Investment newsletter - February 2020

Investment Newsletter February 2020

Black swans & fat tails Back in the early 1600s, most Europeans knew one definitive fact about swans – swans are white.

Every adult swan ever seen by a European was white, therefore (the logic goes) that all swans are white.

Then Australia was discovered and with it a new species of swan… which was black.

Mike Deverell

Investment Manager Equilibrium Investment Management

A black swan is now a term we use to describe a highly improbable event that nobody anticipated and which can have a significant impact.

In financial services, highly improbable events happen a lot more frequently than you might think!

Chart one on the next page shows the daily distribution of returns from the S&P 500 index (the blue bars). The fuzzy orange line shows what we call ‘normal distribution’, which is the way that standard mathematical probability models tells us returns ought to be distributed.

What is clear is that there are a lot more returns in the middle than normal distribution would predict (a so called ‘thin peak’).

If you look closely there are also a small number of blue bars (circled) towards far left and right of the chart. These are the much more extreme market moves of 4% or 5% in a day. Incidentally, the chart cuts

Equilibrium Financial Planning LLP (OC316532) and Equilibrium Investment Management LLP (OC390700) are authorised and regulated by the Financial Conduct Authority and are entered on the financial services register under references 452261 and 776977 respectively. Registered Offices: Ascot House, Epsom Avenue, Handforth, Wilmslow, Cheshire SK9 3DF. Both companies are registered in England and Wales.

Investment Newsletter February 2020

According to normal distribution, such moves should never happen at all! In reality, they do so with relative frequency. We call these ‘fat tails’, because both ends of the chart are fatter than we might expect.

This gives investors a problem. We can factor in normal, everyday risks into investment decisions, and this feeds into market prices. But how do you price a lowprobability-but-extreme event?

Chart one: Distribution of S&P daily returns vs. normal distribution

Frequency

off the most extreme days to make it more readable – there have been 41 days when the daily move was greater than 5%!

Daily return S&P 500

Normal curve

Source: RCM

Pandemic or just panic?

One such black swan event is the possibility of a global pandemic.

off, as shown in chart two. The death rate has also come down and the recovery rate increased.

Serious diseases which spread rapidly and widely are thankfully rare and unlikely events. Arguably, the last pandemic to fall into this category was Spanish flu (although, interestingly, Wikipedia defines HIV as a pandemic). Whilst extremely rare, these events of course can have a very big impact.

A note of caution should be sounded here. China was essentially shut down for two weeks which may have helped to slow down the spread of the virus. However, it has now (officially at least) re-opened and many people have gone back to work. We will perhaps have a better idea of what impact this may have in the next week or two.

The new strain of coronavirus which appeared in China - what we now are told to call Covid-19 - is not a global pandemic. However, according to the World Health Organisation it still has the potential to become one.

Even if the worst is over (still a big ‘if’), the impact of the world’s second largest economy shutting down for a fortnight will have a lingering financial effect.

The virus has, of course, had a significant human impact, and we shouldn’t forget that. But as investors, we must also consider the economic impact and how that might impact on portfolios.

Chart three shows how China’s role in the global economy has evolved over time. The green line shows its economic growth rate, whilst the blue bars show the relative size of its economy compared to the rest of the world.

The most recent data is somewhat more hopeful in that the rate of increase in new cases appears to have tailed

There is a natural instinct to compare the current virus to the SARS epidemic of the early 2000s. However, back

Chart two: New cases of Covid-19 reported each day

Chart three: China’s role in the global economy vs its economic growth rate

Share of global real GDP, % (L) Source: Capital Economics as of 20 February 2020

Real GDP, % change (R)

Source: National Bureau of Statistics, Moody’s Analytics

Equilibrium Financial Planning LLP (OC316532) and Equilibrium Investment Management LLP (OC390700) are authorised and regulated by the Financial Conduct Authority and are entered on the financial services register under references 452261 and 776977 respectively. Registered Offices: Ascot House, Epsom Avenue, Handforth, Wilmslow, Cheshire SK9 3DF. Both companies are registered in England and Wales.

Investment Newsletter February 2020

then China accounted for just over 4% of global GDP. Now, it is around 16% of the global economy.

expand this year at a rate of 2.8%, but they now expect it to grow by 2.5%.

Chinese growth back then was regularly double digit, whereas now it is growing only around 6% to 6.5% per annum. However, it is 6% of a much bigger starting point, which means that China accounts for a very large share of global economic growth.

Given the size of the Chinese economy, this seems quite a limited impact on the face of it. This is because, whilst most economists are assuming a very weak first quarter, they are also assuming a strong bounce in the second quarter. In essence, they expect that all of that money the Chinese didn’t spend in quarter one, to be spent in quarter two instead!

