18 Mar Why plotting a recovery might resemble alphabet soup
We have written to clients twice in as many weeks, given the heightened volatility within financial markets. In view of the anxiety events of this nature can create, and the positive feedback we have had from our readers, we will be producing this update on a weekly basis whilst this volatility persists.
This week’s update is divided into two parts. The first covers the actions we are taking at CDC to protect customers and staff. The second is our latest view of the markets, and why investors will hopefully not feel too downbeat for long.
CDC operating model
With the Government’s recommendation for individuals and firms to limit travel to only essential trips, the CDC board, in order to protect clients and staff as an absolute priority, has decided to suspend all face to face client meetings until further notice. Naturally if any of our clients wish to meet with their adviser, we will happily arrange this, but for now, any financial review meetings which are scheduled, will be conducted via the telephone or Skype. Where you have a meeting scheduled with your adviser, we will be in touch shortly to advise you of the revised format for the meeting.
We have also taken the decision, in order to safeguard staff, to revert to home-working. All staff have laptops and will be able to perform all necessary tasks to enable us to continue ‘business as usual’. On a rotational basis, staff will be attending the office to pick up post and any other tasks needing a physical presence, though as you can imagine in this day and age, there aren’t many.
The investment management process will also be conducted remotely and this operating model has been used a number of times in the past so we know it works effectively.
If you do need to contact a member of the team during this period, simply dial the usual office number, there will be a recorded greeting and then leave a message. The most appropriate member of the team will return your call as soon as possible. Alternatively if you need to speak to your adviser, you are welcome to use his mobile number.
Please be assured that whilst this is a sensible measure to safeguard customers and staff, it will in no way inhibit our ability to manage portfolios, or provide our usual impeccable levels of service.
First the bad news. Financial markets are still trying to come to terms with the impact of the coronavirus. The S&P500 index in America fell 12% on Monday, making it the single worst day for equities since 1987. Both the UK and US equity markets sit just shy of 30% below their all-time highs, making this the fastest descent on record. This is the sad reality of stock market investment, with rises tending to be gradual and prolonged and corrections short, sharp and dramatic.
Whilst it sounds trite, there is nothing markets dislike as much as uncertainty, but at the moment, that is precisely what markets are having to cope with. We refer to the stock market as a self-contained pricing mechanism, which means its purpose is to value future corporate earnings in the form of share prices. Unfortunately, when things are uncertain, the traditional models to assign a value to shares are compromised and fear starts to take over, leading to distortions.
We said in an earlier bulletin we felt stock markets were slow to price in the uncertainty created by people getting sick. Less than a month ago, markets were at all-time highs and confirmed Coronavirus cases stood at 75,000. Whilst this could be complacency, it could equally be parochial. Any problem seems greater when it is close and can easily be dismissed when it centres on an unknown province on the other side of the globe. Ironically the best-performing emerging stock market year to date has been China.
Elsewhere markets are now taking fright at the speed with which Coronavirus has permeated Europe, particularly Italy, where it has become a full-blown tragedy. Moreover it has hit an economic area which was already stuttering badly and where banks have been a hostage to negative interest rates. As we have said before, whilst the notion of negative interests might be appealing, the reality is one of extreme pain and hardship for banks. The new head of the European Central Bank (ECB), Christine Lagarde has generally disappointed investors with her reluctance to throw more money at the problem and not being able to corral Euro finance ministers into a coordinated fiscal package.
But it is not all bad news. The US economy was actually accelerating before the crisis and we still think the first quarter economic data will be in the 1.5-2% range. Second quarter numbers will be hit hard and could well be negative as they were after the Asian flu epidemic in 1958 which killed 70,000 people, but then the economy rebounded in spectacular fashion, notching up an annual growth rate of almost 8% in the five subsequent quarters. In the US we have seen a very tight labour market and we would not rule out a jump in jobless numbers if the economic picture slides as we expect, but this should gradually return to the current 3.5% by the end of 2021.
Having made such a big deal of the stock market rising, President Trump could be hurt politically by its subsequent fall. We still feel the decision to cut interest rates, albeit aggressively, on both sides of the Atlantic is premature but this is not likely to be a short-lived phenomenon. Monetary authorities are likely to be patient, which means it might be some time before they rise again. Interest rates tend to take a while to impact the economy. To provide a more immediate impetus, Mr Trump hatched plans to unleash a huge fiscal stimulus ($1trn), but perhaps just as importantly needs to display strong leadership, which many feel has been lacking.
In the UK, Rishi Sunak was quick on US coat-tails to announce £330bn of fiscal measures here in attempt to provide reassurance to businesses and markets, accompanied by the mollifying words ‘whatever it takes’.
A Coronavirus inspired recession might sound like a good reason to run for the exits (and many will) but it isn’t. Stocks typically rise up to 6 months before there are tangible signs of economic recovery and returns are more often than not, positive over the course of a recession, which sounds counter-intuitive. At CDC we have been considering what type of economic recovery we will see – L-shaped, W, U, V ….. one commentator sees it as capital I-shaped recovery, and whilst this sounds fanciful, it is credible given the huge fiscal and monetary stimulus.
In terms of markets, the fastest recovery happened in 1982 following a 27% decline but, as if to amplify how things have changed, this was in response to aggressive interest rate tightening to choke off rampant inflation. More recently the ground lost by the 2018 fourth quarter sell-off, was recaptured within 80 days. Whilst it is impossible to say how long things will take to recover this time around, what we can say with reasonable certainty is that we are closer to the bottom than the top, meaning investors minded to sell now will probably rue the decision.
One problem with financial markets is they over-react, they do this when prices rise and when they fall. We think concerns might now be starting to look overblown. When the S&P500 was at a level of 2800 (it is now 2500), this was effectively pricing in a drop in corporate earnings of between 50-80%. At the worst of the financial crisis, earnings shrunk by 46%, so this most recent correction strikes us as overdone. Added to which the banking sector is far better capitalised than it was back in 2008.
In terms of investment strategy, by way of a reminder, in the past few weeks we have reduced our exposure to the US and redeployed this in emerging markets and Asia Pacific. China in particular has held up well during this turmoil as mentioned above. We have carried an underweight position to Europe for some time now, and we have recently bolstered our exposure to the UK. We are very happy with this positioning.
Since we repositioned portfolios, events are developing at break-neck speed and prices have become very volatile. This means we will not be making any further sizeable alterations just yet. In times like this, investors often fall into a trap that psychologists term ‘activity bias’, or put more simply, the compulsion to do something, when in actual fact, the best strategy is do nothing. The late American investor Jack Bogle analogised this not as ‘Don’t stand there, do something’ but ‘Don’t do something, stand there’ ! Aside from recent rebalancing, we think this is sensible advice.