At the last ICM we highlighted that there had been a sharp move against the sterling, impacting UK assets and investors. This has unwound somewhat as the dollar has lost some of its strength. The pound now trades at $1.25, not out of place in its pricing since the Brexit referendum. It is reasonable to assume that there would be further weakness were there to be another selloff, or a gradual strengthening with the market if the global economy improves beyond current expectations.
As discussed before, what does this mean for P1 portfolios? Broadly, as we are overweight UK assets, and all fixed income and alternatives are in effect sterling denominated, a rally in the currency is likely to be beneficial from a relative basis. However, there would be an impact on overseas equities and property, where we have unhedged global exposure. Nevertheless, an improvement in the prospects for Sterling are likely to be correlated with a diminishing risk from the pandemic. It is therefore prudent not to have an over reliance on this factor in addition to positioning for a positive scenario.
Following the election in December, the UK is now likely to maintain the same government and leadership for the foreseeable future. Attention is increasingly being drawn to the ongoing negotiations with the EU over a trade agreement, due to complete at the end of the year. It remains highly unlikely that the current government will ask for an extension to the current transition period, and officially, it is required to do so by the end of June. Therefore, the outcomes are most likely to WTO terms, a free trade agreement, or a fudge. The resolution of these negotiations (and pathway through them) will continue to impact the value of Sterling. While there are clearly other major factors at play now, the consensus wisdom is that in a “no deal” scenario Sterling will trade as low as $1.10 against the dollar, while a full free trade agreement will lead to a bounce to $1.40-$1.50. The noise around this will amplify as we approach the end of the year and it becomes clearer what the outcome may be, however, the prospect of last-minute deals remains highly likely.
The major political event in the calendar is the upcoming US presidential election, set for 3rd November. The contest between Biden and Trump is currently polling close, with a narrow lead in favour of Biden. This election may well be less divisive as it would have been if Sanders or Warren were to have gained the Democratic nomination, however, as always, there will be distinct policy differences, some of which will feed through to markets. A Trump win will be a continuation of the status quo. However, a win for Biden may begin to sway US government finances in favour of more spending and higher taxation, which may well impair stock market confidence. Some may be hoping that the removal of Trump may ease US China tension, although, Biden is likely to take a similarly tough line on the fairness of trade, albeit with a less confrontational style.
Elsewhere, a slightly under-reported event, understandable in the current situation, is the increasing tensions between China and India. The long run dispute on border lines between the world’s two most populous countries has been flaring up, with the death of 20 Indian soldiers and an unknown number of Chinese in the June raising concerns. Under normal conditions it is highly unlikely that either country would risk escalating tensions, however, an increasing pandemic in India and the prospect of a second wave in China may incentivise leaders to distract unrestful populations. While we would not consider a full-blown conflict here a likely scenario, if it was to occur it would probably be devastating for markets and may even drag in other nations (eg. Pakistan, US?). While there has been a dispute between the nations for decades there has only been one full blown conflict, in 1962.
The impact on the global economy over the last three months has been one of the sharpest and most severe ever recorded. This is not a surprise given government policy. Most economies are expected to lose up to 20% of GDP in the short term, while under lockdown conditions, with most forecasting that a 5-10% contraction over the year is likely. With such wild swings, there is a huge level of uncertainty in economic forecasts. There have been significant surprises over the quarter, both positive and negative.
One of the most interesting results of the monetary stimulus that has been unleashed is the unprecedented increase in money supply, particularly in the US, where M2 has increased by over 30%. This is through a combination of QE but also the loosening of banking reserve requirements, allowing a wave of new loans to be issued. The result of higher money supply, unless there is a corresponding reduction in the velocity of money, in theory should lead to higher nominal GDP. This means that there will be higher inflation or real growth, or a combination of the two. A decrease in the velocity of money would correspond with higher asset prices. It is easy to imagine that higher inflation would be highly desirable for governments worldwide, who have just taken on large amounts of debt, at historically low interest rates. Central banks would probably be willing to accept a higher level of inflation to clear this headwind to growth.
Looking at US unemployment clearly there has been a very sharp increase in the official rate of unemployment. I have included a further table below that better shows the impact on the labour market. While the unemployment rate has increased, with 17.2m Americans moving into unemployment, those considered employed has fallen by over 21m. Therefore, based on the labour force size in February, the “unemployment rate” could be considered more like 16.6%, rather than the ~14% official figure. This measure has improved significantly in May, down from an estimated 19%.
There continues to be a high level of initial jobless claims, suggesting that businesses are continuing to lay off staff, even if this may be more balanced with rehiring recently. Furthermore, the prospect of a second wave of infections in many states, as discussed, may mean that the desire to hire back workers begins to wane in some areas.
|Date||Labour Force Size (000)||Employment||Unemployment|
As discussed at the last ICM, it is likely that traditional valuation metrics such as P/E ratios are not going to be much use in the current environment. The earnings component is clearly going to take a significant hit this year, and there is the potential for losses in many companies and sectors. This is going to make PE ratios look high as investors are rightfully looking at 2021 expected earnings. However, the note of caution here is that even already downgraded expectations are unlikely to reflect the final outcome for this year for many companies. Current expectations for the S&P are for a >20% decline in EPS this year followed by a 30% rise, taking the index earnings to a similar level they were in 2018. The average level of the S&P in 2018 was around 2700, over 10% lower than the current level. Furthermore, a full rebound in earnings in 2021 may yet prove to be ambitious and it is likely that the risks are skewed to the downside.
