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Investment Commentary – Q3 2020

Investment commentary Archives

In Brief

  • Q3 2020 saw strong gains in most risk assets, except for UK equities.
  • Central banks continued their easy monetary policy, and several large companies, including the US internet giants, benefitted from the general shift to online.
  • UK companies suffered as Brexit worries resurfaced and a second wave of COVID-19 emerged, alongside further personal restrictions to contain it.
  • The US Election, the finalisation (or not) of a UK/EU trade deal, and a severe winter wave of coronavirus remain the key risks for Q4. The upside could come from a vaccine and further fiscal stimulus.

Quarter Overview

In July, markets were buoyed overall by news of successful phase-one trials for a COVID-19 vaccine. There were, however, signs of the virus re-emerging across developed markets, with a severe pick-up of cases and deaths in the US and a more modest uptick in cases in the UK and mainland Europe. This led to halting or reversing previous easing measures and anticipating further monetary or fiscal stimulus from national authorities. Markets broadly pushed upwards during August on the back of some better-than-expected corporate earnings globally. However, countries where second waves of COVID-19 looked to be emerging (most of Europe), or which were still struggling to deal with the first wave (certain emerging economies), were relative laggards. The US Federal Reserve announced a significant policy shift to ‘average inflation targeting’, effectively indicating US interest rates are likely to remain lower for longer. Market exuberance faltered in September, with US technology firms having a ‘valuation sense check’ early on in the month, perhaps to be expected given how stretched their valuations had become. The second wave of COVID-19 in Europe and some emerging market countries and a lack of progress in controlling the virus in the US contributed to a minor sell-off in more cyclical sectors later in the month.  Political concerns also came to the fore with the US election only a month away and, closer to home, renewed Brexit uncertainty weighing UK assets.  Q3 was quieter than the first two of the year and generally positive for risk assets. Market volatility (as measured by the VIX index) receded slightly, although it remains at elevated levels. Globally developed equities (measured by the MSCI World Index) rose just over 3% in sterling terms, and the FTSE 100 fell 4% over the quarter. Oil fell marginally over Q3, whilst gold was up another 6% in dollar terms. Defensive bonds (as measured by the Bloomberg Barclays Global Aggregate, which consists mainly of government bonds) rose 0.6% over Q3, whilst riskier high-yield bonds were up 3.2%.

Looking Forward

Alas, coronavirus is still with us and remains the key risk variable as we move into the year’s final quarter. Globally, countries, cities, and regions are grappling with the trade-offs between introducing economic restrictions to suppress the spread of the virus but damaging growth and keeping the economy open to support growth, jobs, and, frankly, citizens’ mental well-being but fuelling the spread of the virus.

The downside risk is clear from here: the spread of the virus accelerates, dampening economic activity further, either as governments are forced to tighten restrictions further or as scared citizens stay home and not spend anyway. If the virus spreads, expect beaten-up leisure, physical retail, oil company, airline, and bank stocks to underperform.

The upside risk is pretty straightforward, too. There are 11 vaccines in phase 3 trials (i.e. large-scale efficacy tests) at present, according to The New York Times’ vaccine tracker, with a number due to deliver results this quarter. Positive results and approval by a major medical regulator would likely spur a big shift in market sentiment, driving up the prices of those same beaten-up stocks and possibly a big move out of stocks that previously benefitted from the crisis (chiefly large internet companies). Such a move could be reinforced if we get another significant fiscal stimulus, most likely from the US.

It is important to note that even if a vaccine is shown to work well and is approved for use, that isn’t the end of the story. Producing and administering enough of the vaccine to billions of people is a massive logistical challenge and would take time. Unfortunately, even a vaccine wouldn’t mean an immediate return to ‘normal life’.

It is also possible that other positive developments may overtake a vaccine in terms of importance. A cheap, easy-to-produce, and easy-to-administer test would also be a game-changer, as isolating people before they infect others would quickly become possible. A vaccine isn’t the only (slow) route back to normalcy.

Coronavirus remains an open-ended risk, but two other risks seem more short-term and are likely to be resolved in Q4: the US election and whether or not the UK will agree on a trade deal with the EU.

On the first, Joe Biden is currently comfortably ahead in the polls and, as of 9 October on Oddschecker, ahead according to the bookies (at 8/15, an implied probability of winning of 65%). Of course, much could change before election day on 3 November, and it’s not just the presidency at stake—the Senate and the House, too.

Biden likely means higher taxes for US businesses than under Trump and a greater likelihood of antitrust enforcement against the US internet giants. Equally, though, it would likely mean sizeable fiscal stimulus in the short term directly to US citizens, less tweet-induced uncertainty on a day-to-day basis and, over the longer term, more (green) infrastructure spending. Markets thus don’t seem too worried about a Biden win but likely wouldn’t react negatively to a clear victory for Trump given how well they have flourished under him and that he, too, would likely push for further fiscal stimulus over the short term. What would probably be the worst outcome for markets, though, would be a close and contested election, which might delay further stimulus and raise political uncertainty. Trump has so far refused to confirm he’d respect the outcome of the vote and has already cast doubt on the validity of the postal votes preferred by many during the outbreak.

