Monday mashup – parallel universes

Is this a dream?

I have to confess at the start of this piece that whilst I am more than happy to offer you a report of the latest thinking on asset allocation decisions from the experts at Morningstar and my take on their observations, I do so whilst at the same time finding it impossible to rationalise the disconnect between the valuation of global shares (in the main) and the likely economic conditions that will prevail over the rest of this year.

I am not suggesting that I know when the Covid-19 pandemic will end or how it will progress. I am simply observing that what has happened already – ie the known level of economic damage – cannot be seen in any conceivable way as leading to anything other than recessions in all main global economies.

I think we know that much for certain, yet stock market players seem to believe they can see their way through that to justify valuations that were already overly high before any of us even knew what Covid-19 was.

What has just changed?

As I have suggested before, the medical news about the pandemic leads the economic news, so countries that have see a downturn in new cases, or even been able to contain the spread to very modest levels (like New Zealand) are able to relax quarantine restrictions. That is good news of course, but hardly implies a restart of the global economy.

Perhaps more disturbingly, in those countries where the more hard-faced capitalists or free market libertarians have sway (eg the USA and maybe the UK) or egotistical near dictators run the country (eg Belarus, Brazil), the vulnerable elements of the population have been thrown under the bus of perceived national interest (economic or pseudo patriotic).

That being the case, we enter a new phase. If relaxing lockdown prudently or imprudently restarts some consumer activity, the depth of the recessions will be mitigated in the short term at least.

But if the pandemic accelerates (and I think few people understand exactly how dramatic that would be), then the alternative outcome would be even worse than the one that has come to be universally called ‘unprecedented’.

For the moment, some people obviously want to invest money. They may be better judges of the situation than me. If you were investing now, you might like to see what has happened in markets so far this year.

Observations from the Morningstar team in Europe

I have provided above a link to the full commentary for those who are interested. It is 11 pages long but includes various interesting charts. As I had the advantage of listening to a webinar giving the writers’ views directly, I offer the following extracts for your enlightenment.

• The initial heavy sell offs in equities were reinforced by concerns about the willingness of central banks to inject liquidity and stimulate money flows. That prompted a classic rush to safe haven assets like US Treasuries, but investors soon started selling off government bonds to raise cash.

• For a short period the only asset anyone wanted was cash. I think this was partly because people could see companies wanting to borrow and being prepared to pay much higher rates of interest just to build cash flow reserves, so plenty of attractively priced bonds were going to be issued and the big players wanted to take those up, having made large profits when the same thing happened in 2008.

• Gold was generally an asset in favour, with a short interim sell off (possibly caused by central banks raising liquidity, but that is my speculation).

• So at a high level, assets that sold off most were equities and high yield bonds. Emerging market equities sold off the most (they almost always do in such a situation) but the UK was not far behind because the UK is currently a market unpopular with international investors because of Brexit uncertainty.

• In the ‘active vs passive’ funds comparison, good growth funds in the very biggest names and technology did much better than the index trackers, but most other equity funds did worse. This is hardy surprising as many trackers are automatically heavily exposed to the mega cap shares (ie largest companies).

• In Europe earnings downgrades (ie company profit expectations) were the worst since 1974.

• The momentum factor (good stocks keep doing well, bad stocks keep doing badly, to simplify) continued to be a noticeable influence.

• ESG (Environment, Social and Governance) filtered stocks were favoured. This is a trend I have commented on repeatedly.

In summary, you will have had the least painful investment experience in the last 3 months if you had a portfolio biased towards large companies, technology stocks, quality companies (a vaguish concept) and those with strong ESG ratings. And plenty of cash.

I think my readers will not be overly surprised to learn that portfolios built that way look stronger in the current climate and in my view all those factors are relevant for the near future.

In the medium to long term, one ought to be able to pick up bargains that result from this shift. Momentum as a factor has had a very long run while value, companies out of favour but with strong business models, has been hugely negative.

There will in time be a refocus on companies that will do well in a recovery. They may still be in the more modern industrial sectors, have high ESG rankings and be assessed as having some ‘quality’ factors, so I am not saying that current criteria will cease to be relevant, but I think the target companies will perhaps be smaller. That concept may inform your fund research.