Webinar: Long-term thinking in fast-changing markets

26 March 2020

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Watch the latest coronavirus webinar with Trevor Greetham and Melanie Baker

As the situation around COVID-19 continues to develop, Trevor Greetham, Head of Multi Asset and Melanie Baker, Senior Economist at Royal London Asset Management, share their thoughts on the situation.

[ Adam ]

Good morning everyone and welcome to the latest webinar from Royal London Asset Management. To introduce yourself I’m Adam Vaites, part of the wholesale team here, here is my colleague Trevor Greetham, Head of Multi-Asset and my colleague Melanie Baker, Senior Economist. So, the webinar is entitled Long-Term Thinking In Fast Changing Markets, so I'm going to give you a market update on the governed range and GMaps from Trevor. And then, an economist update from Melanie and I'm going to move into a Q and A discussion of what we've been having in terms of questions over the past couple of weeks. So, Trevor, over to you in a very volatile market the moment.

[ Trevor ]

Thanks Adam and thanks everyone for sparing the time. Yes, it's really hugely volatile. If you compare the drop in the Dow Jones index over the last six weeks not, not including the very sharp bounce we've had in the last couple of days. That drop over six weeks is the fastest and largest drop in U.S. stock prices since October 1929. The famous 1929 crash, and so we've had a massive change over this period in economic expectations. If you cast your mind back to the early part of 2020 the world economy had been slowing down because of the trade tensions but we've had a few months of improvements in business confidence. Monetary policy had been eased a lot over 2019 and we were quite significantly overweight equities in the markets at funds we manage in expectation of a pickup in growth over 2020 heading in towards the presidential elections. Obviously, things changed very rapidly with the virus outbreak in China and then also the spreading to Italy in the first instance, which had a very big negative impact on stock markets. So, what we've been doing in funds over that time on the initial drop in stock prices we bought some equities on the view that in the very short term the markets were overly depressed. Within a week though, it was obvious this was a more serious crisis. The Fed cut rates and its emergency meeting the first time. Stock markets bounced and we exited that position and then quite rapidly reduced our positions from overweight equities down to a more neutral level. If you look at the other things that we've been doing in the fund we've also taken more defensive positions for example in currencies where we've been overweight the dollar, overweight the yen, underweight Sterling and that was very helpful when Sterling dropped very sharply in the last week or two. We've also had a relatively defensive regional position -overweight in emerging markets actually worked quite well because China's been controlling the virus better than the developed markets and emerging markets for a period that were outperforming and our sector preference for technology has also worked. So, this is one thing people also spending money on new laptops and new equipment for working from home in the technology sector has managed to continue to outperform in a falling market over this period. We were also underweight commodities and that meant the funds weren't very impacted when the price war broke out between Russia and Saudi Arabia. So, lots of things going on in the funds. High yield exposure has been very painful. We were also overweight high yield bonds at the beginning of the year, and you've seen a really dramatic rise in high yield bond spreads because people have become more concerned that some of these companies may not be able to finance themselves. But one thing to bear in mind though, is that you always have to be forward looking and the volatility that's going on is creating new opportunities. And it's also creating new challenges in terms of risk management. So why are we neutral equities at this stage? Well I think that's very substantial to a risk at the moment. There will be opportunities later on to add value tactically. We find that our process did very well in the last financial crisis and added quite a lot of value over 2008/09. There will be opportunities to move back into more aggressive positions to make some of the money back that we've lost through underperformance in the last couple of months. But you've got to time that right. And at the moment there are two-way pools are really driven around sentiment and valuation. So, sentiment has been extremely hit hard. So, at one-point last week our weekly investor sentiment indicator registered its most extreme pessimistic reading ever. And this is in data that goes back to the early 1990s during the Lehman failure. This indicator was I think three-point nine standard deviations below average which is a very rare event indeed. we managed to get minus four point six in the corona virus selloff. So deep panic much evidence of forced selling. So, the drop in the gold price, the fact that for a period there even inflation protected US Treasury bonds were selling off give you some idea that people were panicking and having to sell anything liquid in order to meet margin calls. And that suggests that there can be a sharp bounce. The positives are that policy has certainly moved and there's an old adage that when the policy makers start to panic the markets can stop panicking. We've been through a few different phases of this but clearly at the moment we have pretty much open-ended monetary policy/ies and pretty much open-ended fiscal policy/ies and Melanie will go through the details of that in just a moment. And so, you’ve got this sort of situation where Central is extremely depressed and valuations will be a lot cheaper than they used to be. And then you suddenly get massive stimulus and it's not surprising that we've seen a very sharp rally. We've been saying for a while there's legitimate two-way risk. At one point in the last couple of days the Dow Jones index had risen 15 percent from its low. We're not looking at this at the moment this recovery though, it is still a sign of a very unhappy very volatile market. But we suspect that as often happens with these sorts of large stock market corrections the market will retest the lows that we've seen recently over the coming weeks and months. And the key reason for this is that what's happening at the moment isn't a purely financial market event like the global financial crisis. What's happening at the moment it's a real event, a real negative shock caused by counter measures to try to control the coronavirus and you've seen a very sharp shutting down in growth, the numbers are really unprecedented. At some point, there will be a decision to reopen economies. And at that point, you will see a very rapid switching back on of economic activity and that I think is what we have to wait for, for a sustained recovery. It’s not happening yet. This is too soon. So, later on I think there will be another low and that further low that's when you want to think very carefully about adding to positions and becoming more positive. And I think there'll be lots of opportunities to be had in the coming weeks, months and years. For one thing the valuation shift that's happened in high yield bonds is absolutely extreme, and it will come a time when high yield bond yields are extremely attractive to new investors. And we'll probably spend years gradually coming down to the levels we've seen recently. So, I'm expecting that to be an extremely positive outlook for high yield bonds coming out of this crisis. At the moment; deep uncertainty, being more neutral, being a bit more circumspect. Makes sense. And they're looking for opportunities to add value as we become out of this situation. Let me stop there and hands over to you Melanie and then I'll come back for the Q and A later on.

