River FOURcast: April 2020

Welcome to our monthly macro update, giving greater insight into our outlook for investment markets and the investment ideas that currently interest us.

We make our internal views more accessible using our four-phase framework, the River FOURcast. Much like a weather forecast, provides a guide to what we think may be coming, and how we could position portfolios. With the current economic uncertainty, the answer is not cut and dry and we explain the current situation further below.

You can read more about the River FOURcast here.

Our FOURcast

  • March saw the escalation of the crisis related to the novel coronavirus, as the infection rate and impact on unprepared health systems became more apparent across the world.
  • Large-scale restrictions on travel, gatherings and the closure of “non-essential” businesses across the world became commonplace.
  • Markets reacted strongly negatively to closures that significantly reduced economic activity.
  • Central banks and governments across the globe have implemented monetary and fiscal stimulus of unprecedented size.
  • These actions allowed equity markets to stabilize towards the end of the month, with most regions finishing the month down 10% to 15% and the quarter down 15% to 25%.
  • Our FOURcast moved from Stable to Downturn due to the sudden economic impact of the virus.
  • Our outlook is cautious, as we believe consensus growth expectations are still optimistic and are not currently factoring in the potential for a prolonged downturn in economic activity.
  • The time will come to re-risk portfolios to capture a return to normality, but things could get worse before that time comes. Remaining well diversified is key.

We believe we are in the Downturn phase of our FOURcast process, although we recognize the need for judgement when using this framework. Downturns are usually preceded by very high equity valuations, gradually weakening economics and poor credit conditions. This was not the case – prior to February, economic conditions were reasonably robust and improving, while real-time indicators are falling sharply today. Monetary and and fiscal stimulus are unprecedented and provide a near-term cushion for the global economy, but are not a solution to the underlying issue of how to control the virus outbreak..

Moving out of this Downturn and on to an economic recovery is dependent on bringing the case growth of the virus low enough to be able to control outbreaks using testing and tracing measures that could allow for most people to return to work. However, even an effective test and trace regime is likely to mean that things like large gatherings and international travel are restricted. Ultimately, it will take either a highly effective treatment or a vaccine for life to return to “normal”.

If testing and tracing fails to control the virus, and outbreaks resume, then the negative impact on the economy will last for longer than we hope.  However, if such a program controls the virus well, or we get an early effective treatment or vaccine, then unprecedented monetary support and fiscal stimulus should support a quicker recovery.

  • Credit conditions have weakened substantially, with the cost of borrowing for both investment grade and high yield companies rising sharply. This is clearly going to make it more difficult for companies to refinance debt, and is a strong indicator of the market’s belief that the credit quality of many companies now needs to be reassessed. The actions of central banks to improve liquidity, extending QE programs to corporate credit and extending loans and grants to businesses, have helped to underpin markets, but we could see further stress in credit markets, especially in those sectors such as energy, travel and leisure that are most directly impacted by the economic shutdown.
  • Near term economic expectations are very weak and we believe there is scope for a downside shock over the medium term as economic factors become fully priced into markets. Consensus growth forecasts in the second half of 2020 still look optimistic to us and could be revised down further as people recognize a “U” shaped recovery is more likely than the “V” shape that some still expect. The amount of stimulus we have seen from central banks means we expect a significant boost to economic conditions once the virus is contained; but such stimulus alone will not lead to a recovery.
  • While global equity valuations are a lot cheaper than they were, the challenge continues to be that we have no clarity as to how long economies will be shut down, hence no clarity on companies’ future earnings. Our estimates suggest that if a moderate or severe economic shock materializes, then despite recent falls, equities, and US equities in particular, would be overvalued on an economically adjusted basis.
Circuit breakers

March became a month for breaking records, with the largest intra-day fall in equity markets “ever recorded”* occurring twice, as markets regularly hit circuit breakers to curb panic selling.  Market volatility was so intense that circuit breakers were even triggered on brief rallies. Moves of plus or minus 5-8% in a day became the norm across all regions. With two Black Mondays and one Black Thursday during the month, these extreme movements in markets will certainly go down in history. Commentators compared this to the Great Depression of 1929, with many market participants expecting a worse outcome than the Global Financial Crisis of 2008.

The one relative bright spot was China, whose market “only” fell 0.7% as they seemed to control their outbreak and were able to get many people back to work. Chinese economic data was very weak (PMI of 35.7 in February) due to the impact of the lockdown, but recovered somewhat in March (PMI of over 50). However, overall Chinese economic levels are still significantly below where they were at the end of 2019 and Chinese industry is exposed to economic weakness in the rest of the world.

*The Dow Jones Industrial Average on March 9th 2020 and then again on March 12th 2020.

 

Oil price war

After a substantial reduction in demand, Saudi Arabia and Russia failed to agree to a deal on oil production on March 6th. The price of oil fell more than 30% experiencing the largest drop since the Gulf War in 1991, after having already fallen close to this amount year-to-date. With demand still anemic, the price of oil remains close to $25 a barrel.

While a low oil price is traditionally supportive for many economies, no price can make airlines, cruise lines and drivers buy fuel that they do not need.

Companies linked to oil production including the large number of shale companies in the US, will be negatively impacted by such a low price, and may default if they are not bailed out. The energy sector is a large employer and contributor to US GDP.

 

The safe havens

In predictable form, with equity market turmoil, investors flocked to government bonds and “safe” currencies or proxies such at the US dollar (USD), Japanese Yen (JPY) or Gold. But even these didn’t remain predictable markets.

The USD first depreciated over 3% by March 9th compared to a basket of global currencies and then surged 8% as global investors flocked to safe haven currencies.  In late March, the Federal Reserve intervened to increase the supply of USD available to market participants causing the USD to come off its highs.

Government bond yields ricocheted from their lowest yields ever, rising substantially before falling back later in the month. The 10-year US Treasury yield fell to 0.54% on March 9th, rising to 1.18% just nine days later and finishing the month at 0.70%. Other global government bonds followed a similar trajectory. Central banks were able to curb this volatility with their injections of liquidity and large-scale asset purchases.

 

Implications For Portfolios

It is clearly a difficult time to be making investment decisions in any multi-asset portfolio. The root cause of this market turmoil still does not have a resolution, and while monetary and fiscal actions are supportive, there could still be more bad news to come. We therefore do not believe market conditions are sufficiently attractive to re-risk, and we believe the key is to remain well diversified.

Within equities, we favor quality companies with strong balance sheets and stable earnings. The yields available in credit look very attractive, but with the uncertainty around default levels and credits needing to be reassessed, we would only access these selectively. We believe there may be opportunities to buy illiquid assets at discounted prices in the near future and are reviewing opportunities in this space.

Two opportunities we particularly like are the Term Asset Backed Loan Facility (TALF) backed by the US Federal Reserve that is being relaunched in May 2020, and the use of structured equity to access equity market rebounds while also offering protection from market falls. Please speak to your usual River and Mercantile contact if you would like further information on these. Wide scale re-risking is not in the cards just yet as there may be more volatility to come.

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