31 Mar 2020
In our commentary from 10 March we noted the fragility of the current financial system and its dependency on cheap debt. Our view is unchanged that, besides the virus, the primary drivers of this bear market are the credit metrics (more on that shortly).
So what else has happened in the interim? The FTSE All Share has continued to slide, while the day-to-day volatility has been extreme, as would be expected at time when the VIX has touched record highs of 82. Just as importantly to us, what still hasn’t happened is a meaningful sell-off in the favourite quality growth names like Apple, Amazon and other “FAANG”-like stocks which remain stalwarts of the bloated passive ETF sector. While most other segments of the market have joined the downdraft, many of these names have so far been far less impacted. By contrast, in the credit markets we are beginning to see the higher quality names start to sell down out of necessity given their greater liquidity. Our sense is that this still needs to happen in equities too.
Where our view has evolved is that parallels with the tech-led technology, media and telecomsbust still hold true in some respects, but the return to the fore of government bailouts has more than whiff of the global financial crisis of 2008/09. This time there are several sectors which are simultaneously experiencing sharp demand shocks which threaten to stop cashflows in their tracks and cast ballooned debt service payments into serious doubt. To make matters more difficult, companies also lose their funding source as liquidity in credit markets dries up as investors charge towards the door as credit losses rise. In time, coronavirus could well be seen as the “Black Swan” event which triggered the end of this cycle, but in our view it will be bond markets which determine the severity of the downturn.
It is an unfortunate truth that the government is not able to bail out every industry without severely destabilising the bond market through which its rescue efforts are funded. Nevertheless, with rate cuts now all but spent, fiscal loosening will be the main policy tool used by authorities to attempt to dig us out of recession. One by-product of this stimulus should be inflation. Could we finally see an end to the longest ever government bond bull run?
In the meantime, emergency board meetings will be underway across the UK corporate landscape and we expect a wave of debt-refinancing to sweep the market. Just as in 2009, this can be a fantastic opportunity for long-term, bottom-up investors such as ourselves. The key is to identify opportunities where there is essentially a decent business which has been unduly caught up in the crunch – and of course to avoid throwing “good” money after “bad”. We are certainly primed for mid-year covenant tests to look ugly, but it is our hope that the vastly better capitalised banks will feel able to look past this.
As the bear market has taken shape, in the income funds we have stuck to our preferred approach of “do nothing”. However, this could well change if and when opportunities emerge for us to become owners of disproportionally hit businesses at compelling valuations.
In terms of positioning, the minimal oil exposure and absence of banks or miners from portfolios has helped us show more resistance to the downward pull of the bear market than the majority of peers. Our exposure to certain retail and leisure stocks has been painful, but overall we are satisfied with the current portfolio construction. Our pharma and grocery companies have held up notably well, while a sustained rotation towards more value-oriented names could yet deliver a meaningful tailwind for relative performance. However, with our investors sitting on paper losses in absolute terms, this is no time to declare any hollow victories. Our focus is to offer the resilience our clients expect from us in this deeply challenging time, and then to ensure we are on the front foot to participate in the recovery as it takes hold.