As already explained in previous market updates, we believe that the impact of the coronavirus pandemic on global economic activity will depend to a large extent on the policy response from governments, in particular on the duration and extent of economic activity shutdowns. We are becoming increasingly concerned about the extent and depth of the economic impact, and a global recession has now become our base case scenario.
It is now clear that H1 earnings will be severely affected around the world. However, countries that have been able to resume activity earlier than others should fare relatively better. This explains the recent outperformance of the Chinese equity market, as the country has managed to contain the outbreak and the impact thereof, and is slowly going back to normal levels of economic activity and demand. However, history tells us that a global recession would most likely imply an underperformance of equities relative to other asset classes. Within global equity markets, the US equity market is most likely to outperform, as it is often perceived to be safer, also from a currency perspective.
Yet, given the recent market sell-off, there are still opportunities to be found in equities. Using data going back to 1873, we find the S&P 500 peak-to-trough decline around a US recession has been 22.1% on average. This suggests that the stock market has now already fully priced a US recession. For emerging markets and European equities, a recessionary scenario is also priced in. So, we are now closer to the end than to the beginning. More negative news, such as company failures, further expansion of the pandemic and potential delays in policy response, will determine when we reach the bottom. Above all, once earnings are announced, they will inevitably have an impact on stock prices and market volatility.
We have been here before: markets will recover and regain their losses. However, experience tells us that this is not a market to buy indiscriminately. We need to make sure that we are picking the right stocks. In a rebound, the tide will lift all boats. But, once the impact on earnings is known, it will become clear who the winners and the losers are. Some companies will have more difficulty recovering, others will never recover.
Picking the bottom of this market is next to impossible as it depends on a number of exogenous and difficult-to-predict factors. As long-term equity investors, we have learnt that the best strategy is to slowly and gradually pick our entry points. Also, we need to be mindful of the significant increase in intraday volatility and bid-ask spreads, that increase transaction costs significantly. This is a potential market of opportunities, but not across the full market spectrum. It is a market for active investors and careful stock pickers. Some of our teams, depending on the value they see emerging in their respective markets, have started to gradually and selectively pick entry points.
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We are sticking to our defensive positioning. The strategy has outperformed the market, both month to date and year to date. We maintain our 5-6% cash position and will wait for four more favorable signals to materialize:
Currently, most signals point to caution.
Emerging Market Equities
The value tilt of our Emerging Markets strategies will typically underperform in risk-off markets. Emerging Stars’ performance trails the market this year, of which the majority was incurred this month. However, over the 25 years that our team has existed, we have learnt to use market overreaction to find opportunities. Hence, we have been gradually changing positioning where better risk-reward emerged. The most likely mistake by value investors in economic downturns is to sit in value traps, i.e. companies that will be either structurally affected by the economic downturn, or for an extended period. Balance sheet health and earnings outlook remain key.
The past week saw wild trading in individual stocks and heavy trading volumes. There are clear signs of technical positions being unwound in some stocks (long or short), which led to price moves unrelated to fundamentals. We are making use of some of these opportunities to add or reduce positions. However, bid-ask spreads are high, and trading is expensive. We have therefore been trading sparingly. For Asia-Pacific Equities, we added to our Japanese yen hedge, at levels where the currency was considered too strong and too much like a safe haven. Our Value style has not helped this year and relative performance year to date was negative of which two-thirds was incurred this month.
Global Consumer Trends
The strategy posted negative absolute returns for both MTD and YTD, and yet strongly outperformed the index. Quality growth stocks again outperformed their cyclical value counterparts significantly. Avoiding cyclical sectors, such as banks, energy companies, airlines and carmakers, had a positive impact on performance. Some segments of consumer spending, like luxury, travel and retail, have been clearly affected by market volatility. Other segments, including consumer staples, home entertainment, e-commerce, food delivery, Indian and Chinese stocks, have shown greater resilience. We keep buying gradually and selectively, as no drastic portfolio changes are needed.
Most recently, we reduced our exposure to sectors more directly affected by the coronavirus pandemic, in particular retail and tech hardware. We used the proceeds to add positions in online gaming stocks that should benefit from the outbreak. We believe risks are still skewed to the downside for valuations and that consensus earnings estimates have not priced in the likelihood of a global recession. As a result, we are focusing on controlling risk. Our cash levels remain broadly unchanged. After a solid 2019, the (almost) first three months of this year have again been strong in terms of relative performance.