What a rollercoaster time we have experienced since January 2020! This applies to the financial world as much as anything. As 2020 began, investors were celebrating the decent gains they had enjoyed in 2019 and anticipating more of the same in 2020. Forecasts of economic growth and corporate profits were unexciting but monetary policy (policy dictated by central banks in relation to interest rates), was expected to remain very supportive of asset prices. In fact the US Federal Reserve had already begun to reverse some of the interest rate rises that had caused stock markets to convulse in the final quarter of 2018.
The outbreak of a new coronavirus in a city in China that few people had heard of (and a few small, related clusters of cases in South Korea and Singapore) was expected by most investors to remain contained in Asia, like bird flu in 1997 and the SARS epidemic in 2002/3. How wrong they were. Appearing in Iran and then in Italy, the virus rapidly spread West and infection rates, hospital admissions and, sadly, deaths skyrocketed. The first cases of COVID-19 were confirmed in the UK at the end of January. The World Health Organization declared a pandemic on 11th March and on 23rd March the UK government finally followed the lead of many other European countries by ordering the first national lockdown.
Faced with a sudden and unprecedented slump in economic activity, which was clearly going to impact corporate profits, but no one knew by how much yet, stock markets unsurprisingly plummeted. By the end of the third week in March, year-to-date gains of 2% – 5% seen in stock markets in January and early February had become losses of more than 30%. The speed of the declines far exceeding those seen in 2002’s dotcom bubble burst and 2008’s financial crisis. The response of governments and central banks to this new crisis was equally unprecedented. In the US, the Federal Reserve cut interest rates by 1.5% to just 0.25% and in the UK the Bank of England cut its rate from 0.75% to 0.2% and then 0.1% just a week later. At the same time, governments around the world abandoned any last vestiges of fiscal discipline as they rushed to announce gargantuan packages of financial support for businesses and workers to prevent recession becoming depression.
In the US, for example, the first emergency fiscal boost amounted to US$2trn or approximately 10% of Gross Domestic Product (GDP). This was clearly necessary and was facilitated by huge increases in asset purchases, (for that read money printing by central banks). Despite the issuing of huge numbers of government bonds, their yields fell sharply in the first quarter of last year.
At the end of the first quarter, the main stock market indices of the UK, US, Germany and Japan were posting year-to-date losses of 25%, 20%, 25% and 19% respectively in local currency terms. 10-year gilt yields had fallen from 0.74% to 0.36%. The price of gold was up by 5% in US$ terms.
With most European countries not beginning their national lockdowns until March and many states in the US not introducing restrictions until April, it was not until the second quarter that the economic impact of the pandemic became clear. It made grim reading. In the US, gross domestic product plunged by 31.4% on an annualised basis and the unemployment rate soared from 3.5% in pre-pandemic February to 14.7% in April. In the UK, GDP contracted by 19.8%, the biggest contraction since quarterly records began in 1955. Thanks to government furlough schemes though, the official unemployment rate remained low, rising from 3.8% at the beginning of the year to just 4.1% at the end of June. In the eurozone, GDP fell by 11.8%.
As the quarter progressed towards the onset of summer, however, infection and mortality rates began to improve, allowing some easing of lockdown restrictions. The anticipation of economic recovery, coupled with investor conviction that governments and central banks would do whatever it takes to combat the economic and financial effects of the pandemic, sparked a strong rally in corporate bond and stock markets. In particular, the US stock market, with its increasingly heavy weighting in technology companies many of whom were immune or even benefited from the changes to lifestyles brought about by the pandemic, had recovered almost all the loss it sustained in the first three months of the year by the end of June. Unfortunately, the UK lagged most of the rest of the world as markets began to recover in the second quarter. This was partly because of its high weightings in sectors in the eye of the economic storm such as banks, oil and mining companies and almost no major technology companies. Of course we also had major concerns about the lack of progress in post-Brexit trade negotiations and the risk that the transition period would end without a deal. Fortunately our portfolios were underweight in the UK during this period.
Stock markets, of course, look forward instead of at the present or past so, even as the second wave of the pandemic was taking hold, news of the vaccines spurred a bumper quarter for share prices. Even the UK participated although, unlike other major markets, its gains in the fourth quarter were insufficient to make up for losses earlier in the year. Looking ahead, the economic prognosis is clearly much rosier with the roll out of the vaccines. The question for investors is how much of the recovery is already built in to share prices.
Gains seen in stock markets (except the UK) in 2020 certainly seem incongruous with what has happened to economies. As a result, valuations of shares and bonds are very high, and for some technology companies stratospheric, leaving little room for disappointment or shocks such as tax increases or regulatory intervention. Nevertheless, with interest rates probably going to remain very low for some time to come and bond yields likely to be similar, equities are the only mainstream asset class through which investors can hope to maintain or grow their capital in real terms.
It would be wrong to expect returns to match the last decade and portfolio positioning will be very important as will be diversifying of investments. Looking further into the future, we are concerned by the potential consequences of all the additional debt taken on by governments to counter and by companies to survive the pandemic. We will also be watching closely for signs of whether the explosion in money supply allows inflation to become an issue of concern. These, though, are unlikely to be issues in 2021.