Chief Investment Officer Update - 15th May 2020

Stay alert! One of the most challenging things about the early stages of virus panic was the total confusion. Nobody knew the medical facts nor what to expect for their jobs or businesses. Then central banks and governments fired their policy bazookas to stabilise the markets and support households and employers, while people adjusted to living under lockdown. Now as we move towards the next stage, relaxing the lockdown, confusion is returning. White House pronouncements seem at odds with health experts and state governments. The prime minister’s advice is only to be followed in part of the United Kingdom. Some are choosing to ignore the authorities and make their own decisions. To give an example, Elon Musk has announced that he will restart production at his Tesla factory in California in defiance of local regulations.

The Coronavirus – two steps forward, one step back?

On a positive note, the growth rate in new infections continues to decline, although the worldwide aggregate number of deaths has passed 300,000. Governments across Europe and governors in the United States have started to relax their lockdown constraints. We can begin to look forward to an eventual post-virus new normal. However some experts have warned that relaxing virus control policies too quickly will lead to a resurgence in infections. We note with concern that new cases have risen again in China, South Korea and Germany, countries which had seemed to have successfully tackled their virus crises.

The economy – jobs and inflation

After weeks of off-the-chart new jobless claims, we finally saw the impact of the virus shut-down on US unemployment. The rate of unemployment jumped from 4.5% in March to 14.7% in April. To put this into context, the rate peaked at 10% during the global financial crisis, with the post war high being 10.8% in 1982. European numbers are unlikely to jump by as much as in the US due to the government assistance schemes to keep workers tied to their jobs. Ireland is a notable exception however, with the unemployment rate reaching 28% in April.  For some historical perspective, during the Great Depression unemployment in the US reached almost 25%.

Another classic sign of economic weakness is falling inflation. The US consumer price index (CPI) decelerated to 0.3% in April. Lower oil prices did help to drag this down, while the price of food at home surged.  The core CPI, which excludes food and energy, dropped to 1.4%, with the largest monthly decline in its history. The Eurozone equivalents were 0.4% for CPI and 0.9% for core CPI. The silver lining to this weak data is that fears of inflation, as witnessed in gold prices, are premature for now at least.

Stock markets – lower earnings, higher valuations or expectations?

As we come to the end of the first quarter earnings season, the stock market has not become any easier to understand. Earnings are falling across the US and Europe, companies are lowering or withdrawing their forecasts for the rest of the year, and yet the market has been range-bound for a month now. This implies that the valuation, or earnings multiple, that the market is willing to pay is increasing, or that the market is expecting a sharp recovery in earnings in 2021. It’s also worth noting that the gap between market leaders and laggards, or growth stocks and value stocks, is growing ever wider. In a low-growth and low-rate world, a premium for higher growth stocks is understandable. We must ask ourselves though, whether the expectations and price for these winners may be too high.

Our investment view

As you’ve heard from us before, we try to look beyond the near-term noise and focus on the longer term for our investment decisions. Even for tactical asset allocation our time horizon is 12 months out. In our centrally-managed discretionary portfolios, the overweight to equities that we built up throughout March was based on the view that the market had over-reacted to the downside and offered higher than normal return prospects for investors with our time horizon. Now that the market has recovered so much of those losses, much faster than we expected, we have removed half of the overweight.

We note that this is not a negative view on the market nor a prediction that it will fall again.  It’s simply recognition that the opportunity for extra returns has decreased, and therefore our overweight has decreased.  Also, recognising that the prospects for bond returns are particularly unattractive, we returned the proceeds instead to short duration corporate credit. This does have some sensitivity to bond yields and the stock market, but only at a low level.  And as we mentioned last week, we have also raised our cash holding, to give us more flexibility to respond to further developments.