Investment Commentary | Third Quarter 2020
7 min read
‘The Lipstick Effect’ was a term attributed to Ronald Lauder, then head of the cosmetics company founded by his mother Estée.
He observed that sales of luxury cosmetics rose strongly in the weeks after 9/11, and same held true during the last economic crisis in 2008-09. Whilst sales of Cartier watches and Ferraris collapsed, small, affordable luxuries held up well as consumers awarded themselves a treat – something nice to make them feel better about life.
As with so much else, the current crisis is different and Estée Lauder reported falls across their make-up, fragrance and hair care products. There’s little point wearing lipstick under a face mask and those who are working from home have been focusing purchases on hygiene over appearance. Call it ‘The Dettol Effect’ as consumers treated themselves to a stockpile of bleach and a steady supply of antiseptic hand wipes.
One thing which hasn’t changed during this recession is that short-term inflation has collapsed and interest rates have too. The US central bank, ‘The Fed’, has suddenly decided that it wants to get inflation up. They’ve been floundering around trying to get it to their 2% target for years but keep missing it on the downside as structural forces like technology and globalisation pull it down. Further complicating matters is the fact that inflation will be extremely volatile due to unprecedented changes in what we are buying – you couldn’t get bread-making yeast for all the gold in Fort Knox in March, yet couldn’t give away oil or airline tickets.
Why the focus on getting inflation up after forty years of trying to keep it down? One answer is the high levels of debt accumulated by governments who have simultaneously seen tax revenues collapse and their spending soar on support measures. The UK government spending deficit this year will go from 2% of GDP to 20%, and the ratio of total outstanding government debt to GDP will exceed 100% across many economies. As some point in the future, markets might start to worry about all this debt and demand higher rates to compensate them for the extra risk.
There are several ways to deal with these debts, assuming we rule out reneging on it of course. Option one is to grow the economy quickly to increase the GDP part of the equation – difficult to engineer in a mature economy. Secondly, they could raise taxes to pay the debt down – but the numbers here don’t look good as the deficit this year is expected to be £375bn in the UK meaning our annual income tax take of £200bn would have to almost double to balance the books.
Finally, they could inflate the debt away. The amount of debt is fixed, but if inflation rises, it becomes easier to service as your income and GDP rises relative to the debt, though around 30% of UK government bonds are linked to inflation.
Central banks such as the Bank of England could also throw markets a clever feint to reduce the debt. They have been buying huge amounts of debt to bring down long term rates in a process called Quantitative Easing. Might one arm of the state find a clever way to cancel the debt issued by another arm? Perhaps the government could package up all the debt incurred during the crisis, take advantage of current low rates, and issue a single massive ‘Covid’ bond with a maturity of 100 years? When the time comes to repay the principal sum borrowed, inflation and growth will have massively reduced it in real terms. Demand for long dated bonds has grown with ageing populations, and Austria and Mexico have joined the 100-year bond club in recent years.
Whatever they choose, the past is a very different place and we need new, creative ideas from politicians and central bankers to ease the financial pain, before scientists come up with the solutions to rid us of this virus.
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Global Economy
With restrictions on daily life easier than they were at the start of the pandemic, economic activity has rebounded, however global GDP will likely fall around 6% in 2020 and by 10% in the UK.
Why is the UK doing relatively badly? We have a higher percentage of our economy which is involved in activities like leisure and recreation and are more geared to the service economy. This has its advantages – many can work from home – however more of the UK economy has been affected by restrictions.
The wildcard is now the emergence of successful vaccines. Here, the UK is well placed due to strong science at the institutions and companies doing the research and the money the UK government has invested. Until then, uncertainty will be high and business and consumer confidence low. For many companies and employees the next few months will bring more bad news.
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Inflation and Interest Rates
September saw a shift in policy by the world’s most important institution, the US central bank known as ‘The Fed’. It has spent the past 40 years trying to keep inflation low, with the current target of core inflation (stripping out volatile elements such as food and energy prices) at 2%. It is now saying that, having seen inflation under-shoot this target for many years, it will allow it to rise and will not raise rates until is it above target and the US has full employment.
Why would they do this? For now, weaker growth and higher unemployment are the biggest risks and outweigh inflation concerns.
They wish to inflate away the high levels of debt accumulated by governments and businesses. That said, as we discuss elsewhere, the world’s economic structure is not as it once was and many forces which have depressed the rate of inflation over recent decades are still mainly intact.
