At the end of the fourth week of lockdown across much of Europe, senior investment strategist Daniel Morris and Guy Davies, Chief Investment Officer for active equity strategies, review recent developments in financial markets.
They reaffirm our cautious optimism on the outlook and our belief that it is now opportune to gradually increase risk allocations in portfolios. Quality stocks, whose current valuations reflect indiscriminate selling, are a particular area of focus.
The first two weeks of April have seen a pretty strong bounce in equity markets. How is your team managing in what remains a very challenging and volatile environment?
Guy: Firstly, I would like to emphasise that our portfolio management teams – be they in Asia, Europe or the US – are fully operational, working well with excellent connectivity. Each day, the team heads meet for 30 to 60 minutes to exchange views on the situation in their markets. Here in the UK, we have been working remotely for three weeks now. Apart from a greener view of the world out of my living room window, I barely notice the difference.
In context, it has to be said that first quarter was a horror show for equity markets (see Exhibit 1 below), particularly relative to the more sanguine expectations at the start of this year.
It may seem hard to believe, but the main stock market indices reached record highs as recently as 19 February. That feels like an age away now. Since then, the scale of the moves resulting from the coronavirus pandemic have been unprecedented. US equities dropped into a bear market at the fastest ever pace, ending the first quarter down by 20%, and that includes a rally of 15% from the lowest levels of the year.
Indiscriminate selling was apparent during the first sell-off. Subsequently, bond proxies did best, followed by quality stocks, which outpaced cyclicals. Equity markets rallied into the end of March, led by those stocks that had fallen by the most.
Of particular note is the fact that much of the leverage appears to have been cleared out, so the market is much cleaner. That is a positive.
OPEC’s failure, at a meeting in early March, to agree oil prices led to the price of Brent crude falling deeper than the 33.5% decline in October 2008.
Implied volatility hit record highs before fading towards the end of the quarter. Even today, 9 April, the VIX index remains at an elevated 55 relative to 14 at the beginning of the year.
As to what have we been doing, we have been using volatility to increase the return potential of our funds and client portfolios. We are mindful of the need to identify problem areas. In particular, we expect corporate stress over coming months. This is also reflected in the rise in risk premiums in corporate debt markets.
By way of example, we have had a particular focus on two names in our global concentrated portfolio that have higher levels of leverage. We have had multiple calls with those companies over the last month. We have been stress-testing different
scenarios. This has made us confident about holding these names, although we expect to see continued volatility.
Trading has been focused. In addition to upgrades on volatility, we have looked to improve the liquidity profile of certain strategies. In some areas, we have begun to consider some more cyclical names.
How do you assess the consequences of support from governments and central banks against the lack of earnings visibility?
Guy: COVID-19 is primarily a global public health crisis, but the measures to combat the pandemic have also created an economic crisis. So far, the impact on the global economy has largely been contained through the unprecedented actions of central banks, monetary authorities and governments. Nonetheless, there are significant implications for companies and stock prices.
Currently, there are doubtless bargain hunters seeking to re-risk, but making assumptions about company earnings is tough, even with thorough analysis and detailed knowledge of the companies in question.
There are estimates that a 1% decline in global real GDP growth could result in a fall of 25-30% in EPS growth. This raises two questions. Firstly, is this fully integrated into market valuations? Secondly, when will the market stop focusing on the near-term recession and begin to price a recovery? Earnings growth for 2021 will be critical in gauging the impact of the pandemic.
The week beginning 13 April will see the start of companies reporting first-quarter earnings. Some of the big financial groups will be among the first to publish earnings. I am thinking about names such as Bank of America, Citigroup, and Wells Fargo. News on how these companies are coping with the burden of COVID-19 will be important for equity markets.
Many companies are removing guidance on future earnings, so the market will be volatile and grabbing at the smallest pieces of information.
So what factors do you have in mind when you try to differentiate between the opportunities and the value traps?
Guy: A short and brutal recession followed by a robust recovery is still possible, but volatility is likely to remain high.
For me, there is comfort in holding good quality companies with manageable debt loads and generating free cash flow, which are trading at a discount to history. They offer a superb investment opportunity for those able to see through market gyrations.
We manage a range of strategies by region, market capitalisation, industry, and while there are differences in style, most are biased towards quality.
No time to sell risky assets
Guy: In summary, we are cautiously optimistic and seeking to add to our risk positions in equity and credit markets.
Any developments on the relaxation of isolation measures will by key for financial markets. Massive support from central banks and governments has contained the impact so far, but not all companies and households are getting the support they need.
We remain braced for bad news in the short run. The human cost of this crisis will be hard to bear. However, society will ultimately learn to live with the virus and the economy will recover.