Please see below the latest market insight from Karen Ward at JP Morgan, with particular reference to the ongoing complexities of Brexit.
An American colleague joined me on a call recently and was perplexed by the fact that I was talking about Brexit. “Isn’t Brexit done?”, he asked me. Alas, no. While the UK did officially leave the EU on 31 January, for the economy nothing actually changed since the UK entered into an 11-month period of transition. During this period, the UK and EU were supposed to agree on a future trade arrangement to commence on 1 January 2021. The clock is well and truly ticking.
Negotiations are proceeding slowly and significant differences still remain. At the root of the problem is the same issue that has plagued the discussion for the last four years. The UK wants to regain control – to become fully sovereign – setting its own rules and regulations overseen by British courts. However, the EU is not willing to grant significant access to the single market without guarantees that standards will not be undercut to gain competitive advantage.
So what happens next? Either the next six months will see a breakthrough and a free trade agreement (FTA) will be established or the UK will leave and trade on World Trade Organisation (WTO) terms.
Trading on WTO terms has been used synonymously with ‘hard Brexit’. What exactly does that mean? The short answer is potential tariffs, more customs paperwork for businesses that trade with the EU and potentially the need for the UK to be removed from EU supply chains if regulatory conformity cannot be guaranteed. It is these nontariff barriers that we would expect to have the most economic impact. There could also be significant ramifications for financial firms since the UK would lose its passporting rights – its ability to serve EU clients from the UK. Advocates for a hard Brexit argue that a clean break would allow the UK more flexibility in negotiating future trade deals with other trading partners, although any benefit from these agreements would still only be seen once these trade deals had been implemented, which is often a lengthy process.
What will happen and what will be the implications for markets? In our view, the announcement of a comprehensive FTA might see sterling rise to 1.45 against the US dollar. By contrast, in a no-trade deal scenario we see sterling closer to 1.10 against the dollar. Much weaker sterling would partially help the UK to cope with new trade frictions.
Our central expectation is that despite ongoing near-term sabre-rattling, by year end pragmatism will prevail and a relatively narrow trade deal will be agreed. When ‘Brexit’ was added to the English dictionary, the word ‘fudgery’ should also have been included.
We expect a significant amount of ‘fudgery’ in order to get a partial trade agreement done. This may, in fact, involve highlevel agreements that disguise what is essentially a transition to iron out the finer details. Such a narrow trade deal will likely still be disruptive to economic activity in the EU and the UK over the long term. But we expect various arrangements to ease the near-term burden of the change for both sides. We expect that both sides will want to minimise the day 1 disruptions given the extent to which both economies are still struggling to overcome the Covid-19 recession. Therefore, changes may well be phased in over time, spreading the economic cost over a number of quarters if not years. The UK could thus claim the sovereignty to set their own rules and standards without initially making substantial disruptive changes.
While this outcome is our central expectation, there are significant risks around it that investors should be mindful of. Sterling may be particularly volatile and, with almost 80% of revenues coming from abroad for the FTSE 100, this will also have implications for the stock market, since higher sterling could put downward pressure on earnings and vice versa should sterling fall, all other things being equal. However, we caution against relying too heavily on the FTSE rallying in the event of a hard Brexit as a disorderly Brexit would be likely to impact both UK and EU activity negatively, depressing some of the overseas earnings that matter to UK companies.
We will continue to provide the most up to date information on the markets and economy. Please check in with us again soon.
Please see below a useful update received from Blackfinch Group which covers this week’s events from around the world.
Restrictions on social gatherings are reintroduced along with some tighter local restrictions. The government does not rule out another national lockdown if necessary.
MPs voted to back the Internal Markets Bill that will give the government the power to override parts of the Brexit agreement with the EU. The bill passed by 340 votes to 263.
Data from the Office for National Statistics (ONS) shows that the UK has lost 700,000 jobs since March, with a further 5 million people still temporarily out of work.
Four-week grocery sales growth slowed by 8% in August, the lowest since April, with shoppers spending £155mln less in supermarkets. The data showed the impact of the hospitality sector reopening, with alcohol sales falling and personal grooming sales increasing.
Inflation, measured by the Consumer Price Index, fell to 0.2% in August, from 1.0% in July, impacted by the Eat Out to Help Out scheme and the reduction in VAT on the hospitality sector.
The Bank of England policy committee votes unanimously to leave interest rates on hold, noting that UK economic growth in July was around 18.5% above its trough in April, but remained 11.5% below the fourth quarter of 2019. The bank ‘stands ready’ to adjust interest rates, bond buying and other monetary policy measures if necessary.
