Since our last update, it is fair to say that the investment environment has not changed significantly for the major economies and markets around the world. Governments have reacted to Covid-19 in various ways, but in general the effort to restrict activity in order to reduce transmission continues. Indeed restrictions are tightening aggressively again in UK and Europe. Although knowledge about the virus and how to treat it has improved significantly, the delivery of an effective vaccine is clearly still a long way off. While economies continue to struggle, it is somewhat surprising that stock markets have remained reasonably stable after the wild swings experienced in March.
In this commentary, we seek to explain this complex and unchartered situation and aim to set out the implications for the global economy and markets.
A different kind of crisis
In our last note, we explained that the current financial crisis is unusual when compared to other crises in history. At the end of a typical business cycle, the economy slows down and goes into recession. There is often a catalyst such as the bursting of a bubble (dot-com stocks in 2000 and US real estate in 2008), which triggers the general slowdown. Policymakers generally react to this by applying financial stimulus in various ways and eventually, the economy starts to recover. Consumers start buying more, companies expand, employment rises, which in turn encourages consumers to buy more and the virtuous circle continues, driving growth.
In spring 2020, the shock to the global economy originated from outside the financial system. The pandemic caused governments to apply restrictions, which in turn caused a recession. The conundrum now is that the external influence which caused the recession has not gone away, and nobody knows when it will. In order to fix the global economy, the virus needs to be brought under control. Financial stimulus alone cannot solve the problem while the virus remains at large and activity continues to be restricted.
US Federal Reserve and other central banks have injected trillions of dollars into the financial system, but this has only served to prop up economies, rather than inject stimulus. This immense financial crutch is designed to bridge the gap, for people and businesses, until the economy can stand on its own two feet again. The money thrown at the system so far has mostly served to replace activity that would otherwise have been lost, rather than provide a boost.
Policymakers will be under pressure to continue pumping money into economies until the virus can be controlled.
Over the summer, stock markets remained relatively stable while the economic storm continued. Although markets and economies often move in different directions, the current divergence is perhaps more surprising, when sentiment is so fragile. Two concepts help explain the current dichotomy. The first focuses on the role of interest rates, and the second involves the extent to which tech companies are increasingly dominating certain indices.
The role of interest rates
In addition to the massive cash injection into the economic system, the Federal Reserve and other central banks around the world have reduced interest rates to record low levels. This has a wide range of economic effects on businesses and individuals, but it also directly affects stock prices.
In the economy, ultra-low interest rates affect businesses and consumers in similar ways. It becomes cheaper to buy things on credit, whether it be a firm buying equipment or a family buying a new car, and there is an incentive to bring forward such decisions while rates are so low. For investors, low interest rates increase the relative value of stocks. The low interest rate reduces the return on cash and bonds, encouraging investors to buy stocks instead.
Companies dominating markets
Some indices have performed surprisingly well in spite of the ongoing economic malaise. In the US, the S&P500 rose 3.2% in the first 9 months of the year, whereas other indices, such as the UK FTSE100 have struggled, falling 22.6% in the same period.
The S&P500 index is increasingly dominated by companies in the tech sector, and specifically Apple, Amazon, Alphabet (Google), Microsoft, and Facebook. These stocks are deemed ‘the big five’ driving social and cultural change around the world. Many of the digital brands we all know and use fall under one of these companies. For example, Skype is owned by Microsoft, and WhatsApp is owned by Facebook.
These companies were already growing healthily prior to the pandemic, due to the rapid expansion of the internet in recent years. Almost 60% of the world now has access to the internet, and the number is growing at a rate of almost a million users each day. The pandemic has served to accelerate the use of technology, from e-commerce to cloud computing and virtual meetings. So companies such as Apple and Facebook have actually benefitted from the effects of coronavirus, while companies whose revenues are not dependent on the internet have generally faced a headwind.
Tech and software companies now constitute around a quarter of the value of the S&P500, and their growth is distorting the index. The enthusiasm for these companies has pushed their share prices to levels that are hard to sustain, and there is risk of a bubble in the sector. In contrast, sectors such as oil, banks, and retail continue to languish, and these stocks feature more prominently in indices such as the FTSE100.
Given these unusual dynamics, what are the main risks to economies and markets at the moment?
There are perhaps two main risks we perceive as the world waits for the pandemic to end:
The US Federal Reserve and other central banks around the world need to keep pumping money into the economy. How long can this be sustained?
With interest rates already at record lows, policymakers have limited power to cut rates again. Following the lead of the European Central Bank, many central banks, including the Bank of England are now weighing up the viability and implications of negative interest rates.
In the short term, global economic growth will be sluggish until the virus is brought under more control and business activity can start returning to normal. In the long term, it is clear that governments are preparing strategies to encourage growth. This will include holding interest rates lower for longer, and accepting a higher level of inflation than in recent decades. The extensive government borrowing being generated now will need to be managed into the future, and higher inflation makes it easier to erode debt over time.
A note about the US election
High drama in US politics, as Trump defied the polls once again to push Biden to a close contest in the race for the White House.
It is a widely held belief that stock markets prefer Republican governments over Democrats, but history contradicts this belief, and the impact of Covid-19 complicates the picture. The reality is, the actions of the Federal Reserve in response to the virus will have a far greater impact on markets, in the long run, than the outcome of the election.
What does all of this mean for Oakham’s investment strategy?
There can be no doubt that the global economy is in unchartered territory and the outlook for markets is uncertain. Over the summer, this has encouraged us to be cautious and we have therefore sought to reduce risk in portfolios. We have lowered exposure to stock markets, in anticipation of further swings and wobbles caused by news flow regarding the virus, restrictions and developments in economies.
Long term strategy
While we are minded to exercise caution, we remain disciplined and focused on our long term investment philosophy. In the midst of a storm it is important to remain focused on the horizon. Our portfolios are well diversified and designed to reduce volatility. We continue to focus on large multinational companies that benefit from long term trends which are more structural and less cyclical. Strong global companies with healthy balance sheets will weather the current storm better than their competitors, and opportunities for growth will arise as less robust companies succumb to the headwinds. It is worth repeating a phrase which is particularly apt in the current circumstances; “Bad companies are destroyed by crises; good companies survive them; great companies are improved by them.”