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Equities
The outlook for equities has been tied to the current crisis so why have indices remained high despite rising cases in the UK and Europe and the high levels in the US?
At the time of writing, there were far fewer hospitalisations and deaths, due to the relative youth of the sufferers and the better treatment protocols. A large number of people have already been exposed to the virus. Markets are also aware that the levels of testing are many times greater than during the initial stages. And finally, several vaccines should report efficacy results in the coming months.
As we wrote last quarter, we have been gently adding to names we think may benefit from a recovery. Equities may well be a bumpy ride for investors, but on an 18-month view many companies can take advantage of their strong balance sheets and emerge well.
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fixed interest
Our views on bonds is largely unchanged in recent months. In absolute terms, the income offered by government bonds is extremely low and fundamentally unattractive, but for now they continue to provide a ‘shock absorber’ for bumpy equities.
Corporate bonds are a little more interesting. Whilst credit risk has undoubtedly risen as a concern in the minds of investors, government and central bank action should keep confidence higher than it would otherwise be. The main issue is really the split between the winners and losers in the ‘Covid economy’; companies which can exist online are flourishing whilst many sectors – bricks and mortar retailers, property companies, travel, leisure – continue to suffer greatly. For now, the actions of the Bank of England (buying corporate bonds to push down yields and soak up supply) should help get many through the crisis but highly indebted companies are still to be avoided
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uk
UK equities drifted lower in the third quarter, with the MSCI UK All Cap falling 3.5% over the period. Equities struggled to gain any momentum, despite improving UK economic data and positive updates on vaccine developments. Positively, data from retail sales, travel activity and monthly GDP for the months of June and July showed that the UK economy was recovering, again boosted by support schemes from the Government. However, fears over a second wave of the coronavirus drove investor sentiment, with the rate of infections accelerating through the quarter, and surging through September. The imposition of further lockdown measures across the UK was a significant setback in the re-opening of the economy.
Cyclically sensitive sectors were again the hardest hit in the quarter, notably the oil and gas and financials sectors. Banking stocks were particularly weak, as investors worry about the impact of a prolonged period of rock bottom interest rates and increasing loan loss reserves on their profits. Furthermore, oil majors BP and Royal Dutch Shell were both down over 20% in the period. Together, these sectors form a significant part of the FTSE 100 index, thus dragging the index down as a whole over the period.
As we enter the final quarter of the year, significant uncertainty remains. In addition to the surging cases of coronavirus, we also face the big unknown relating to the impact of job losses if or when various job support measures are withdrawn, as is expected at the end of October. In addition to this, Brexit negotiation talks at the time of writing appear to have stalled, with the Government seemingly refusing to drop plans to override sections of the Brexit divorce deal.
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north america
US equities continued their recovery in Q3, the S&P 500 rising by 8.9% in US dollar terms. For much of the quarter, performance was very uneven. Until the end of August, around half of the S&P 500’s 13% gain was down to just 7 stocks – Facebook, Amazon, Netflix, Google (Alphabet), Microsoft, Apple and Nvidia. These companies, known collectively by their mnemonic FANGMAN, were viewed by investors as winners from the “working from home” trend amid Covid-19 lockdowns. This performance was boosted by speculative fervour among investors and may have been inflated by large scale option buying from Japanese tech incubator Softbank, which was revealed at the end of August. However, September saw a change in investor behaviour sparked by a sudden sell-off. All bar one of the FANGMAN stocks underperformed in September as investors sought safety and rotated to those companies seen as benefiting from the opening up of the US economy post-lockdown.
US equities safely navigated an unusual Q2 earnings season. Going into the results, analyst expectations implied a 44% year-on-year decline in earnings. Analyst uncertainty was heightened by an unprecedented shortage of company guidance for future sales and earnings growth. Overall, US companies beat these low estimates, albeit still recording a 34% fall in earnings from the prior year’s Q2.
Looking ahead to Q4, uncertainty looms. The US Presidential election is due on November 3rd and the quarter began with news that President Trump had contracted Covid-19. A further fiscal stimulus package for the US economy is currently deadlocked in Congress while infection rates are climbing across much of the US.
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europe
European markets moved sideways in the third quarter, demonstrating much lower levels of volatility than seen earlier in the year. The pan-European STOXX 600 index was flat in the three months to 30th September, with strength seen in cyclical sectors like automotives and chemicals (bouncing back from significant first half declines) whilst the weakest sector was the banks.Purchasing managers indices (indicative of business confidence) showed consistent returns in confidence in the manufacturing segments of the economy since April. However, in the service industries, the recovery has been more muted. This trend has therefore been of particular benefit to the more industrial economies in the Eurozone, such as that of Germany.