UK retail sales volume, including petrol, rose by 0.8% month-on-month in August according to the ONS, meeting analysts’ expectations. Year-on-year growth increased to 2.8%.
The Federal Reserve makes no changes to policy at its latest meeting, although it did guide that it intends to keep interest rates low until 2023. The central bank also implicitly ruled out the possibility of negative interest rates.
Weekly initial jobless claims rose by 860,000, marginally above estimates, with continuing claims at 12.63mln.
Donald Trump reportedly gives his ‘blessing’ to a partnership between TikTok and US firms Oracle and Walmart, easing talk of a ban on the service in the US.
The Bank of Japan leaves monetary policy unchanged and upgraded its assessment of its economy, stating that data was improving after the shock caused by the COVID-19 pandemic.
The Organisation for Economic Cooperation and Development (OECD) predicts that the global economy will shrink by 4.5% in 2020, better than the 6% collapse it has forecast in June. The data suggests that should the pandemic be contained then global Gross Domestic Product (GDP) will rise by 5% in 2021, but if there are major second and third waves of infection, then this will likely reduce the growth to 2-3%.
Oil prices came under pressure after OPEC downgraded its outlook for global oil demand for the rest of the year and the International Energy Agency (IEA) cut its oil demand forecast for 2020 for the second month running.
The total number of daily cases reached new heights, but the number of daily deaths remains below April’s peak.
Pfizer announce that the effectiveness of its COVID-19 vaccine could be confirmed by October.
Novavax Inc announces expansion of its deal with India’s Serum Institute to produce 2bn doses of its COVID-19 vaccine annually, with all planned capacity to be brought online by mid-2021.
Moderna Inc states that it may soon submit its COVID-19 vaccine for emergency authorisation for people at high-risk, should the latest trials prove at least 70% effective.
We will continue to provide the most relevant articles and original blogs so please check in again with us soon.
Please see below for the latest Blackfinch Group Monday Market Update:
House prices rose 1.6% in August from July’s level according to the Halifax House Price Index. The annual increase in house price accelerated to 5.2% from July’s 3.8%, hitting its highest level since 2016.
Reports suggest that the UK is willing to walk away from Brexit negotiations in mid-October if a free trade agreement hasn’t been agreed upon.
A week of Brexit talks conclude with the EU telling Britain that it should urgently scrap a plan to break the divorce treaty, but Boris Johnson’s government have refused and continued with a draft law that could collapse four years of negotiations.
A rise in the number of COVID-19 cases in the UK brings fears of a second wave, forcing the government to reimpose some restrictions over social distancing. Daily cases have risen to close to 3,000, from c.1,000 at the end of August.
The British Retail Consortium’s figures report that year-on-year growth in retail sales rose 3.9% in August, but city centre shops continue to struggle.
UK gross domestic product (GDP) rose for the third month in a row in July, up 6.6%, although this is still 11.8% below January’s level.
A report from the National Institute of Economic and Social Research forecasts that the UK economy will emerge from recession at the end of the third quarter.
Comments from Donald Trump that he may seek to ‘decouple the US economy from China’ suggest that the trade war between the two nations is far from over.
The US revokes visas for over 1,000 Chinese students on grounds of ‘national security’.
Initial jobless claims for the week are an exact repeat of the previous week’s number of 884,000. Continuing jobless claims rose to 13.39mln, above analyst expectations of 12.92mln.
Once again mutual agreement between the Democrats and the Republicans fails to be reached over details of a further COVID-19 support package.
US inflation rises by 0.4% in August, higher than forecast, but below the 0.6% rise seen in July.
Insee, the national statistics institute of France, forecasts that the economy will contract by 9% this year, down from earlier predictions of an 11% drop.
EBC President Christine Lagarde announces that monetary policy remains unchanged, but that the bank has to carefully monitor the ‘negative pressure on prices’ that the Euro is exerting.
Revised GDP figures for Japan show that the economy shrunk by 28.1% in the second quarter of the year, worse than preliminary estimates released in mid-August.
China reports its largest jump in exports in 18 months, rising 9.5% in August compared to a year prior.
AstraZeneca confirmed that it had halted work on its COVID-19 vaccine, currently in development with Oxford University, after a ‘serious event’ during the trial process, reported to be a member of the clinical trial falling ill. However, trials officially restarted over the weekend.
