Tatton News Archive

New article from Tatton Investment Management: Unprecedented quarter or calm before the storm?

6 April 2020, 12:00am

This week marks the end of the first quarter of 2020. Rarely if ever does it happen that one news story swamps all else as much as the coronavirus pandemic has, but in the future we probably will not remember much else about the last three months. The economic and financial news stories and outlook pieces at the beginning of the year hardly seem relevant now, but it is worth looking back – if only to put this crisis (and what might happen when it subsides) into context.

Even before the first case of coronavirus made headlines, the global stock markets were in a precarious position. Global growth slowed notably in 2019 and, while there were some promising early signs of a recovery, we were still waiting for tangible improvement. This was in stark contrast to the mood in capital markets, which seemed to be banking on the renewed monetary push from central banks of Q4 2019 and a steadily rebounding global economy showing up in the economic data flow. Easing trade tensions between the US and China, plus the manufacturing sector coming out of its third midcycle slowdown of the past decade, had many investors decidedly bullish. As a result, the equity rally that had been building since the Autumn continued, despite corporate results not (yet) living up to lofty expectations.

This led to concerns that if rebound expectations were delayed, then equity valuations (price-to-earnings-ratios) were becoming quite stretched and vulnerable to corrections. As has repeatedly been the case in recent years, this was coupled with a general anxiety that the longest business cycle ever had to end sooner or later, bringing down the ten-year bull market with it. We, like others, pointed out that economic cycles do not die of old age: they end because of central bank action (either forced or through error) or external shocks. As long as the business environment remains stable, and markets have enough liquidity, growth keeps on going.

At Tatton, we took a cautiously optimistic stance, keeping portfolios broadly in a neutral position, but with a 3% overweight towards Emerging Markets and in particular China, where a massive fiscal stimulus package was being put together.

Of course, we all quickly learned that the mother of all external shocks was just around the corner. After initially brushing off coronavirus as a problem on the other side of the world, which was based on the historical experience of the first SARS virus outbreak in 2003, on 20 February, markets realised the potential gravity of the situation. Over the next month, the S&P 500 lost 34% of its value, and all the world’s major equity indices entered official bear market territory (defined as a stock market decline in excess of 20%). Government orders shuttered the global economy, ending the longest expansion cycle in history, and plunging us all into a deep recession.

To make matters worse for markets, two of the world’s largest oil producers – Saudi Arabia and Russia – decided they could no longer deal with the supply glut that had been building through production cut compromises – resulting in a hugely untimely price war. This sent crude oil into free-fall and left energy producers (who usually provide market support through large capital expenditures) uncertain about their ongoing ability to service their capital, be it debt or equity. It resulted in crude oil’s worst quarterly performance on record, as shrinking demand was met with burgeoning supply – almost maxing out storage capacity. We cover this in a separate article below.

Initially, the market reaction could have been described as rational, stock markets fell by around 10% as investors revised their expectations. Safe-haven assets like gold and government bonds initially shot up, with bond yields (the inverse of price) sinking to historic lows. But the sell-off worsened, which led to a self-perpetuating downward spiral. When shoppers began panic-buying staples such as toilet paper and hand sanitiser out of a natural urge to ‘do-something’, investors fell victim to a similarly irrational ‘sell anything that is liquid’ cash-grab mentality. For a while, even the safe havens suffered losses – the complete opposite of the 2008/2009 sell-off. Most sectors of the economy were now feeling the pain – though far from equally. The chart below shows the sectoral breakdown of companies facing ratings downgrades

At the point when policymakers were weighing up the costs of a global economic depression and a virus death toll comparable only to the 5 million deaths caused by the 1918-1920 Spanish Flu pandemic, governments and central banks stepped in to make clear they would “do whatever it takes” to prevent such an outcome. Central banks acting as the unlimited ‘buyer of last resort’ in capital markets decisively ended the ‘dash-for-cash’ spiral. Fears that capital markets would saddle global society with a financial crisis on top of the health crisis were decisively quelled.

In combination with government support measures aimed at preventing the unintended consequences of a complete economic shutdown, this calmed investors’ fears of a complete and lasting economic meltdown. While corporate earnings prospects for 2020 remain dire or at least completely uncertain, the likelihood of a collapse of the corporate debt markets now appears more limited.

In terms of recovery hopes, the main shining light has been the sheer size of the support measures undertaken. The US Federal Reserve led the way by lowering overnight rates to zero and pledging virtually unlimited funding for buying government debt and even private sector credit, which is a novum for the US. An international USD shortage was addressed by extending USD swaps to the central banks of 14 countries. Other central banks took similarly unprecedented measures and, crucially, governments took the opportunity to unleash a wave of fiscal bridging support and stimulus for the time when economic activity restarts.

