Thursday, 2nd April 2020 13:21 - by David Harbage
“March winds and April showers bring May flowers” so says the nineteenth century proverb. Well, we can’t be sure what April will bring but March 2020 was the stormiest month – stock market wise – that the writer can remember.
This blog has regularly provided an update on what has been occurring in financial markets and it may be helpful to follow up the previous article “A new threat” dated 6 March 2020 by sharing the author’s current thinking. In particular, to comment on the prime issues or concerns that long term investors in stock exchange assets face, provide brief feedback on the performance of previously mentioned investments in 2019 to date and comment on the outlook.
This report can be summarised by saying that after worrying about trade tariffs and Brexit last year, investors now face a new fear – of an entirely different sort – in the form of COVID-19, better known as the Coronavirus. The first case was reported in Wuhan, China on 31 December 2019 and the disease has subsequently spread around the world. Beyond the human tragedy, the cost to the global economy – as workers are quarantined, manufacturing output stalls and travel is disrupted – will be significant and is, as yet, open ended.
Given the huge media attention and speculation that the world is about to experience a recession and financial crisis unlike any other in living memory, this blog goes beyond its normal remit of advising our views on the market and detailing transactional activity over the past quarter period, as it seeks to address private investors’ most commonly asked question surrounding stock market investment: “Should one be invested in equity (company stock or shares) or real assets when the prognosis for the Coronavirus disease, and its potential impact on the world, is so uncertain?”
The stock market endeavours to quantify the risks, as well as the merits, of individual asset classes, but investors should be mindful of their own appetite for stability (reliability of income and preservation of capital worth) as well as objectives before making financial decisions and investment selections. Incidentally, it might be helpful to write the latter down, putting numbers to the estimated amount of income on offer from various assets alongside anticipated living, plus exceptional capital, expense.
Subject to being comforted by the appropriateness of equity investment – successful businesses offer the prospect of real (inflation beating) growth in income (via higher dividends), in turn leading to the potential for the asset’s capital value to appreciate – something which is generally considered to demand a time horizon of at least five years (but preferably ten years plus), let’s consider the specific risk of the Coronavirus to corporate health.
The prime threat is that the disease becomes more aggressive, more difficult to treat with existing remedies and the pace of contagion accelerates – resulting in more workers being quarantined and consumers reluctant or unable to travel or socialise. According to the population affected, so an economy’s ability to function will be jeopardised; this can be considered at both a global and local level. The longer that a factory or other workplace in the economy is ‘closed down’, the more likely it is that wider permanent damage will be caused as an adverse effect ripples out from the site.
One can look back at previous pandemics: the Russian flu of 1889/90, which caused 1m deaths worldwide, the Spanish flu of 1918/19 (resulted in an estimated 25-50m deaths), Asian flu of 1957 (2m deaths), Hong Kong flu of 1968/69 (between 1-4m deaths), while Avian or bird flu in 1997, SARS in 2002, Ebola in 2014 were less fatal. Studying these global viral or bacterial diseases is interesting as a means of trying to assess the potential magnitude of the problems which Coronavirus could cause, but such history is of limited use as populations continue to concentrate in cities and the global economy has become so much more inter-dependant. While medical science has, of course, advanced, it took two years to find a FDA approved vaccine for Ebola.
In terms of the impact within the UK of previous pandemics, it is estimated that the Russian flu cost 132,000 lives, Spanish flu 228,000 lives, Asian flu 33,000 lives and Hong Kong flu 80,000. By contrast, our ‘ordinary’ perennial flu has been attributed as the cause of approximately 15-20,000 deaths in Britain over the past decade; although the quality or reliability of such data is probably low. It should be recognised that there is no cure for the common cold or the flu (although there are vaccines and medicines to ameliorate the virus) and descriptors such as flu or pneumonia (an infection causing inflammation of the lungs) have often been ascribed as the cause of death when another disease may have been contributory.