These articles provide concise well-informed views that cover the whole of the market and are useful to maintain your up to date view of the markets globally.
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Please see below for the latest Markets in a Minute update from Brewin Dolphin, received late yesterday 02/09/2020:
Global share markets mostly rose over the past week, driven by growing signs of an economic recovery, positive news on coronavirus developments, and the US Federal Reserve’s shift on inflation targeting (see below).
Sentiment in the US was so bullish that the S&P500 set fresh record highs every day last week, helped by a cooling of the US/China tensions. The UK, however, was a notable underperformer, with the FTSE100 weighed by a stronger pound. This reduces the value of multi-national companies’ dollar-based earnings.
A mixed start to the week
The UK markets, along with many in Europe, were closed on Monday, although in the US it was business as usual and shares fell slightly.
On Tuesday, however, US shares rebounded, with the Dowgaining 0.76% and the S&P500 rising by 0.75%, while the Nasdaq continued its extraordinary rally, rising by 1.4% to 11,939.67.
In the UK it was a different story, as the continuing strength of the pound and Brexit uncertainties saw the FTSE100 fall by 1.7% to 5,862.05, its worst level in three months.
In early trading on Wednesday, UK shares were heading up, as Nationwide reported house prices had had risen to an all-time high of £224,123 in August, as activity rebounded after the lockdown was eased.
Hang Seng: -1.2%
Shanghai Composite: +1%
*Data for the week to close of business, Tuesday 1 September.
New global coronavirus cases have been trending sideways for a month now. Infections in emerging economies may be slowing especially in Brazil, South Africa (which has gone from 13,000 new cases a day down to around 2,000), Pakistan, Mexico and Saudi Arabia. In addition, new cases are falling in developed countries, led by the US which has seen a sharp decline, and also Japan, both of which are helping to offset some worrying rising trends in Europe.
Encouragingly, the death rate in this second spike of cases in developed countries is far lower than the highs of April, even though the number of new cases being detected is well above the April highs. This is likely to be because there is more testing of younger people and therefore more cases detected among younger, more resilient populations. This is helping to avoid a return to a generalised lockdown and helping keep confidence up.
UK piles on the debt
Although the UK has only just entered a recession, recent data has started to illustrate the true extent of the damage so far suffered during the coronavirus pandemic. The Office for National Statistics has revealed that, following the sheer cost of its Covid-19 response, UK government debt has risen above the £2trn mark for the first time.
According to the data, spending on measures (such as the widely used furlough scheme) meant total UK government debt was £227.6bn higher in July 2020 than it was a year before. At the same time, tax revenue has been hit hard by the fact many businesses and people are earning and spending less. Combined with greater government borrowing, this is the first time UK government debt has been above 100% of gross domestic product (GDP) since the 1960s.
Jackson Hole Symposium
In his speech to the annual gathering of central bankers and policymakers in Jackson Hole, Wyoming, US Fed Chair Jerome Powell confirmed it is moving to a system of inflation “average targeting”.
This is important because it means that it will allow inflation to run above 2% to make up for a previous undershoot. The Personal Consumption Expenditure (PCE) price index is the Fed’s preferred inflation index for the 2% target, and in the chart below you can see it has been running below 2% for a sustained period of time for the past decade.
According to the St Louis Fed, even if you allow for 2.5% PCE inflation, which is an overshoot of inflation of 0.5%, it will take until 2032 to make up for the inflation undershot over the past decade. So, the implication is that the Fed wants to let the economy to run “a little hotter”, with faster-rising prices, without the need to raise interest rates or tighten monetary policy when inflation is above 2%. It also likely means that US interest rates will stay at, or near, 0% for a long time, which should be a positive for investment assets. Indeed, many think that the US will need to return to near-full employment and inflation of at least 2% before the Fed will consider raising rates again. We expect further guidance on this at the next Fed meeting later this month.
US/China tensions cool
Powell’s speech came in a week of broadly positive economic news for the US. At the beginning of the week, both the US and China affirmed their willingness to negotiate and declared they were ready to progress with trade talks. With tensions between the two nations a recurring source of stress for investors, this update was welcomed by markets.
US economic data
US Durable goods orders in July were up 11.2% vs expectations of 4.8%, helped mostly by new orders for vehicles and parts (+21.9%), electrical equipment and electronic products. Durable goods orders are a proxy for business investment demand and it has now risen for a third consecutive month – a sign things are really normalising.
