On 1 January the FT carried the story, ‘Economists see little change for UK growth in 2020’. If only. After six months the economy had shrunk by more than 20%. The cause of this decline needs no discussion, and of course the virus has impacted all economies, not just the UK. After comparable declines across the globe in the first half of the year we saw the beginnings of a recovery – only for this to be stifled by resurging infection rates in the third quarter. Considering the world of investments, perhaps unsurprisingly after such huge hits to economic output, the gyrations in financial markets have been bewildering. This note tries to make sense of some of these.
With three-quarters of the year now behind us, we take a brief tour of how the key asset classes have fared in 2020 thus far. We do this within a framework of the key drivers of asset prices. This enables us both to offer some explanation as to why different markets have performed as they have, and also to make some observations about what we might expect in 2021.
Interest Rates and cash deposits
We begin with the simplest, but arguably most important asset class – cash deposits. Returns here are driven by central banks who use the lever of interest rates to target low but positive inflation. Here in the UK interest rates had crept up to 0.75% by the time the virus struck – having spent most of the previous decade at just 0.5%. In response to the likely deflationary effects of the virus, rates were cut via two, quick slices to a new all-time low of 0.1%. In the US, interest rates had struggled up further, reaching 2.5% in late 2018. However, by the beginning of 2020 they were already falling once more. In response to the pandemic, they were cut further, from 1.75% to what the US central bank, the Federal Reserve, regards as the lower bound – a range of 0-0.25%. Finally, turning to the eurozone, the European Central Bank’s marginal lending rate was already in negative territory, at -0.5%, and there it has stayed. With the Federal Reserve indicating that interest rates are unlikely to move until 2023 at the earliest and other central banks unlikely to break ranks, cash deposit rates are now the one unmoving part of the investment picture.
Fixed Income Securities
Returns from a bond are determined by three characteristics: the credit quality of its issuer (its rating) the time remaining to repayment of the original capital borrowed (broadly,
its duration) and the fixed amount of interest it pays (its coupon). In times of recession or risk aversion, investors will prefer high quality bonds – despite the lower coupon usually on offer from such bonds. Less obviously, they will also prefer longer duration bonds. This is because as interest rates fall, as they almost always will in challenging times, the value of the fixed coupons on a bond increase – and the longer the duration, the greater the value of these payments.
Within this framework, it is evident that highly rated, long- dated government bonds are the fixed income assets of choice in a downturn. They are preferred to shorter dated bonds which offer little benefit from the interest rate cuts that come with economic weakness, and also to those bonds that carry an element of credit risk such as corporate or high yield bonds, which suffer amid increased caution about interest and capital payments.
As the chart of UK bond sectors below shows, this has indeed been the experience of 2020 thus far, with longer dated, higher quality (in this case those issued by the UK government) bonds, shown by the blue line doing better than both shorter dated counterparts (purple), and lower quality bonds such as those issued by investment grade companies (green) and those issued by companies with sub-investment grade ratings – known as high yield bonds (red).
Bonds with stronger credit ratings and longer duration outperform in 2020
Equities
The value of a share is driven by investor expectations about the future profits of the issuing company, together with the discount rate at which these future profits are translated into a present value – the value at which the share changes hands at any given time. This discount rate is made up of a core, or risk-free rate, to which is added a risk premium.
As the economy weakened in March, we saw the impact of these drivers of valuation. Falling profit expectations bore down on the value of equities – share prices fell sharply. Rising risk aversion, resulting in rising risk premia compounded this; not only were investors downgrading their profit expectations, but they were applying a higher discount rate to adjust for the greater uncertainty of those earnings being delivered. This ‘double hit’ explains the steepness of the falls, though to some degree, falling interest rates will have cushioned this. However, such an effect is weak compared to the combination of the first two. Hence, despite the aggressive interest rate cuts, the onset of the pandemic saw share prices fall precipitously, most notably in the early days as it became clear that the virus was going to have a major impact on growth – and therefore profits.
An understanding of the key drivers of equity prices, as set out above, is also helpful in deciphering why different equity markets, sectors and stocks performed as they did. Unsurprisingly, the shares which fell furthest were those issued by companies where profits were likely to suffer most, or where a prolonged lockdown presented an existential threat to the business.
To illustrate this point let us consider some UK stocks. At -77.3%, year to date, the shares of jet engine manufacturer Rolls Royce have been hardest hit of all UK Large Cap listed companies. The prospect for future sales of aero engines has, of course, been hugely impacted by the virus. Not far behind, at -62.5% is International Airlines Group, owner of British Airways and the Spanish flag-carrier Iberia. Following these are the major oil companies Royal Dutch Shell and BP, pushed down by falling oil prices and the banking sector, where the mandatory suspension of dividend and potential loan losses have borne down on the shares.
