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Looking forward, post-coronavirus and beyond

Quarterly Market Overview: April-June (Q2) 2020

As many economies take their first steps towards reopening, there has been considerable debate on recovery paths, from V-shaped to U-shaped and more in between.

With a V-shaped recovery, the economy will bounce back quickly to its baseline before the crisis. This is one of the most optimistic recovery patterns because it suggests that the downturn did not cause any lasting damage to the economy. Under a U-shaped scenario, the economic damage lasts for a longer period of time before eventually reaching the baseline level of growth again.

In the first quarter of 2020, we said that it was possible we could see both. The second quarter was an opportunity for this story to play out, with weaker economic data coming through as expected on the one hand, but with a stronger appetite for market risk on the other.

In June, the US National Bureau of Economic Research provided data showing that the longest-running US economic expansion in history (from June 2009 to February 2020) had come to an abrupt end. While economic and market fundamentals had continued to be supportive, the global pandemic was enough to curtail continued growth.

At the same time, policy makers around the world pledged unprecedented levels of monetary and fiscal stimulus, with both central banks and governments encouraging markets to look further out along their investment horizons.

With interest rates close to 0%, the ‘opportunity cost’ of forgoing near-term earnings in favour of longer-term growth becomes more attractive. So far in 2020, this has benefitted companies in ‘growth’ sectors such as technology and healthcare.

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(MSCI USA Net Total Return in US dollars, calendar quarter performance, %)

MSCI USA, Net Total Return, in US dollars

US equities see their best quarter returns since Q4 1998

1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020

21.6%

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Source: Bloomberg, MSCI: please see important information. Data to 30June 2020.Past performance is not a reliable indicator of future results. Investors may not get back the amount invested.

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The health and economic effects of the pandemic are already immense, but investors need to assess how long they will last. Will the economy bounce back quickly, or will the damage last for a longer period of time?

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The most hated global stock market rally in history?The breakneck speed of the rally in risk-appetite from the March low point was turbo-charged by monetary and fiscal policy accommodation.

Given this, it’s no wonder that some consider this to be the most hated rally in history, perhaps even more disliked than the previously assumed holder at the end of the global financial crisis in 2009. Two factors come to mind supporting such a claim: first, the sharp increase in money market fund positioning (which invests in highly liquid near-term instruments such as cash and short-dated government bonds ), and second, the challenge of remaining invested.

The chart shows the Money Market Fund Monitor, from the Office of Financial Research, US Department of the Treasury.

Between February and May this year, these funds have seen over $1 trillion of inflows in aggregate. Some of this might reflect short-term corporate balances, as well as the reduction in appetite for assets perceived as riskier, such as equities, in favour of cash.

At over $5 trillion at the end of May, this is equivalent to around a quarter of US GDP in 2019. Should there be any reallocation of assets away from cash, this could be positive for the balance between demand and supply across risk assets.

The first half of 2020 has witnessed significant levels of market volatility, as both equities and bonds have, at times, seen very large and very quick movements in price.

With this volatility, we have been reminded of phrases such as ‘correction territory’, ‘bear markets’ and ‘bull markets’ and what they all mean. A market is said to be in correction territory if it suffers a fall of 10% or more from a previous high. A fall of 20% or more from the same high would be defined as a bear market. Equally, a rise of 20% or more from a new low would be seen as the start of a new bull market.

While the speed of equity markets falling into correction and bear market territory was among the fastest in history, the following upturn was equally swift. The MSCI All Country World US$ price return index fell into bear market territory against its 12 February peak (MSCI: please see important information) in just 20 trading sessions (excluding the US market holiday on 17 February). However, following the lowest point on 23 March, the same index rallied more than 20% by the close on 8 April. Having experienced a bear market, it turned into a bull market in just 12 trading sessions.

Providing outsized policy pressure-release-valves to markets, the US Federal Reserve (Fed) followed up in its March announcement by committing to buy corporate debt for the first time. It announced it would be extending its support in early April by buying high yield bonds, specifically to include ‘fallen angel’ corporate debt. In financial market language, fallen angels are bonds which were previously rated as investment grade, but which have subsequently fallen into sub-investment (known as high yield) grade, usually when the issuer has fallen into financial trouble.

Providing indirect support for the lower grades of the corporate credit market, particularly for US shale energy debt, was

important. With the Fed acting to provide an effective ‘fire-break’, this reduced the risk of a financial contagion into other risk-assets.

The coordinated policy response, alongside a $2 trillion US fiscal stimulus signed at the end of March, drove a swift recovery in risk appetite in Q2, especially so for US equities given their relative exposure to technology and healthcare companies. Looking at MSCI USA (Net Total Return, in US dollars), after falling -19.8% in Q1, the worst performance since Q4 2008 in the midst of the Global Financial Crisis, the same index rallied 21.6% in Q2, delivering the best quarterly performance since Q4 1998. (MSCI: please see important information.)