US housing data, which is vital in supporting economic growth, has been really encouraging. July new home sales came in significantly above expectations at $900k versus the estimated $790k, surging to the highest level since the 2009 financial crisis. Existing home sales increased by a record 24.7% in July to an annual rate of $5.86m, the highest level since December 2006. The median house price rose to 8.5% on an annualised basis, the highest since April 2015. Pending home sales also rose 5.9% in July compared to June, after a huge 16.6% increase in June over May.
Australia enters recession
Having avoided a recession even during the financial crisis of 2008/09 (thanks to huge demand from China for its iron ore and other commodities), the world’s longest economic expansion has finally ended. After almost 30 years of uninterrupted growth, Australia’s economy contracted by 7% in the June quarter, following a 0.3% contraction in the first three months of the year.
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Please see the below investment outlook received from J.P. Morgan today (Tuesday 23rd June):
In early June the market was pricing in a V-shaped recovery from the pandemic-driven economic contraction. We expect the recovery to be more gradual, with a few stop-starts along the way. Extremely low interest rates will help, but unemployment and corporate deleveraging could be a drag on growth.
The extent of near-term uncertainty, as well as the potential for political risk to mount as we approach the US election, could generate more market volatility.
For individual market sectors, the outlook depends on the path of the pandemic. If a full and sustainable reopening of the economy becomes possible, we may see a further rally for the most beaten-up sectors, coupled with a style rotation. For now, we believe it makes sense to maintain a nimble approach, with a focus on quality and an eye to ESG risks.
Low-risk options for income seekers are increasingly scarce. Rather than stretching for yield, investors may be better off being selective within fixed income and using a wider range of income-providing asset classes, including real assets for those who can accept lower liquidity.
Developed market government bonds look less and less likely to play their traditional roles of providing income and protecting portfolios in periods of market stress. Investors may need to look beyond the traditional 60:40 portfolio, with a greater role for alternatives and flexible fixed income strategies.
No one predicted that in the first half of 2020 the world’s economies would be brought to a virtual standstill by a global pandemic. Even had we have known the virus was coming, we would not have predicted that by mid-year the S&P 500 would have managed to climb back above 3000 (EXHIBIT 1).
We have global policymakers to thank for the market’s resilience. According to current analysts’ expectations, the policy response has helped one-year forward earnings expectations to find a floor and start to improve. In the sharp rally since 23 March, markets looked to be pricing that the combined actions of governments and central banks in recent months will have successfully absorbed the economic losses of Covid-19 to engineer the perfect V-shaped recovery (EXHIBIT 2).
While the policy response has been commendable, we believe the market’s expectation of the recovery in early June was too optimistic. It’s not that we believe people will permanently change their behaviour – we are social animals, after all. We just think it will take a little longer to get back to full normality.
Chief among our concerns is that the virus itself may linger and some need for social distancing will remain, in countries such as the US and UK, at least. In addition, high unemployment and a dramatic increase in public and private debt may serve to restrain spending in the recovery. We may also be at the beginning of a period of difficult political fallout as politicians seek to apportion blame for the crisis. The US election of 3 November could have important market implications. With the UK having left the EU but not yet having secured a new trade deal, Brexit might also – once again – generate volatility.
In summary, we acknowledge that the commitment from governments and central banks shouldn’t be underestimated. And, if more stimulus is needed, it will come. This makes us cautious about being underweight risk assets. But we need to see that policy action is influencing fundamentals. Valuations and uncertainty around the economic and earnings outlook make us cautious about advocating an overweight position in equities. We therefore think investors may benefit from having more than one toe in this rally, but not from jumping in with two feet.
In what follows, we provide greater information on our view of the shape of the recovery. We then consider three investment themes for the second half of the year:
1) Considerations for investors in the near term, given uncertainties and potential volatility
2) Options for investors in need of income
3) Rethinking a 60:40 portfolio in a world of zero bond yields
WHAT SHAPE WILL THE RECOVERY TAKE?
As shutdowns are eased around the world, forecasters are debating the likely shape of the recovery. The optimists point to a V-shaped recovery, the pessimists L-shaped, and the cautious look for something less linear, such as W, U or √.
In truth, it is very difficult to know at this stage. The risks aren’t black swans, they are known unknowns, but we simply don’t have enough information at this stage to form our judgment.
The first set of known unknowns relates to the virus itself. As the economic and fiscal costs have become apparent, politicians have hurried to ease shutdowns, whether the infection is under control or not. It is possible that the combination of a degree of ongoing social distancing, track and trace systems, and better hygiene practices will mean that the reopening happens without a reacceleration in infections. But there is also a risk that the infection rate will pick back up. Governments may be reluctant to re-impose shutdowns in such a scenario, but there will still be economic costs if people choose to socially distance voluntarily (EXHIBIT 3).
