Nedbank Private Wealth manages mainly multi-asset portfolios, so our communications don’t tend to focus exclusively on one asset class. However, today we propose discussing equities. Why? Because when you consider the news headlines, and then consider equity markets, we appear to be living in a parallel universe.
Consider Universe A. We’ll call it The Real World. In The Real World, we are in the midst of a global pandemic the likes of which we have not seen in living memory. China’s Q1 2020 GDP number was negative (-6.8%), which is the first year-on-year decline in four decades. The US$350 billion bailout fund for keeping small businesses afloat ran out within weeks. Meanwhile, as ambulances were turned away by Spanish hospitals, doctors openly called the actions of some European states genocide. Most rich nations are in lockdown, with police given the powers to question the purpose of anyone’s journey. Oil made headlines as its price went negative for the first time, and US unemployment has gone to an all-time high of 30 million – a figure that dwarfs the unemployment levels of the global financial crisis – and the US president suggested injecting disinfectants.
We know that for the foreseeable future consumer spending will remain supressed and, although some economies are reopening, it is possible that lockdowns could continue in some shape or form for some time to come. Among this, there is the terrible toll of the human cost, with far worse to come from the world’s poorest countries.
Then consider Universe B. We’ll call it The Parallel Equity Universe. It is a universe where British Airways announces 12,000 redundancies and the stock market doesn’t blink. It’s a universe that doesn’t appear to have read some of the above headlines. In The Parallel Equity Universe, the S&P500 is up 34% since its low on 23 March. Other markets are also up, with the Eurostoxx 50 up by 26% and the MSCI Emerging Markets Index by 20% as at the time of writing.
We all know that sometimes there is a disconnect between markets and reality. Markets are known to be forward looking, especially in developed markets, where any known information and expectations have usually been priced into a stock, and that forward-looking timeline can sometimes be two years, or even longer. But it seems that no bad news is being priced into the value of many stocks.
The global economic outlook remains at best uncertain, corporate earnings will no doubt be slashed and, until companies know what their future cash flows are, markets cannot know how to discount those cash flows and place a value on assets. As such, it is difficult to explain this rebound in equities around the world. In our minds, there is a risk of another ‘correction’ or fall in equity markets in the near term.
What is causing this and, perhaps more importantly, is it a bubble?
We believe the likely cause of the rebound is excess liquidity. Quite simply: there is too much cash out there with nowhere to go. Many investors had been waiting for an opportunity to invest at more attractive equity valuations, which the virus presented them with and, because cash does not represent an attractive option, stock markets have been the main beneficiaries. Additionally, much of the government stimulus has, more often than not, ended up in corporate pockets, who in turn have often been buying back their own stocks – you will recall Trump’s corporate tax cuts led to corporates buying back some of their shares and this trend has continued. But this does not necessarily represent a bubble. While equity buybacks may have kept some share prices afloat, this has in turn meant that corporates haven’t had to cut as many jobs as they would have done had their share price plummeted even further. This in turn boosts the wider economy as the employees of those companies spend.
However, if we are right, and the rebound is caused by excess liquidity instead of economic fundamentals such as positive corporate earnings and low unemployment, we will see some further sharp movements in global stock markets. In other words, we are anticipating more short-term volatility: there is currently no light at the end of the COVID-19 tunnel and so we have adopted a defensive position across our portfolios.
Let’s remain focused on the equity element of our portfolios as this is where markets appear to have the greatest disconnect. What do we mean when we say that our equities are defensively positioned? Equities are broadly categorised by sector, style and region. Grouping equities together into these categories makes it easier to explain how portfolios are positioned. By sector, we currently have a bias towards consumer staples and healthcare, and we are underweight consumer discretionary, or cyclical stocks.
Very broadly speaking, cyclical stocks are companies that sell goods and services that people can easily do without, or for which there are cheaper versions. They are often described as luxury goods. So when the average consumer is feeling optimistic, they will buy more of these goods and services.
Meanwhile, defensive stocks are those which you buy regardless of market conditions, think toiletries, food, or electricity. These companies tend to provide regular dividends and see stable earnings regardless of the state of the overall stock market.
During a time of crisis, people focus on their basic needs (hence toilet paper and pasta scarcity in supermarkets) and, for those of you who are familiar with this, Abraham Maslow’s hierarchy of needs, helps explain consumer’s psychology:
Although Maslow never used a pyramid to explain his theory, this now iconic representation gives the impression that the hierarchy of needs is a fixed and rigid sequence of progression. Instead, Maslow always described his views on human needs as being relatively fluid i.e. that there are many needs present in a person simultaneously. In the same way, a consumer’s perception of their own basic needs will vary over time. When faced with political persecution, for instance, the vast majority of refugees fleeing for their lives will pick up their smart phones first.
To state the obvious, if we are right in our assessment that some stocks are not reflecting all the bad news that is out there, it is important to establish which these are while identifying companies that have balance sheets and earnings flows that can withstand another storm. This analysis will vary by region – we have spoken before of the headwinds that emerging markets will face in financing the cost of the pandemic, for instance. Our bias during this time of uncertainty is therefore for large, developed market companies whose cash flows should remain robust. We acknowledge that if our assessment is incorrect and markets continue on their upward trend without any further periods of volatility, we risk not participating as much in the recovery as if we had bet on a rosy Parallel Equity Universe.
Clients of Nedbank Private Wealth can get in touch with their private bankers or relationship managers directly to understand how their portfolios are responding to market events or call +44 (0)1624 645000.
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Rebecca joined Nedbank Private Wealth in May 2004 having moved to the Isle of Man from Barcelona to pursue a course in Business Studies with the Isle of Man Business School. Rebecca was appointed to the role of investment counsellor in March 2019 to focus exclusively on the company’s discretionary investment management services. She works closely with our teams of private bankers to provide support in advising our clients with integrity, and to give additional technical investment expertise where more complex portfolio requirements exist. Rebecca is a Chartered Fellow of the Chartered Institute for Securities & Investment and a Chartered Wealth Manager.