There we were, December 31st looking ahead to 2020, summer sporting events, concerts, Summer and so on
And here we are now…
There’s a lot to think about, even worry about…..toilet roll for example
Most of us rely on some form of invested money for our pensions, ISA savings etc, and in the eye of the current storm, it can seem like a whole world of worry. In the short-term and immediately, there is a lot of headlines and Tweets to mull over
So, I thought it might be useful to ask investment insiders for their thoughts and consideration, which will be fluid as the effects of the Covid-19 outbreak continues
A plunge in oil prices, Covid-19 and travel bans have sent markets reeling
The start to 2020 has been a tough one for the global economy, having met with a variety of fund managers, stock brokers, economists and commentators in recent weeks, I thought I would set out what is driving our advice for investment strategy in the very short-term
• Saudi Arabia fired the first shots in a price war, sending oil prices down by more than a quarter. Given the rising tensions between Saudi Arabia and Russian ally Iran, there is also the possibility that a real war could ensue. Financial markets would then demand even more return for the risks
• The steep drop in oil prices makes it more likely that some oil producers will default on their debts. This is concerning because US oil producers have accounted for an outsized share of new credit extended over the last decade
• Given roughly 13% of the US high yield bond index is made up of oil producers, there is also the risk that bond fund managers may need to “fire-sell” good assets if investors start to redeem funds.
Some commentators fear another financial crisis. Financial crises are different to normal recessions: they tend to be deeper and with less of a V-shaped recovery. Fund managers I have spoken with do not think that a financial crisis is likely.
There is a deep literature on financial crises, and they almost invariably have common markers. They tend to be preceded by an extraordinarily rapid increase in leverage (of a speed that we have not seen over the last 10 years), often as a result of financial de-regulation (quite the opposite to today) and an overextension of credit to un-creditworthy borrowers as a result of imprudent lending standards, especially by weak banks with inadequate capital (again no systemic evidence of that today).
Main concerns are about the ability of some companies to finance themselves should profits plunge for more than a couple of quarters, but as it stands interest coverage ratios (the ratio of annual profits to annual interest expense) are reasonable
• Lower oil prices could provide a modest boost to consumers and firms via lower energy bills. But if they are unable to spend the effective increase in disposable incomes due to travel restrictions or supply-chain disruption, it may not provide much of a lift
• The direct loss of employment from any disruption to the oil industry wouldn’t be significant. Just 0.2% of US employment is in oil & gas extraction or pipeline construction.
It’s impossible for anyone to predict the virus’s course – there is an absence of conviction among medical experts, let alone investment professionals.
• Financial commentators tend to view the financial implications in terms of three broad scenarios: (i) Covid-19 and the associated disruption could be on the cusp of dissipating rapidly; (ii) it could continue to worsen into the second quarter, greatly disrupting profits before the world gets back to normal in the second half of the year; (iii) it may escalate further, with lasting economic effects into 2021.
These scenarios give us a best case, a worst case and something in the middle, so we can model the effects on equity prices, weight them by probability and add them together
Assigning an equal possibility to all three suggests that equity markets, as of the end of last week, were trading where they should – somewhere in the middle of the two extremes
By assigning an equal weight to all three of these scenarios is the mathematical expression of “we don’t know”. The median outcome suggests that staying invested with a preference for more defensive factors within equity allocations makes sense.
Where are we now?
• China’s oppressive coping strategy really does seem to have beaten the virus. Daily new cases have slowed to a trickle. For the last two weeks, between 88% and 100% of new cases have been in Hubei province, where it all began
• The mortality rate is starting to level off, the severity rate has plunged and the recovery rate has surged to 90% outside of Hubei (it’s 67% across China as a whole)
• The daily change in new cases outside of China is rising exponentially. We focus on this metric because during the 2003 SARS outbreak the peak in new cases coincided with the trough in equities and other risk assets. This also bore out early last month when new Chinese cases peaked and markets thought we weren’t going to see epidemics in other countries.
