What next on the radar after Covid?

The calendar quarters of 2020 have differed significantly from each other. In the first three months we experienced a swift move from complacency to panic. The health crisis ‘over there’ rapidly morphed into a market crisis closer to home as the penny dropped that this was a global problem that recognised no borders. The second quarter saw the economy catch up with investors. It was the worst three-month downturn in activity on record in many places, the UK included. The third quarter has been something of a phoney war, with furlough schemes and pleasant weather disguising the true scale of the crisis.

The next three months are likely to be very different again. For the lucky among us, the biggest problem may be coping with the tedium of working from home as the evenings draw in and the heating goes on. For others, however, the autumn will bring home the harsh reality of an economic disaster postponed. The reduction of government support will see the sharpest rise in unemployment since the early 1980s. The Office for Budget Responsibility forecast in July that unemployment would rise to over 4 million in the final quarter of the year, before averaging 3.5 million in 2021.

That’s the first thing we’ll be watching closely in the run up to Christmas. The next is Covid-19 itself. The picture on the evolution of the pandemic is mixed and no-one really knows where the infection rate goes from here, how that translates into hospitalisations and deaths, what measures will be required to contain the second and subsequent waves, whether the virus is weakening or mutating, and a whole host of other imponderables. What looks certain is that when the anniversary of the first national lockdown rolls around next March we will not be back to normal.

The third focus in the final three months of the year is Brexit. What is in no doubt now is that the UK will leave the EU at the end of the year. What no-one can predict is what the UK’s relationship with the rest of Europe will look like in 2021. The pound is inevitably bearing the brunt of the uncertainty, although the weakness of the dollar has disguised this to some extent. It seems futile to speculate now on whether it is a good or bad thing that we are leaving. But I don’t think anyone, had they known what lay ahead, would have chosen to layer such a rupture on top of a global pandemic.

The final big scheduled event in 2020 is, of course, the US Presidential election. This has the potential to be the most important of all from a markets perspective and already the futures markets are anticipating a big spike in volatility around election day. Even putting to one side the prospect of a contested result, the fact that both candidates are plausible winners means that markets will be seriously unsettled. The uncertainty could last longer if lawyers are called in. That’s before we’ve even started calculating the impact on different sectors of a Biden or Trump victory.

The race to the White House

Source: Refinitiv, 1.9.20, national polling, ten-poll moving average

Have the investing rules changed?

The conventional wisdom says that while the investing environment may change, the fundamental rules of the game remain the same. I wonder. The pandemic has changed many of the things we took for granted about the way in which we worked, consumed, travelled and amused ourselves. Might it also have altered some of the basic truths of how we manage our money?

The first ‘rule’ that some have started to question is the basic 60/40 balanced fund that has been the bedrock of financial planning in recent decades. In the generally kind markets of the past 40 years or so, holding 60% of your portfolio in shares and the remainder in bonds has been a sensible approach. The shares have provided the growth while the fixed income has offered stability. With interest rates falling to historically very low levels today, both shares and bonds have enjoyed a tailwind.

In the US, where the data is best, this has led to a combined return of around 10% a year over that period from a 60/40 portfolio. That compounds up nicely over time and it’s been a fine time to be a baby-boomer investor. But looking forwards the outlook is less clear-cut. Interest rates at or below zero leave little scope for either capital growth or income from government bonds, so investors will need to go up the risk scale to corporate credit. As for shares, there’s no technical limit to how high they can go, but valuations are at the top end of their long-term range. At the very least, investors will probably need to hold more shares in future if they want to achieve an acceptable level of return, but that means their portfolios will be more exposed when the inevitable downturns arrive.

The second investment adage to come under scrutiny recently is the so-called 4% rule. This says that if you only take 4% from your retirement pot in any one year you should avoid running out of money. Again, this rule worked well when capital gains and income together delivered much more than 4% on average each year. Not only were you likely to replace the money you withdrew, you would more than likely keep up with inflation too.

Again, there’s a question mark over this rule. It’s still feasible to draw-down 4% a year and to be OK, but it may be prudent to think through the alternatives, however unpalatable they might be: spending less, waiting longer to access your savings or taking a bit more risk with your choice of investments.

Delay retirement for a higher income

Source: Fidelity International, October 2020.

