Investment Outlook 21st May 2020
A fortnightly look at global financial markets by deVere Groups, Senior Investment Strategist Tom Elliott.
Global stock markets become a bit more stable
Stock markets price in future economic activity, not lagging economic data
Replacing dividends with corporate bond interest and structured product coupons
Sterling falls again
Market sentiment: Settling down. Stock market volatility remains high, but is coming down as investors appear happy to consolidate April’s strong gains and adopt a ‘wait and see’ position. That means waiting to see if the gradual unwinding of lockdowns will lead to a rebound in global economic activity from the third quarter, and a return to 2019 levels of corporate profitability (or higher) by the second half of 2021. This would be consistent with a U-shaped economic recovery, and with the IMF baseline forecast of a fall of world GDP of 3% in 2020 followed by growth of 5.8% next year.
Meanwhile the bond market looks stable, a large increase in supply by governments has had no discernible impact on yields thank to massive purchases by central banks and many investors’ continuing wish to remain in safe haven assets.
Other scenarios. If the global economic recovery is faster than the above scenario, we will get a V-shape global GDP chart, and we may see a further rally in stocks over the summer. Cyclically-sensitive sectors, such as industrials, banks and luxury goods might start to outperform. If the recovery is slower, perhaps a U with a long dip at the bottom, another stock market sell-off is possible as analysts push-out the eventual recovery in corporate earnings. However, given the speed with which market sentiment turned in late March, investors may be cautious about being overly pessimistic and being caught out of the market when a recovery rally starts.
The long-term investor, of perhaps 10 to 15 years. Current volatility is (almost) irrelevant to long-term investors, and certainly should not be traded unless the aim is to make stock brokers rich. A diversified portfolio of global developed and emerging market equities can reasonably be expected to deliver long-term stock market total returns of circa 4% to 6%*. This may seem modest compared to history, but will be generous in comparison to the near-zero expected return on dollar cash deposits, and barely positive returns on G7 government bond yields.
Is there a data disconnect? The stock market rally of late March and April took place as economic data deteriorated sharply. May has seen further miserable data. In the U.S, unemployment now stands at 14%, the Economist Intelligence Unit suggest GDP might fall by 3.5% this year, and the federal government budget deficit has already jumped to 14%. Yet stock market investors appear unperturbed, particularly those in tech and healthcare stocks who have seen their investments have a relatively ‘good’ crisis. There is no disconnect between the stock market rally and the economic data. Stock markets are said to look six to twelve months ahead, ie they are pricing in an economic recovery starting in the second half of the year. Meanwhile, economic data is a lagging indicator, a snapshot of the economy in the recent past that stock market investors have already discounted.
Dividends. Some companies have chosen to cut their dividends, some have had dividend cuts forced upon them because of financial embarrassment or by regulators. For many companies, the drop in dividends will be temporary. For some, a permanent re-adjustment to lower levels. For many investors who look to dividends as an important source of income, this means uncertainty. There are some alternatives.
One way of replicating the ‘natural’ income from equity dividends includes selling the underlying stock, but obviously this eats away at the capital. Another is to diversify into corporate bonds. Interest payments from these have seniority over dividend payments, and so are more secure (although beware default risk in the high yield market). Another approach is the use of structured notes. These will offer a steady, pre-determined coupon (ie, interest payment), with certain conditions applying regarding market movements over the investing time period. Although not guaranteed, the income tends to be higher than available from stock market dividends.
Brexit and sterling. Following Bank of England governor Andrew Bailey’s recent admission that negative interest rates are under ‘active review’, sterling has weakened a little more (currently standing at $1.22). It remains unloved as interest rates fall, as trade talks with the E.U stall, and on fear that foreign financing to plug the hole created by the country’s large current account deficit could evaporate if poor economic and trade policy choices are made.
The third round of E.U/ U.K trade talks has ended with no progress on four areas of contention. These are the Irish border question, the ‘level playing field’ demand of the E.U on issues such as employment rates and environmental protection, the role of the European Court of Justice (ECJ) in overseeing the eventual trade agreement, and fisheries. It’s an open question as to whether the two sides are playing brinkmanship, or if the U.K really is really happy to leave the E.U trading arrangements on 31st December with no deal in place. The country could potentially face massive disruption to its E.U trade. Perhaps its leaders hope voters won’t notice the economic cost amongst the damage done to the economy by the covid-19 crisis.
*Such as those forecasted by JP Morgan Asset Management, Guide to the Markets ‘Long term capital market assumptions’, Q2 2020 UK edition.