[ Melanie ]

Thanks Trevor. All right. Let me just kick off a bit with what the economy is doing, what we can see the economy doing, and not to state the obvious but large chunks of activity have dropped away quickly. So, in China, virus case numbers have dropped, and economic activity has been gradually returning towards normality. But things there still aren't back to pre-crisis levels. And meanwhile as we're all aware of this has become a Europe-centred pandemic spreading into the U.S. and economically very large proportions of the global economy are currently seeing serious disruption as social distancing measures have proliferated. Measuring the scale of the drop-in activity is a challenge but we have got some data to go on. So, high frequency data things like traffic congestion, restaurant bookings. These sorts of data we've got for the US for Europe. They're consistent with very sharp, recent drop offs in activity. And we've also got PMI business survey data now for the major economies for March. And frankly these have sunk to levels last seen during the financial crisis. So, if we just look at the U.K. for example the PMI crudely currently maps on to low single digit declines in Q1 GDP already. But for GDP Q2 really is where the damage will show even more strongly. And you know, business survey they capture breadth not depth. So, the asked companies have I fallen, not how much has actually fallen. So, given some sectors of the economy have closed and thinking again about those high frequency data it is plausible that the decline in Q2 GDP quarter on quarter could be even low double digits. But we've also seen signs of unemployment rising, so that includes a spike in U.S. jobless claims data, and it is worth pointing out that some fiscal policies including the UK wage subsidy will help cushion that. But we know that very large numbers of people in the UK have been applying for Universal Credit for example. OK, look, so much for the near-term picture. Clearly not pretty. Looking beyond that and into prospects for recovery. Like how the virus situation evolves as Trevor has said, is of course uncertain. But what we can say is that crucial for the recovery is economic policy support and we've seen a lot of policy support. So, in an economic shutdown imposed by the government arguably it's almost incumbent on them to step in and support households, businesses, for the public sector to effectively substitute for the private sector. And of course, these policy actions can't stop a downturn, but they can do a lot to ensure a recovery. So, if you look at economic support can continue support companies to help them retain workers, it can help viable companies survive, can support those who are not able to work. These are so-called bridging measures. Central banks can help keep financial markets functioning, keep capital flowing, and via QE importantly of course, help keep government borrowing costs down. And then general fiscal monetary stimulus that will be helpful in strengthening the recovery when it comes.

