‘second waves’ of the virus, an uncertain economic outlook and the actions of central banks should continue to underpin government bonds. However, longer term concerns remain about the implications of growing levels of government debt and the extent of monetary stimulus. While the backdrop for corporate bonds has improved, a focus on quality companies will remain key at a time when default rates look set to rise.
The source data for each graph is supplied by Thomson Reuters DataStream, as at 30 June 2020 total return, local currency unless otherwise stated.
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