While we do not yet know enough about this new disease (beyond the elderly or those with respiratory problems seemingly at most risk), the fear of contracting Coronavirus has prompted dramatic action on the part of governments and corporations. State-driven self- isolation may have been helpful in reducing the spread of the disease (enabling hospitals to cope with the influx of patients), but we now have reached the point of likely global contagion. The speed with which it infects more of the population, the extent to which individuals are quarantined or decide to self-isolate is an unknown, but will determine the economic impact. Certainly, in terms of getting out of the economic lockdown, the immediate need would seem to be a robust test for the virus to confirm immunity for individuals to enable them to resume normal working and behaviour.
Stock markets respond to material changes and anticipate future prospects. Both UK and other government bonds and investment grade corporate bonds appreciated as investors have sought stability, away from the turbulence in the pricing of more economically sensitive, risk assets. These gilts and quality bonds anticipated central banks’ monetary easing – lowering interest rates in order to stimulate economic activity and restore confidence in jittery illiquid financial markets. The month of March saw unprecedented levels of central bank and government intervention. In the UK we have seen interest rates cut from 0.75% to 0.1% and a raft of measures aimed at supporting wages for individuals and easing taxes on corporates alike. Of greater importance, the United States’ Federal Reserve made emergency rate cuts – something only previously seen this millennium following the September 11th 2001 terrorist event and in the financial crisis of 2008 - of 0.5% and 1%, taking federal funds rate to a range of 0%-0.25%, alongside US$2 trillion plus of grants to businesses and individuals.
By contrast with fixed interest, equity markets have fallen in response to the prospect of Coronavirus delivering a negative hit on corporate profitability – notably in anticipation of supply shortages and weakening demand. The first quarter of 2020 recorded falls of 20% in most developed stock markets (US 20%, UK 25%), the worst quarter since 1987 and the worst first quarter of the year since records began. The FTSE100 index began 2020 at 7,561 and rose to 7,690 on 17 January before plummeting to 6,500 on 1 March and closing the first quarter of 2020 at 5,663. Wall Street was making new highs as recently as 19 February, before ‘cottoning on’ to the pandemic threat. Individual company share prices have been marked down, as one might expect, based on the particular activities of their industry (for example airlines) or specific risks (such as businesses carrying higher levels of debt).
Amongst the high profile constituents of the FTSE100 index, the business of the owner of British Airways, International Consolidated Airlines Group was perceived as being particularly exposed to the fallout from the pandemic threat - as was cruise line operator Carnival (whose Diamond Princess ship in Tokyo captured global media headlines in January). In the first three months of 2020, the shares of International Consolidated Airlines Group and Carnival fell by 68% to 200p and 73% to 980p respectively. Other sectors which typically suffer in an economic slowdown or outright recession include banks (as interest rates fall and bad debts rise) and oil companies (as demand falls); Lloyds shares have fallen 49% to 32p and BP shares retreated 31% in the first quarter of 2020. The former has announced that it is cancelling its dividend, due to be paid on 3 April, in response to a request from the UK Prudential Regulation Authority that banks preserve capital to serve their customers.
The oil sector has been adversely impacted by a dispute between Saudi Arabia and Russia over production quotas, which resulted in a marked rise in supply and prompted the price of oil to halve in the month of March. Such an event would have been the prime event in a normal quarter’s news flow, but has been relegated to being a sideshow because of fears on a pandemic-induced recession. In the normal way such a collapse in the price of oil and a cut in interest rates would be amongst the biggest levers one could envisage to stimulate economic activity in both business or for the consumer’s benefit – as both either lower normal living expenses (manufacturing, heating, transport) or the cost of servicing capital (debt, mortgages).
Elsewhere, the shares of life and general assurer Aviva have struggled given its role as an asset manager (whose revenue is dependent on the valuations), but the company’s report in March on its financial performance in 2019 impressed via higher profits, dividend, solvency ratio and net asset value, accompanied by lower levels of debt. Domestic builder of new homes Redrow advised the market last week that it was closing all its sites - to workers and prospective purchasers – suspending land purchases and postponing payment of its interim dividend to conserve cash. With the shares underpinned by asset value and negligible debt, the business is well positioned to thrive again just as soon as the economy leaves its ‘lock down’ mode. Aviva shares fell 37% and Redrow stock retreated 52% in the period under review.
