13 Mar 2020
The impact of the coronavirus is being felt throughout the world, with global growth expectations being revised down sharply and many suggesting a global recession is now inevitable. The decision by Saudi Arabia over the weekend to slash the price of oil, following a failed attempt to get Russia to agree to supply restrictions in response to falling global demand was the tipping point for financial markets.
The performance of our Value equity funds has been disappointing YTD after a very strong 2019. Our view for some time has been that equity markets (especially in the US) were expensive and that within the market there were some stocks that were very expensive – their valuations driven higher by falls in bond yields. Whilst we recognized the risk of a recession, we felt to position for this by holding equities with low volatility was potentially dangerous. This view was driven by our belief that policymakers would be in no mood to see a recession develop and would therefore introduce ‘shock and awe’ policies. We believed investors would regard these policies as inflationary and pro-growth. Consequently, our portfolios hold stocks sensitive to economic growth (for example banks and industrials) that we believed were cheap on a through the cycle basis.
Unfortunately, many of these cyclical stocks have performed poorly recently (whilst other more highly valued stocks which we feel are also very sensitive to economic growth have held up better). Still, we think it is important for us to maintain an eye on the normalised profitability of these businesses, and we think we are paying very attractive prices on their long-term earnings prospects.
The Investec Cautious Managed Fund has not been immune to the pain felt on our equity-only portfolios. Whilst the Fund’s short position on the S&P500, alongside our exposure to gold and silver has offered some protection, this has been offset by the cyclical nature of the stocks we hold. The portfolio is positioned for the environment detailed above so the Fund’s bond portfolio is low duration. If this view is correct, then we fear we will move into an environment in which bonds no longer work as an offset to equity weakness and bonds and equities become more correlated. Therefore, our low allocation bonds should help relative to others.
We think those ‘shock and awe policies’ which we highlighted above will come earlier than expected. We have already seen the Federal Reserve make an emergency rate cut (at a time when US equities were very high and several indicators suggested the US economy was reasonably healthy), and now the Bank of England has followed suit. This suggests the Fed and other Central Banks are unlikely to sit on their hands if the prospects for economic growth deteriorate further. Policies could include further interest rate cuts, more Quantitative Easing and even the introduction of Modern Monetary Theory (which would see the printing of money to finance government programmes).
Even before we see Modern Monetary Theory, governments could simply increase spending with this financed by increased borrowing in the bond market. Indeed, with the US budget deficit increasing significantly, the UK budget very clearly signalling a loosening in the fiscal purse strings and even talk of a government financed Green Deal in Europe this move to increased government debt already appears to be well underway. What’s more, the Central Bankers and academics are increasingly vociferous in their views that Governments should be taking on more responsibility for economic growth. The mood music implies a change of policy from inflation targeting (i.e. keeping prices under control) to targeting nominal GDP (i.e. any combination of inflation and real economic growth). This would be a very significant change.
The outlook for equities under this scenario would be dependent on whether the economic growth or the higher bond yields have the greater effect on valuations. While not sure in what direction this would send equity markets, we think it would be a much better environment for value than it has been for many years.