The most significant risks in the future seem to be a close Biden victory, with Trump refusing to hand over power or Biden winning the popular vote, but Trump narrowly won the electoral college.

Lastly, we still do not know the outcome of the UK’s Brexit saga. In theory, a trade deal, if it is to be done, should be completed before the European Council meeting on 15 and 16 October. The two sides are still stuck, mainly on fishing rights and state aid. There is a deal to be done here, and it would be in both side’s interests to get one done, but politics could still get in the way. It remains to be seen whether a deal is done before the 15th or in a special session sometime afterwards, but
before the transition period ends on 31 December 2020, or not at all.

Brexit uncertainty and the resurgence in coronavirus cases have not been kind to UK equities, which have seen a sustained selling period over the last few years. It is fair to say that they remain one of the asset classes that global investors most hate. Nothing perhaps exemplifies this (and, by contrast, how popular the US tech giants are) more than Apple’s market capitalisation, which overtook the entire FTSE 100 in late August. The contrast is clear – the FTSE 100 (packed full of banks, oil companies and miners) has performed poorly over the last few years in terms of profit growth but is now very cheap, whilst Apple has generated substantial profit growth but is now very expensive.

Will cheap shares or expensive but higher-quality shares win out in the future? That, of course, depends. In the case of UK equities and the pound, these are likely to bounce significantly if a UK/EU deal is done. Likewise, they will likely see further falls if the talks break down completely, although possibly only in the short term and probably not to a large extent, given how far they have already fallen. Markets often hate uncertainty even more than a terrible but specific outcome. So, they may rally after an initial fall as investors realise they face a more forecastable future path. Overall, we think exposure to the UK is sensible given how extremely cheap they are and the considerable scope the country has to surprise the upside.

We are not sure whether ‘value’ or ‘quality’ assets are likely to win out in general, so we choose to maintain diversification across both these styles and across asset classes, investment styles, currencies, countries, and fund managers. Such diversification is crucial to building robust portfolios and will remain our primary focus in the future.

PAY GROWTH STRONGEST IN A DECADE

The latest batch of labour market statistics shows that UK workers’ basic pay is growing the fastest in nearly 11 years. According to the Labour Force Survey data, average weekly earnings, excluding bonuses, rose by an annual rate of 3.6% from the three months to May 2019. This was at the top end of forecasts submitted in a Reuters poll of economists and the most significant recorded increase in pay growth since mid-2008. The data also showed that wages continue to outstrip inflation. Indeed, in real terms, regular pay increased by 1.7% from March to May compared with a year earlier; this represents the highest absolute growth rate since autumn 2015. This recent acceleration in wage growth has stemmed mainly from two factors that have impacted the data since April. The first relates to pay rises for some NHS staff, which have contributed to an overall increase in public sector pay growth to 3.6%, its highest level since June 2010. In addition, introducing the new National Living Wage rate and National Minimum Wage rates has boosted wages for lower-paid workers in sectors such as wholesaling, retailing, hotels, and restaurants. Commenting on the figures, Matt Hughes, Deputy Head of Labour Market Statistics at the Office for National Statistics (ONS), said: “The labour market continues to be strong. Regular pay has grown at its fastest for nearly 11 years in cash terms and has been quickest for over three years after taking account of inflation.”Policymakers will undoubtedly have noted this latest pick-up in pay growth. The Bank of England (BoE) has previously said it expects wage growth to ease back to 3% by the end of this year, but these latest figures clearly show wages rising significantly above that forecast level.

UK PRODUCTIVITY PUZZLE

Recently released figures have revealed that the UK’s sustained declining labour productivity continued during early 2019. The UK has suffered from weak productivity since the 2008 global financial crisis. In the ten years following the financial crisis, productivity stagnated, with the UK witnessing the slowest growth rate since modern records began. Indeed, BoE and ONS data analysis suggest it was the least productive decade since the early 1820s when the country emerged from the Napoleonic wars. Several possible explanations for this poor performance have been proposed, including low growth in company investment and a rise in the number of jobs in traditionally less productive sectors. However, low productivity presents a clear challenge to policymakers as it poses a severe risk to long-term economic growth prospects and plays a key role in squeezing living standards. Worryingly, the latest data published by ONS shows that UK labour productivity, as measured by the amount of work produced per working hour, fell by 0.2% in the first quarter of 2019 compared to the same period a year earlier. This was the third consecutive quarter of negative productivity growth, the first time since 2013. Head of Productivity at ONS, Katherine Kent, commented: Our latest figures represent a continuation of the UK’s productivity puzzle. This sustained stagnation in productivity in the last decade is at odds with what we’ve seen after previous economic downturns when productivity initially fell but recovered relatively sustainably. ONS also estimated the impact low productivity has had on wage levels. Its analysis suggests that if productivity had grown in line with its long-term trend average, wages would now be just over £5,000 higher for the average private sector worker.