The rebound in the market has contributed to a rise in valuations, with the combination of earnings falls and price rises pushing the prospective PE of most markets above recent highs. Global equities now trade on over 19x forward earnings. Dividend cuts have been a blow to many investors who have relied on this income, and cuts from some dividend stalwarts has led to negative market reactions. However, in a world where income is scarce, those companies and markets that are able to maintain dividends may command a premium in time. Again, it is unlikely that using any yield measure on the market will provide much insight into valuations. Indeed, high dividend yields may be forewarning cuts.
We have previously not looked to over interpret index level price to book data, as it is increasingly difficult to analyse, particularly for tech heavy markets such as the US. However, comparisons of recent price to book values may be another tool to assess the “cheapness” of markets. Book values should be more stable than earnings through this crisis, and in theory should provide a better indication of the long-term value of companies. Nevertheless, another point of caution here is that there are likely to be ongoing impairments to book values over the coming months as boards reassess the value of their assets and write down acquisitions. Anecdotally, we have already seen this with BP in the quarter, effectively writing off around 15% of their book value, equating to ~1% of the FTSE 100 value. So, while the price to book values at an aggregate level does not look expensive, and is in line with recent historical levels, they are not cheap. Furthermore, with a likely headwind of book value impairments, it is limiting the potential upside from this point without stretching the P/B to an unsustainable level.
Using the most basic view, to consider the drawdown from index levels prior to the selloff, we can gain an insight into what the market may be implying. The most extreme of these is the US, where the S&P 500 is now within 10% of its all-time highs, an incredible situation given the shutdown of economies globally. Overall, it is therefore very difficult not to imply from current market pricing that investors are expecting an easy exit from the pandemic and a swift return to normality. Unfortunately, there is likely to be complications and we are already seeing the economic implications of the crisis in GDP and employment data. While there may indeed be a speedy return to growth, it would be naive to ignore the growing risks.
Monetary policy globally has continued to remain very loose, although after the initial shock and awe policy changes, there have been few further changes that have surprised markets. The next potential change may come from the introduction of negative rates in the US and UK. Both the Fed and BOE considered the use of negative interest rates unnecessary and possibly counterproductive, however, there are increasing rumblings that a cut to below zero may be considered and required.
This is to some extent being priced into markets as an outside chance (Appendix 8). It is likely that there would need to be a deterioration from the current economic forecasts to compel the Fed to use this unorthodox policy tool, although this is clearly a possibility. There are very few that are expecting higher rates any time soon and Fed Chair Powell has guided that the current low rates are here to stay for at least the next one to two years.
Following the dramatic parallel shift down in the US yield curve in the first quarter, there has been remarkably little change in expectations over the last three months. The two points to note are the short term expectations for more rate cuts have now moderated, where the market is now expecting stable Fed rates for the foreseeable future. Second, is the further deterioration in medium term prospects, with 2-10 year yield continuing to fall. Interestingly, this indicates that the bond market is once again at odds with the equity market. There has been talk of yield targeting, much like has been done in Japan, where the Fed in effect will shape the curve. Eg. “10-year treasuries will yield 0.5%”. The more recent actions by the Fed have been increasingly to support of companies through the purchase of corporate bonds. This has been done through an index approach and has therefore provided broad support for credit markets and has allowed companies to issue debt at record low levels.
The Bank of England has maintained rates at 0.1% and extended quantitative easing by £100bn. It is likely that they are now in a wait and see mode, needing to observe the state of the economy post lockdown before taking further action, and perhaps wanting to keep some policy in reserve to guard against any further market turbulence. The ECB has acted much more rapidly than in previous crises. However, given the already loose state of monetary policy in the Eurozone, it has been difficult for the ECB to generate much in the way of positive surprises. There is now a corporate bond buying programme, in addition to the QE and negative interest rates already in place. It will be difficult for the ECB to cut rates further or expand QE to have a meaningful effect. Any more policy loosening may therefore become more inventive.
Overall, it is reasonable to expect that there will continue to be very loose monetary policy for the foreseeable future. There is also asymmetry as additional loosening is likely if there is further weakness in the economy or markets, but Central Bankers will be very unwilling to tighten, even if there is an improvement in the data. Nevertheless, expectations can change very quickly.
Oil bottomed out in April, after global equity markets, as the full effects of the economic disruption and fall in oil consumption became apparent. The crunch point was felt most severely in the US where storage capacity became overwhelmed, leading to a historical negative trading value in some WTI oil futures. Brent was not as severely impacted. As US production has fallen and OPEC (plus Russia) have agreed to production cuts, prices have rebounded somewhat. However, it is difficult to see that, at $40/bbl, the price will be able to move significantly higher in the short term, as this will lead to an opening of the taps by OPEC and potentially the US once more. It also remains likely that oil demand will remain well behind the expectations at the start of the year and there will not be any catchup consumption.
Iron ore has also made a recovery, continuing a longer-term trend since prices bottomed out in 2016. This was driven by proposed infrastructure spending in China and resulting surge in steel manufacturing. Increasing demand coupled with continuing issues with production in Brazil has supported the price, even though economic growth is expected to be weak, historically a negative for this commodity.
Gold rose sharply at the beginning of the quarter and has consolidated over the last couple of months. There is still a strong demand for safe haven assets and the low interest rate environment continues to limit the opportunity cost of holding gold. More recently, there are signs that there will be another leg higher. In any broader market disruption, it is reasonable to anticipate that the demand and price of gold will increase. The gold price is now challenging recent highs and is approaching the all time highs seen in 2012. There continues to be positive momentum behind the price.