Exchange traded funds (ETFs) will typically be very diversified (investing in the hundreds of company shares, bonds or other assets) and will track very closely, if not perfectly, the relevant headline indices of the various asset classes. While also typically well diversified, actively managed (trying to outperform rather than match a benchmark index) investment trusts have typically weakened further than the asset classes that they invest in; as sellers outweigh buyers, so the difference between the trusts’ share prices and the underlying worth of their assets (net asset value, expressed as NAV per share) have typically widened.
This was particularly true of trusts specialising in UK medium sized and smaller sized companies, which had enjoyed a strong final quarter of 2019. However, the enthusiasm that greeted the general election result dissipated as investors worried about the outlook for the domestic economy, potentially isolated from the European trading bloc from January 2021 and by HM Government in borrowing to shore up the economy. The latter, together with the measures taken by the Bank of England in cutting rates, caused a run on sterling against the US dollar - falling from US$1.32 to $1.15 in ten days before the £ recovered to end the quarter at $1.24. Concerns that much of Britain’s consumer industries – such as hospitality, leisure, retail, construction - would come to a halt led to dramatic falls in share valuations.
The share prices of the likes of Schroder UK Mid Cap investment trust and JP Morgan Smaller Companies investment trust typically fell by 10% more than their respective underlying net asset valuations; with the former ending the quarter on a particularly large discount of 22%. Traders have been able to take advantage of the significant moves in share prices – over and above underlying asset movement caused by the market’s volatility – essentially ‘playing the discount or premium to NAV. As an example, one could have exited Pantheon International investment trust in early January, having seen the share price of the FTSE250 index constituent rise strongly to almost reach its net asset value. In the last week of the quarter, the shares could be repurchased on a near 100% discount - with the latest valuation of PIN’s portfolio of private equity holdings indicating a NAV of 2768p per share.
The significant fall in share prices prompted a search for diversified good quality investments which produced two interesting prospective investments in venture capitalist Draper Esprit and European Opportunities investment trust. The latter, managed by the highly regarded Alexander Darwall since its launch, has an outstanding record of consistently and significantly outperforming its peers and benchmark via a concentrated portfolio which can include UK listed businesses. Currently the underlying investments have a bias towards information technology (28% of the portfolio) and healthcare (25%), as well as Germany and the UK geographically.
In the search for undervalued assets but also ones which can enhance a portfolio via further diversification by asset type Draper Esprit, which specialises in high growth digital technology businesses, has appeal. The venture capitalist’s portfolio of businesses has a net asset value of circa 665p comfortably in excess of the share price and a low price to earnings multiple (3.1 times, based on profits to 31 March 2019), the consensus of broker forecasts suggest a fair value of 660p per share. The wish to diversify also persuades for consideration of Gold as, historically, the precious metal has performed well at times of slowing GDP and falling interest rates. Previous blogs have pointed to the use of an exchange traded commodity fund, such as the i share Physical Gold ETC as a means of capturing the gold price (albeit in a sterling priced form).
In mid-March, we witnessed a fast moving deterioration in the news flow (featuring President Trump's decision to ban European travellers to the US) as well as market sentiment (in particular surrounding the anticipated impact of a Coronavirus-driven shutdown of the global economy). Another week on, following massive government support for businesses and consumers - which will raise borrowing to unprecedented levels, and the prospect of a recession looming, which will likely feature deflation – investors have to consider how their long term savings are positioned and if they need to assess the magnitude of the risks they are taking in the current allocation of their liquid assets.
