Investment Commentary – Q3 2020

In Brief

  • Q3 2020 saw further strong gains in most risk assets, with the main exception of UK equities
  • Central banks continued their easy monetary policy and a number of large companies, including the US internet giants, benefitted from the general shift to online
  • UK companies suffered overall as Brexit worries resurfaced and a second wave of COVID-19 emerged alongside further personal restrictions to try to contain it
  • The US Election, the finalisation (or not) of a UK/EU trade deal and a serious winter wave of coronavirus remain the key risks for Q4, whilst 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 serious pick-up in cases and deaths in the US and a more modest up-tick in cases in the UK and mainland Europe. This led to some halting or reversing of previous easing measures and to the anticipation of further monetary or fiscal stimulus from national authorities. Markets broadly pushed upwards during August, on the back of some better than expected corporate earnings across the globe. 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 major 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. Second waves of COVID-19 in Europe and some emerging market countries, and a lack of progress in controlling the virus in the US, then 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 on UK assets.  Overall, Q3 was a quieter quarter than the first two of the year and it was generally positive for risk assets. Market volatility (as measured by the VIX index) receded slightly, although remains at elevated levels. Global developed equities (measured by the MSCI World Index) rose just over 3% in sterling terms, and emerging market equities were up 4.7%.  However, the FTSE 100 fell, down 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 mostly of government bonds) rose 0.6% over Q3 whilst riskier high yield bonds were up 3.2%.

Looking Forward

Coronavirus, alas, is still with us and remains the key risk variable as we move into the final quarter of the year. 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 versus 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, which would be certain to dampen economic activity further, either as governments are forced to tighten restrictions further or through scared citizens staying home and not spending anyway. If the virus continues to spread, expect already beaten up leisure, physical retail, oil company, airline and bank stocks to underperform further.

The upside risk is pretty clear 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 have 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 as producing enough of the vaccine and administering it to potentially billions of people is a massive logistical challenge and would take time. Unfortunately, even a vaccine wouldn’t mean the 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 it would quickly become possible to isolate people before they infect others. A vaccine isn’t the only (slow) route back to normalcy.

Coronavirus remains an open-ended risk, but two other risks at least 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, Jo 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 that’s at stake, it’s the Senate and the House too.

Biden likely means higher taxes for US businesses than under Trump as well as a greater likelihood of anti-trust 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 win 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.

A close Biden victory with Trump refusing to hand over power, or Biden winning the popular vote but Trump narrowly winning the electoral college seems the biggest risks in the future.

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. As of yet, the two sides are still stuck, mainly on the topic of fishing rights and state aid. There is a deal to be done here, and it would be in both sides 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 period of selling over the last few years. It is fair to say that they remain one of the most hated asset classes by the global investor. Nothing perhaps exemplifies this (and, by contrast, how popular the US tech giants are) than Apple’s market capitalisation overtaking that of 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.

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

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

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