The supposed ancient Chinese expression, “May you live in interesting times,” certainly describes the period we’re living in.
We had the “coronavirus crash” in March where sharemarkets fell faster and deeper than at any time since the 1930s. Those events were set off by governments across the world putting economies and industries into hibernation, and communities into lockdowns to contain the dangerous pandemic.
Yet, sharemarkets performed an about-face over the June quarter.
The US S&P 500 Index closed the June quarter about 20 per cent higher than it began, its best quarter return since 1998. Over the same period, the global and Australian sharemarkets, as measured by the MSCI ACWI Index and S&P/ASX 200 Accumulation Index, respectively, also recorded double-digit gains. An upshot is that these sharemarkets are now not far off their mid-February highs.
All this took place despite the fight against COVID-19 being far from won or over. Economic uncertainty also remains high because we most likely can’t return to normal business life and social interactions until a globally distributable vaccine becomes available.
Many countries have succeeded in flattening and even bending the infection curve, but coronavirus is advancing in the US, Brazil, Russia and India, all countries with large populations. The UK too seems to be losing ground again.
Central banks fire policy missiles
So, what explains sharemarkets’ recent sunny tone? A four-word explanation – extraordinary central bank policies.
Ultra-low official interest rates and quantitative easing policies put in place by major central banks, such as the US Federal Reserve, Bank of Japan, and European Central Bank, helped drive strong returns from sharemarkets as well as other risk-asset returns over the post GFC decade.
Commentators described those policies as being akin to central banks’ firing a bazooka. Taking that analogy further, recent central banks’ policies can be likened to firing heavy artillery.
“Whatever it takes” seems to be the adage of central banks. The US Federal Reserve has been buying corporate bonds, something they previously shied away from. The Bank of Japan has been dialling up its equity-buying program.
The amount of support through global central bank stimulus (and government spending) has been estimated at a staggering US$18 trillion ($26 trillion), with interest rates slashed to zero per cent or below (after taking inflation rates into account) in most major economies.
It has meant, among other things, that borrowing costs for high-grade US companies are now below January levels.
In a zero-interest rate world awash with liquidity, returns from term deposits and governments bonds are unappealing to investors. Consequently, vast amounts of money are going into sharemarkets and driving them higher.
Disconnect between markets and economies
Despite all this, we remain cautious because there is a disconnect between sharemarket performance and economic fragility.
Figures like the US unemployment rate falling to 11.1 per cent as the economy added a record 4.8 million jobs in June, while encouraging, can’t be taken in isolation. The American economy is still down nearly 14.7 million jobs since February and the number of Americans filing for unemployment increased to 19.3 million.
With the spread of the COVID-19 virus accelerating in the US, many economists expect the recovery to be bumpier and job gains more muted.
Small and medium-sized businesses account for around 50 per cent of US employment. A second wave of disease would certainly spark another round of firings and insolvencies.
A recent New York Federal Reserve study found that only one in five small businesses can survive a two-month loss of income. Many such small businesses are even cutting back on rehiring even as they reopen.
For the hardest-hit sectors, things may never return to normal. Another recent survey found that 17 per cent of US hotels and restaurants, which are big employers, believe their revenues will never return to pre-COVID-19 levels.
Investing, not trend following
Many competing forces at work and investors must be nimble to steer their portfolios though this complicated situation.
Sharemarkets could keep rising, lifted by the amount of money flowing through the financial system. Against that are uncertainties because the pandemic is unbeaten and economies can’t return to normal until it is.
The way we are approaching it is to be intensively aware of the risks at play and map future scenarios. Rather than going all-in, or avoiding risks at all costs, we’re choosing to increase our exposure to investment-grade credits (corporate bonds issued by companies with strong finances), as they provide exposure to companies’ cash flows, but with lower risks than would be the case if we bought their shares.
We’re also choosing to participate in equity markets through derivatives such as swaps and options, rather than buying shares. Again, we’re doing this because of our risk focus. By using swaps and options, our portfolios can benefit when sharemarkets rise, earn a return when they fall, or be cushioned from the full impact of market falls.
Derivatives enable us to invest humbly. Using derivatives is an open acknowledgment that we are uncertain about market direction and thus hedging against downside risks is important. It has been integral to our investment management through the mayhem of March and will remain important in the months and years ahead.
There is absolutely no doubt we are living, and investing, in interesting times – and this is expected to continue for some time. While it’s difficult to predict the longevity and depth of the uncertainty, incorporating some flexibility into your portfolio can help give peace of mind and better manage your risk exposure.
Jonathan Armitage, CIO, MLC
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