We are closely tracking how the virus progresses as well as using high frequency data to gauge the extent to which economic activity is normalising (EXHIBIT 4). To find the latest statistics on these, please refer to our On the Minds of Investors piece, Monitoring the global impact of Covid-19, which is updated twice a week.
As the weeks and months drag on, the more lasting consequences of the recession will become more evident. Policymakers globally have made a gallant attempt to limit the impact and absorb the losses of Covid-19. Grants and subsidies aimed to shift the losses on to government balance sheets. These, in turn, were shifted to central bank balance sheets as asset purchase programmes were expanded to absorb the additional issuance. Governments have been able to issue record high levels of government bonds, at record low interest rates.
Furlough, or short-shift schemes have been the cornerstone of the policy response in Europe (EXHIBIT 5). However, unemployment has still risen in the UK. The moves on the continent of Europe have been more moderate, but we suspect this is flattered by people not categorising themselves as unemployed because they are not actively looking for work due to either a need to look after children or a choice to remain socially isolated.
In the US – which hasn’t adopted widespread furlough schemes – unemployment rose to 14.7% in April though came down slightly in May to 13.3%. We would be considerably more worried about a double-digit unemployment rate were it not for the fact that the US social safety net has been made considerably more generous. Indeed, estimates suggest that 75% of those that have lost work are in fact better off given the additional USD 600 a week that has been added to unemployment benefits. This boost to benefits is set to expire on 31 July and, though an extension of some sort looks likely, it is likely to be less generous. We are therefore monitoring labour market data closely to gauge any shift in unemployment from those currently classified as temporary to permanent (EXHIBIT 5).
What will be the lasting consequence of higher levels of public debt? Is a new wave of austerity ahead? Public sector pay and benefit freezes – which were an important component of the spending restraint in the last expansion – seem unlikely given the degree of austerity fatigue in the population. Wealth taxes may be appealing given the resilience of asset prices, but these policies run into the practical problem that much of people’s wealth is stored in housing assets and held by individuals that are asset rich and income poor. One off ‘Pigouvian’ income taxes on higher earners are also being touted. We see it as more likely that finance ministers will forge ahead with plans to tax the large multi-nationals that obtain tax advantages by choosing favourable domiciles.
There is one global debt-reducing strategy we see as almost inevitable: interest rates will be held down for the foreseeable future. One suspects that policymakers are hoping for a repeat of the post-war period, in which a combination of yield curve control and financial repression kept the interest rate below nominal growth and helped erode government debt as a percent of GDP (EXHIBIT 6).
Lower interest rates will help corporates, which, on aggregate, have also experienced a significant rise in debt as a result of Covid-19. While we don’t expect governments to focus on deleveraging, the same may not be said for the corporate sector. Corporate deleveraging may constrain investment spending and employment growth and, in turn, the economic recovery.
So what is the letter most apt to describe the economic recovery? Our standard alphabet might not suffice but, in our view, expecting a symmetrical V is too optimistic. The recovery is likely to be more gradual, with a few stop-starts along the way. All the while, investors should be mindful of some sizeable tail risks lurking.
One such risk is China’s relationship with the world in the wake of Covid-19. Our opinion is that de-globalisation is easier (politically) said than done. China is highly integrated in global supply chains. As the 2019 trade war demonstrated, it is very hard to reduce trade links without causing significant economic harm in western economies. However, it does seem likely that China will come under scrutiny for regulatory standards, which may in turn raise inflationary pressures. Despite the economic realities, rhetoric towards China may intensify for short-term political reasons.
Nowhere is this more evident than in the US, which enters full election mode in the coming months. At this stage it is still difficult to say anything definitive about who will win, whether the victor will have full control of Congress, or the impact on markets.
The top priority for whoever emerges successful will be to manage the recovery as the economy restarts in earnest in 2021. Tough choices will need to be made about whether to push on with further stimulus or to try to tighten the purse strings as the recovery takes hold. President Trump had already flagged his desire for a second round of tax cuts prior to Covid19, but with US national debt-to-GDP now set to rise above 100% this year, further corporate tax cuts could face greater opposition. While Trump is yet to lay out a clear agenda for a second term, the tough-on-China and tough-on-trade stances that were at the core of the 2016 Republican campaign will remain a key tenet of his approach.
