Quarterly Review

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Quarter ending March 2020

Our Reviews look back at the markets over the last quarter as well as our thoughts on today's major issues.

Review of the markets over Q1 2020

Despite an early wobble, as Middle East tensions rose following the assassination of a senior Iranian general by the US, global equity markets were in buoyant mood and ensured 2020 got off to a good start. The US and China eventually reaching a ‘Phase One’ agreement on trade after months of uncertainty provided support, as well as better economic data indicating that the global economy was improving, and the near-term threat of recession was receding. In addition, and perhaps not totally unexpected, central banks signalled that they would remain accommodative in the year ahead. In the UK and Europe, there was also some relief when, on 31 January, Brexit (at last) happened, but little change was expected in the short term given the length of the transition period.

However, and as if to shake us out of any complacency, an unforeseen event happened when an outbreak of the novel coronavirus began to spread from China to other regions of the world. The measures applied by China as it attempted to contain the virus led to a marked disruption to its economy, and, given its position within the global supply chain, concerns grew that this might be indicative of similar disruption in other economies if the outbreak became a pandemic. These concerns caused investor sentiment to shift towards safe-haven assets such as government bonds and gold.

As the spread of the virus outside China accelerated investor nervousness grew, and equities were dumped in favour of defensive assets causing government bond yields to reach new lows, and gold to surge to near all-time highs. There were few places to hide and all equity market sectors saw a decline, although cyclical sectors, such as tourism, travel and leisure stocks experienced the sharpest falls as governments issued guidance and applied restrictions on unnecessary travel. The acute reaction of the markets caused central bankers to issue statements expressing that there was little doubt that economic activity would be severely hit in the coming months, raising expectations that additional policy support was on the cards.

March brought no respite - the global equity market rout continued as headlines focused on the rapidly rising human cost of the pandemic, whilst the magnitude of the economic cost remains uncertain. Such was the pace and extent of the retreat in the US equity markets that on several occasions trading was halted in an attempt to limit the losses. By the end of the month unemployment numbers in the US had begun to hit record highs.

As fears grew of a worldwide recession central banks around the world reacted with unprecedented levels of support for their economies. The US Federal Reserve slashed interest rates twice in quick succession to a range of 0.00-0.25%, while the Bank of England cut rates to just 0.1%. The US Congress agreed to a $2 trillion aid package – the largest economic stimulus in US history, and the UK government announced an eye-wateringly large support package for businesses and citizens. Meanwhile, the European Central Bank kept interest rates on hold at -0.50% and announced €750bn in asset purchases; gaining agreement for further region-wide fiscal support is expected to be a challenge given the relative strength of individual economies within the block.

For investors, the safe-haven qualities of government bonds, increasingly supported by central bank purchases, have to be weighed against the surge in government borrowing created by the unprecedented levels of stimulus being applied, and the likelihood that it will lead at some point to the inflation. But for now, this is less of a worry than containing the virus.

Market Returns to 31 March 2020

Asset Class 3 Months 6 Months 1 Year 3 Years
FTSE All Share -25.1 % -22.0 % -18.5 % -12.2 %
S&P 500 -14.2 % -13.1 % -2.8 % 15.0 %
FTSE World Europe ex UK -17.5 % -16.7 % -8.0 % -1.6 %
TOPIX -12.0 % -11.0 % -2.9 % 2.5 %
MSCI Asia ex Japan -12.8 % -9.3 % -9.0 % 4.1 %
MSCI Emerging Markets -18.4 % -15.1 % -13.5 % -4.0 %
UK Gilts 6.3 % 2.2 % 9.9 % 14.5 %
IBOXX Sterling Corp Bond -5.6 % -5.8 % 0.0 % 5.6 %
FTSE EPRA Nareit Global Real Estate -23.7 % -26.6 % -19.8 % -8.7 %
Brent Crude Oil (US$/bl) -53.3 % -49.5 % -50.2 % -37.0 %
GSCI Commodities Index -38.4 % -37.9 % -38.0 % -34.3 %
Gold (US$/ounce) 11.7 % 7.3 % 28.5 % 26.0 %

Source: FE Analytics - rebased in Pounds Sterling

The Outlook

Has anyone ever seen a black swan?

