CIO Update

CIO Update

When we consider the last six weeks, we should not lose sight of how remarkable markets have been. For example, we have experienced the fastest US equity correction in history - in the space of just 22 days markets plunged more than 20%, a magnitude which, by convention, defines a “bear market.” Of equal significance the VIX index, often called Wall Street’s “Fear Gauge”, hit a record high – over 85, implying future daily moves for US equities in excess of 5%. Fund-flow data indicate the extent of investor risk aversion, with investors withdrawing large sums of money from equity and bond funds alike, instead moving into cash funds. Interestingly, sustainable investing funds have bucked the trend, with Goldman Sachs noting that “ESG-linked funds” have received almost USD 100 billion of inflows in 2020. Credit markets were also heavily impacted, with USD and EUR high-yield spreads widening to a recent peak of 1100 bps and 904 bps respectively. We all know the culprit behind these moves: the coronavirus pandemic and the associated economic impact of containment measures. While the economic impact on both the US and European economy is only starting to show in the conventional economic data, the early signs are disconcerting. On Thursday US initial jobless claims were reported at 3.28 million, more than four times the previous record high of 695,000 - recorded back in 1982. We expect second-quarter economic data to show severe contractions in GDP in both the US and Europe.



Utilising market prices to infer investor expectations is fraught with challenges. We know that market prices do not only reflect fundamental expectations, but they are also impacted by technicals and sentiment. In periods of market stress, technicals and sentiment often dominate fundamentals, which can lead to counter-intuitive outcomes, such as the correlations between risk-on and risk-off assets breaking down. We recently experienced this when gold, US Treasuries, and equities sold off simultaneously as investors rapidly liquidated financial assets. Another severe dislocation occurred in the US dollar funding markets, where substantial demand for US dollar liquidity led to rising funding costs and strong performance from the US dollar. Despite these caveats, it is a worthwhile exercise to determine what’s priced in the main financial markets we follow.



We look at current equity pricing from two angles:
Price to earnings ratio (P/E) - This valuation metric is typically not helpful for shorter-term investing as the chart overleaf shows. However it helps to contextualise how expensive or cheap the market is compared to history. The chart overleaf confirms this assessment by showing how US equities have historically performed, conditioned upon the starting forward P/E level.

 width=520 height=270 /><br/><br/><em>Past performance is not a guide to future returns. Source Bloomberg</em><br/><br/>Extracting market-implied pricing from the P/E ratio requires an earnings forecast. Typically, the market view is represented by “consensus”- the aggregate estimates from hundreds of sell-side equity analysts. However, in times of economic stress, these analysts tend to be “behind the curve” and do not update their models fast enough to incorporate the latest information. Currently, according to FactSet data for 2020 and 2021, consensus earnings for US equities have only fallen 8% and 5% respectively. In order to get a more accurate estimate for potential corporate profit impairment we utilise dividend futures. Dividend futures pay out based on the future quantum of dividends paid by corporations. Because, unlike consensus earnings, the dividend future market is tradable, it reacts in real time to the markets’ expectations of potential profit and dividend impairment. US dividend futures for 2020 and 2021 have fallen by around 20% and around 40% respectively. While there may be good reason for earnings and dividends to diverge it is still a useful proxy. Based on this measure, we could expect a further 10-30% downgrade in US earnings which, taking the mid-point downgrade assumption, would inflate today’s forward PE from 15.8x to a less attractive 19.8x. As reference, the forward P/E of US equities was as low as 10.5x in the Global Financial Crisis (GFC).<br/><br/><img class=alignnone wp-image-5891 size-full  data-cke-saved-src= src= alt=

Past performance is not a guide to future returns. Source Bloomberg



Corporate bond spreads can be used to estimate the implied annual default rate in credit markets. Simplistically, the credit spread represents the compensation required by corporate bond investors for assuming the risk that the underlying company will default. Current spreads for EUR and USD high yield over government bond yields are 8% and 9% respectively. Assuming these spreads represent pure compensation for default, and assuming a 40% recovery rate post-default, the implied 12-month default rate for each market is 13% and 15% respectively. As a comparison, based on Moody's data, the realised default rate for EUR and USD high yield during the GFC peaked at 13.1% and 14.7% respectively. As per our prior observation, we acknowledge that this is an oversimplification, particularly since we know investor risk appetite is currently very low and that credit spreads include a risk premium. Still, it provides a useful framework to compare with historical default rates.

 width=509 height=306 /><br/><br/>Past performance is not a guide to future returns. Source Bloomberg<br/><br/> <br/><br/><strong>COVID-19 WATCH</strong><br/><br/>Over the past seven days confirmed cases of Covid-19 have more than doubled, taking the total number of people infected to over 650,000. Deaths unfortunately also doubled from seven days previously to in excess of 30,000. Both Italy and the US surpassed China’s case-count, with the latter becoming the first country to register more than 100,000 confirmed cases.<br/><br/>In our previous CIO Update of 23 March, we illustrated the importance of measuring the growth in Covid-19 cases against various exponential growth rates to determine whether a given country was on the path to successfully containing the spread of the virus. As per the updated chart below, we note that infection rates in Europe have begun to slow; however the US does not yet show signs of successful containment. We believe that the next week will be critical for confirming these divergent trends.<br/><br/><img class=alignnone wp-image-5893 size-full  data-cke-saved-src= src= alt=


In this CIO note we expand our analysis in order to generate a Counterpoint which asks how confident one should be in the reported Covid-19 growth rates, and does the reported data reflect the “real-world” medical - and thus economic - reality?

To do this we use testing data. Unlike confirmed cases and deaths, there is no central authority for the number of tests each country has undertaken. Data is aggregated using country-specific sources and therefore the results need to be treated with caution. In the chart below, we normalise testing counts by considering the number of tests each country has conducted for every one million inhabitants. It follows that those countries that have done more testing relative to their population size are likely to have more reliable infection-count data than those with a lower figure due to the larger sample size. A higher figure often indicates that a country experienced the Covid-19 outbreak earlier than peers and it may also indicate which countries have dealt with the outbreak with greater diligence.


Non-Independent Research

The information contained in this article is defined as non-independent research because it has not been prepared in accordance with the legal requirements designed to promote the independence of investment research, including any prohibition on dealing ahead of the dissemination of this information.

How to Use this Information

This article contains general information only and is not intended to constitute financial or other professional advice or a recommendation that any recipient of this information should make any particular investment decision. Always consult a suitably qualified financial advisor on any specific financial matter or problem that you have.

Except insofar as liability under any statute cannot be excluded, neither Brown Shipley nor any employee or associate of them accepts any liability (whether arising in contract, tort, negligence or otherwise) for any error or omission in this article or for any resulting loss or damage whether direct, indirect, consequential or otherwise suffered by the recipient of this article.

Investment Risk

Investing in stocks either directly or indirectly carries investment risk. The value of equity based investments may go down as well as up over time due to factors such as, market volatility, interest rates, and general economic conditions.