For the Democrats, as the most left-leaning candidates exited the primary race, so did their policies. Yet it is clear that presumptive nominee Joe Biden’s vision for corporate America is still very different to that of President Trump. Two topics that investors will need to monitor closely are a proposal to use anti-trust legislation to clamp down on ‘Big Tech’ and plans for corporate tax changes. Biden’s campaign team has also been keen to emphasise its candidate’s tough-on-China credentials. Historically, escalating trade tensions have favoured the higherquality US stock market relative to other regions, but a ramp-up in pressure on the tech titans would pose risks to US market leadership given the high weights to the technology and communication services sectors in US indices.
The second half of the year may therefore put us in the unusual position in which the political risk premium may be higher on US assets than on those of continental Europe, where the signs look increasingly positive. Though it still needs to be ratified by all EU member states, the European Recovery Fund is a significant step forward. Not only will it provide invaluable short-term help for countries like Italy but it provides a strong signal for the long term with regards to the fiscal integration that is much needed to complement the monetary union.
If the recovery in the US lags due to lingering Covid risks, and perceptions of political risk change, we could see downward pressure on the dollar.
CONSIDERATIONS FOR INVESTORS IN THE NEAR-TERM GIVEN UNCERTAINTIES
While the S&P 500 suggests a V-shaped recovery is priced in, at the sector level the narrative is more nuanced. From the start of the year to the S&P 500 trough in March, some of the most obviously affected sectors were hardest hit. Meanwhile, the likely winners from people remaining at home, other than for their food shop, outperformed.
The bounce-back since March has included some of the worst performers during the sell-off (EXHIBIT 7). For example, energy, autos, clothing retailers and restaurants have all outperformed during the rally, presumably on hopes of a partial rebound in activity as the economy starts to reopen. But some of the perceived beneficiaries of a world with more working and shopping from home, such as home improvement retailers, tech companies and industrial (including warehouse) properties have also rallied strongly. Meanwhile, despite improvement from their lows, airlines, hotels, department stores and retail properties remain among the weakest performers year to date.
What are the risks and opportunities from here under different potential scenarios:
Scenario 1: A full and sustainable reopening of the economy with social distancing no longer required. The most beaten-up sectors could rally further, while the sectors that have gained the most could be vulnerable to profit taking and rotation into cheaper companies as it becomes clear we won’t all work and shop from home forever. This would also likely coincide with a style rotation from large cap to small.
Scenario 2: An acceleration in infection rates leading to renewed shutdowns. At least part of the rally since March could reverse for most sectors, but those most exposed to further shutdowns could suffer the most as solvency concerns increase.
Scenario 3: Partial reopening of the economy but with some social distancing remaining in place. Sectors that might be able to reopen with some social distancing, such as department stores, autos and energy, could benefit further. Airlines, hotels and dine-in restaurants could struggle as solvency concerns increase. The most expensive stocks among the current winners could also suffer from valuation deratings and earnings disappointments, as unemployment remains elevated.
Which scenario plays out depends largely on the path of the virus itself, which is unknown. Given this uncertainty, we think it makes sense to avoid potential value traps, where solvency concerns could increase further. But we also think it makes sense to avoid the most expensive companies, where there is a lot of good news already in the price.
We also think this recession will increase the momentum behind sustainable investing. Robust ESG screening processes should capture the risks to corporate earnings from potential changes to taxes and other political interventions. The crisis has underscored the benefits of screening companies on nonfinancial metrics such as corporate governance and human capital management. We believe companies will increasingly be rewarded for demonstrating responsible capitalism given that there are, unfortunately, likely to be more lasting consequences of this recession for lower income and minority groups. Finally, although governments will be strapped for cash coming out of this recession they will also been keen to support infrastructure projects that can fuel the recovery. We expect these projects to be focused on the shift to a zero-carbon economy. The European Green deal is one such example.
An active, nimble approach, with a current focus on quality companies (EXHIBIT 8), a keen eye on valuations, and consideration of ESG risks, therefore appears the best way of navigating the uncertainty facing investors.
SEEKING SUSTAINABLE INCOME
Central bank actions so far this year have performed the essential role of keeping government borrowing costs low but, for those seeking income, the negative side effect is that lowrisk income options are increasingly scarce.
