Jupiter: Markets caught in a tug of war as crisis moves to next phase

Markets caught in a tug of war as crisis moves to next phase

Markets are caught in a tug of war between the economic effect of the virus and the vigorous response from policymakers around the world, said Matthew Morgan, Product Specialist, Multi-Asset. The tiniest slip in either direction can result in big price movements.

Most market participants would agree that central bankers and governments around the world have learned their lessons from the global financial crisis, when they were slower to react, said Matthew. This time around, they have acted fast to show markets they really will do ‘whatever it takes’ and have backed this up with tangible action. Along with increasing optimism around medical treatments, vaccines and loosening lockdowns in some countries, this has driven risk assets to rebound about halfway from their mid-March lows, albeit with plenty of dispersion within sectors and regions.

For this reason, the Multi-Asset team are optimistic over the long term, said Matthew, although they are a little more cautious in the short term. He noted sentiment seems to be skewed more towards the good news, like stimulus and the speed of relaxing lockdowns, rather the potential downsides. The team expects markets to gradually realise that the recovery may be slower paced than is currently priced in.

For example, Matthew noted that more and more businesses will risk insolvency as the lockdown restrictions go on, and it is uncertain if current policy can deal with that. When restrictions do start to lift, how many businesses will open if it means losing their government subsidy when consumer demand is still weak? Other negative impacts of the crisis include continued higher savings rates for consumers, and elevated costs for companies as they are forced to reconfigure supply chains, all of which can drag on growth into the future. As the picture evolves, the Multi-Asset team expect policymakers to continue to provide support and to innovate, but there will be diminishing marginal effect of policy action.

In their strategies, the team have relatively consistent core holdings compared to the start of the crisis, believing the high quality of underlying assets can see them continue to recover. The one key change has been a shift from equities into credit for generating income, given the general uncertainty around dividends.

Will M&A activity help underpin equity markets?

Although markets currently have a positive tone due to an anticipated return towards normality alongside immense policy initiatives, this is unlikely to last says Alastair Gunn, Fund Manager, Value Equities. His concern is that many analysts’ forecasts are based on modelling the start of a recovery from the beginning of September 2020 and then trending their estimates back to normality just two to three quarters later. Yes that’s possible, says Alastair, but the more markets rally the greater the risk they forget to discount the possibility of a second wave of infections and don’t fully capture the ongoing disruptions. After all, we may still be over a year away from a vaccine.

Alastair asks us to consider three things that underpin equity markets. Firstly, earnings momentum. Not only is this likely to be absent for the next couple of quarters, there is also a risk that there will be further fund raising by companies, soaking up liquidity. Secondly, dividends, where there is little support given the clear trend to suspend or even cancel payments. Thirdly, M&A. Most corporates are too scared to consider acquisitions at the moment given their immediate focus on hoarding liquidity - hence dividend suspensions, halting buybacks, freezing capex. However, Alastair thinks that private equity groups could step in as many are sat on large cash piles following record fund raisings last year when global intermediaries channelled money towards alternative investments.

For example, the largest alternative asset manager has $550bn of assets under management, of which $153bn is cash awaiting an opportune time to invest - which could be now. However, says Alastair, they may be currently limited in their ability to deploy this cash quickly because the leveraged debt markets do not yet appear to open for business. A lot of leveraged buy outs and private equity deals are funded with debt tranches that end up in collateralised loan obligations (CLOs), but with credits spreads twice as wide as earlier in the year, this is currently eating into the distributions paid to the most junior portion of a CLO, ‘the equity’, who are paid with the interest remaining after the fund’s debtholders are paid. Here, Alastair thinks the Federal Reserve’s recent move to buy triple-A tranches within CLOs should help the market to normalise. Which, he believes, could mean a return to market-supportive M&A activity, mostly likely in stressed areas of the market such as transport, leisure and energy.

Amid Covid-19 uncertainty, India should gain from oil price slump

Avinash Vazirani, Fund Manager, Emerging Markets, discussed the macro factors that are having the greatest impact on India currently. The first of these, of course, is Covid-19. India has adopted a ‘cluster containment’ strategy, which aims to detect and isolate cases. Interestingly, India’s infection and mortality rates appear to be significantly lower than other countries. While reasons for this are unclear, it doesn’t seem that India is hiding cases, and Avinash highlighted that a recent report from Reuters suggests that overall deaths have actually fallen since the lockdown was implemented.

Avinash explained the base case scenario for Covid-19 on which he is basing his thinking on Indian equities. First, he expects the lockdown will be lifted gradually in cities by the end of May – and it has already been lifted in rural and semi-urban areas. Second, there will not be a vaccine made available this year. Third, there is no ‘silver bullet’ treatment, and there might be a second wave of infections in autumn or winter of this year.

In terms of other macro factors impacting India, the sharp fall in the price of oil, from approximately $65 to $25 a barrel, is predicted to save the country between $50bn and $60bn in import costs. The government has enabled new legislation allowing it to keep around $35-$40bn of these gains via taxes, although this legislation has not been implemented yet. Instead, to date, retailers have been keeping the margins, and there has been little impact on diesel and petrol forecourt prices. Avinash said that industry will likely benefit on balance once the lockdown is lifted and costs are rationalised.

Positively, so far there haven’t been generalised rights issues or across-the-board dividend cuts in India, which is different from most other countries. There have been two exceptions to this – one large company has announced a rights issue, and the Reserve Bank of India (RBI) has asked banks not to pay dividends, although this is simply in line with recommendations by most major central banks globally.

Looking to Japan for income, and lessons from history

Japan was a topic of discussion for George Fox, Analyst, Independent Funds, particularly its role as a potential source of income and what Japan’s experience can tell us about the tug-of-war between inflationary and deflationary forces.

With over half of the dividends in the FTSE 100 Index now cancelled, in a pattern also repeated elsewhere, investors are forced to look further afield for income. Many investors had previously been disposed to see Japan’s abundance of very strong balance sheets as a troubling lack of efficiency, but in the current environment it is looking much more like a virtue. Around 55% of non-financials in the TOPIX Index came into crisis in a net cash position (compared to the best market in Europe by that measure, Germany with 33%). Japan has also yet to have the political backlash against the continuation of dividends, so it well placed in relative terms to be a source of income for equity investors.

Japan can also perhaps be instructive when it comes to the competing inflationary and deflationary forces impacting the world economy. George highlighted the massive stimulus measure to combat the economic disruption of Covid-19 as having clear inflationary potential, but that we should take it for granted that an inflation spike is on the horizon. After all, George pointed out that one doesn’t need to look hard to see strong deflationary forces too (the oil price crash is just one example). Japan’s own experience of poor demographics and high indebtedness is that people will tend to save more and spend less, thereby depriving the economy of inflation. Much the same could happen in the US, UK and Europe, so investors should think twice before assuming that inflation is on an inevitable upwards path.

Please note: Market and exchange rate movements can cause the value of an investment to fall as well as rise, and you may get back less than originally invested. The views expressed are those of the individuals mentioned at the time of writing, are not necessarily those of Jupiter as a whole, and may be subject to change. This is particularly true during periods of rapidly changing market circumstances.

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