In the space of a few months’ markets have gone from highs to crashing lows and now appear to be having an unexpectedly good rally, according to Royal London Asset Management’s head of sustainable investment Mike Fox.
Looking at the year to date performance of both the S&P 500 and FTSE 100, this rally is evident.
Performance of indices YTD
Source: FE Analytics
Manager of the £1.7bn Royal London Sustainable Leaders Trust, the FE fundinfo Alpha Manager called the past couple of months a “stunning recovery”, adding that this intense market cycle is different from previous ones due to one thing: speed.
“In previous bear markets and recessions these moves would have taken months, maybe years to play out. In today’s markets, weeks are like months and months are like years,” the sustainability head said.
After the initial shock in March where markets heavily sold-off and economies were flooded with emergency stimulus to deal with the coronavirus impact Fox anticipated that as and when the panic subsided – which it did mid-May according to him – that the risk-reward balance would be restored.
But, “markets are submissive to no one however, and rode straight on past us,” he added.
There are three reasons why markets have continued to rise beyond Fox’s original expectations.
Infinite money + finite assets = rising prices
The first is “infinite money vs finite assets”, by which Fox refers to the balance between central banks printing – seemingly – infinite billions and the few securities listed on equity and debt markets which Fox says are “now being bid up by infinite money”.
As central banks fell back onto quantitative easing (QE) in the early days of the crisis to lessen the economic impact Fox points out: “the amount of money being created by central banks, trillions and trillions of it, is – in all practical senses – infinite”.
“And their promise – threat? – to continue doing this until economies recover is stark,” he said.
Asking “Where does all this money go?”, Fox said that it’s not finding its way into corporates and consumers because they’re already occupied with servicing their existing debt. Ultimately, he said it’s ending up in the few securities listed on equity and debt markets.
“It is simple economics to know infinite money vs finite assets will result in rising prices,” RLAM’s head of sustainable investments said.
There is no alternative (TINA)
TINA – ‘there is no alternative’ –is the idea that realistically corporate pension funds and individuals savers actually can’t ensure having enough for their retirement pot by owning government bonds and low interest rates alone, a statement Fox agrees with, adding that they cannot turn to cash to help because the yields are “pitiful too”.
That leaves equities as their only alternative, according to Fox.
“This speaks to an idea we think is under discussed, that the value of an equity is both a function of the future profits of the company it is attached to, and the required return of the investor to own it,” Fox said.
According to RLAM investors have historically wanted 6-8 per cent per annum returns “to compensate them for the risk of owning them”.
He explained: “If cash returns zero, government bonds 0 -1 per cent and credit 2-3 per cent – these are not forecasts but sensible numbers relative to today’s reality – then investors will be willing to take lower equity returns.
“If 6-8 per cent per annum goes to 4-6 per cent per annum then equity prices will, and have, readjust upwards.”
Global economies are reopening for business
After more than three months of essential shopping only in the UK saw, all non-essential retailers reopened this week, something which has already happened in other parts of the world, which should give economies a boost as more people return to work and start spending.
Fox said: “Investors have also been spurred on by the early signs of economic reopening being faster and less impaired by a second wave of virus infections than expected.”
Taking the US as a case study and they have seen records amount of people in unemployment as a consequence of the crisis with more than 20 million Americans losing their jobs in April, reaching a post-wartime high of 14.7 per cent unemployment rate.
But Fox said that the forecast for the US economy in May was that they would lose another 7.5 million jobs when in fact it created 2.5 million jobs.
“For those wishing to believe in a V shaped economic recovery, this was encouraging,” said the RLAM fund manager.
Yet, these three points can be interpreted differently by investors, Fox warned.
“Place these three points in front of a bear, and they will say this is a liquidity fuelled rally and the economic recovery is too nascent to prove anything,” he explained.
“Place them in front of a bull, and they will say the Fed is doing what it has done since Alan Greenspan in the 1980s, and supported the business and investment cycle until the economy recovers, which has now started to happen.”
“We have to confess to not finding either of these choices attractive,” Fox added.
Nevertheless, the Royal London Sustainable Leaders Trust manager said its investment process works well without having to place bets on the outcome.
“We would however say that a bit more caution seems sensible given overall market levels, and that when we look at the output of our investment process it is telling us more defensive, less cyclical investments have the best risk/reward,” he continued. “This is very different from March, when our process was telling us nearly all risk was priced too cheaply.”
Looking ahead, Fox said it was important to focus on “the reality in front of us at the moment, rather than devising grand theories about how all of the above influences markets in a multi-year view”.
He added that investors cannot even rely on or use theories that came out of the 2008 global financial crisis as these didn’t come to fruition: markets are still waiting for the quantitative easing (QE) inflation or growth to become a sub-trend.
“What we can see though is the world in front of us becoming more digital, less carbon-intensive, more health-focused and generally more attractive for socially and environmentally useful companies, which will remain the bedrock of our sustainable funds,” Fox concluded.