The credit-rating agency, Moody’s, estimates that for every 1% reduction in China’s GDP, this has an impact of 0.4% on global GDP growth.

They estimate that the virus may reduce global real GDP by 0.8% in the first quarter of this year and 0.3% for all of 2020. Moody’s were expecting the global economy to

What actually happens remains to be seen. However, if the spread is contained, from an economic point of view the effects are likely to be temporary.

Market effects The concerns about the virus have, of course, had an impact on stock markets.

As you would expect, the impact on Chinese equities has been most significant, but western markets have been hit too.

Chart four shows the returns of the MSCI China Index (blue line) over the past three months. The FTSE All-Share Index is also shown for comparison (red line).

In mid-January, both markets fell sharply with the MSCI China dropping 10.97% from 13 to 31 January. The FTSE All-Share Index peaked slightly later but dropped 4.69% from 17 to 31 January.

We believe they look better value than some western markets based on the ratio between market prices and the underlying earnings of the companies.

We still believe this is the case despite recent events.

Clearly, the earnings part of the price/earnings ratio is more in doubt in the short term, with the impact of the virus on company profits still uncertain.

We will continue to monitor carefully and react accordingly. However, if the improving medical picture is confirmed and economists are right that Chinese consumer spending is merely deferred rather than lost altogether, we can look through the short-term worries and concentrate on the fundamentals.

However, since then both markets have recovered somewhat and, despite the volatility, have remained very much in positive territory over the past three months. In fact, Chinese equities have done extremely well returning 8.14% over three months boosted by the trade agreement with the US. We have thought for a long time that there is good value in Chinese equities and in emerging markets in general.

Chart four: MSCI China Index vs FTSE All-Share Index

A - MSCI China (8.14%)

B - FTSE All Share (3.67%) Source:FE. 11/11/2019 - 11/02/2020

Equilibrium Financial Planning LLP (OC316532) and Equilibrium Investment Management LLP (OC390700) are authorised and regulated by the Financial Conduct Authority and are entered on the financial services register under references 452261 and 776977 respectively. Registered Offices: Ascot House, Epsom Avenue, Handforth, Wilmslow, Cheshire SK9 3DF. Both companies are registered in England and Wales.

Investment Newsletter February 2020 General economic view Whilst the spread of the coronavirus has had tragic and serious consequences, the economic effects so far have largely been felt within China and in the supply chains of global trading companies.

Elsewhere, consumer and business confidence does not appear to have been materially weakened and UK and US economic data has been generally ahead of expectations.

In the UK, retail sales and property price data are pointing to a marked recovery in consumer sentiment since last autumn.

As such, the Bank of England is likely to keep interest rates on hold for the moment but may well reduce rates later this year as uncertainties over the Brexit trade arrangements loom.

The US Federal Reserve is likely to keep rates on hold throughout 2020, especially given it is a presidential election year.

The central bank, in common with many other central banks, has a very accommodative monetary policy along with additional liquidity measures that are usually positive for stock markets.

Equity markets We remain optimistic about equities, in particular in the UK and Asian and Emerging Markets which we believe remain relatively undervalued. Conversely, some markets, notably the US equity market, are trading at historically high valuations and are narrowly focused on a few high-growth technology stocks which are vulnerable to earnings disappointments.

Fixed interest We remain wary about having too many bonds with yields generally at very low levels. However, they remain a good insurance policy against an economic downturn. We still like short-dated bonds and prefer corporate bonds to government bonds.

Commercial property Given the rising risks and concerns over liquidity, we have a low property exposure compared to our strategic weighting. Overall, UK property returns are likely to be in the low single-digit percentages although there are a few segments of the market that may offer higher returns, especially if growth in the UK economy remains stable.

Cash With interest rates remaining at record lows, returns on cash will remain below average for the foreseeable future.

Balanced asset allocation For a typical balanced portfolio, we are underweight fixed interest and traditional equity, and are very light on property.

This is balanced by holdings in defined returns and alternative equity, giving an overall risk/return profile roughly in line with our long-term average position.

These represent Equilibrium’s collective views and in no way constitutes a solicitation of investment advice. The value of your investments can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested. We usually recommend holding at least some funds in all asset classes at all times and adjusting weightings to reflect the above views. These are not personal recommendations, so please do not take action without speaking to your adviser.

Equilibrium Financial Planning LLP (OC316532) and Equilibrium Investment Management LLP (OC390700) are authorised and regulated by the Financial Conduct Authority and are entered on the financial services register under references 452261 and 776977 respectively. Registered Offices: Ascot House, Epsom Avenue, Handforth, Wilmslow, Cheshire SK9 3DF. Both companies are registered in England and Wales.