• South Korea and Italy are of more immediate concern. It’s possible that the daily changes in new cases in Korea has peaked, but it is too early to say for sure, but seems to be following the Chinese roadmap, even without the draconian lockdown, which is good news for now
• In the last few days new cases in France, Spain and Germany have started to rise too. There is a risk that as virulence peaks in one country it springs up in another, preventing a market recovery for some time.
Will we have a recession?
Analysis suggested that 2018 and 2019’s policy easing across the world was not due to lift profits until the second quarter (it lifts equity valuations immediately, but takes a long time to feed through into real economic activity), and in the meantime the economy and financial markets were vulnerable to another setback.
Given the Covid-19 outbreaks, leading economic indicators are likely to lose momentum again and the recent underperformance of more economically sensitive sectors seems likely to continue.
Stock market corrections greater than 15% are very rare outside of recession, so, as ever, it’s the risk of a US and global recession that we need to monitor most closely. Last week’s falls in equity markets invited comparisons to October 2008, but it is important to remember that the US had already been in recession for 10 months back then.
Today, the world is very much not in recession, while the probability of the US falling into recession in the next 12 months was negligible before Covid-19 struck
• Central banks are cutting rates, and not because they mistakenly set them too high to begin with
• The threat to economic growth from Covid-19 or government reactions to it comes via three main channels: (i) tourism, (ii) the supply chain, (iii) sentiment.
• Many Chinese tourists have stopped departing from China. They make up more than 25% of all tourist arrivals in Hong Kong, Japan, South Korea, Vietnam and Thailand, so these countries are particularly vulnerable to this channel
• The supply chain is the bigger threat. That said, the PMI surveys conducted in mid-February – before the outbreak in Italy and Korea but when Chinese factories were still in mothballs – didn’t report all that much of an increase in supplier delivery times
• The US, supplier delivery times were actually improving. Anecdotally, Chinese factories are springing back to life, but some of the daily data disputes this. Coal consumption by the six major Chinese power suppliers is still 35% below where we would expect it to be at this time of year
• Data from the service sector (the largest sector of the Chinese economy at around 45% of gross value added) looks better: property sales in Beijing were down 95% year-on-year in mid-February but in early March they were higher (i.e. missed activity is being recouped).
• Expressway traffic is also back to within a few percent of last year’s norm. That said, there are also anecdotal reports of empty shopping malls: people are returning to work but not, perhaps, to their usual consumption habits.
• South Korean and Italian disruption adds to supply chain pressure. Italy puts huge pressure on the European automotive ecosystem via MTA Advanced Automotive Solutions, which has plants in the quarantined zones. A 10-day shutdown of FCA, Renault, BMW and Peugeot’s plants would shave off 0.6% from eurozone industrial production, according to Oxford Economics.
Declining sentiment not only derails consumption and investment directly, but can tighten financial conditions which could lead to weaker firms going bankrupt, as we discussed at the start of our note.
Central bank action is designed to support sentiment (of course, it can’t do anything to help immediate supply chain dislocation). However, markets have been anticipating rate cuts
The most current outlook from economists is that there isn’t much evidence that a Covid-19-induced recession would trigger a financial crisis. Especially when we consider that monetary policy is currently set so loosely – most recessions, and especially financial crises, are triggered by a monetary policy mistake.
There remains some growing concern about rising unemployment, especially from airline companies, the tourism and leisure industry and, of course, services companies such as HSBC.
US jobless claims increased by 3,000 to 216,000 last week, but this is still below 2019’s average of 216,500. Given the extreme skills shortages registered by many hiring surveys across the world, firms might actually hoard labour as they worry about their ability to re-recruit staff if the Covid-19 disruption proves to be relatively short-lived
Commentarys and actions taken by fund managers appears to be some moves away from companies reliant on the social aspect of life for the time being, but they are not running for the cover of hiding money under the mattress
Don’t cash an investment in before you take advice, or at least get opinions from other investors or advisers
During the heady days of the Dot Com stockmarket crash in 2000, I guided clients through a rout that seemed never ending. Clearly, for some tech companies, it was the end, but other industries grew as did other asset classes
Uncertainty is a short-term challenge, but for many of us, our investments are a long-term play and we need to remember that before making a decision in 2020