The stronger performers have been unsurprisingly, those involved in the healthcare sector such as AstraZeneca but also others who are either beneficiaries of a population in lock-down, such as online gambling companies or whose profit stream is little impacted by the economic consequences of the virus, these include technology related companies such as Avast, Aveva and Ocado. The latter has also been a beneficiary of the boom in the home delivery of groceries, helping it to a gain of 126%, making it the top performing stock in the UK Large Cap Index of 2020 to date.
The sharp divergence in performance between winners and losers will of course be mirrored across markets all around the world. This brings us to an important point. The UK stock market, thanks to its heavy weightings in oils, financials and other cyclical companies contains a far greater proportion of ‘losers’ than most other markets. This has come through in stark terms in its relative performance this year (see chart). We have included the technology-heavy US index, the Nasdaq, to highlight just how marked the differential is. An investor in a Nasdaq tracker fund at the start of the year would now have an investment worth almost 65% more than one who had invested the same amount into a fund tracking a UK Large Cap Index. We return to this point below.
Bottom of the class: UK shares lag other major markets by a wide margin
Commercial Property
It is helpful to think of the drivers of commercial property investments as being a blend of the drivers of fixed income and equity investments. A commercial property will generate a rental income related to the capital value of the property itself. This is akin to the coupon on a bond, but while the face value of the bond is fixed for its lifetime, the capital value of the property will fluctuate as the prospects for rental income improve or deteriorate with the fortunes of the economy in which it is located. This might be considered the equity component of commercial property returns. So while the income stream is attractive, the increased doubt about whether it will be paid, together with the reduction in economic activity and the lockdowns which have kept people out of offices, shops restaurants and bars and the UK commercial property have hit commercial property hard this year.
Given the challenges of obtaining timely and accurate aggregate valuations for the property sector, it is difficult to say how far commercial property prices have fallen. Our estimate would be that the fall is similar to that of UK equities. This is because, while commercial property would be expected to outperform equities in a more normal downturn, the effects of a locked-down population on footfall and therefore the expectations for rental income in this recession means the fall is likely to be as steep as equities.
The 20-20 Vision Portfolio
Having reviewed the performance of asset classes over the first three quarters of the year, it is an interesting exercise to consider how one might ideally have been positioned to navigate the minefields that were investment markets in 2020.
Taking fixed income first, the ideal portfolio would have positions in long-dated, high quality bonds – as the value of these would have risen, cushioning the fall in value driven by sharp declines in equity markets. Considering equities, ideally the portfolio would have included large allocations to overseas markets, particularly the US where companies with strong growth profiles, and more resilient business models are more in evidence than here in the UK. Turning to commercial property, we should note its sensitivity to the UK economy and, therefore, the UK equity market – and should have adjusted our overall allocations accordingly. Finally, we’d have wanted some, though not too much, cash. In times of turmoil the presence of a bedrock of solid, if unexciting cash provides comfort, although we must also note that over a longer time period, with inflation running ahead of deposit rates, it is also a negative returning asset class.
While this is clearly an exercise in driving by the rear-view mirror it is nonetheless helpful in seeing how we might build in a degree of resilience into portfolios looking ahead. With that in mind, we turn our thoughts to 2021.
Looking Ahead – 2021
As the quote at the beginning of this note demonstrates, even the most uncontentious statements about the future can be blown a long way off course by events. So, with the usual caveats about the challenges of forecasting, we make the following observations about 2021 and beyond.
- Interest rates are likely to remain pinned close to zero through 2021 and beyond, so cash is likely to continue to lose value in real terms. Cash should therefore be minimised to that required for peace of mind and/or upcoming capital expenditure.
- Fixed income returns will be very low, and will come from either duration, or credit risk. Only the former offers portfolio diversification benefits from equities. This is likely to cause challenges and require significant thought for the more cautiously structured portfolios, balancing generating returns without increasing overall risk.
- Any easing in the number of new coronavirus cases should enable equity markets to make some headway as profit expectations recover but interest rates stay supportive. A vaccine, or rapid retreat of the virus, would cause a steeper rally in share prices, and is likely to see some rotation in markets as investors look to the recovery of those businesses that have suffered most from the economic consequences of the virus. More than ever, equities are the key for growth in portfolios and choosing the right geographical areas is paramount.
- Commercial property returns are likely to follow the direction of equity markets, although the impact of permanent changes, such as much more working from home will need careful monitoring.
We hope you have found this note helpful. If you have any questions or comments please get in touch.