MARKETS:
(Data compiled by TOMD)

In the UK, the main blue-chip index, the FTSE 100, was up 2.17% in the month to end at 7,586.78. The mid-cap index, the FTSE 250, followed suit, gaining 1.05%. In European markets, the Euro Stoxx saw a drop of 0.20% in the month. In the US, the Federal Reserve cut interest rates at the end of the month, the first cut in a decade. Contrary to expectations, the head of the US central bank said the move might not be the start of a lengthy series of cuts to shore up the economy against risks, including global economic weakness. The Dow Jones and NASDAQ closed the month up 0.99% and 2.11%, respectively. On the foreign exchanges, sterling closed the month at $1.21 against the US dollar. The euro closed at €1.09 against sterling and at $1.10 against the US dollar. Brent Crude dropped 0.51% to close at $64.06 a barrel in the month. This drop came despite a bigger-than-expected decline in inventories in the US and a drop in crude production among OPEC members, along with Libya cutting exports. US output remains well supplied. Gold closed the month up 0.32% at $1,413.71.

INDEX VALUE
(at 31/07/19)
% MOVEMENT
(since 30/06/19)
   FTSE 100 7,586.78 +2.17%
   FTSE 250 19,666.42 +1.05%
   FTSE AIM 931.46 +1.32%
   EURO STOXX 50 3,466.85 -0.20%
   NASDAQ Composite 8,175.42 +2.11%
   DOW JONES 26,864.27 +0.99%
   NIKKEI 225 21,521.53 +1.15%

FEARS OF IMMINENT RECESSION

Although the economy returned to growth in May, fears of a slowdown are mounting, with some economists warning that the UK may be on the verge of a recession. Official gross domestic product (GDP) data released by ONS shows that the UK economy grew by 0.3% in May, compared to the previous month, when Brexit-related shutdowns at car plants resulted in a contraction of 0.4%. However, despite the modest monthly rebound, the latest batch of GDP statistics still suggests that the economy has witnessed a distinct loss of momentum since the start of the year. Analysts have also warned that June’s growth figures will need to be relatively strong if the UK economy is to avoid an overall contraction throughout the second quarter. The June data released in several closely watched business surveys from the manufacturing, services and retail sectors suggest this is unlikely to be the case. Indeed, in its August 2019 review of UK economic prospects, the National Institute of Economic and Social Research (NIESR) suggested that economic growth in the UK has stalled. The renowned think-tank also said that chances are now one in four that the Brexit crisis has already tipped the country into a technical recession, defined as two consecutive quarters of negative growth. The NIESR assessment also warned that risks to economic growth were heavily skewed to the downside, given the increasing chance of a no-deal Brexit and the possibility this could be disorderly. The report concluded: “The outlook beyond October, when the UK is due to leave the European Union, is very murky indeed with the possibility of a severe downturn in the event of a disorderly no-deal Brexit.”

NO-DEAL BREXIT PROSPECTS RISE

The possibility of a no-deal Brexit has increased significantly over the past month despite further warnings over the potential economic consequences such a situation could incur. On 23 July, Boris Johnson was officially confirmed as the new leader of the Conservative Party and, thereby, the country’s new Prime Minister. Although widely expected, the decision has undoubtedly increased the prospect of a no-deal Brexit. Mr Johnson is firmly committed to leaving the EU on 31 October, with or without a deal. While the new Prime Minister has stressed that he plans to renegotiate the Brexit deal his predecessor had previously agreed to with the EU, time is tight. There is no guarantee any discussions will prove fruitful. Mr Johnson’s task was to prepare the country for a no-deal Brexit, and Michael Gove recently confirmed that the government is now “working on the assumption” of a no-deal Brexit. However, it remains unclear whether MPs could ultimately frustrate Government plans and effectively block a no-deal Brexit. Indeed, while the chances of no deal have certainly increased, many other possible scenarios still appear plausible. These include leaving the EU with a new or amended deal on 31 October, delaying departure, a General Election, a second referendum, and cancellation of Brexit altogether. The Government’s insistence that it is prepared to leave without a deal did have an immediate economic impact, with sterling slipping to a two-year low against the dollar. In addition, warnings have been issued over the likely consequences a no-deal Brexit could have on public finances. In its first assessment of a no-deal scenario, the Office for Budget Responsibility suggested that such an outcome could add £30 billion a year to public borrowing by the 2020/21 fiscal year.
It is important to take professional advice before deciding on your finances. Information within this document is based on our current understanding and can be subject to change without notice, and the accuracy and completeness of the information cannot be guaranteed. It does not provide individually tailored investment advice and is for guidance only. Some rules may vary in different parts of the UK. We cannot assume legal liability for any errors or omissions it might contain. Levels and bases of, and reliefs from, taxation are currently applied or proposed and are subject to change; their value depends on the investor’s circumstances. No part of this document may be reproduced without prior permission.

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