Economic Performance & Outlook
Back in January, policy makers set out growth projections for this year and next, relying on past experience to (reasonably) accurately forecast growth. Now, after a few months living with the Covid-19 virus, the range of scenarios is so wide as to make any predictions for the next year or two a stab in the dark.
While we now know far more about the virus and its behaviour than we did in January, the key driver of uncertainty at this stage is around where government and populace will settle on the balance between resuscitating the economy and fending off further waves, particularly next winter. A vaccine or effective antidote would clearly be a game changer here, but may well be a year or more away.
Perhaps the nearest parallel for the coming year is the post-war periods after both 1918 and 1945. During the war, the economy functioned very differently to normal, and the major players ran up huge government debt. When the war ended, the traditional pre-war economy had to be restored as soldiers returned to civilian life and armament suppliers wound down much of their activity.
In general, post-1945 was well handled in contrast to post-1918. Major government investment (including the US-funded Marshall Plan) helped economies recover fairly quickly. Much of the recent government action – both monetary and fiscal – suggest that the lessons of 1945 have been well learned. There are, however, some important and concerning differences between 2020 and 1945:
- In 1945, much of the world had not been greatly affected by the war, leaving many countries free to kick start a recovery. This was particularly true of the US.
- There was no imminent danger of the war returning — now there is the very real possibility of a second wave.
- Physical reconstruction was a priority and provided immediate focus.
- While current Sino-American hostility might present a parallel with the Cold War, Russia’s global economic importance in 1945 is completely eclipsed by China’s today.
Governments, then, have a reasonable economic track to follow but there are likely shocks to come. This is not helped by incompetent leadership in the US and the increasing assertiveness of China.
Putting this into a longer-term context, what can we say?
- If anything, big tech such as Amazon, Facebook and Google have benefitted from the pandemic, operating under close to monopolistic conditions. It is not clear what could hamper their progress as demand for their products continues to grow and consumers remain generally happy. But at some point, something will happen: monopolies do not last.
- The reality of climate change seems to be hitting home. Virtually all countries – including most US states – have emission-reduction targets. The move to renewables, carbon reduction and new technologies is unstoppable.
- We do seem to be moving away from a period of rapid expansion in global trade and open immigration markets. While globalisation has generally been good for economies, it has proved deeply unpopular with many citizens.
- Inflation and interest rates remain low. If nothing else, this means that a year like 2019, with asset values pushed higher by falling interest rates, is unlikely to be repeated soon.
- We question the long-term effects of heavy central bank interventions. The stimulation for recovery post-2008 and now post-pandemic were intended to be short term but have become normalised.
In terms of our investment thoughts:
- Taken overall, the market view is of a gradual easing of lockdowns with some form of vaccine appearing on a 12-month time horizon. We think this is relatively optimistic. However, the sheer volume of monetary and fiscal stimulus provides a huge cushion of support against downside market scenarios.
- This volume of stimulus calls into question the whole idea of ‘risk-free’ returns. At yields below zero, many government bonds are essentially uninvestable and certainly not risk free.
- Inflation is clearly going to be very low in the immediate future. Consumer demand is weak and unemployment is high. However, we may already have the seeds of future inflation on a three- to five-year time scale. This suggests the need for some asset diversification.
- Uncertainty is exceptionally high, which makes the assessment and spreading of risk more important than ever.
Bond performance over past year
All bonds 10+ years, 09/07/2019 – 09/07/2020, local pricing
The German 10-year bond yield continues to trade well below zero, illustrating ongoing high demand for Europe’s most highly rated debt. US Treasury yields have declined sharply and their spread over German Bunds has halved to date in 2020. At these levels, bond yields look to be signalling a major recession.
Where bonds are not being used for matching, and where it’s possible to take some risk, it seems sensible to either shorten duration or move into alternative investments, such as credit or emerging market debt.
Equity performance over past year
09/07/2019 – 09/07/2020, local pricing
Since equity prices fell off a cliff in February through March, we have had a major recovery, such that the overall fall, year to date, averages less than ten per cent. The US has performed better than other markets, helped by being home to the big tech companies, the injection of cash into equity markets from the US stimulus, and perhaps an unrealistically rosy assessment of the economic outlook on the part of investors. What markets are saying, therefore, is that there is going to be some pain over the next one to three years but, on a longer-term view, we will return to ‘normal’ growth patterns.
Within equity markets, there are considerable sectoral differences which suggest that there are major beneficiaries and losers from Covid-19. Worst affected sectors include travel, leisure and financials. Those doing best include tech stocks and online retailers.
Finally, we expect emerging markets, relatively attractively priced, to outperform developed markets over the medium term, albeit with increased volatility. There may be a short-term case to increase this allocation beyond that indicated by world market indices.
We continue to believe that property yields are attractive relative to other asset classes but the prospects for different areas of the market look very different. We recommend clients who are below target weight to remain there. The Irish property market is looking slightly expensive and we have been advising clients for some time to reduce local exposure in favour of a more diversified allocation to European property.
Commodity performance over past year against equities
09/07/2019 – 09/07/2020, US dollars
Commodity markets, dominated by energy, experienced a similar sell off to equities in early spring, but a far more sluggish recovery since. We believe prospects for commodities remain tempered due to lower demand in commodity-intensive industries and lower growth expectations in China, which had been a significant consumer. In the longer term it is worth considering the significant shift across the globe to a focus on renewable energy and this will be a key consideration in future for commodity and equity investors.
In this switch to renewables, there are going to be opportunities as particular commodities experience shortages. Examples of this could be nickel and copper, needed for electricity distribution.
Hedge fund performance over past year against equities
09/07/2019 – 09/07/2020, US dollars, hedge funds priced monthly
The absolute performance for hedge funds has been disappointing, however their defensive attributes did make a difference during the brief market downturn.
There have been distinct sharp movements in currencies in recent months, with the coronavirus fallout continuing this theme. These funds will be useful for diversified investments.
Global Tactical Asset Allocation Funds
With a wide range of assets held, these funds should provide improved diversification but have yet to prove their worth.
These vehicles, which invest in floating-rate instruments with a strong covenant, provide a premium over cash in return for illiquidity and credit risk. They also provide diversification. Under all but the most extremely negative scenarios they now look to be attractively priced and offer the potential for strong risk-adjusted returns from here.
Portfolio Structure & Risk Management
- It is very important that clients have a disciplined management framework for determining how to structure portfolios and how to adjust that dynamically over time.
- Acuvest recommends that portfolios comprise a diversified mix of asset types which balances the desire for high returns with management of the associated risks. For this purpose, we group assets into three categories: growth (including equities and property), managed risk (including global tactical asset allocation funds, certain types of hedge funds and sub-investment-grade credit risk) and defensive (including bonds and cash).
- Within clients’ portfolios, we have been running a high cash position, but had advised clients to increase their allocation to equities (from negative to neutral) following the sharp fall in markets in February and March. Given the extent of the recovery in equity markets since that time, we have now changed our view back to negative, and are working with our clients on finding more attractive investments in credit and infrastructure.
- In a low-return environment, keeping fees low is particularly important.