Is the coronavirus bear market over already?

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Feb 1961 to Dec 1969

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Nov 1970 to Nov 1973

Apr 1958 to Apr 1960

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Past performance is not a reliable indicator of future results. Investors may not get back the amount invested.

The longest-running US economic expansion in history is over

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Looking forward, post-coronavirus and beyond

Best and worst days tend to cluster

Source: Bloomberg, MSCI: please see important information. Data from 4 Jan 2000 to 11 Jun 2020.

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The importance of staying investedRelated to the increase in money market funds is the challenge to stay invested during periods of heightened market volatility.

The emotional pull to switch into cash, with the intention of mitigating further losses, can be incredibly tempting. This really speaks to human behaviour. While unemotional mathematical models suggest we should all be equally balanced between the opportunity for the same profit or loss, it’s a natural human trait to be more wary of expected losses.

From the chart, we can see that the days of both significant upside and downside performance often tend to be clustered together.

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Financial markets have relied on the unprecedented accommodation from policy makers to support risk appetite and central banks globally have been synchronised in their actions.

So far in 2020, we have seen an overwhelming breadth to cuts in key central bank policy interest rates.

However, there has been arguably greater distinction within the range of fiscal policy responses. As Fed Chair Jerome Powell pointedly remarked in May, central banks only have ‘lending-tools’, they do not have ‘spending-tools’.

Ultimately, while banks can lower the cost of lending, the principle remains that money borrowed has to be paid back. While interest rate cuts typically act with a lag of between 18-24 months, it is fiscal policy that has the ability to deliver a

‘right-now’ plan, with the cost borne and shared across the tax-paying base. This last point is a critical distinction and explains why some countries and regions have differences in the pace and scale of fiscal policy accommodation.

Counting additional government spending and forgone revenue measures (but excluding loans, equity and guarantees), the US has seen fiscal stimulus at over 12% of GDP according to the International Monetary Fund (IMF) latest estimates in June. In some other countries, the scale of this stimulus has been a lot less than this, with a G20 group of nations average at less than 6% of GDP. But as well as the size of fiscal stimulus, its coordination alongside monetary policy has also been important.

As governments around the world seek to exit their virus-induced economic lockdowns, the pace and scale of the recovery could be very different from country to country. For example, while China demonstrated a carefully choreographed coordination of monetary and fiscal policy measures at its National People’s Congress in late May, the 27 European Union leaders continue to debate the shape of the planned region-wide fiscal rescue package and the component parts of grants versus loans.

Ultimately, while banks can lower the cost of lending, the principle remains that money borrowed has to be paid back.”

More than ever, markets rely on coordinated policy action

So, while sharp declines in markets can naturally be disconcerting, it is important to remember that remaining invested over a long timeframe, through the various ‘ups and downs’ in markets, tends to be the better option in terms of achieving longer-term investment goals.

Quarterly Market Outlook: April-June (Q2) 2020

4

Governments’ borrowing rises – but how to pay it back?In May, the UK government saw its public sector net debt rise, as a percentage of GDP, to over 100%1.

The last time it breached this mark was in 1963. The UK experience has been common to governments around the world looking to support economies forced into an emergency stop because of coronavirus.

With public debt rising, reducing this is likely to be at the forefront of policy discussions for years to come. As governments face the question of how they will pay this back, rather than finding one good solution, the reality is that they will likely have to consider a ‘least worst’ outcome.

Throughout history, the ratio of a country’s debt to GDP has been typically reduced in one of three ways:

Pay it back Either through economic growth leading to higher taxation revenue, or direct control over taxation and spending ‘austerity’ plans.

Inflate the debt away Either through a direct rise in inflation, reducing the real value of debt, or indirectly through financial repression, where government debt servicing costs are held below inflation. But negative real interest rates are effectively a relative tax as it represents a transfer from savers to borrowers.

Don’t pay it back Either through an explicit default or a restructuring of the debt burden.

If we can exclude ‘default’ as the worst of the ‘least-worst’ options, this leaves two central ways for governments to pay back debt. But because these are not mutually exclusive, governments have often used these choices in combination.

While economists determine both choices as viable options, elected political leaders are unlikely to favour a reliance on austerity. This leaves inflation and financial repression as the likely preferred tool of choice. Helpfully, this is not a new policy, and government bond markets have been complicit in its use before coronavirus, and might likely continue to be so afterwards.

With central banks engaged in a new wave of monetary stimulus and quantitative easing, government bond markets continue to be manipulated by their actions. As central banks take a greater share of the size of their sovereign bond markets, the yield on such government bonds arguably reflects less about the outlook for economic growth, and instead the markets’ expectation for central bank intervention.