And if we look at the UK for example what we've seen is substantial co-ordinated policy action that fulfils these functions. So, with two fiscal packages in a week in mid-March which is quite something that we also saw in the Bank of England. we cut interest rates to near zero, we launched QE. We've had some substantial fiscal announcements in Europe, big expansion of the ECDs asset purchase program, plenty of monetary policy easing in the U.S. and large fiscal package in train there. But the governments, central banks, they’re willingness to innovate take swift extensive action has been impressive. The virus permitting, a kind of a roughly U-shaped recovery makes sense to me. So, let me just finished with a minute on that central case is something of a U shape path. Arguably the recovery leg will be slower of course than the sharp falls off an activity we're seeing now. But that u shape is dependent on at least a couple of things. First the virus numbers themselves peaking in the coming months or so. Europe and U.S. and so social distancing can then be eased, and the economy can recover through Q3 through Q4 but clearly huge amounts of uncertainty on that. And second policy being successful in avoiding a financial crisis and avoids leaving corporates and households so financially damaged that we then get a long period of balance sheet repair, low investment, and low spending post-crisis.

Adam back to you.

[ Adam ]

Thank you very much Melanie. And so, for the past couple of weeks we've been getting some questions from clients, so well the first one to kick off this – How has diversification worked in the funds in this pretty severe sell-off?

[ Trevor ]

Well that's a very good question. I mean, diversification is about investing in a range of different asset classes that tend to behave differently at different times. So, you get a better risk return trade off than you would have investing in any of them individually. Diversification has worked between what we've always described as the growth assets and the store of value assets. So, the growth assets are UK and Global Equities, Commodities, Commercial Property and High Yield Bonds, I think you'd be put in there as well. And the store of value assets are, UK government bonds, UK index linked bonds, we have cash funds. We also have some investment grade credit funds. So, within the growth assets diversification has been very poor. And you would expect that. So, this is a situation where the big thing going on is the switching off, as we’ve heard from Melanie, of swathes of the world economy. That's going to affect equity profits and therefore stock prices, is going to affect cash flow and therefore high yield bonds, is affecting demand for physical goods, therefore commodities, not helped by the fact we've now got this price war going on between Russia and Saudi Arabia - really to try and drive U.S. shale out of business. And commercial property is also going to be hit, particularly retail. And so, you haven't had much diversification between the growth assets, and I think you can't really expect that very much if the magnitude of this change in economic expectations. On the other hand, you have seen a cushioning effect from the holding in cash obviously, from the holding and government bonds, and to an extent in corporate bonds as well of higher quality. And so, you have seen diversification, but you've almost got two assets at the moment. You've got your growth assets and your safety assets. And for those of us who've been managing multi asset funds for a while and I started of managing them in 2005, this is very reminiscent of the Lehman financial crisis period where no one cared about this growth asset, or that growth asset. You were either growth or not. They call them risk assets. Risk assets or safe havens. And what we'll see for a period here is the financial market equivalent of everybody rushing to one side of the boat and then everybody rushing to the other side of the boat. So, you're not going to get much diversification between growth assets, but you will get diversification if you've also got safe haven exposure. And I think that's important. And given the volatility it's important not to jump too much on these bandwagons as people move to one side of the boat or another. This big rise in markets it's in the last few days it's still very, very sort of panicky feeling and I think that could be a little bit careful not to become too undiversified at these times.