Such risk ‘budgeting’ is personal, based on an individual’s circumstances, objectives and tolerance of turbulence in income receipts and capital valuations. As far as the writer is concerned, government bonds (both conventional fixed interest and inflation-linked) and corporate bonds now have less appeal at this point in time. The former because governments are going to inevitably be having to carry ever higher debt burdens, will have to issue more stock and, having held up relatively well in 2020 to date, the yield on offer is negligible. Debt issued by investment grade (good quality, as assessed by the credit agencies) companies, which currently yields 2.5% - based on the i shares £ Corporate Bond ETF - have a little more appeal, but a diversified basket of equity (notwithstanding the prospect of more headline-making company failures and cancelled dividends to be reported this year) has more to commend it over the appropriate longer term at current depressed valuations.
It is to be hoped that the US stimulus has provided markets with confidence, even while the medical reports surrounding Coronavirus and the economic shutdown in the US and Europe accelerates. Evidence that the virus appears to be losing its strength in its place of origin (Wuhan in China) is encouraging, but the medium term outcome on global financial health remains uncertain. After seeing the FTSE100 index trade in a range of 7,000 to 7,700 in 2020 until 25 February - before briefly falling below 5,000 on 22 March and subsequently stabilising around the 5,500 level - there might appear to be greater potential upside, than downside, taking a medium term perspective on the worth of UK equity. Savvy investors should appreciate that although the news flow will remain poor, markets will anticipate the future and look ‘across the valley’ to an eventual resolution.
While it will be almost impossible to catch precisely the bottom in markets, brave investors may choose to follow the lead of a number of prominent fund managers who have begun to buy company shares. One could select economically less sensitive stocks like the food retailer J Sainsbury or utility National Grid, choose to focus on quality businesses like GlaxoSmithKline or Unilever, or turn to one of the many ‘Value’ shares who have fallen much further than the wider UK stock market such as Legal & General or Segro. However, given the wish to avoid the inevitable corporate casualties of the pending downturn, it may be more prudent to gain exposure to the UK’s largest businesses via the i share FTSE100 ETF (at a cost of 0.07% per annum) or, if wishing to taking a stake in the world’s largest listed businesses, the i share Core MSCI World ETF (at an annual cost of 0.3%).
The reader might be interested to learn that in the portfolios that the author manages, there are overweight exposures (as compared to informal benchmark positions) to Cash – ranging between 10% and 25% of total worth, according to the mandate – Flexible Assets (typically between 12% and 13%) and UK Equity (between 23% and 40%. By contrast, the same portfolios tend to be underweight Bonds (between 4% and 12%), Property (between 12% and 17%) and Overseas Equity (between 9.5% and 22%).
So, back to the original question,”Should one remain invested in equity when the prognosis for the disease and its potential impact on the world is so uncertain?” As the answer will almost certainly depend on the circumstances of the questioner, he or she should revisit the standard basic principles and features of such investment – and ask if it is suitable for them, in terms of:
(a) time-scale, as mentioned earlier, anticipating the monies being undisturbed for a period of 5-10 years or longer
(b) acceptance of volatility (price movement), with its lack of guarantee in terms of return (of capital, as measured by share price, in particular, but also income pay-out)
(c) diversification, ensure that long term savings are spread between differing asset types and also that the equity investment is sufficiently diverse (by business activity, geography and individual company)
(c) current and future income is key to valuing an asset, with the prospect of today’s income rising in future years (if dividends are increased). Such an asset, along with property that produces rent, offers the potential – albeit not a guarantee – of its income keeping pace with inflation and, in turn, the prospect of preservation of the real (as measured by the purchasing power) worth of its capital.
Having said that, in the current crisis, with the lack of visibility on when the economy begins to function normally again, it is expected that many companies will suspend their dividend payments as they seek to conserve cash and reduce debt. Currently the FTSE100 index yields 6.1%, which compares favourably with the British Government 10 year gilt’s 0.35% and best no-notice Cash deposit accounts of 1.1%.