Potentially sustainable withdrawal rate in at least 90% of the projected scenarios, assuming death at 93 years.

Past performance is not a reliable indicator of future returns 

Forget the V-shaped recovery, the future is K

In recent Outlooks, we’ve talked about an alphabet soup of different-shaped recoveries for both the economy and markets. We hoped for the V, feared the L and accepted that the messy reality might resemble a W or Z. What all of these patterns imply, however, is a single direction of travel for all investments - up, down or sideways at the same time. The truth is, however, that the market is an average of both winners and losers. It’s time to get our heads around the K-shaped recovery.

One of the key lessons from this year’s pandemic is the way in which pre-existing trends have been accelerated and exaggerated by the Covid outbreak. Companies that were in trouble are in even greater difficulties now, while last year’s winners are running ever further ahead of the pack today.

The most obvious winners are the technology stocks which have led the market higher this year. They are benefiting from the digitisation of our lives and the powerful network effects and economies of scale they enjoy. Quite different is the fate of companies in the parts of the economy hardest hit by the pandemic - bricks and mortar retail, banks, travel businesses. It is no wonder that earnings forecasts are diverging so spectacularly at the moment.

The more interesting question for investors is how much of this well-understood story is now priced into markets. In other words, are technology stocks now overvalued and airlines a contrarian value opportunity? My suspicion is that the pendulum has further to swing in both directions. The lesson from 1999 is that ‘irrational exuberance’ can continue a long time after it is identified.

At some point, value will return to favour but there will be casualties along the way as some business models are simply blown away by the forces unleashed by the pandemic. It’s worth remembering, too, that in the long run it is earnings that drive the lion’s share of market returns as the chart here shows. You can pay too much in the short term but in time a genuine growth share will come good. A misplaced value bet can always go to zero.

Earnings drive returns in the long run

Source: Credit Suisse, forward looking P/E and earnings per share

What could go right?

I’m a natural worrier. I should really be a bond investor. I remind myself, therefore, to keep an eye on the glass half full argument so I don’t talk myself out of the ‘triumph of the optimists’ that is the long-term history of stock market investment.

Goldman Sachs is never knowingly pessimistic. So, it’s usually safe to go to them for a Pollyanna view of the world. Recently, the bank came up with ten things that might go right with the markets, which I thought I’d share:

  1. The early ‘hope’ phase of a new market cycle is typically the strongest.
  2. The economic recovery will look more durable as a vaccine becomes more likely.
  3. Economic revisions are rising.
  4. Bear market indicators are not flashing red.
  5. Policy support remains strong.
  6. Shares are pricing in too much risk.
  7. Negative real interest rates support valuations.
  8. Shares are a good hedge against returning inflation.
  9. Shares are cheaper than corporate bonds.
  10. The digital revolution is just getting going.

How are our recommended funds doing?

Every quarter I return to the current year’s recommended funds to see how they are faring. As the chart shows, the first nine months of 2020 have provided yet another divergence - between the two Fidelity funds which have regained all their losses to stand almost exactly where they started the year and the two other recommendations which have not.

The Fidelity Global Dividend Fund and the Fidelity Select 50 Balanced Fund make a good case for the benefits of diversification - geographic and across asset classes too. Unfortunately, the Liontrust UK Growth Fund and the Artemis Global Emerging Markets Fund have been too focused on the wrong parts of the market. A good time to remember that we don’t invest on a nine-month horizon.

Diverging fortunes

Five year performance

% (as at 30 Sept) 2015-16 2016-17 2017-18 2018-19 2019-20
Fidelity Global Dividend 31.7 6.9 8.5 16.6 -0.2
Fidelity Select 50 Balanced - - - 6.2 -0.1
Liontrust UK Growth 25.7 11.5 9.4 3.0 -11.0
Artemis Global Emerging Markets 36.1 23.2 3.8 3.8 -8.9

Source: Morningstar, 30.9.20 bid to bid with income reinvested in GBP terms. Excludes initial charge. Figures rebased to 100 on the chart as at 1.1.20.

Past performance is not a reliable indicator of future returns. When investing in overseas markets, changes in currency exchange rates may affect the value of your investment. Investments in emerging markets can be more volatile than other more developed markets.

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