16th October 2020
Welcome to the Whitechurch quarterly investment review. This review covers the key factors that have influenced investment markets over the past quarter and the Whitechurch Investment Team’s current views and broad strategies being employed.
After the significant gains made in Q2, the UK market experienced a relatively disappointing quarter. As per our last review, it was small and mid-cap stocks which, again, outperformed their large-cap counterparts. Over the course of the period, the FTSE100 index was down -4.8%, whereas the FTSE250 showed positive growth of 1.3%. The majority of the gains across both indices occurred during July and August, buoyed by the easing of lockdown restrictions and the fresh optimism associated with the announcement of government incentives, such as a 6-month stamp duty holiday and the Eat Out to Help Out scheme.
Broadly speaking, UK stocks lagged other major regions during the period, compounding the poor performance year-to-date. To put this into perspective, the FTSE UK index has returned -22.5% since the beginning of January, versus growth of 2.9% from the FTSE All-World ex-UK equivalent. Data from the ONS showed that UK GDP contracted -20.4% during Q2 – the worst among the G7 nations. Contraction levels from the other advanced economies over the same period proved less damaging – France -13.8%, Italy -12.4%, Canada -12%, Germany -10.1%, the U.S. -9.5% and Japan -7.6%. The numbers are indicative of the genetic make-up of our economy, which is heavily-reliant on the services industry. Chancellor of the Exchequer Rishi Sunak was quick to point out that “social activities, for example, going out for a meal, going to the cinema, shopping – those kinds of things comprise a much larger share of our economy than they do for most of our European comparative countries”.
Q3 was initially touted to be a period of significant turnaround, however, as companies began to count the cost of the first half of the year, the news-flow turned fairly sour rather quickly. An already challenging environment for retail and a near-decimated airline industry also soon led to announcements of thousands of job cuts, which included the likes of Boots and John Lewis, as well as further announcements from Rolls Royce, British Airways and EasyJet. The deadline for employers to begin contributing towards wages of staff who had previously been furloughed under the government’s broadly well-received scheme also loomed. Last quarter we reported that many companies were forced to cancel, cut or defer dividend payments in an attempt to shore up their balance sheets. Whilst Q3 saw some firms resume payments which had previously been postponed until next Spring, others were left with no choice but to retain cash for a further reporting period.
In summary, unlike Q2, where investor confidence was lifted by signs that the rate of new coronavirus infections was on a downward trend, Q3 was a quarter which saw the daily number of confirmed new cases in the UK begin at 730 (1st July) and finish at 7,143 (30th September). This worrying trajectory, along with the resurgence of localised lockdowns and Brexit headlines towards the end of the period, weighed on investor sentiment. The latest signs that the economicrecovery was already running out of steam has ultimately added to a wave of significant outflows away from UK Equity funds. Despite contrary inflows into sustainable funds, many global asset managers have also taken steps to reduce their overall allocation to the UK, citing that UK equities, although possessing attractive valuations, carry enough signs of domestic weakness and political risk for them to remain out of favour with investors for the time-being.
Global equity markets rose modestly during the quarter, despite uncertainty remaining. The challenging conditions and unprecedented fiscal and monetary response continued to dominate the headlines, with key political events, such as a change in leadership in Japan and preparations for November’s US election, taking a somewhat backseat role. Broadly speaking, Q3 began with the promise of dwindling coronavirus-related hospital admissions, as the effect of national lockdowns earlier in the year were generally accepted as successful in containing the virus. However, as governments addressed the difficult balancing act between slowing the spread and economic damage limitation, July and August saw a welcomed return to restriction- free movement across some regions. As a result, we almost inevitably saw a resurgence of global cases throughout September, particularly in Europe, followed by a renewed effort to, once again, tackle the spread of the virus.
In the US, whilst monetary policy remained supportive throughout the period, hopes to conclude a possible fiscal stimulus package have not been forthcoming and is looking doubtful this side of the election. Q3 also saw the Fed confirm plans to adopt an Average Inflation Targeting programme when setting interest rates, meaning they will only intervene once the 2% level has been breached, thus allowing for temporary instances of inflation. The latest Nonfarm payroll confirmed US unemployment stood at 7.9% at the end of the quarter – notably stronger than the 14.7% high reported at the end of April. While the unprecedented vaccine effort has required significant government outlay, the estimated $4 billion spent on development so far pales into insignificance relative to the forecasted expected economic loss. The Congressional Budget Office estimate that the virus-induced slowdown will cost the US economy $7.9 trillion over the next 10 years.
