UK Economic Outlook: Flying Felines
In April equity markets bounced from the lows they experienced in mid-march. Only time will tell if this a dead cat bounce, but the height of the fall and speed of the recovery does suggest it may have certain deceased feline qualities about it. Having fallen 34% from its peak, the MSCI world index is now 25% higher than the lows seen in mid-March, taking it to a level last seen at the end of May 2019. Effectively this is saying that a global pandemic and the shutting down of a large proportion of the global economy has resulted in investors losing 1 year of global equity returns. Of course this story is different in different equity markets: in the UK investors have lost around 4 years of returns, European investors about 15 months of returns, US investors 6 months of returns and investors in emerging markets about 3 years of returns.
These facts tell us a couple of things, firstly diversification is vital. UK investors with a home bias will have been hardest hit by the falls. But it would be a mistake to think about this as superficially as only geography, that somehow the markets are thinking that some countries are expected to weather the storm better than others.
In our view it is actually more a story about the sectoral breakdown of the respective indices – most large cap companies are fairly well diversified internationally already. The FTSE All-share has a sectoral exposure of 26% to financials; 10% to oil and gas; 7% to resources (mining in particular) and 1% to technology. Meanwhile the S&P 500 has a 26% exposure to technology; 15% to healthcare 10% to financials and just 6% to energy and resources. These sectors have experienced very different fortunes over the last 2 months. With the global economy in lockdown, demand for oil has fallen to such an extent that the price briefly turned negative with producers paying customers to take their product as there was nowhere left to store it. This has had a predictable and significant effect on the share price of oil companies. The same is true to a lesser extent with non-oil commodities. Meanwhile technology companies have benefited from their employees being able to work remotely (it’s pretty hard to dig for copper from home) and from those working remotely or stuck at home requiring some form of entertainment. Netflix is up 47% since the lows in mid-march and is trading at an all-time high, Amazon is also up 40% since the lows and is trading 17% above its previous all-time high. Exxon the world’s biggest oil company by market capitalisation (ignoring Saudi Aramco, which has a negligible free float) has fallen 37% since the start of the year.
And whilst sectoral splits may explain some of the differential in performance between markets, it isn’t the whole story. It doesn’t necessarily tell us if current valuations and the rapid correction are realistic. To some extent the rebound is explainable by market participants re-evaluating the path of future dividends. From peak to trough expectations of S&P500 dividends payable in 2022 fell 43%. This has since rebounded a little and is now down 26%; other things being equal this should have led to a decline in equity prices of around 16% which is almost exactly what has occurred. In addition we have had some quite significant decreases in long dated bond yields which are also positive for equites as future dividends now have a higher net present value. On the negative side however it is extremely likely, given current uncertainties and volatility, that the premium required for holding equites has increased possibly offsetting any fall in the risk free rate. And that’s ignoring direct central bank intervention in markets, which is like ignoring the room in the elephant.
The measures are clouded in uncertainty – we cannot know the expected level of future dividends and the equity risk premium is unobservable. So whilst we may be able to say that equity market valuations are currently consistent with the inputs we cannot say those inputs are correct.
This is why Kempen currently prefers to invest in assets that haver predictable cashflows and focus our attention for opportunities across the credit spectrum, and why we prefer assets that take advantage of pension funds’ long dated investment horizons to earn illiquidity premia. We believe this will result in better outcomes and more stable funding ratios in the long term.