UK equities have rebounded with global peers; however, they still lag for the year, having underperformed significantly during the selloff. Domestic stocks were helped on a relative basis by the rebound in Sterling, which came of lows to trade close to a three-year average. This particularly helped mid and small cap exposures, with the FTSE 250 outperforming.
UK equities in aggregate continue to be disadvantaged by their sector breakdown, being heavily weighted towards areas that appear to now be unfavourable (eg. Banking, energy). It is therefore reasonable to anticipate that if there were another selloff, UK equities would once again underperform. This is likely to be compounded by falls in sterling, which is considered a “risk on” currency.
There is likely to be additional volatility to domestic stocks and the currency over the coming quarters as the EU Brexit negotiations continue. Most analyst predictions are suggesting that Sterling will fall to $1.10 in a “no deal” scenario and rally to $1.45 if a free trade agreement is reached. There may also be scope for additional, smaller, positive surprises through other trade deals, such as Japan and Australia. The more of these that are agreed, the less severe the negative outcome will appear.
The Asda income tracker for March was released in the quarter. Unsurprisingly, this had already shown a deterioration in household finances as wage growth slowed. Forward looking guidance anticipates discretionary spending power to deteriorate further, as job losses and fewer hours worked puts downward pressure on incomes. Furthermore, in the medium term, inflation may also be a greater headwind, although it has provided some relief in the shorter term. Appendix 11 is perhaps giving an insight into the start of this.
There has been data indicating that households are increasingly saving too, probably because government lockdown measures as well as a more conservative outlook. This will weigh on the economy in the short term, but a more robust consumer balance sheet may result in a release of pent up demand in the medium term. However, much will depend on the impact to incomes over the next several quarters and any continuing restrictions.
Portfolios continue to be heavily weighted towards equities through the bias in the WMA asset allocation, as well as our generally positive view, particularly towards mid and small cap. We have looked at continuing to ease out this bias as discussed.
US equities have been strong, outperforming peers from the trough. The market initially benefitted from a heavy weighting to tech and healthcare, which are perceived as areas that will be able to succeed, even in a worst-case scenario. However, towards the end of the quarter, the rally became broader based, with those shares that were hardest hit rallying as lockdown measures were eased and there was a surprise gain in the May jobs report.
Valuations in the US market as a whole remain relatively more expensive than global peers (Appendix 6). Furthermore, on an absolute basis, the US market is now at a level objectively considered “expensive”. As previously discussed, some caution is needed when it comes to looking a P/E metrics in the shorter term as the hit to earnings may only be for one year. However, taking this into consideration, the market is now at a level that even if a reasonable best-case scenario were to occur, there appears to be little in the way of upside. Many commentators are suggesting that some of the strong momentum has been created by the flood of money created by the Federal Reserve and banking system, creating a sugar high with money needing to be allocated. Retail investor enthusiasm also appears to have been a factor.
We have an underweight positioning to US equities, although this was reduced at the last ICM. The underweight reflects the high premium that US equities trade, both relative to other regions, and on an absolute basis.
European equities have lagged slightly from the lows, although have performed better more recently as the recovery became broader based and Europe was usurped from its title of top COVID hotspot. Signs that European economies are opening up has helped domestically focussed stocks and the belief that the global economy is also returning to normality has invigorated the European market, which is more heavily skewed towards cyclicals and benefits from global growth and trade.
We continue to be slightly cautious on the outlook for European equities given their dependence on external demand. Furthermore, with bloating government deficits on top of an already heavy debt pile, the prospects of another debt crisis and political or social disruption is now higher than ever. Taxes on corporations and individuals are likely to be a greater burden than in other regions.
Japanese equities have continued to trade roughly in line with global peers over the quarter, meaning that there has been very little disparity YTD. However, most Japanese companies have very robust balance sheets with large cash balances, perhaps making them better able to cope with global economic disruption. However, the index and national economy remains heavily dependent on the success of the global economy, particularly in manufacturing.
Our inline position to Japan through a passive holding appears comfortable given the above but also acknowledging that the relative valuation of the market to others continues to be somewhat less attractive than it was a year ago.
Asian & Emerging market equities
Asian and emerging market equities have lagged global counterparts in the rally. EM has been particularly hard hit, likely a result of South America being the newest hotspot for the outbreak. While many Asian and EM countries have coped well in containing any COVID outbreak, many economies remain heavily dependent on developed market demand, which has disappeared. The lingering questions around debt and currency sustainability for a number of countries remain, and the potential for currency and funding crises is high.
Conversely, EM economies will benefit from the flood of US dollars deployed by the Federal Reserve and the potential for a weakening dollar if the global economy can move towards normality.
In the longer term, it appears that the friction between the US and China will continue and there will be an increasing polarisation of the global economy and trade, with countries forced to pick sides. The recent flaring of conflict between China and India also has the potential to disrupt the region. A more polarised world may lead to better benefits from diversification, but it is likely to come with increased risks. We have a small overweight to the region based primarily on the continuing low valuations, however, this was moderated at the last rebalance, to acknowledge the increasing risks now present.
Government bond yields have remained at historic lows, as most investors continue to assume that central banks will hold off raising interest rates for as long as possible. Furthermore, central bank support for credit, through purchases, have meant that spreads have come down from their extremes. Corporates have been keen to take advantage of low rates, particularly for the highest rated companies, to secure financing and build cash balances.
Going forwards, spreads will be influenced by the fortunes of the global economy and the speed normality returns. Liquidity in the market is being underwritten by central banks who are willing to extend purchases to ensure that funding for companies remains cheap. High Yield spreads have similarly closed, although they remain 300bps wider than under normal conditions. While a wider spread is reasonable, and some of this will be given up in capital losses over the coming years, there is still a good opportunity for capital returns, in addition to the ongoing high level if income. The asset class now appears more attractive, particularly relative to equities. A likely period of corporate deleveraging will also benefit bond investors, generally at the expense of equity holders, as free cash flow is used to pay down debt rather than on capital expenditure for future growth or payouts for shareholders.
Property continues to trade at more depressed levels than broader equities as investors continue to remain concerned that physical spaces will be one of the last to recover, and that there may be more permanent changes to usage. The level of ambiguity in valuations remains although some transactions are now beginning to happen. It may take several months before the true impacts are felt on values as those now being negotiated are finalised.
The fallback of property has always been the relatively consistent income. This is now uncertain, with many tenants deferring payments, potential CVAs (or equivalent) and likely bankruptcies on the horizon. This may lead to a cloud over the sector until there is a greater degree of certainty. It is likely that valuers will mark down vacant properties until tenants are installed.
Our alternatives allocation has performed strongly over the quarter, however, some of this was a rebound in some of the more market sensitive positions (eg. Infrastructure). The standout performer has been the Blackrock Gold and General fund, which for most clients has delivered over 30% in the three months since it was purchased. The fund has benefitted from the rising gold price but also the unwinding of some of the gold miners discount, as we discussed at the last ICM.