The scale of the moves seen in markets corresponds to both the extent of damage being wreaked on the global economy through current lockdown measures and the tremendous size and speed of policy response, from both a monetary and a fiscal perspective. On the former point, we know that the current economic downturn will exceed anything seen for almost a century. But we also can see that the response from central banks and governments is intended to reduce the longer-term fallout from the widespread cessation of many forms of economic activity.
A month ago, we outlined four factors which may enable a floor to be reached for equity markets. These were:
- Aggressive policy action in the form of both monetary and fiscal measures
- Valuations pricing in a substantial downturn in corporate earnings
- Peaking volatility – which tends to precede a market trough
- Peaking in Covid-19 infection rates
In each case, we have seen substantial progress and, in a number of instances, the newsflow has (positively) surpassed expectations. Certainly, not only the cuts in interest rates but also the sheer scale and breadth of asset purchase programmes, particularly from the US Federal Reserve, have been a positive surprise. Furthermore, the extent of measures to underwrite both credit and wage risk in the global economy have also been taken positively.
On valuations, markets have bounced back very strongly but, at the lows, they were arguably (and rightly) pricing in a reasonable recession. They are now pricing in a return to growth, certainly for 2021.
Volatility remains high by historic standards but has declined. As markets fell sharply and volatility spiked, certain investors were compelled to de-risk, creating a downward spiral in prices. The risk of a disorderly meltdown has receded and markets are, for the time being, demonstrating both relative resilience and calm.
Finally, while the human cost of the Covid-19 outbreak continues to be terrible, there are encouraging signs that infection rates are peaking and that lockdown measures are working. Furthermore, while we remain a long way from normalcy in our daily lives, the discussion has moved towards how and when economies can start to re-open. Indeed, next month it is likely that many major economies will tentatively start on this path. In addition, over 80 potential vaccines have now been identified and a number are currently undergoing trials, raising hopes that, alongside more effective treatment options, a medical solution may soon be identified (even though it would take quite some time to become widely available).
Having had incrementally positive newsflow over the past month, markets now face the uneasy prospect of dealing with the reality of the downturn. Macro indicators, including from the labour market, are now corroborating why economists’ estimates suggested that developed economies may show double-digit declines in GDP over the course of the second quarter. Furthermore, corporates are withdrawing earnings guidance and reporting huge hits to revenue and profits, alongside widespread suspension or cessation of dividends and buybacks. While markets have so far remained relatively impassive in the face of the onslaught of negative reports, this may well become more challenging in the near term as the scale of economic and corporate destruction is laid bare. Expectations have adjusted sharply; reality may well still bite.
Looking forward, it is clearly impossible to predict with confidence what the economic and corporate backdrop will look like over the next year. Nonetheless, with positive newsflow on infections and a strongly supportive backdrop from policymakers, we should see a return to growth later this year. Certainly, this is what markets currently expect. No-one is assuming an immediate return to the pre Covid-19 world and it is widely anticipated that social distancing measures will reduce activity in certain areas for the foreseeable future.
When looking to make predictions over the longer-term implications of Covid-19, it is tempting to extrapolate current experiences far into the future. In a number of instances this will likely prove to be the correct conclusion, but this may largely be due to the deep recession and lockdown measures acting as an accelerant to existing trends. For example, the move to online retail and consumption was already well entrenched. In other areas, such as airlines, there is a tremendous challenge over a potential secular change in demand. For property, if home working becomes more embedded, even on a part-time basis, this may materially reduce demand for prime office space, while commercial will likely suffer from ongoing trends in the retail sector.
For FCIT, we came into 2020 with a relatively sanguine view on the global economy. This was clearly misplaced and we were not positioned for the sharp downturn in markets which resulted as a function of the pandemic. The direct and indirect impact of our gearing decision has been the main source of our underperformance and, indeed, our underlying portfolio of investments posted modest relative gains against sharply declining equity markets.
Year to date, we have made a number of changes to the portfolio. In advance of the downturn, we divested a portion of our higher-yielding equity portfolio to fund investments in two global equity strategies; one focused on sustainable opportunities and the other on value and quality stocks. While it’s still early days, both of these areas have performed relatively well in recent months. In addition to these changes, after the crisis began to unfold, we reduced allocation to US value stocks, increasing the tilt within our US exposure to growth-oriented opportunities. We also reduced exposure to European stocks. While many of our European stocks are globally focused companies and we have little by way of domestic exposure, we are concerned that this crisis will, once again, expose the frailties of the European project and view the area as structurally less well prepared to deal with some of the resultant economic challenges than elsewhere. As part of these recent portfolio moves, we modestly reduced gearing. Having held our gearing levels during the market downturn, we have taken advantage of the rapid bounce in stock prices to lighten exposure.
Coming back to predictions. The lesson from recessions is that the stronger companies with better business models and dominant market positions will tend to fare better during recession and post recovery. There is every likelihood that lower quality and more cheaply priced stocks will enjoy a recovery when growth resumes. Companies with a weak balance sheet or market position will, however, lose out to dominant incumbents who will be relatively strengthened by the downturn. This should be true both across and within sectors – even within those sectors which face secular challenges such as airlines and travel companies.
Our approach recognises that opportunities will extend beyond narrow sectors and segments of the market. Diversification across a range of geographies, sectors and investment styles, and accessing selective opportunity in the private markets space has, over many decades, provided shareholders with consistent long-term returns with lower volatility than a narrow approach. For this reason, we remain focused on long-term opportunities across both listed and private equity markets.