Return-of-capital is as important as the return-on-capital

John Leiper - Head of Portfolio Management - 27th March 2020

Last week, we considered the debt story behind the coronavirus. The fear of a large debt overhang, as the economy slows, led to concern that households and companies could start to default on their debt. This led to a global sell-off and liquidity crunch across financial markets as individuals, families and corporations scrambled for US dollars, tightening conditions further.

At the time, we pointed to the massive monetary and fiscal stimulus unveiled across the globe which will provide households and companies liquidity to sit-out the virus before a return to normality.

What’s happened since then?

Well, the Fed announced quantitative easing to infinity and beyond. This huge stimulus means there is no upper limit to the amount of government or investment grade corporate bonds the Fed can buy to support the economy. This is QE4 on steroids not too dissimilar to the promise Mario Draghi made in 2012 to ‘do whatever it takes’ to support the economy.

We’ve also seen the US senate pass a whopping $2 trillion virus rescue plan that includes a version of ‘helicopter money’ which means sending money directly to households and companies. The true size of the full stimulus is in fact much larger and likely closer to $6 trillion.

What does this mean for markets?

As a result of the above policy action, liquidity improved noticeably this week. Securities that were trading at wider spreads than normal, or not trading at all, are now trading at much improved levels. The panic that seemed to grip markets last week now seems less tangible.

To provide an example, the chart below shows the daily price moves of the S&P 500. The chart goes a long way to showing just how volatile markets have been over this time with prices swinging wildly up and down from day to day. Notably, by the close on Wednesday, we saw the first two days of consecutive gains in 30 trading sessions. This has only happened a handful of times previously and whilst it may not sound much, it’s psychologically important and could point to a bottom in markets. Then, on Thursday, equity markets rose again, marking a third day and taking the S&P 500 to its best three-day return since 1933. As explained later, we participated in this rally by increasing our equity exposure mid-week.  

The white bars represent the daily percentage price move of the S&P 500 equity index. Source: Bloomberg.

Recent equity market gains have also been broad based as evidenced on Tuesday when 90% of the stocks on the New York Stock Exchange closed higher. Historically, ‘90%-up days’ have pointed to potential market lows, or at least the start of a bottoming process. Whilst such technical indicators should be taken with a pinch of salt, multiple 90% days helped confirm bottoms in 2008/2009, 2010, 2011, 2015 and 2016 (https://www.cnbc.com)

Other examples of market stress are also showing signs of improvement. These include the US dollar index, which rose dramatically as a shortage of dollars led to significant currency appreciation, and US financial conditions which had tightened dramatically. As shown in the charts below, both have reversed over the last few days.

Following a sharp and sudden rally, the US dollar index (in white) is now falling back from recent highs, just as the MSCI World equity index (green) is also starting to pick-up. Source: Bloomberg

Financial conditions (in white) tracks the overall level of financial stress in the US. This index is showing signs of bottoming-out and improving. This is consistent with a pick-up in the S&P 500 equity index (green). Source: Bloomberg

Whilst these indicators are clearly positive, it is prudent to remain cautious. The recent improvement in risk sentiment stems from the fact the Fed has fixed (for now) the liquidity issue. They have done so by pumping huge sums of money into the economy.  However, more may yet be required given the large level of global debt and potential for blockages in the financial plumbing.

This is evident in the chart below which shows the TED spread. The TED spread shows the difference between the rate at which banks lend to each other and the equivalent government yield. It is a measure of financial stress within the banking system and the fact it remains at elevated levels is a cause for concern. However, our view remains that the Fed is aware of this risk and made it clear it can and will act where required. 

 Source: Bloomberg

Monetary and fiscal policy can only take us so far. The true bottom in markets may only materialise once the number of new coronavirus cases starts falling globally.

Source: Bloomberg

Whilst we are not yet at that point, for me, the chart above provides reassurance that the Chinese roadmap remains in place and that most countries are working their way through the crisis. Pay particular note to South Korea which has proven resilient as detailed in this excellent article from the New York Times (https://www.nytimes.com). We noticed this trend a couple of weeks ago and purchased a position in South Korean equities at that time.

The US and UK are now also on the coronavirus journey. The positive news for the UK is the trajectory seems shallow relative to its peers. Indeed, it is reassuring to know that as of the 19th March, the UK government actually downgraded the virus which is no longer considered an HCID (high consequence infectious disease – https://www.gov.uk). For some reason this has not yet appeared in the mainstream press. Further, Neil Ferguson, who led the Imperial College report that warned of a potential 500,000 deaths has now back-tracked, confirming the virus will probably kill under 20,000 people (https://www.newscientist.com).

Changes made to the portfolios

Our overriding objective over the last two weeks has been to improve the liquidity profile of the portfolios. This approach is in-keeping with our philosophy that, at times such as these, the return-of-capital is as important as the return-on-capital.

