The third quarter began with easing lockdowns and businesses beginning to reopen with the adoption of new measures to cope with the coronavirus pandemic. Initially, global PMIs indicated confidence in the recovery of both manufacturing and services, while high frequency data, rising manufacturing activity, improving consumer demand and falling new jobless claims pointed to a recovery in global economic growth.
A level of positivity was drawn from the improving data and Covid case numbers remained low for an extended period, creating the illusion that the virus was largely under control. Even where we have seen steadily rising cases, hospitalisations and deaths have so far been subdued, bringing into question the virus’s virulence and increasing our confidence that the worst is behind us. Alas, it has become apparent that it is largely the demographics that are keeping these values low, with new cases being skewed towards the young.
With cases now seemingly peaking everywhere, there has been renewed talk of nationwide lockdowns and global equity markets have recently soured as a result. To add to concerns over the virus, Brexit negotiations appear to be going to the wire and the US has a presidential election to contend with. In addition to the direct impact of Democrat/Republican policy on the economy, the election could be disruptive, with President Trump refusing to commit to a peaceful transition of power and the potential for voter suppression tactics to spill into retaliation. The immediate lack of another US stimulus bill is also dampening sentiment. With both parties yet to compromise, it’s looking more likely that one won’t be agreed until after the election.
Boris Johnson set out a raft of new coronavirus restrictions including the rule of six; a 10pm curfew for the hospitality industry; face masks for shop workers and taxi drivers; and rising fines for breaking these rules. He indicated that the measures could remain in place for six months, which would mean a long difficult winter for some, but they are a far cry from the full lockdown of March. We view this as a response to a certain level of ‘Pandemic Fatigue’ whereby individual caution may have dissipated.
This time round, opinions on such measures are more divided and there is growing pressure to allow individuals to freely choose their risk of exposure. What appears to be lacking is a clear endgame: is the virus to be openly endemic or are we targeting its eventual demise? Studying historic pandemics, it does appear that containment by stringent desocialisation measures is effective and this is corroborated by the situation in China where there are now very few cases. The country appears to be somewhat of a diamond in the rough, with its economy growing faster than expected in August and the capacity to lock down an entire city in response to two new cases.
At the time of writing, UK equities have fallen -5% during the quarter, while global equities are otherwise higher; US equities rising +4.7%, European equities up +0.5% while Chinese equities are up +10%. There was volatility during the period, most notably in the first days of September when the VIX reached 33 as technology stocks sold off. The Nasdaq fell over -10% in three days, but this move served only to wipe out most of the gains seen in August. During this time some sector rotation was evident as cyclical stocks, Industrials and Materials picked up, but much of this rotation has since been reversed.
The contrast between regions is stark in 2020. US and Japanese markets are marginally positive, while China has experienced double digit gains. Europe has not fared so well (down -8%), but the DAX has been resilient (down only –2%), as it was already feeling the pain of industrial recession. Sweden has also shown resilience, having relied only upon voluntary social distancing guidelines. UK markets are down over -20%, with Brexit now well discounted and reflecting a higher exposure to Consumer Services, Financials and Energy.
The Energy sector has given up all its gains since March and UK oil majors are back at mid-March lows. The oil price has steadied at around $40 per barrel but confidence in a demand recovery is beginning to wane even as inventories subside.
Precious metal prices continued to rise, with gold reaching $2,060 but now falling below $1,900 as the US Dollar firmed following a recent bout of weakness. The dollar was down almost -8% against a basket of currencies between May and August.
Now that the dust has settled, it is worth considering the long-term implications of the emerging new paradigm. Over the last decade, the easing policy used by central banks has been the printing of money to buy financial assets. The by-product of this activity is close to zero interest rates across the world and these are expected to be sustained for at least the time it takes for the economy to recover from the pandemic shock. The coordination of monetary and fiscal policy that we have seen this year intends to get money directly into the hands of spenders and, in this type of environment, inflation becomes a very real concern. Cash could become a risky asset. This view is supported by the Federal Reserve’s move to target an average of 2% inflation - instead of a fixed target – which gives it scope to allow inflation to rise above this level.
Central banks must now perform a careful balancing act: inject money directly into the hands of spenders, giving way to inflation, while ensuring borrowing costs remain low to sustain a colossal global debt pile. From here, will quantitative easing be required for both fiscal stimulus and yield control? In this scenario, we could see both equities and bonds perform, while the value of cash erodes.
We look through the annals of history for guidance; the 1930’s and 1970’s are periods that share many similarities, for example. Two features appear to play out: equity markets perform well if bond yields can be kept from rising too sharply and equity markets can be hindered by policy that has a detrimental impact on business investment and decision making.
So, once the US election and (if/when) Brexit is concluded, markets may have more of a direction in which to build. In terms of existing policy, the new jobs support scheme unveiled by Rishi Sunak looks to be the necessary support while gently letting down some smaller businesses that cannot operate in the current environment. There will be job losses and businesses may fold, but a certain level of the new normal must be accepted, and it at least puts an end to the limbo created by the furlough scheme.
After a strong recovery in equity markets, many investors find themselves trying to justify current valuations. Aside from the reflation argument, the bull case is that valuations still underestimate the impact of low rates. A P/E ratio of 25 indicates an earnings yield of 4% which could be an acceptable risk premium against a risk-free asset that yields almost zero.
High valuations in the technology sector can also be justified by scalability and high but less cyclical revenue growth that has high barriers to entry owing to scale and network effects. Technology companies may also have the capacity for far higher earnings if they were to cut back on things like customer-acquisition costs and R&D and settle for lower growth. It is our view that technological innovation will drive growth in the decades ahead and this is a key theme in our investment process.
Looking forward, another earnings season may assist to propel markets and a strong wealth effect, driven by the strength in housing markets, should bolster consumer demand. There may be some surprises on the upside, with further developments of vaccines and improvement in testing or protection. With the sheer amount of stimulus present, any semblance of returning to normal will almost certainly drive up asset prices.