Investors have been turning to higher risk asset classes, including equities, for income over recent years, yet dividend cuts have become a hot topic as companies look to shore up balance sheets against the shock from Covid-19. While we acknowledge that many companies – particularly those who are receiving government support – may find it difficult to maintain payouts over the coming months, it is essential not to mistake what, for many firms, will be a cyclical issue for a structural one. On a regional basis, we see US dividends as most resilient. The lower dividend payout ratio of the US market provides companies with more flexibility to maintain dividends in periods of weaker earnings. Higher use of buybacks provides a buffer for companies to cut before dividends are hit. Regulatory pressure on banks, in particular, has also been lower so far in the US than in Europe.
Riskier parts of fixed income, such as corporate credit and emerging market debt, are other areas that may warrant attention when hunting for income. The Federal Reserve’s decision to buy both investment grade and high yield credit for the first time helped to pull spreads back from their widest levels in March, but credit spreads still sit significantly above their levels of the start of 2020. Central bank purchases in both the US and Europe should provide something of a backstop for corporate bond prices in the second half of the year, although we advocate an increasingly selective approach as investors move further down the quality spectrum and the need to differentiate between (more temporary) liquidity issues and (more permanent) solvency issues becomes more important.
Outside of fixed income, real assets may also have a larger role to play in portfolios as an alternative income source. While asset prices in areas such as infrastructure have not been immune to the pressures seen in public markets so far this year, income streams have broadly remained stable. But, of course, investors will need to be able to accept lower liquidity as the trade-off for moving into these types of asset classes.
The risks of overstretching for yield when hunting for income have been made very clear by the market volatility so far in 2020. Higher levels of income can only be achieved via higher levels of risk in some shape or form. Rather than ramping up risk to achieve a fixed yield target, income-seeking investors may be better off using a wide range of asset classes to build well-diversified portfolios that are in line with their risk appetite, and accepting the level of yield available as a result.
60:40 WHEN BOND YIELDS ARE NEAR ZERO
Perhaps the clearest investment challenge that will endure well beyond Covid-19 is that of how to construct a portfolio in a world of very low government bond yields.
Government bonds have traditionally played two roles in a portfolio. One is to provide a steady and stable source of income. The other is to protect a portfolio in times of market stress. Traditionally, recessions would coincide with central banks cutting interest rates, sending bond prices higher at a time when stock prices were falling. This reduced the overall scale of capital loss in bear markets.
As we look ahead, developed world government bonds don’t look like they will serve either purpose. Even long-duration government bonds provide very little – if any – income in much of Europe. And unless central banks entertain the idea of taking interest rates into negative territory (or deeper negative territory, for those already deploying negative interest rates) then bond prices cannot rise much in periods of market stress.
Meanwhile, shifting to, say, a 90:10 allocation or substituting government bonds for high yield bonds would help boost return prospects but result in a portfolio that was far less able to weather bouts of volatility.
The challenge is therefore to find assets that have low correlation to stocks and ideally provide income along the way. While there are still highly rated government bonds – such as Chinese government bonds – that offer modest positive yields, in our view it may be better to look to the alternative markets. EXHIBIT 10, taken from our Guide to Alternatives, shows the asset correlations. Within liquid strategies, macro funds have tended to do a good job of providing downside protection. Less liquid options include direct real estate and core infrastructure, which both have relatively low correlations to stock markets and offer relatively strong income.
J.P. Morgan is a global leader in financial services, offering solutions to the world’s most important corporations, governments, and institutions in more than 100 countries. This in-depth analysis of markets by a world leading financial services organisation can prove valuable as we venture into the unknown as Coronavirus restrictions are gradually loosened and we attempt to return to ‘normal’.
We still believe now as much as ever that gaining a consensus view of the markets by reviewing the opinions of a variety of market leaders is key. Market behaviour is very much on a knife edge right now, and it is important that we frequently review these views so that we are well informed and in turn can keep you up to date.
Please see the below weekly market commentary update from Brewin Dolphin received yesterday (2nd June 2020):
Share markets had a positive week with most assets rising despite increasing political tensions between the US and China over Beijing’s imposition of security laws in Hong Kong.
There were widespread demonstrations in the city and markets were cautious ahead of President Trump’s speech on Friday in which he would outline his response. However, there was a collective sigh of relief when his speech, which took place after the UK and European markets had closed, lacked any threat of direct action against China or any intention to pull out of Phase 1 of the trade deal.
As a result, US markets closed effectively flat on Friday and UK and global markets rallied on Monday, having lost ground ahead of his speech last Friday. But the best gains were seen in Asia.
• Hong Kong’s Hang Seng closed up by 3.36% yesterday.