In fixed income we reduced exposure to high yield and emerging market debt. These positions are typically less liquid and could suffer during a prolonged sell-off should one materialise. We believe it is better to be safe than sorry and as such we are now underweight these asset classes.

Within credit we are overweight investment grade bonds. This follows the Fed announcement on Monday that it would start buying investment grade bond ETFs and that it would do so via BlackRock, one of the largest ETF providers. Since then approximately $3.7 billion has flowed into the US listed iShares Investment Grade Bond ETF. We believe such flows are likely to continue and earlier this week we purchased two new investment grade bond ETFs (both issued by iShares by BlackRock). 

Investment grade bonds enjoy improved credit and liquidity risk profiles, relative to high yield, and will benefit directly from the Fed’s novel decision to buy corporate bond ETFs as part of QE4. The chart above shows daily fund flows into the iShares Investment Grade Bond ETF. Source: Bloomberg

We reduced exposure on some of our European government bond positions, bringing our prior overweight allocation towards neutral. This follows Germany’s decision to abandon ‘Schwarze Null’, literally translated to ‘black zero’ but referring to Germany’s long-term commitment to running a balanced budget. Germany’s massive spending plans could see its deficit rise to 5% of GDP. We believe developed market government bonds will underperform going forward as the vast increase in fiscal spending (to deal with the coronavirus fallout) leads to increased bond issuance and higher bond yields. This is also the case in the US where we are positioned for a steepening of the yield curve.

The chart above shows the difference between the 30 and 2-year US Treasury yields. Since late February this spread has started to increase. This means longer dated yields are rising more than shorter dated yields, or to re-phrase, the curve is starting to steepen. We believe this trend will continue and have positioned the portfolios accordingly. Source: Bloomberg

In equities we switched one of our satellite positions from businesses engaged in the exploration and production of gold to physical gold itself. Gold is far more liquid than investing in companies involved in its extraction and is not subject to the idiosyncratic factors that come with the mining sector. Further, physical gold is in demand with severe shortages globally. Setting that aside, the macro case for gold also remains clear. QE to infinity and the abundance of liquidity it brings will undermine the value of fiat currencies (such as the US dollar) to the benefit of hard assets of historical significance, like gold. We continue to hold for the longer term. 

Finally, as mentioned at the start of this note, we recently increased exposure to global equities. We did so on Wednesday morning following the notable improvement we saw in risk sentiment. We did so via the MSCI World Equity ETF. This ETF is large, liquid and benchmark neutral making it ideal for tactical trading opportunities. We intend to hold this position into month-end as global asset allocators look to rebalance their portfolios towards equities.

Looking through the economic numbers…

Finally, a few words on the very negative economic numbers that have started being published. Notably, yesterday’s US unemployment rate which rose to 3.3 million people, way ahead of expectations of 1.5 million and beating the previous record of 695,000 in 1982.

Poor economic numbers are inevitable following the government-imposed cuts to economic activity to bring the coronavirus under control. Assuming the coronavirus follows the China template, and once it is safe to go out again, we should see a similar reversal, particularly in consumption and service sectors alongside a general rebound in the economy. The chart below shows a significant fall and dramatic rebound in forecast real GDP for the G8 group of countries. It is likely that markets are already pricing this in as equities rallied aggressively on Thursday, despite the poor jobs number.

Source: Bloomberg

Final Thoughts

We are currently in lock-down. The introverts are rejoicing, and the extroverts are clawing at the walls. Whichever camp you may find yourself in, this can be a stressful time and I thought it could be useful to entertain an optimistic, but no less realistic scenario.

In three short weeks UK peak spread may have come and gone. The weather will get warmer, slowing the spread whilst hospitals manage a more orderly workflow and test-kit availability allows for better separation of the sick and healthy. Some semblance of normality returns, as broad shutdowns are replaced with something more practical. In the meantime, real progress is made on an effective vaccine in time for winter. Meanwhile Asia continues its economic recovery providing hope, guidance and a clear roadmap for Europe.

Returning to the portfolios, our disciplined approach to good fund management has helped us effectively navigate the last few weeks. Our decision to improve the liquidity profile across the portfolios provides insurance and protection against the worst of any downside outcome. Simultaneously, elevated cash levels enabled us to re-engage with the market this week as risk sentiment picked-up.

As always, we believe this is the time to remain calm, patient and focused on the fundamentals whilst relying on sound risk management practices.

John Leiper – Head of Portfolio Management

This investment Blog is published and provided for informational purposes only. The information in the Blog constitutes the author’s own opinions. None of the information contained in the Blog constitutes a recommendation that any particular investment strategy is suitable for any specific person. Source of data: Bloomberg, Tavistock Wealth Limited unless otherwise stated.  

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