Chris Brown, CIO, 19th March 2020
Here is another market update. For a change, I thought I would do it as a Q&A with the sort of (tougher!) client questions I would expect to receive over the next few weeks. As ever, if you have any questions that are not covered below please get in touch. It is business as usual at IPS, even though many staff are now working remotely (in line with government guidelines).
Why don’t we just own “safe” assets today?
The real challenge for investing today is that the only true safe asset this year has been high quality government bonds. However, there are two big problems with buying bonds today. First, and most importantly, yields on them are near historic lows. The 10 year interest rate is 0.8% in the UK for example. This is below the Bank of England’s inflation target so you are pretty much guaranteed to lose money in real (inflation adjusted) terms over longer time horizons if you own them.
Secondly, it looks like the government fiscal response will be to socialise the losses of the shutdown. By this we mean that the economic rescue package (at 15% of GDP in the UK and rising) will be designed to cover businesses and individuals stopping work at the expense of ever higher government debt. This is putting pressure on government bond markets. As an example, the UK government bond market has now fallen over -10% from its peak in early March. There is also a real risk all this stimulus eventually (when the storm has passed) triggers a burst of inflation. This would make the real return from government bonds even lower. There are no safe investments today!
This forces us to focus on return seeking assets. These are by definition volatile and creating today’s losses. However, the good news is that – for longer term investors which I hope you all are – today’s levels look very attractive. We have seen a liquidity driven sell off in many asset classes (including supposedly safe ones like gold and higher quality credit). This has left prices at what looks like historic lows. Our property trust is currently trading on a 13% yield. Royal Dutch Shell – admittedly being hit by the collapse in oil prices – has a 15% dividend yield. These prices are set by whoever wants/needs to sell today rather than reflecting any loss in the value of the underlying asset. A UK windfarm remains a UK windfarm. Today’s losses mean future returns for our portfolios are rising.
Why didn’t you cut risk before all this happened?
Previous virus outbreaks (including SARS in 2003 and Swine Flu in 2009) saw short sharp market sell-offs in the affected regions and then markets quickly returned to business as usual. This is initially what we saw with Covid-19 and by early February it looked like China was starting to have the virus under control and equity markets remained up for the year. It is the speed of the subsequent outbreak in the rest of the developed world and the drastic actions that are being taken to slow it down that are unprecedented. As an example, the chart shows how long it has taken for a bear market (defined as a fall of over 20% in the US S&P equity index) to develop from a market peak. The current sell off is the fastest in history. Equally, we may be in for a slow and grinding bear market or a short sharp recovery. It is impossible to tell today but we are keeping our risk assets on to make sure we benefit as and when the recovery comes.
Is this a market to buy?
Over longer term time horizons our answer is yes. The journey to making these gains is essentially unknowable however. This feels most like we are fighting a war. (The UK government’s new Covid-19 bill gives them unprecedented powers to fight this outbreak for example). The good news is that the young look to be unaffected and, ultimately, we will win this war, either via a vaccine or the virus passing through enough of us that we develop the so-called herd immunity. However, wars have a habit of going on longer and having a far greater cost than people thought going in to them. That said, it is worth remembering that equity markets have delivered around a 7% return since the 1900s – a period that includes 2 world wars and the Great Depression. Whatever happens from here, we are surely better off than in 1944 for example (a date that preceded a multi-decade bull market).
If you have money to invest and are feeling brave, our instincts are to come up with a plan and stick to it. This could be scaling over time or at certain price targets. For those that this is excitement enough, we fully understand. All we can say is that it is these sorts of markets that our risk and stress testing approaches are designed to navigate and we will not be forced sellers at the bottom – which is the only sure way to turn a paper loss into a real one.
When will all this be over?
To quote Jeremy Grantham (the famous GMO fund manager) in 2009:
“Be aware that the market does not turn when it sees light at the end of the tunnel. It turns when all looks black, but just a subtle shade less black than the day before”
Certainly, we think the date the virus stops accelerating in Europe and the US will be important. Unfortunately, this looks to be some time away (with Italy being the country that should hit its peak first). Also, the scope and effectiveness of the financial support measures will be key. The more they are quick, easy to access and generous the better. This is not a time to be worrying about people abusing the help on offer or to get too cute on targeting. The size of the UK intervention is impressive (15% of GDP and rising looks like it could cover almost all private sector GDP for the next 3 months!) but how available it is to businesses in the real world is the concern. Finally, if a vaccine is available in time for next winter that will surely help.
What are we doing with the portfolios?
Our stress testing and risk management approach means that we are able to maintain our current positioning without being forced to sell various positions. This means we are keeping our equity and alternative positions (including renewable energy, infrastructure and property) as they are so we can benefit as and when today’s gloom starts to lift. We also have cash on the side-lines to put to work as and when the opportunities arise.
We however, sold our investment grade (lower risk) corporate credit positions. The tail risk – widespread defaults and bankruptcies – remains there even with today’s large fiscal stimulus measures. The returns on these bonds remain low (anchored by low fixed interest rates) so we do not think we are giving away too much upside to manage our downside risk.
In a crisis such as this, you only truly lose money if you sell and realise your loss today. Needless to say, this is not our plan. Overall, we are keeping within our risk framework and making sure we capture the recovery as and when it comes. We will of course keep you in touch as markets move but I would not expect us to deviate from this general principle whatever the future holds.