[ Adam ]

Thank you, Trevor.  I think the next question is pretty-tricky but, when can we expect a return to normality? and what is currently, so the first part, and second part is what is currently driving performance?

[ Trevor ]

Melanie, if you could answer, you know, what do you think in terms of the signals that might get the economy switched back on. I'll come back to the psychology in the markets of these different shaped recoveries.

[ Melanie ]

Sure. I mean look the return to normality is a really difficult one because it depends on things that you know most of us aren't expert in which, which is the evolution of the virus. So, you know I've pencilled in a profile whereby we can start getting back to normal in Q3 and part of that is based on what we've seen in China. You know as the numbers come down in terms of new cases, look under control, governments can move towards rather than shutting down activity and social distancing measures they can move towards going back to more intensive contact tracing those kind of things instead and that enables activity to return to normal. But it's  clearly killing uncertain

[ Trevor ]

Yes, and I think in terms of the markets, this is again very familiar for anybody who's dealt with shocks in the past. So, you know I've been working in financial markets since the very early 1990s and so that would include things like the Long-Term Capital Management failure in 1998 or the 2001 attacks on the World Trade Centre - September the 11th, or the Iraq war. or the Lehman failure. Many other things. The Asia crisis in the mid-90s – at all these times there's a big shock like this and a big change in expectations. You get the cycling through psychologically different shapes of recovery in people's minds. So, you start off with a V shaped recovery. Now I have to say initially we were underestimating the severity of this crisis. And so initially we were thinking that there could be a relatively small impact on growth and policy would ease and the markets would get back to normal and that's what happened in terms of market reaction to the China shutdown earlier in the year. And we move very quickly on from that and you have to move on as the facts change. But that would be the V shaped recovery. The U-shaped recovery which people are talking about is where yes, you have a decline and then you have to wait and it's a real waiting game to wait until you get to the point where growth then switches back on. And the longer we wait the more cash flow is pressured and the more difficult it is for people to live their daily lives. But at some point, there would be the switch back on and that's the U-shape recovery. I think that's where the market psychology is at the moment. My concern is that we will retest the lows in stock markets and possibly make further lows in the next few weeks and months because you don't get to the stage where people say it's not a U-shaped recovery it's an L shaped recovery capital L. This is obviously a contradiction in terms because a capital L goes down and then it stays down. But people do start to worry this is going to go on forever. And I don’t think we think we've yet got to that point of maximum stress on the health services, for people thinking this is going to go on forever and that's why I'm concerned that could be further downside. Once there is a recovery, we get to w. Once there is a recovery in the economy people will then say but what if there's another flaring up of the virus once people start to increase social contact again? What if it comes back to China? So, I think the heightened volatility is going to be with us for some time. We've got to be aware of this psychology and investing now with the benefit of some experience. And just aware of the fact that we're likely to be in a pretty choppy period for quite some months possibly the next year or so, maybe even longer. If it takes that long to commercialise and distribute a vaccine. So, we have to be aware that's difficult and do our best to add value tactically at this time. So, selling rallies, buying dips is the sort of thing we were looking to do.

[ Adam]

Thank you, Trevor and Melanie. I think you've touched on it a bit, but I think we just have a little bit more. How does this recession compare to the 2000s? and 2008?

[ Melanie ]

Maybe I can start on that one. I mean it kinda doesn't in a sense. So, economically this is clearly a deeper pullback globally then than 2001/2 and it is really evolving like 2008 either. So, as Trevor already 2008 was a banks cantered crisis, much centred crisis. This isn't serious. That should mean the economy can recover faster with virus permitting. But yeah look there are clearly ways, as Trevor’s already alluded to where this becomes more drawn a downturn. So, things to watch within that sort of second wave of a virus, but of course things like also wash policy as well. There is a risk that policy support gets withdrawn too rapidly. So monetary policy tightening, even you know a comeback for austerity measures.