Headlines continue to be dominated by Covid-19 and the different strategies and successes being observed across the bloc. Whilst second waves are being experienced by many European countries, some have a much firmer grasp on the spread of the virus than others. A return to economic normality, predicated on a controlled virus situation, is crucial to the recovery story in Europe, as it is elsewhere.
Investors are closely watching the banking sector as a proxy for the state of the European economy. European banks took enormous provisions in the second quarter as accounting rules required them to anticipate future loan losses. As we transition from emergency fiscal and monetary stimulus to a more sustainable support system (in line with the realisation that Covid-19 may be around for some time), it remains to be seen how personal and business finances will fare in the months ahead. This is especially relevant in those sectors where businesses remain less viable due to social distancing requirements.
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japan and the far east/emerging markets
The Japanese stock market continued its good run between July and September, led by computer gaming companies as consumers opted to stay at home. Not all technology companies did well, however, as the office equipment companies such as Canon and Konica Minolta suffered as people worked from home.
The main news was that Shinzo Abe, the longest serving Prime Minister, chose to step down for health reasons after eight years in office. His legacy includes a more energised and less conservative country whose economic growth rate picked up on the back of his initiatives after a couple of moribund decades. His successor, Yoshihide Suga, is likely to continue in the same vein.
Whilst Japan had a relatively low level of deaths related to COVID-19, it is a major exporting economy which has suffered as others have during the crisis with GDP expected to fall around 6% this year.
Emerging market stocks have recovered to levels close to where they started the year. As elsewhere, much of this is due to the strength of tech stocks which are either immune to or benefit from the trends which have been accelerated by the pandemic.
Several countries have seen interest rates slashed in response to the slump in GDP, with Brazil falling from 14% to 6% and India from 8% to 4% and this has certainly helped investor confidence. Adding to this, the weaker Dollar will help companies’ cost of borrowing further (companies often issue bonds in Dollars and the repayments drop when that currency falls).
That said, Emerging Market investors are closely watching the US presidential election for signs of anti-globalisation rhetoric, or indeed outright hostility to countries such as China, which may upset trade flows and future economic growth.
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fixed interest
Government and corporate bonds were relatively stable over the last quarter. Improving economic data and continued intervention by central banks have been successful in restoring calm and lowering volatility in bond markets. UK Government bonds (‘gilts’) produced a slight negative return over the quarter, corporate bonds a positive one.
Government bond yields remain pinned down
With lockdown restrictions eased, the UK economy has shown signs of recovery after the sharp contraction of the second quarter. However, the better outlook has not resulted in a significant rise in government bond yields (prices falling). There is still uncertainty about the path of the pandemic and the sustainability of economic recovery. As such, the Bank of England continues to provide support by buying gilts through its quantitative easing (QE) programme. The Government remains a heavy issuer of gilts to finance its spending commitments, further increased after the Chancellor’s Summer Statement. With the 10-year gilt yield at 0.25%, the cost of government borrowing remains low.
Further support for gilts has come from a seeming willingness of the Monetary Policy Committee to consider moving base rates into negative territory, as is the case in Japan and the Eurozone. Whether introduced or not, it seems likely that rates will not rise for many years. Indeed, in the US, the Federal Reserve Chairman has highlighted that the Fed is “not even thinking about thinking about” raising rates. The Fed is also willing to tolerate a higher level of inflation in the near term to meet its objectives.
Corporate bonds continue to receive support
Given the intervention by central banks and improving economic fundamentals, investment grade and high yield corporate bonds have provided positive returns during the quarter. Spreads – the difference between government and corporate bond yields – have continued to narrow to closer to pre-pandemic levels. Fund flows into the asset class have been strong as investors seek secure income at a time when the real (after inflation) returns from cash and government bonds are negative, and the outlook for dividends remains uncertain.
Companies have used strong investor demand and relative stability to issue record amounts of bonds ($1.92tr this year in the US) to bolster balance sheets or refinance with longer maturities. Default rates among companies with high yield debt are still low but look set to rise over the next year with companies in the retail, leisure, travel and commodities sectors amongst the most vulnerable to weak economic recovery.
An uncertain economic outlook, with low interest rates and still subdued inflation, combined with ongoing intervention from central banks should continue to underpin government bonds. Against this background, broad fixed interest exposure is sought to provide diversification as well as secure income in portfolios.
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