US equity markets moved higher during July and August, buoyed by signs of a return to some normality and hopes of a vaccine. However, stalled fiscal stimulus talks, a rise in European cases, and investor woe regarding the upcoming election, saw all major indices contract during September. This was also indicative of the change in sentiment towards technology stocks throughout the month. After a strong rally in August, their poor performance during September weighed on the markets overall, not helped by growing national security concern over China’s technology sector giants. Overall, the ground made up since the beginning of the outbreak has been extraordinary, and Q3 still saw 10 of the 11 market sectors return positive performance. Consumer Discretionary (+15.1%), Materials (+13.3%) Industrials (+12.5%), and Information Technology (+12.0%) led the way during the period. Investors will be hoping for both progress with vaccine and therapeutic development and a smooth US election during Q4. Both could well act as a further lift, particularly for those at the epicentre of coronavirus pain, such as travel and leisure, and retail.
In Europe, rising infections continued to stunt growth throughout the quarter. Despite the concern, major indices recorded marginal gains over the course of the period, largely driven by much-improved manufacturing PMI data and the performance from both Consumer Discretionary and Materials sectors. The easing of widespread lockdown measures early in the quarter also saw improving automotive and luxury brand retail sales. However, a wave of fresh measures towards the end of the period, such as further localised lockdowns and tightened travel restrictions in France and Spain, dented investor optimism once more. Central government support has been active throughout. In July, after several months of discussions, the EU launched the European Recovery Plan. Under this programme €750bn will be raised through the bond market and then channelled, in the form of grants and loans, to those member states most affected by the COVID-related recession. Inflation during the quarter drifted into negative territory and in September to its lowest level since early 2015.
Despite the relative strength of the Yen, Japanese equities experienced a stable and positive quarter. Notable contribution from Industrials and Transport sectors, as well as a return to circa 80% of pre-coronavirus factory output all played their part, as valuations continue to remain inexpensive comparable to other regions. August saw long-standing Prime Minister, Shinzo Abe, announce his resignation on health grounds, with Chief Cabinet Secretary, Yoshihide Suga, confirmed as his replacement at the subsequent election. The consensus view is that Japan have, thus far, remained relatively unscathed by the pandemic, and the expectation is that, with the exception of mobile telecommunications, existing economic policy will be maintained under Suga – a fellow Liberal Democrat. Prospects of further structural reforms also helped investor sentiment during September. Whilst there are signs of positivity, government debt remains the highest in the world among major nations, at circa 240% of GDP, whilst historically weak monetary policy and a deflationary environment continue to add further cautionary notes.
After a near 35% sell-off in Q1 and a 20% rebound in Q2, Emerging Markets continued their recovery with solid, yet muted, quarter. Overall, the asset class outperformed the S&P500, despite lagging year-to-date. The extent to which growth companies outperform value stocks across Emerging Markets continued – a trend only seemingly exacerbated by the pandemic. Notable drivers for performance throughout the period came in the form of technology-driven markets, such as South Korea and Taiwan. Year-to-date contribution, however, has been dominated by China, with Brazil by far the biggest detractor. It is no secret that Brazil has been hit hard by the pandemic, with only the US registering more deaths. That said, there have been some reasons for optimism. Brazilian Materials, Consumer Discretionary, Energy and Industrials all outperformed the Emerging Markets Index during Q3, with the highest amount of IPOs in the pipeline since 2007. Another casualty was Turkey, who, despite interest rate support from their Central Bank late in the day, recorded a circa 14% currency decline versus USD.
China are no strangers to virus outbreaks and as such were able to contain the domestic spread of the virus relatively successfully through a series of strict measures early on. Last quarter we reported that China was the first major economy to lift lockdown restrictions after a sharp fall in case numbers. Whilst some measures remain, China has largely been able to return to pre-virus conditions. Despite question marks over data, and all the connotations that go with being the reported source of the pandemic, China is responsible for more than a third of the Emerging Market Index’s performance since March’s lows. Specifically, just 3 stocks; Alibaba, Meituan, and Tencent, have accounted for more than 80% of China’s outperformance this year-to-date. During Q3, they contributed more than 30% towards the MSCI Emerging Markets Index’s gains. However, the aforementioned tensions with the US government did serve as a fly in the ointment, with international restrictions imposed on tech giants Huawei, TikTok and WeChat.
