“The Pessimist complains about the Wind; The Optimist expects it to change; The Realist adjusts the Sails.” William Arthur Ward, writer
Despite the release of data showing the UK economy suffered a record contraction in activity in April and cautionary comments from the Chairman of the Federal Reserve Bank of America (Fed), the past few weeks has seen stock markets continue to try and put the events of March down as a bad dream. At the time of writing this commentary, it looks as though stock markets will end the month of June slightly down on fears of a second wave of Covid-19 infections but this doesn’t tell the full story as the path of markets has trended upwards as they continue to climb the wall of worry.
Investors can be overly sensitive to successive waves of good and bad news and when we hear news of double digit economic contractions we must remind ourselves that GDP numbers are like yesterday’s weather report but share prices are more reflective of the long range weather forecast.
The slowdown in the level of Covid cases in the developed world, combined with some easing of lockdown restrictions, has given hope that the global economy will recover – and in reasonably short order. The vast policy response from governments and central banks has averted the worst of the financial pain from the Covid-19 crisis leaving investors to gauge the long term costs and opportunities.
At any given time, investors express a wide range of views about asset prices and the future. But whether your view is bullish or bearish, it pays to retain a healthy sense of realism, scepticism even, about the short term path of stock markets. In darker moments it can feel as if the world has been permanently damaged by the Coronavirus pandemic and that we have lost some of our brightness for the future. Unusual and negative events can warp our minds and if we are not extremely careful we can come to believe that the unusual is usual and that this is what the world will look like forever. The investing analogy is that when dramatic events occur our time frame contracts even more than normal.
There is absolutely no doubt that 2020, and to a lesser extent 2021, will see disastrous company earnings test the mood of investors but if balance sheets can cope with what should be a relatively short term fall in earnings then the value of a company’s share is always the discounted value of the long term free cash flows unto eternity.
Courtesy of extraordinary monetary policy in the form of bond buying by central banks, with the promise of more to come, the discount rate is now substantially lower having come down from circa 3% to below 1%. This pushes up the current value of long term corporate earnings.
Combining the fall in the discount rate with a fall in company earnings of say 35% compared to 2019 suggests an incredibly wide range for estimated fair value of the US stock market of anywhere between -15% and +30% from 2019 levels. At the time of writing the US stock market is currently minus circa 10% from its 2019 peak which, remarkably given the recent rally, implies that the risk reward for investors is tilted firmly towards the upside.
The determination on the part of central banks to make cash and bonds yield nothing, or even less than nothing in real terms, has an effect on all assets but essentially income producing shares and growth stocks become even more valuable. In other words, investors should value post pandemic dividends and growth more highly than they would have valued the same assets beforehand. Stock market indices should reflect this by trading at a higher level.
Do we think, for instance, the long term free cash flows of, for example, Amazon, Tencent, Microsoft and Alibaba are higher or lower than at the start of 2020? Companies with solid growth prospects which are at the forefront of disrupting old business models, will retain a valuation premium and in a world of ever lower interest rates and few alternative worthwhile investments, some would justifiably argue that the shares of the companies mentioned, and indeed some others, should be higher.
Shocks are inevitable but for strong companies, the appealing underlying prospects ought to survive the challenge. After all, normalised annual increases in sales earnings and cash flows should exceed the rate at which investors discount these outputs.
The recovery in investors’ risk appetite can also be explained in part by the more recent encouraging economic news on developed countries progress out of lockdown. Recent US jobs figures pointed to a decline in the unemployment rate and railroad traffic has been improving since the end of April. Tentative signs from Europe that a recovery is underway and activity is resuming as economies emerge from deep freeze have also provided further evidence that the much hoped for V-shaped economic recovery remains a possibility. Sentiment was also bolstered by Europe increasing its monetary and fiscal stimulus efforts.
Looking at the surface one could assume that not much has changed, but within equity markets there have been some signs of a shift in tone. The US NASDAQ, with its tilt towards technology companies, remains one of the better performing equity markets globally. It was however the announcement of the proposed EU recovery fund which saw some of the more ‘unloved’ areas of equity markets recover sharply.
Our equity exposure retains a healthy balance between exposure to growth orientated companies and also to the more unfashionable areas of equity markets. Companies in the latter area tend to be more geared to the real economy and recently this has been an uncomfortable place to be, but during the month there were hints of a possible shift in market favour. This rotation into more cyclical equities was apparently catalysed by the announcement of the EU recovery plan.
Whilst there will inevitably be further infighting within the Eurozone, and objections from those that trumpet austerity, the market regards the plan as a step toward long-awaited fiscal co-ordination. This apparent breakthrough led to the euro strengthening, and importantly allowed the US dollar to weaken, taking the pressure off some of the more vulnerable economies within emerging markets. If this rotation is ‘for real’ (and there have been many failed attempts in the past), the equity exposure in our funds tilted towards value stocks will perform handsomely. If this turns out to be another false start, we should continue to see benefits from funds exposed to the growth theme.
The last two months have provided credence to those that believe that central banks will forever be able to control the path of asset prices. Governments have adopted a wartime response of huge, debt-funded fiscal spending, aided by central bank liquidity. To provide further fuel to aid recovery, the Federal Reserve has hinted at quantitative easing on an unlimited scale, they have provided a commitment to underpin interest rates at near zero until at least the end of 2022 and have agreed with the Treasury to fund government activity.
The priorities of the Federal Reserve are clear; take the edge off shocking events even if it means inflation and the distortion of asset prices. The Fed’s mandate is to pursue maximum employment and stable prices. The way to achieve this is to keep a lid on interest rates even if it means inflating asset prices.
Other central banks are following similar policies with game changing quantitative easing programmes and government stimulus worth an estimated $16 trillion and rising, almost twice the World Bank’s estimated loss of global economic output this year. This surplus liquidity will feed its way into asset prices which bodes well for equity valuations.
In a world where holding cash or buying bonds has been made as unproductive as possible, Clarion firmly believe that a carefully selected portfolio of equity based funds remains one of the few ways of achieving meaningful returns over the medium to long term.
Throughout this crisis we have resisted making wholesale changes to our portfolio funds believing that mass selling of distressed shares should be avoided at all costs. We have however been prepared to tweak portfolios where we considered the balance of risk and reward was in favour of making changes. For instance, we have recently been increasing our exposure to Japan which we believe remains one of the cheapest stock markets in the world. This will also allow us to benefit from the safe haven qualities provided by the Japanese currency.
We will always be on the alert for similar opportunities which will enable us to improve future returns for our clients’ investments without increasing the risk profile of the Portfolio Funds.
In conclusion I would like to take this opportunity on behalf of everyone at Clarion to wish you well, to stay safe and to look forward to brighter days ahead. For our part Clarion remains open for business and all our staff are working effectively from home and will continue to do so until it is safe to operate from our office. We continue to provide a diligent service to our clients and we are available at any time to discuss any concerns and/or problems. The welfare of our clients and our staff remain at the forefront of everything we do.
Keith W Thompson
Clarion Group Chairman.
Creating better lives now and in the future for our clients, their families and those who are important to them
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