In the UK, emergency government spending measures will cost around 2.5% of GDP (depending on the uptake of the furloughed worker scheme). A further £330 billion of business guarantees and loans should help steady the ship for the rough ride ahead. In the US, the Senate passed an emergency response bill of just over USD 2 trillion, equivalent to 9% of GDP.

The European Union (EU) has yet to settle on a coordinated fiscal response, but most major economies, including Germany, announced substantial measures to see workers and businesses through. These measures are almost entirely to be paid for by government borrowing, which itself can be ‘monetised’ by central banks’ extraordinary measures if required to keep interest rates and longer terms yields steady. In effect, central banks have been authorised to print/create money for governments to use in short-term emergency spending. That may indeed cause problems further down the line, but as global policymakers have almost all realised, right now, there is simply no other choice.

When looking at the numbers, comparisons to the financial crisis – or even the great depression of the 1930s – are not hard to find. But rather than reeling off scary statistics, the key question is: how bad will the damage be? The answer to that depends on how long this forced hibernation lasts, and what the authorities do in response.
While China’s re-emergence after barely eight weeks of social distancing and shut-down are encouraging, neither the US and Europe has reached the ‘peak’ of the virus and may not for some time. However, the quick and decisive economic response from governments is encouraging. In an ideal scenario, measures would be perfectly timed and targeted to get just enough money to keep businesses and individuals tied over so they can resume their usual spending patterns once the lockdown is lifted. In that ideal case, we would see a sharp V-shaped recovery, where growth returns exactly as before.

Of course, in the real world, perfect timing and targeting are not possible. Some businesses will suffer irreversible damage, bankruptcies will rise and so too will unemployment. If the collateral damage proves too much, a prolonged ‘U-shaped’ recession could set in (or, in the extreme case, the dreaded ‘L-shaped’ permanent deterioration). But given the measures already in place, there will be winners too. The emergency fiscal and monetary measures may last longer than the lockdown itself, after which the added stimulus could lead to a strong rebound – particularly if pent-up demand comes out all at once. As outlined before, in that case an overshoot on growth and inflation seems more probable than a prolonged downturn.

Or in other words, monetary and fiscal policy can play a crucial role in limiting the collateral damage, but pandemic and virology science will determine the timing and success of the recovery. Whatever the case, the determination to avoid economic disaster is clear among policymakers. There are certainly challenges to overcome on that front (Germany and the Netherlands’ blocking of the Eurozone ‘coronabond’ being a prime example).

‘Tumultuous’ would be an understatement when describing the first quarter of 2020, ‘unprecedented’ captures reality more adequately, but is also a frightening adjective.

The table of asset class returns for the quarter isn’t pretty, but it conveys the pain that investors have endured since the year began. However, the three and five year annualised figures also show that the longer-term investment time horizons that our portfolio investors base their planning on have not been disproven, in spite of the first quarter’s events. The returns also illustrate why diversified investment portfolios, made up of holdings across many asset classes, generate significantly less extreme returns when compared against single asset class investments.

The levels at which the crash left stock market valuations at quarter-end reflect investor uncertainty and negative expectations around both the global economy and corporate results in the near term. However, compared to the lower levels plumbed just a week before the quarter ended, concerted actions taken to protect economies and private households have created something like a ‘safety net’, which appears to have been accepted as averting the very worst outcomes – including a full-blown financial crisis.

For now, capital markets have stabilised and there is a healthy improvement of sentiment based on the good that can come from the sheer size of intervention packages over the longer term. That said, even the boldest policy actions cannot prevent the misery that the coming weeks and months will bring – not only to those affected by the virus itself, but also in the economic collateral damage brought in by the social distancing measures aimed at limiting the loss of human life.

We should remain realistic and accept that as long as virologic or behavioural science cannot provide a more definitive time frame for the economic suppression, then assessments of the likely economic cost, and thereby justified discount to stock market valuations, remains impossible.

As the shut-down progresses, the economic pain of individual corporate defaults and the ‘scaring’ from mass-unemployment (and underemployment), are likely to depress market sentiment again. This bear market is therefore likely to progress along the lines of historical precedent, with the crucial difference that if any form of medical advancement is found, forward expectations can improve just as rapidly. Overly active portfolio management in such an unpredictable environment remains challenging, but also carries the prospect of generating long term value.

Tatton’s investment team is therefore decidedly busier than most employees around the world. In our investment committee meeting next week, we will determine the future course of portfolio activity.

We are satisfied with the way we constructed risk-profiled, diversified portfolios for our clients, and that we held our nerve in what bordered on emotional market chaos around us. Our response ensured clients remained within the boundaries of what their risk profiles suggested to be possible and to be expected. While we are saddened for clients by the overall poor capital market returns, we do hope and believe that this 2020 market crash has born fewer surprises than many clients experienced during the 2008/2009 bear market, before Tatton was managing their investments.