If you have travelled to Australia then you may well have seen a black swan; it is the state bird of Western Australia. Outside of Australia black swans are rare; certainly, some were exported to other countries as ornamental birds like peacocks, and like many other captive birds they occasionally may have found their way out into the wild, but generally they have failed to become established.

It is the bird’s rarity value that persuaded Nassim Taleb, a finance professor and former Wall Street trader, to popularize the term ‘black swan event’ when describing an event which (i) is beyond normal expectations that is so rare that even the possibility that it might occur is unknown, (ii) has a catastrophic impact when it does occur, and (iii) is explained in hindsight as if it were actually predictable.

What we have experienced during the last three months has been described as a black swan event. There will be much debate over whether the pandemic was predictable, but most will agree that the impact has been catastrophic in terms of the human tragedy, as well as the damage caused to the global economy even though the full extent is yet to be revealed.

In our January newsletter we predicted that global growth in 2020 would be slow and steady with limited risk of a recession; this was based on robust labour markets and a degree of carry-over from the easing of monetary policy in 2019 which had helped to offset the negative effect of rising trade tensions. We advised caution over expecting any further reduction in interest rates to have the same impact upon asset prices and market returns. Our view was that economic growth would need to be the key provider of support for risk assets in 2020, although we also expected some support to come from fiscal policy. In light of what has happened during the last three months we were far too optimistic. Clearly, we weren’t looking out for a black swan!

The performance table above illustrates the returns achieved by the primary markets to the end of the first quarter, but these figures mask the size of the ‘peak to trough’ falls which occurred as a wave of indiscriminate selling hit the equity markets. Since then, beginning around the third week of March, global equity markets have begun to show some stability; this is in direct response to the unprecedented levels of financial support offered by central banks and governments to businesses and their citizens as they seek to avoid the inevitable recession becoming a depression.

What’s next?

Although the recent improvement in the global equity markets has provided a welcome pause for breath, we do not believe that we are out of the woods yet. After all, investors are still nursing paper losses for the period, and there appears to be a divide developing between investor sentiment and the underlying economic conditions.

In the last couple of weeks, analysts at some investment houses have increased their forecasts for global equity indices for the coming year. This is predicated on the pledges of central banks to purchase certain assets, including riskier credit, thereby easing the pain for many companies who have borrowed excessively. The ability of central banks to influence the markets is indisputable; after all, the last eleven years since the Great Financial Crisis (GFC) are testament to this, but this situation is vaguely reminiscent of the significant and influential statement uttered in 2012, by the former head of the European Central Bank, Mario Draghi, when he said ……‘the ECB is ready to do whatever it takes to preserve the euro’… at a time when debt issues were pushing the European Union to the verge of collapse.

Meanwhile, the global economy is deteriorating. US employment insurance claims in the last month have hit 22 million, and US retails sales and industrial production have collapsed. Beyond purchasing the bare essentials, spending has all but stopped as consumers are restricted by the lockdown, and many are struggling on reduced income and face the risk of redundancy. Economic data in the first quarter was poor but is expected to be truly awful in the second quarter. The global economy is likely to contract by more than it did in the GFC in 2008, with corporate earnings expected to be severely bruised in 2020 and to not recover until 2021.

Certainly, there is perhaps some comfort to be gained from the IMF forecast of a rebound in growth in 2021 to 5.8%, against a pre-virus estimate for 2020 of around 3%. But this forecast is based on the following assumptions: (i) that there is no second or third wave of the virus (ii) that economic activity will resume in the coming months and (iii) that global fiscal and monetary stimulus will lay a suitable foundation for the next business cycle.

Are investors putting too much faith in the support from central banks and governments? It is difficult to determine whether the amount of support pledged is necessary simply to buy time until the virus is under control, or if it indicates just how vulnerable the underlying financial system has become after a decade of boosting returns by increasing the level of indebtedness.