After a fairly sanguine second quarter, it was a relatively uneventful quarter for Fixed Interest securities. In the US, election uncertainty gathered pace, with an outcome fallout likely, regardless of the result. The Fed’s decision to leave policy unchanged, for now, saw the US 10-year Treasury finish the quarter at 0.68%, 3 basis points higher than at the beginning of July. Meanwhile, the US Dollar index was down 3.5% over the same period. In the UK, Brexit uncertainty resuming towards the end of the quarter and a suggestion of negative interest rates from the Bank of England saw the UK 10-year equivalent yield just 6 basis points higher, at 0.23%. Further complications came in the shape of the Internal Market Bill, which aims to alter the terms of trade between the UK and Northern Ireland.
Despite sentiment towards continental Europe improving in the early part of the quarter, worrying signs in September saw the European Central Bank announce a relaxation of regulations on bank leverage, which would potentially free up to €73bn of capital, in an attempt to boost bank lending. They also announced the launch of a review of its Pandemic Emergency Purchase Programme, which was expanded to €1.35trn at the end of Q2. Further afield, the People’s Bank of China continued to inject liquidity into the financial system through the repo market, the Bank of Japan decided to leave its negative 0.1% short-term interest rate unchanged towards the end of the quarter, and Emerging Market bonds failed to repeat their heroics of Q2. As for Corporate Bonds, High Yield outperformed their Investment Grade counterparts, whilst the spread over government bonds increased in September. The move saw signs of a return to the “risk-off” theme prevalent within the sector year-to-date.
We reported last quarter that trading in most open-ended UK property funds was suspended in Q1 in line with FCA rules. We also noted that, following guidance from the Royal Institution of Chartered Surveyors (RICS), the Material Uncertainty clause had since been removed in part, for example, from Industrial property. In an update on 9th September, the RICS announced a further easing of the restrictions on most other property classifications. There were also welcomed signs of the easing of lockdown restrictions earlier in the quarter, which saw many office workers return, as well as the reopening of shops, pubs and restaurants. Optimism was fairly short-lived, however, as the resurgence of coronavirus cases took hold. The upshot is that, whilst some UK Direct Property funds have re-opened, many remain suspended for trading. The current situation, along with the M&G incident towards the end of 2019 has been enough to invoke a further consultation by the FCA. In September they announced proposals to introduce an extended notice period (“potentially of up to 180 days”) for investors to notify a fund provider before their investment can be redeemed. Whilst just a consultation at this stage, the FCA feel there is a need to reduce the potential for harm to investors from the liquidity mismatch in open-ended property funds, and are currently open to consider alternative measures that might achieve the same outcome.
As part of the fallout from the pandemic, practicality and logistical issues have hampered transactions throughout the year. Physical site visits became virtually impossible for a considerable period of time and travel restrictions further hampered the industry. There is no doubt that commercial property has been one of the hardest hit areas of the coronavirus pandemic. In the UK alone, total investment volumes into commercial property in the first half of 2020 were nearly 40% lower than the 10 year H1 volume average, with only Wales and the West Midlands reporting an increase. Despite the changing habits of workers opting to work from home, office space still made up 44% of the amount invested – in line with its 10-year average. Perhaps not so surprisingly, it was the already struggling retail sector which saw just 10% of the share, 50% below its 10-year average.
Given its typically inverse relationship with raw material prices, the weakness of the US Dollar throughout Q3 helped commodities achieve another positive period. Whilst gold and platinum registered moderate increases, it was the rising price of silver (+26%) that was largely responsible for the double-digit gains seen in precious metals. A strong run in copper, iron ore, steel, and zinc meant that industrial metals too registered a solid Q3. Agricultural raw materials, such as animal proteins and livestock were other notable beneficiaries, as investors continued to diversify across various alternative asset classes. US and UK-listed commodities have now recovered to just 1.1% lower than where they were at the beginning of 2020.
The energy market experienced a mixed period, with natural gas being the standout performer, after US giant Berkshire Hathaway announced a purchase of transmission and pipeline assets from Dominion Energy in July. The move meant that the natural gas price finished the quarter at its highest level since November 2019, returning 44.3% during the quarter, and 15.4% year-to-date. Brent Crude Oil remained at around $40 per barrel during the quarter, edging 0.65% lower overall. Global uncertainty and, more specifically, the potential of extended supply cuts by OPEC weighed on the price.
Despite bond yields remaining low, the combination of near-zero interest rates, attractive safe-haven returns and an understrength dollar steered many investors away from holding cash as an asset class during the quarter.
In the short-term, cash deposits insulate investors from the price volatility seen in other asset markets. However, in the long-term, the real value of cash deposits is likely to continue to be eroded by inflation. We currently only hold cash for short-term tactical reasons or within lower risk strategies, where the risk profile dictates a need for a larger cash allocation.
Whitechurch Investment Team,
Quarterly Review, Q2 2020
(Issued October 2020)