So those are some of the things that will be on my watch list

[ Trevor]

And I would just add to that that the that the 2001 recession wasn't a recession in the UK. So, the housing market in the property markets remain very strong at that time. And so, the U.K. managed to avoid a recession. 2008 was the global financial crisis which was everywhere. And so, they're very different. And every recession is different. This recession ends what was the longest expansion in the US economy in economic history going back all the way to the eighteen fifties. So, on my reckoning I think it will be counted as a ten year and nine-month expansion versus a long run average of about a five year expansion. So, there's been a very long expansion. We couldn't see what was going to bring it to an end in January. And then we've had one of these black swan events with the coronavirus certainly creating recession now

[ Adam]

Thank you. So just another question. Some thoughts on inflation. We've got a lot of queries on are commodities the place to be. I’d be interested to get your thoughts.

[ Melanie ]

Let me start just on the inflation point, so there is this bit tricky right, so near-term less inflation is more likely. So, this is partly about what's happened to commodity prices and things like discounting but looking more medium term / longer term, number of things can help inflation higher and provide some upside risks. So one is that I'm currently assuming that central banks won't be in a big hurry to tighten policy and they'd like it to be reasonably tolerant of inflation overshooting their targets for a little while. Especially in the US and Euro area where policymakers have been worried about inflation being too low. And you know, fiscal stimulus will probably linger to often lurch into austerity measures and then it will probably lose some supply capacity in the economy as a result of the crisis. So, you've got demand being supported, lingering policy stimulus. It's the kind of backdrop where you might expect higher inflation to emerge.

[ Trevor]

I totally agree. And I think there are two phases here again; and it's a huge tactical, macro call to decide when to shift. So, at the moment we're in this deflationary world with a big collapse in the oil price as Melanie's mentioned, you're likely to see government bond yields go lower if the stock market's retest their lows. But at some point, I think in the recovery, so we can wait and see that we'll know that when we see it because we'll be out in the streets again. So, when the recovery comes the question will then be how strong will that recovery be? How inflationary will policymakers let it be. And I think they will let inflation rise as Melanie’s suggesting there. So, I think there’ll come a time when the fact that in our multi-asset portfolios we have we have commodities will be really useful as an inflation hedge. At that stage you’d probably want to be overweight commodities and underweight government bonds. Things like commercial property it's bound to have a correction here, but commercial property is a real asset. Rents rise with inflation, so commercial property could also be actually quite strong in that environment and ultimately equities although when you get very high uncontrolled inflation. If we were to see that, equity multiples tend to come down. So equities didn't do brilliantly in the 1970s but they did fantastically in the 1980s and once inflation started to come back down again because earnings have expanded with inflation in the 70s. So, earnings and rents are real variables and will give you some kind inflation protection. So, it's a huge call out there and I think it's premature at the moment to talk about inflation skyrocketing. We've got to get through this V or U or L shaped recovery first but out there it's a massive call,

[Adam ]

Thank you, both. Clearly a lot to think about there. Just more of a question of how is working from home for both of you? How are you and the team adapting to this in terms of obviously making key decisions and making tactical asset allocation moves as a team?

[ Trevor ]

I’d say it’s really good actually. Maybe I’ll stay at home forever. I mean seriously the team is very closely in contact with each other. In some ways the fact that we're having these sorts of calls or skype meetings with our computers in front of us and data and we can swap data and share screens etc it means actually we're getting a lot of information flow and honestly these times we're speaking about markets on a higher frequency than we normally would. But I personally think it's working extremely well thank you.

[ Adam ]

Thank you, Trevor and Melanie thank you everyone for listening. If you do have any further questions, please do get contact with you all our Royal London contract. Thanks very much.

[ Trevor ]

Thanks everybody.

 

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