With interest rates close to 0% in the US keeping control over short-term borrowing costs (and expected to remain there to the end of 2022 at least given the most recent Fed member ‘dot-plot’2 of near-term rate expectations), there has been much discussion around whether the Fed might reintroduce yield curve control, a policy used in the 1940’s. Yield curve control could allow central banks to control longer-term borrowing costs, and, in doing so, force the buyers of government bonds to accept below inflation rates of return.

1. UK Office for National Statistics (ONS), May 2020 release, published 19 June 2020. 2. The dot-plot is a graphical representation of where US Federal Reserve officials expect interest rates to be over the forecast period.

Looking forward, post-coronavirus and beyond

5

The outlook for inflation

The coronavirus pandemic has seen central banks and governments deploy huge amounts of monetary and fiscal support for their economies and financial markets.

While this policy action has undoubtedly had some success during the lockdowns, markets have started to reflect on the consequences of this policy support, and one area is the outlook for inflation.

Currently, inflation expectations continue to be relatively low and importantly remain below the 2% target that the Fed continues to hold to, even when looking along a medium-term horizon. However, while inflation looks under control for now, some analysts worry that this might not always be the case.

Certainly, the pandemic and the consequent policy response has only served to fire up the debate between those that see risks of high inflation going forward, versus those that worry about falling inflation, or even deflation.

In one camp, there are those who worry that it might push inflation up. As the US government has engaged in ‘helicopter money’ where they have given direct cash transfers to citizens, the Fed has overseen a 30% plus growth year-on-year in real money supply, greater than during the global financial crisis3.

In the other camp are those who see a risk of weaker inflation, or perhaps even deflation, noting the huge increase in the US unemployment rate to 11.1% in June, from 3.5% in February4, and the impact this might have for US households’ appetite to spend versus save.

In any event, for an inflationary outlook to take hold, it probably needs policy makers to continue to add monetary and fiscal stimulus at the same outsized pace going forward. More likely is that, as we emerge from the shadow of the coronavirus and economies start to reopen, the level of accommodation will be gently moderated in unison as the lockdown is eased. This appears to be the central case that financial markets are holding to currently.

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US Federal Reserve is growing real money supplyat an unprecedented rate in modern history

Source: Re�nitiv, US Federal Reserve, US Bureau of Labor Statistics. Monthly data to May 2020. YoY denotes Year on Year. M1 denotes a measure of money readily accessible for spending. CPI denotes Consumer Price Index

(US M1 YoY % change, less US headline CPI YoY % change).

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3. US Federal Reserve, US Bureau of Labor Statistics as at May 2020. 4. US Bureau of Labor Statistics as at June 2020.

Currently, inflation expectations continue to be relatively low.”

Quarterly Market Outlook: April-June (Q2) 2020

6

US domestic politics risks progress in US/China trade relations

Second wave risk

Coronavirus, unemployment and civil unrest has created significant domestic political headwinds for US President Donald Trump.

This has not gone unnoticed in financial trading markets which currently show Trump’s likely challenger, presumptive Democratic nominee Joe Biden, taking a clear lead in recent weeks.

Assuming these correlate with actual voting intentions, this could well carry an unintended consequence for risk-appetite. As Trump sees headwinds to his domestic popularity, there is a risk that he might judge as an acceptable risk the opportunity to create a distraction by escalating the confrontational rhetoric towards China.

While more hostile language has been noted from both Trump and Biden, it is interesting that this appears at odds with the mood-music from the US Trade Representative (USTR) body. This is led by USTR Ambassador Robert Lighthizer, chosen by Trump to ‘put America first’ in trade discussions with China.

Recently, Lighthizer said he felt “very good” about the progress of the ‘Phase One’ trade agreement made with China which he said is honouring the pact despite the coronavirus pandemic, and “on the structural changes, China has done a pretty good job”. It is also notable that, following the recent steps by China in May to tighten security laws for Hong Kong, markets judged Trump’s much-hyped retaliatory press conference as heavy on rhetoric, but light on actual measures that could have damaged the existing US-China trade position.

Markets are still trying to weigh up how far Trump and the White House might go with any reescalation of tensions. While there is clearly political capital accrued in being seen to be tough on China, there will be concerns that increased tensions may damage the US economy which is in the early stages of restarting post-coronavirus.

If the US-China Phase One trade deal is torn up, then China will not buy US agricultural goods promised under the deal. With the US election approaching, the White House will be aware that the US farming sector is a key source of votes. While a steady drum beat of strong rhetoric is inevitable, for now the market believes that the economic realities of coronavirus will keep both the US and China away from a dramatic re-escalation in trade tensions.