Having successfully ‘hurdled’ the above barriers to entertain equity investment, the individual who actively monitors and manages their investments may be tempted to sell part or all of their stock market assets – in the belief that they will be able to buy them back at a lower price. However, history suggests, and industry professionals (independent financial advisors and fund managers) agree, that this is a high risk strategy, because financial markets can move very quickly – often in response to knowledge that has yet to become public – and most traders do not beat the market.
The twitchy investor has to take a view on the Coronavirus and the economic consequences of the disease. If one thinks it could be truly pandemic and extend beyond the elderly to afflict say 5% of the world’s population, with a resultant 1% rate of fatality (equates to 3.350,000 and 670,000 people in the UK, for instance), then there is almost certainly further downside potential in equity markets from today’s valuation (especially on the more elevated valuations prevalent on Wall Street).
A more optimistic or benign perspective might suggest that a vaccine will be found by the end of the year for this dangerous variant of flu, that warmer temperatures will act as a headwind to the disease and that, aided by governments and central banks’ efforts to stimulate demand, the world’s economy will recover to the point of real GDP growth resuming in 2021.
However, until evidence of the latter appears, and with the media likely to maintain a focus on the human and economic damage wrought by the Coronavirus, investor sentiment is likely to remain fragile and equity markets are set to exhibit negative momentum and high volatility. It is important for investors in equity to appreciate that markets will be ready to bounce back or, for that matter, to fall heavily upon any change in the news flow.
History shows that the combination of irrational emotive forces and computer-driven trading activity will take share prices lower or higher, (as relative valuations can be ignored at times of extreme positivity), than a fair or sensible price. That should not matter much to the long term prudent investor – whose eye is probably on the dividend outlook – but to expect markets to behave in this way is to be mentally prepared. Incidentally, in terms of income pay-outs from UK listed businesses in 2020, we expect to see a 30% reduction in dividend income as companies are encouraged to conserve cash until ‘social distancing’ is eased and the economy resumes a more normal path.
With the benefit of being able to look back, we can see that many of the threats to equity investment have proven to be temporal (prompting the saying that “stock markets climb a wall of worry”) but, of course, one can never be sure of how a particular new risk could pan out. In our digital world, bad news travels fast, and the authorities’ fear of Coronavirus could have as a great an adverse impact on the global or our local economy as the disease itself. Being dispassionate and applying a ‘head over heart’ perspective, the on-going provision of heath care and other vital public services is dependent on a flourishing economy, featuring profitable businesses employing people and paying taxes.
No-one can be sure of how dangerous the virus will prove to be, how long governments will enforce a lock down and the extent of the consequent economic damage. Your fund manager has experienced more than forty years of economic crises and stock market turbulence, dating back to the early 1970s, and considers this pandemic-induced event to have been the most dramatic. Certainly the fastest – as we moved from the peak of a global bull market in February 2020, into a bear market (considered to occur after a 20% fall) and the most shocking, in terms of its surprise factor (as the closure of the global economy represents a new development).
Although 2020 will be a ‘write-off’, as both the global and domestic economy is set to shrink, with many businesses failing (or, in the case of transport providers, being taken into partial public ownership perhaps), there is the prospect of higher public spend on infrastructure (as governments seek to ward off a longer term depression) coming to the rescue, aided by supportive monetary conditions (interest rates remaining low), over the coming decade.
However, having asked ourselves the question, ”In two years’ time will we look back on the events and market performance of early 2020 and deem the valuation of listed company shares and domestic commercial property at the time as having been attractive?” we believe the answer will be “Yes”. Opportunistic buyers will certainly be taking the perennial risk of being ‘early’ and it would be our recommendation to gently finesse any new investment into risk assets. Accordingly, although the immediate future looks opaque leaving economists, market commentators, fund managers and individual investors wrestling with a raft of issues – from the state of public finances to how individual companies survive – this writer is retaining a belief that a market-driven economy can be rebuilt and wishes to take a stake in that by owning real businesses.
“Though April showers may come your way, they bring the flowers that bloom in May”. It may well be that investors will have to be more patient and have to wait until May 2021 or even 2022, for their dividend income to bloom again and capital worth to recover.
The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.