29 Apr When the market starts to bear its FAANGs
It is clear that the lockdown is to remain part of our lives for a few more weeks yet and in maybe a lesser form, for a good deal longer than that. Undoubtedly it will be quite some time before we can identify with what we previously regarded as ‘normal’.
Whilst upholding the lockdown is unquestionably the right decision for moderating the infection rate and ultimately improving health outcomes, as we have said before, we do have serious concerns about the impact this is having on the economy. Indeed Boris Johnson’s return to work has coincided with some pretty vocal lobbying around the possible indicators for when some of the restrictions might be lifted. The timing couldn’t be more apropos. Last week gave the first real tangible sign of just how badly the economic picture has deteriorated with the publication of the UK Purchasing Managers (PMI) data. The chart below refers to services:
The Purchasing Managers Index is an indicator of economic direction elicited from purchasing managers as to whether their respective markets are expanding or contracting. A reading above 50 indicates expansion, below that represents contraction. As you can see, last week’s reading was the worst in living memory. We have said previously, the longer the paralysis, the tougher restarting the economy will be, so we do see some sectors being given some respite in the next few weeks.
In our last update on 16th April I put my neck squarely on the block and said I felt the initial ‘panic’ phase for equity markets had passed. As readers of the briefing might recall, this is an important milestone because once it is over, this usually heralds a period of stability. Whilst being a relatively small sample, and as such should be taken with a pinch of salt, in the 2 weeks before we last wrote to you, 50% of trading days saw a move in the FTSE100 of more than 2% in a day. During this period, the market experienced negative returns 50% of the time.
Contrast this with the period since. Volatility has moderated with 2% moves in a day only witnessed 30% of the time. Moreover the index has only fallen 10% of the time and rewarded patient investors with a near 6% return. In fact, since the low point reached on 23rd March, the top 100 UK companies have bounced 19%. Not quite enough to recoup the full extent of first quarter losses, but certainly an encouraging start.
The US market recovery has been even more rapid and whilst this is most certainly welcome, the rebound does mask significant dispersion between sectors. The chart below shows the difference in return between the MSCI World index (a broad spread of international stocks) and FAANG stocks. The market loves a good acronym.
FAANG stocks is the collective term for Facebook, Amazon, Apple, Netflix and Google (which actually trades as ‘Alphabet’). As you will see, technology stocks have massively outpaced the general index over 5 years. In fact Facebook, Amazon, Microsoft (not Netflix) Apple and Google are now the 5 largest companies in the US by market capitalisation, and account for 20% of the stock market. Whilst not in the top 5, Netflix is still three times the size of Cisco Systems (itself once the largest firm in the US) and bigger than Exxon.
The lockdown, has merely served to give these stocks extra juice, on the premise we order more stuff and sit watching movies whilst in isolation. For the record, at CDC we certainly don’t!
Whilst we don’t necessarily question the logic, we are very circumspect around whether these companies can continue to keep powering ahead, after all it didn’t end well when something similar happened twenty years ago. The irony here is it was the dot-com bubble bursting that knocked Cisco off its perch as the largest US corporation, from which it has never truly recovered. The fact that the US market is so concentrated, not to mention expensive, was one of the primary reasons we reduced our exposure in March.
At the time, we introduced Asia Pacific to portfolios so it is worth a few words about China where this all started. First quarter GDP announced recently showed a 6.8% fall compared to the equivalent period last year. Since China had already been through lockdown, the CSI 300 index in China was already in recovery mode and the grim GDP figures did nothing to derail this rebound. Chinese stocks are down only 6% since the start of the year.
Continuing with the theme of investment strategy, looking further back, to 8th April to be precise, we talked about increasing our exposure to high yield bonds. At the time we had identified that yields in this area had spiralled up to such an extent that their return was about 9% more than that on the equivalent government bonds. This is known as the ‘spread’ and had widened because investors were looking at the extended lockdown and making a judgment that many companies (particularly those with high borrowings) would struggle to meet their debt obligations.
We had a suitable trade teed-up and ready to move but it is not just equity markets that have experienced rapid price movements. This extends to bond markets too. The yield differential dropped and is now down to around 6.5%, which is still high by historic standards, but not sufficient to tempt us. We think investors in this space have got ahead of themselves and are simply too sanguine on the prospects of certain corporations being able to service debt. This is a question of margins. A ‘spread’ of 6.5% is not sufficient reward for us to commit to this area, but 8 or 9% would be. Thus, for now we propose sitting on the sidelines and if and when spreads back up nearer to our target level, we are ready to pounce.
Dr Andrew Mann