June 2020

The rear-view mirror and the telescope

Introduction

Anne, sister Anne, do you see anything coming ?

Echoeing Charles Perrault, it would be easy to say: “I see nothing but a rising stock market and declining interest rates”.

Since March 20, 2020, equity market participants have gone from a fearful mode to one that is optimistic about the future. The main stock market indices have resumed an almost continuous upward trend. At the same time, the benchmark interest rates of the investment grade world have fallen significantly.

Markets

In order to try to guess what lies ahead, it is necessary to break down the major sets, the indices, into sub-indices and to divide the time, the current year, into 3 main periods in order to better observe how anticipations and reality have produced their effects. Equity markets are only the reflection of expectations; the gap between the real world and the financial world is sometimes immense.

  • The observation periods chosen for the S&P 500 observation are :
  • January 1 to February 19; the “normal” time before the fall.
  • February 19 to March 20; the time of the equity market downturn.
  • March 20 to date; the time when the markets rebound.

For the current year, the S&P 500 posted a performance of -3.7% as of June 5, 2020. A layman would not find this particularly worrying, but the investor knows that this figure cannot summarize the fate of each of the companies that make up the index, nor the yo-yo that their prices have been.

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The above table shows that four sectors outperformed the benchmark: Consumer Discretionary*, Information Technology, Telecommunicationsand Health Care; these same sectors were also among the favourites at the beginning of the year.

 

Would an investment policy based on a sectoral approach provide the key to a fair allocation of capital? To answer this question, let us look at the cases where this is justified as well as the counter-examples.

The Healthcaresector is among the best performing sectors, as it enjoys a higher demand for its products, focusing hopes for new therapies or a vaccine. This sector would provide a yes answer to the above question.

But then how can we explain that, in a period of economic crisis, we must rely on Consumer Discretionaryto make profits? Indeed, what is discretionary is what is not essential, what is sacrificed first in the event of a recession.

The explanation can be found in the content of the sectors.

In the “Discretionary” sector we find Amazon; a stock long cherished by investors, it has also benefited from the lockdown periods as online purchases were high in demand.

The second part of the explanation lies in the weight that Amazon represents in the index. Amazon alone accounts for more than 4% of the S&P500, but above all 40% of the Discretionary Sector. It’s a bit like the tree that hides the forest. In this same sector, 80% of the companies show a negative performance, of -15% on average. 

In the same vein, don’t look for MasterCard, Visa or PayPal in the Financials sector, they are in the IT sector because their profits are more about the data they collect about their customers rather than the margins on transactions.

Since the S&P500 is a market capitalization-weighted index of each company, in the end only a small number of large capitalizations made the performance of the index.

In conclusion, the sector approach does not work, at least for the time being. A thematic approach and rigorous “stock-picking” are to be preferred.

It is possible to sum up what we have been through by pursuing the themes that were already in favour at the beginning of the year, namely those of technology in a trading world dominated by a few global players. To this was added the theme of health, whether curative or preventive, to explain the overall performance.

These themes should endure because the fundamentals that were present are reinforced by health imperatives that will last for a long time to come.

Intrest rates

When talking about rates, we must distinguish between:

  • The “risk-free” type of loans (US Treasury Bills, Bund)
  • Investment Grade bonds (AAA – BBB+)
  • The High-Yield

The economic slowdown induced by the containment will have benefited “risk-free” borrowing. In an effort to protect themselves, investors swallowed this class of bonds. US 10-year rates have gone from 1.91% at the beginning of the year to 0.92% today.

The Investment Gradesphere experienced a differentiated fate, especially for borrowers who suddenly, faced with fears of a prolonged economic crisis, moved from Investment Gradeto High-Yieldin their perception of risk.

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The High-Yieldalso segregated its population only to populate the contingent of the probable “Junk”. Default rates have risen sharply and the outlook for 2020 is not good.

J.C. Penney and Hertz are two examples of companies that are certainly a hundred years old, but which were fragile when the health crisis hit and became insolvent.

The rescue plans articulated by the various central banks have made it possible to reduce these gaps to lower levels, however they remain higher than at the beginning of the year. The perception of an overall increased risk of default remains.

Corporate results

There is little we can really learn from the results of companies, many of which refusing to give an indication for the future. It is possible to read, for example, the number of new subscribers to Netflix, or Zoom, but it is not easy to know whether this will last after the end of the lockdown period.

The Cycle

The question in every economist’ mind is the shape of the curve of the cycle and therefore which letter symbolizes it. A “V” for a rise as rapid as its fall? U-shaped, to mark a small pause between the fall and the rise? An inverted “J”? A “W”?
No one can predict when and how much. And everyone knows that you don’t restart a big machine as quickly as you turn it off.

Moreover, the negative effects of the pandemic have not yet all occurred. There are still bankruptcies and layoffs on the horizon; the extent of this future reality will be compared with the expectations of the financial markets; this is when the adjustment will take place between the real world and the financial world. In the capital market, investors have sought to adjust their portfolios to growth where they think it will continue to occur in the future: mainly sectors allowing teleworking, health and electronic means of payment. Sectors to which should be added that of “Non-cyclical Consumption”, sought for its predictability and dividends.

Therefore, we carefully avoid in our list of actions those that resemble “straw fires” and unjustified price-to-earnings ratios.

 In the face of so many uncertainties the primary mission is to maintain the value of assets, both nominal and inflation-adjusted.

Perspectives

The social tensions induced by unemployment are already present.

Political tensions are innumerable and mix with social tensions.

Nation-states are turning in on themselves and favor the domestic focus rather than the international view.

Geopolitical tensions are growing, putting the USA and China apart. The quality of their economic and political relations is at its lowest and verbal confrontations are numerous. We are concerned about this new Cold War because it is accompanied by military tensions in the China Sea and interferences in the Hong Kong situation.

This web of tensions, woven with social threads ready to be broken, does not bode well, and a spark, or a sign, could be all that is needed…

Summary

As you could read from the above, we are very cautious about the short-term outlook and are taking active steps to reduce risk exposure.

W.I.S.E. Management SA
8 june 2020