Corona Virus Chronicle (VI) - Fast moving with a downward trajectory
We are very uncertain about the future in every respect. We feel that there will be further negative market reactions and at this time we find it is difficult to envisage that there will be any good corporate news for quite some time.
The US Federal Reserve, yesterday evening (UK time) cut its Funding Rate by 1%, or 100 basis points. That effectively marks the zero bound level of interest rates in the US. We spoke of stresses in the US Dollar based banking system last week and it is obvious, now, that these have not abated. The rate cut was accompanied by the decision to buy US Treasury bonds to bring down interest rates across the yield curve. At the press conference, J Powell the Fed Chair advised that the only thing the Fed can do is “reach out” to directly
affected industries. Markets took the view that there is not much more Central Banks can now do…..This interpretation caused Asian markets to fall dramatically overnight, with a consequent follow through in Europe.
Just how far can markets go?
We need to provide some sense of where equity markets are. This can be done by considering the level of current market levels and see how they have performed over a certain time frame; 10 years. Looking at broad indices, and rounding numbers, we can see; the UK’s FTSE100 has returned 80% over 10 years, annualised at 6%. The S&P 500, the US equivalent is up 230% or 12% annualised at the close of business on Friday.Long term returns should be adjusted for inflation of course, but with inflation falling and being held at
extraordinarily low levels, then this adjustment is relatively small. Allowing for 2% per annum in the UK and US, then inflation adjusted returns are 10% for the S&P and 4% for the UK. Generally, investors expect to earn 5% from the stock market after allowing for inflation. On this very simplistic viewpoint the S&P, plus the NASDAQ can adjust lower by quite a large amount yet, whilst the FTSE 100 and European Bourses are at,or close to 10 year historic norms. Another point to consider is that indices – as at close of business on Friday
– still have not breached the lows of 2018.
In this environment the European and UK markets will definitively breach the lows of 2018 simply because the situation is so bad in Countries like Italy and Spain. It feels like the US will follow suit and a reversion back to 5% after inflation levels is surely on the cards. This would be somewhere under the 2,000 level to 1,900, a drop of some 700 points, or another 24%. If the US does start to mean revert, the outlook for European Bourses will be bleak.
With this market backdrop, we are thankful that our clients have responded positively to our cash proposition. We now feel that it is right to consider the absolute safety of short dated Government Bonds. We do not know how the virus will spread and we do not know the extent of the damage it will cause. We are very uncertain about the future in every respect. We feel that there will be further negative market reactions and at this time we find it is difficult to envisage that there will be any good corporate news for quite some time.
We have discussed leverage and balance sheets, particularly noting our concerns in this area. The viewpoint has been expanded upon in the financial press as well, over the weekend for instance in The Times.Unwinding leverage is difficult in a normal market, we only need to look at the travails of stressed companies trying to sell of businesses to pay down debt when market conditions are optimal. To do so now is impossible. It is likely that we will see real distress and probably this week the start of a string of news flow on Corporates going into an administrative procedure. Airlines, cruise lines, hotels and restaurants are probably first in line. Property companies involved in providing buildings to this sector will probably follow on…. And the big point from this is extrapolating the financial losses to the source of the funding. Who has provided these companies with their funding?
Thankfully, these days it is not just banks and thankfully again, we live in an age where banks have never been kept under tighter controls and scrutiny, to the extent that overall exposure is lower by an order of magnitude in comparison to 2008. Private equity and specialist loan funds have taken up the void created by banks withdrawing from high risk lending and of course the corporate bond market. We can see that stresses in corporate bonds have caused spreads to widen out and this is a major area for concern.
With the outlook becoming even more difficult we feel it is right to seek shelter in the haven of UK Government Bonds. Our thoughts are that as this is a position to protect clients, rather than make money from falling rates and this strategy will best be served by owning a 2 year Gilt Edged Bond. At the time of writing our investment models for discretionary clients are 100% cash. This will change to reflect the addition of the highly liquid and secure two year Gilt. This will provide ultimate levels of protection. The reason for two years is simply that the only “current coupon” Gilt matures in July 2022. It carries a semi-annual ½% coupon (1/4% twice a year) and is priced slightly over 100% at 100.75 to yield 0.20%. We will of course retain a cash balance to ensure immediate liquidity for clients. Gilts are the most liquid and safest investment, they trade on a very tight “bid to offer” spread of between 5 and 2 basis points and there has always been a liquid market in which they trade.
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About the Author
Peter Smart, Head of Investments
Peter has been involved in investment markets since 1985, working within the private client areas of two global banks and for 22 years as the fixed income specialist for the UK Wealth manager, Brewin Dolphin. More recently Peter formed part of the investment team at bridport in Jersey specialising in the provision of specialist, income focussed portfolio’s.