New article from Tatton Investment Management: Fading threat of financial crisis re-opens old divide

13 April 2020

These “strange times we live in” are even stranger for those of us working in and around capital markets. Despite the COVID-19 death toll rising to horrifying and previously unthinkable highs, stock markets staged another phenomenal recovery week. At the same time, while economic data flow has only just begun to show the global economy’s ‘medically-induced coma’ (since lockdown only began mid-March) it has already hit depressed levels never seen in our lifetimes. The very real pain felt by people most exposed to the economic shutdown is now starkly visible. Companies are warning everywhere about the risk of defaulting, corporate earnings expectations are in freefall, and we can only draw comparisons with the breadlines captured during the Great Depression era of the 1930s.

Yet stock markets have recovered somewhere between one-third and half of their late March losses. Did they overreact previously? And, as reality catches up with prior market expectations, are things turning out not to be quite as bad as originally feared?

Well, it is a bit more complicated.

What stock markets fear even more than lower corporate profits are corporate bankruptcies (defaults). These do more than just lower the expected return-on-capital; they put the return?of?capital in its entirety at highest risk. That is why we saw sheer market panic in the middle of March, which forced central banks to step in with all their might to prevent the virus crisis causing an all too unhelpful financial crisis on top. Effectively, the central banks’ objective was to allay fears of mass corporate defaults by intervening in the debt markets to an extent that substantially lowers the risk of widespread defaults. At the same time, injecting vast amounts of additional liquidity helped satisfy the urge of so many to hold more of their capital in cash while the uncertainties of the virus crisis reign.

As we wrote before, this, together with government’s fiscal support pledges, has put a safety net underneath capital markets. The sense of universal crisis has eased and markets are seemingly indicating – and forecasting – to the public and politicians that the collateral damage to the economy will indeed be quite limited. However, the extent of this ongoing recovery is quite possibly overshooting what authorities deemed necessary to prevent capital markets from disrupting society’s attempts to contain the loss of life from COVID-19.

The issue is that nobody can know and the recovery in risk asset markets is most likely not suggesting a benign impact either. Markets are merely reacting to the double boost of much reduced default risks emanating from bond markets and plentiful liquidity from central banks.

Given we know the shutdown will end eventually, at which point the economy can be revived from its ‘coma’, it does indeed appear rational to buy those business assets at still much marked down prices, rather than be stuck in negatively yielding government bonds, especially when inflation is becoming a real possibility again.

So, here is the investment dilemma. Due to central bank pledges, markets have possibly attained a resilience to short-term bad news that is normally not part of the market valuation and investment behaviour equation. On the other hand, we may be experiencing a bout of artificial calm and exuberance in stock and bond markets, which underestimates what the true medium-term damage from the COVID-19 ‘economic coma’ will be. If the pain to the economy drags on and the negative news-flow becomes overwhelming, while authorities simply execute what they have already announced without introducing ever new superlatives, then stock markets may well re-assess their fast-rising valuation levels against the backdrop of ever-faster falling earnings outlook expectations.

That is why Tatton’s Investment Committee decided this week to rebalance all portfolios approximately back to the neutral position we had held in mid-February, while retaining the underweight to the UK that the unequal movement of regional markets has created. This means that, depending on the respective portfolio, equity positions will be raised some percentage points back to neutral. We will maintain our overweight to emerging markets, with a focus on China and its far eastern neighbours, at the expense of an underweight to the UK. Should markets subsequently retest their previous lows (which, as outlined above, is possible) then we would see this as a signal to increase from the neutral position to overweighting equities across portfolios.

While I always like to end on a positive, it is difficult at the end of this week. Not only in face of the mass loss of human lives every day, but also because the recovering asset markets are creating frictions and opening up new divides which could become unhelpful. If wider society no longer feels that we are ‘in this together’ – because capital owners once again turn out to be the relative winners – then authorities will find it much harder to continue in their aim to protect the wider economy through fairly blunt but effective measures. There is also a real risk that last week’s rise of political finger-pointing and lack of international cohesive action will deteriorate into an ‘everyone for themselves’ frenzy. In the short-term at least, all eyes are on the European Union’s ability to agree an act of fiscal solidarity to heal some of the divisions that have arisen between countries of the less affected north and the truly virus-ravaged south. We dedicate a separate article to this issue below.     
 

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