We certainly expect the markets to remain volatile until the virus is truly contained, although we may have to accept that coronavirus may never be eradicated, and we may all require to be vaccinated at some point; despite recent positive news, a viable vaccine still seems some months away. Eventually, the current containment measures will be relaxed, and individuals and businesses will escape the lockdown and begin to pick up the pieces, but life may never return to exactly how it was before this crisis began. Even if the virus is brought under control within a few months it could take years for demand to recover completely.

We expect consumer and business confidence to remain subdued for a time until there is a sense that the worst is past. Businesses will have to consider how they will repay any loans, and, in some countries, austerity may be introduced to repay the huge increase in public debt. Individuals may become more fearful of travelling abroad and so demand could stay weak for some years.

The global economy’s capacity to produce goods and services should rebound as firms re-open and people who were temporarily laid-off go back to work. But some businesses will not survive this crisis, and a proportion of the recent (and future) rise in unemployment figures may become permanent.

In summary, it could take some years for many economies to return to the pre-crisis levels of output, and given that share prices are supposed to reflect a company’s ability to earn and grow its future profits, the pace of recovery in the global equity markets may be slower than many will be hoping for.

What action have we taken?

Two important questions currently hover over the markets: how and when will the shutdowns end, and how will the world have changed by the time that economies reopen? It is perhaps too early to answer the second question with any confidence, but we can consider the first.

Certainly, there have been some recent encouraging signs that the virus is coming under control, especially in parts of Europe, but it is likely that it will still be some weeks before the restrictions are eased. How the restrictions are eased is likely to vary from country to country with governments following their own path, but in any event re-openings will be gradual.

This has implications - a gradual opening is likely to mean that the economic recovery is drawn-out; it is also likely that there will be significant variations in the performance of different sectors (influenced by when restrictions affecting different sectors are lifted as well as consumer behaviour).

There are several publications circulating which consider a range of possible scenarios for economic recovery. These try to differentiate between the possible shapes of the recovery by assigning letters from the alphabet, for example: V-shape, U-shape, and L-shape, and each has a different possible outcome for markets.

In the short term, a V-shaped recovery is generally positive for equities and corporate bonds, but negative for government bonds because inflation is likely to have stirred from its slumber. A U-shaped recovery implies that it takes until 2021 for recovery to truly begin, which makes equites and corporate bonds less attractive and government bonds flat. A L-shaped recovery implies that control of the virus remains elusive and governments are forced to increase the size of the stimulus to avoid an economic depression; this would be negative for equities and corporate bonds with refuge only likely in safe haven assets, although liquidity squeezes are likely and would support holding Cash.

In March, we decided to reduce our exposure to the equity markets because of the uncertainty over the magnitude and duration of the coronavirus pandemic, and the impact that the measures to contain it are likely to have on the global economy. Despite the recent improvement in the markets, we are concerned that when the full extent of the impact on the global economy becomes apparent prices may struggle to gain further traction and could even fall back, consequently we are, for now, content with our asset allocation. In truth, no-one knows as we are all sailing in uncharted waters.

The following table illustrates the current asset allocation of our Core growth portfolios across the six risk profiles they span:

Defensive Growth (A)Conservative Growth (B)Cautious Growth (C)Balanced Growth (D)Adventurous Growth (E)Global Opportunities (F)
Fixed Interest48%40%27%19%7%0%

Despite the huge uncertainty, the one factor investors can control is time, and time has always proved to be a great healer. This is not the first crisis, and neither will it be the last, and history shows that recovery eventually comes with exceptional rewards for patient investors. Of course, to reap these rewards investors need to continue to participate and avoid the temptation of trying to time the markets.

Risk warning: Investors should be aware that past performance of investments is not a reliable indicator of future results and that the price of shares and other investments, and the income derived from them may fall as well as rise. The content of this bulletin is for general information and reflects the general market view of Parallel Investment Management Ltd. - it should not be interpreted as recommendations or advice. Although endeavours have been made to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. We cannot accept responsibility for any loss as a result of acts or omissions taken in respect of the content.

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