Equity valuations entered the year at slightly elevated levels, driven by the US. However, concerns over the spread of the coronavirus have kept gains moderated and has meant valuations have not become more stretched. However, it is now a certainty that quarterly and annual earnings figures will have been impacted by the virus containment efforts. As a result, in the short term looking at traditional metrics such as PE or Dividend yields are unlikely to be useful, and many managers are now considering balance sheet strength and cash liquidity as their primary metrics. Nevertheless, if we believe that the impact of the virus on the economy is transitory (at least for most companies) then considering the price on historical earnings can be a good measure of the potential bounce in the medium term and should therefore not be ignored.
Dividends are likely to be cut by many companies, however, likewise, their ability to generate cashflows in the medium term is unlikely to be impaired in most cases.
The most interesting measure at a company and index level currently may now be price to book. However, care is still needed as the book value of many companies is not wholly reliable in normal times and much of the book value may be based on the economic usefulness of assets which could easily have been impaired.
Stepping back, valuations have come down a long way since the last rebalance and are as a result objectively cheaper than they were, they are not outside of the historical “fair value” range in aggregate although they are now veering in the side of cheap. There has been some movement in the relative value between geographies, with notable changes in the discounts of Asia/EM, and a widening of the discount of the UK.
The UK market is now at the most significant discount to global equities that we have seen over the last several years and are, on a P/E measure, the lowest-rated region globally. While there does continue to be some aversion to the UK relating to the political situation, the extension of the discount is primarily due to the makeup of the UK market relative to others, having a larger than usual weighting to oil, commodities and financials.
As discussed, the E part of the P/E measure is likely to be very volatile and uncertain over the coming quarters and resultingly, the measure is likely to look objectively high. We will need to bear this in mind at the next several ICMs and continue to consider the historical ability of companies to make a profit.
Investors searching for safe havens benefitted government bonds, where yields have fallen aggressively over the quarter. However, fears of economic disruption and the increased potential for defaults led to credit spreads widening across the board. Credit spreads are now higher than any time since the financial crisis and probably rightly so. With such a lack of cash flow, defaults and breaches of debt covenants are increasingly likely, furthermore, the potential for recoveries is also impaired and much of the collateral used may now be worth significantly less than it was. However, on the positive side, investment-grade issuers may be spared through government and central bank programmes to buy or guarantee company debt. Nevertheless, given the heightened level of uncertainty volatility in the credit market is likely to continue.
There is an increasing concern over liquidity in all debt markets as investors rush to shorten their duration exposure and increase credit quality. However, this is likely to be a shorter-term issue and provided there is continued government and central bank support, calls on bond market liquidity should moderate.
We typically use investment grade and strategic bonds within portfolios which over March were impacted negatively, after providing an element of protection. It is difficult to say there is now value in any of the primary fixed income markets as government bond yields remain low and while credit spreads have widened, it is rightfully reflecting the premiums that should be awarded to investors at this time of heightened risk. There may be an opportunity to increase exposure here once we feel the worst is passed as it is unlikely that spreads will fall as quickly as they have widened.
Looser monetary policy was already likely this year, however, the spread of the Coronavirus has made central banks much more willing to cut rates in an attempt to protect economies from a slowdown in demand.
The Federal Reserve initially attempted to shock markets by implementing a 50bps cut to rates outside of the usual meeting schedule. While markets were at first boosted by the news, the selling quickly resumed as investors were both concerned that the Fed new something they didn’t and questioned the logic that lower interest rates would cure the virus or solve what was ultimately likely to be a supply side issue. In the end, lower interest rates are likely to be a cure for the symptoms rather than an antidote.
While a 50bps cut appears aggressive, the market continued to price in more to come from both the Fed as well as other major central banks. Even if the virus was cured in the near future, it is unlikely that there will be a speedy reversal to these cuts. Lower actual and expected rates have pushed bond yields lower, with most major points on the yield curve reaching all time lows. The Fed have now effectively committed to unlimited QE, in an unprecedented move to shore up liquidity in markets.
The Bank of England has followed the Fed, also cutting rates by 50bps, to 0.25%, and then again to 0.1% as well as a range of other measures directly aimed at the anticipated issues caused by the spread of COVID 19. The 50bpsw cut as implemented on the day of the government budget on 11th March, in a clearly coordinated effort to reassure businesses and individuals. While the date of the cut was a slight surprise, the magnitude was not.
The ECB has had less flexibility in loosening monetary policy as rates are already deeply negative at -0.5%. However, they have announced an expansion in asset purchases on top of their existing package, and it is likely more is to come.
Overall, the collapse of interest rate expectations has led record low government bond yields once more. In the UK the 2-year bond yield went negative and the whole yield curve in the US was below 1%, also for the first time ever. Most central banks have now exhausted their conventional monetary policy levers and if the situation worsens, it is likely we will see QE (and others?) pulled out of the bag.
As many commodities have been linked to the fortunes of China (eg. Copper, Iron Ore), they have suffered on coronavirus fears, and the likely depressed demand. The most notable and impactful move has been in the oil markets which were already at a possible period of oversupply, following increases in production from non-OPEC countries such as the US and Norway. The oil price fell from a high of $68 in January to under $30 in March, over 55% lower. This will clearly have an impact on inflation over the coming months.
On the other hand, the safe haven of gold staged another rally although was suppressed by liquidity driven selling in March. The metal rallied on both the assassination of Qasem Soleimani and as the virus outbreak became more apparent. Furthermore, the prospect of lower interest rates made holding gold more attractive.