• Overall, the MSCI Asia ex-Japan index jumped 2.27% on Monday alone.
• Indices in Europe, the US and UK all finished higher yesterday; the FTSE100 gained 1.5%.
Last week’s gains: *
• FTSE100: 1.4%
• Dow Jones: 3.75%
• S&P500: 3%
• Dax: 4.6%
• Nikkei: 3.7%
• Hang Seng: 1.5%
• Shanghai Composite: 1.4%
*Data to close on Monday 1 June 2020
“The speed at which the economy is able to open over the next two months will be an important factor determining the trajectory of unemployment thereafter.”
PMIs signal slow improvement
Two surveys over the weekend suggested China’s recovery was continuing, with manufacturing activity expanding.
• China’s National Bureau of Statistics manufacturing PMI hit 50.6 in May, slightly down on April but above the key 50 level that indicates expansion.
• The private Caixin/Markit manufacturing PMI came in at 50.7 for May, above expectations of 49.6. • In the UK, the IHS Markit/CIPS Manufacturing PMI came in at 40.7, still firmly in contraction territory but sharply up from April’s reading of 32.6, suggesting the easing of the lockdown is stemming the decline in activity.
• Eurozone manufacturers appear to have passed their nadir, with the region’s manufacturing PMI rising to 39.4 in May from 33.4 in April.
PMI Data June 2020
Source: Datastream June 2020
Chancellor Rishi Sunak confirmed on Friday that the furlough scheme will be gradually unwound. Starting from August, firms will have to pay employer national insurance and pension contributions for furloughed staff. In September, they will have to pay 10% of their wages, rising to 20% in October.
This comes despite plenty of lobbying for less burden on business. The Institute of Directors said only around half of firms can afford this. The speed at which the economy is able to open over the next two months will be an important factor determining the trajectory of unemployment thereafter. However, companies will be able to bring back staff on a part-time basis from 1 July, a month ahead of schedule, giving companies some flexibility in adapting to the new levels of demand.
Sunak also extended the Treasury’s self-employment income support scheme, so that those eligible would be able to claim another payment, albeit to a lower level of 70% of average monthly earnings. The first payments had been based on a ratio of 80%. Welcome news nonetheless.
Boost for Europe
The European Commission has proposed a €750bn package, dubbed “Next Generation EU”. The fund would consist of €500bn in grants to hard-hit member states which would not have to be repaid, with a further €250bn in loans. This follows a proposal from France and Germany of €500bn, which the EU’s so-called “Frugal Four” (Austria, Denmark, the Netherlands and Sweden) countered with a proposal of loans only. Since any proposal requires agreement from all 27 member states, we would not be surprised to see them meet somewhere in the middle.
The general sense within the market seems to be that the worst of the virus is over and the re-opening of the economy will proceed. There are varying degrees of caution over the process which makes it hard to draw conclusions about how well it will go.
Asia is an example of how well the virus can be contained. As we expected, privacy concerns are causing resistance to the track and tracing amongst western populations, and the lack of an effective app means any track and trace programme will be limited in its effectiveness.
As the crisis appears to be ebbing and the UK government is loosening restrictions further, support for containment measures is starting to decline. Indeed, police have said that the lockdown is no longer enforceable, and scenes from parks around the country this past sunny weekend have shown crowds clearly breaching social distancing regulations.
So far, however, there have been very limited instances of cases starting to rise as a result of lifting lockdowns, although it is early days. Denmark remains on a downward trajectory despite lifting its lockdown early, as does Sweden despite much less strict suppression measures. The exceptions are largely in the US where, although the overall trend is lower, several states are seeing an upward trend including California. In Europe it is probably the more general persistence of cases in Italy, where lockdowns are being lifted, that is of greatest concern.
But convincing evidence of a second wave is lacking, which is good news, but there is no room for complacency.
Stories regarding vaccines continue to support investor sentiment despite the challenges of producing these to a scale which would facilitate global herd immunity. However, a variant of these stories relating to GlaxoSmithkline was that the company plans to produce a billion doses of adjuvant. This can boost the effectiveness of a vaccine, reducing the quantity, improving the response and creating longer lasting immunity. With so many vaccines in early trials, we await news of concrete developments.
These weekly updates from Brewin Dolphin provide their view of the markets, the frequency of these reports is particularly useful given the present high levels of volatility.
We try to take on board a wide variety of fund managers’ and investment experts’ opinions such as Brewin Dolphin to give you an informed and overall view of the current climate we are in, the consensus view and any variation in views.