Nevertheless, despite the Phase One agreement signed earlier in the year, some $370bn of Chinese exports into the US are still subject to tariffs, including $250bn tariffed at 25%5. Equally, this provides for some upside risk should trade relations confound the sceptics with a Phase Two deal at some point – though now likely after the November election.

The coronavirus pandemic continues to dominate the list of economic risks to be balanced against the outsized policy accommodation from central banks and governments.

Some countries, notably the US, as well as a number of emerging and developing economies, have arguably never left the first wave of the pandemic. For those, cumulative case growth continues to show little signs of flattening. For other countries, it is the risk of a second wave of infections which is the worry.

A significant second wave of infections would undoubtably damage risk-appetite, but it is also true that economies are unlikely to bear the same impact. With the element of surprise gone, as each day goes by, the virus presents a better-

understood set of risks which governments, companies and consumers are getting better at managing. While different areas of economic activity will likely recover at different speeds, in aggregate, just as the impact from successive waves will be met with greater preparedness and resilience, so the same might be said of risk appetite.

Considered to be a constant for investing, markets must always climb a ‘wall of worry,’ reflecting the set of risks which could derail sentiment and risk-appetite. Coronavirus means that we now have another risk to monitor.

5. US Government, Office of the United States Trade Representative.

Looking forward, post-coronavirus and beyond

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As the coronavirus drum beat softens, other risks are ready to take its place

Where next for the US dollar?

The direction for the dollar is very important.

A stronger dollar keeps a lid on global liquidity which tends to discourage capital flows into emerging markets and, in so doing, keeps global growth suppressed.

In such a low inflation rate environment, longer-term earnings growth companies, such as those in the technology sector, are sought out. Conversely, a weaker dollar outlook can support an increase in liquidity and, by supporting growth and inflationary pressures, can challenge US equity performance relative to the rest of the world.

While we have seen significant growth in liquidity as a reaction to the coronavirus pandemic, the key questions remain; will the pace of policy accommodation

continue or, once economies emerge from lockdown, will this relative pace of money supply growth ease?

The dollar outlook is also central to determine which equity ‘styles’ could be favoured especially between growth and value equities. Faster global growth could well encourage a stronger global reflationary narrative which would encourage value and cyclical stocks to see relative outperformance, likely favouring emerging markets.

In contrast, if growth disappoints and financial repression becomes the default tool, this would favour growth stocks as they would be scarcer and more highly valued. If this is the case, US equity outperformance, relative to non-US equities, might continue to be a dominant theme as it has been for much of the time since the global financial crisis.

While markets look to potential game-changing news around vaccines currently in trial, other risks will limit the markets’ ability to become complacent, and, in so doing, could test a reemergence of market volatility.

One ongoing risk is the oil price. During April, the group of members that represent the Organization of Petroleum Exporting Countries (OPEC) together with a key group of non-OPEC members (including Russia), agreed to significant production cuts of almost 10 million barrels per day,

equal to around a tenth of daily global supply in 20196.

However, OPEC is well known for the difficulties in keeping member cohesion and discipline around quotas. Should supply increase above the pace of recovery in demand as energy consumers globally emerge from their economic lockdowns, this could present another risk for market volatility to rise.

Another risk closer to home is the ongoing trade talks between the UK and the European Union. With the UK

Prime Minister, Boris Johnson, refusing to countenance any extension to the transition period which is due to end 31 December this year, the second half of 2020 is likely to see greater risks for UK sterling and UK risk-assets in particular. With the latest fourth round of UK EU talks in early June ending in deadlock, a reversion to World Trade Organization tariffs in 2021 is still a tail-risk to bear in mind.

6. Organization of Petroleum Exporting Countries, press release 12 April 2020.

Quarterly Market Outlook: April-June (Q2) 2020

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Important information

The performance indicated for each sector should not be taken as an expectation of the future performance. Investors should be aware that the price of investments and the income from them can go down as well as up and that neither is guaranteed. Past performance is not a reliable indicator of future results. Investors may not get back the amount invested. Changes in rates of exchange may have an adverse effect on the value, price or income of an investment. Investors should be aware of the additional risks associated with funds investing in emerging or developing markets.

The information in this document does not constitute advice or a recommendation and you should not make any investment decisions on the basis of it. This document is for the information of the recipient only and should not be reproduced, copied or made available to others.

Brooks Macdonald is a trading name of Brooks Macdonald Group plc used by various companies in the Brooks Macdonald group of companies. Brooks Macdonald Asset Management Limited is regulated by the Financial Conduct Authority. Registered in England No 3417519. Registered office: 21 Lombard Street, EC3V 9AH. Brooks Macdonald Funds Limited is authorised and regulated by the Financial Conduct Authority.

Registered in England No. 5730097. Registered office: 21 Lombard Street, EC3V 9AH. Brooks Macdonald Asset Management (International) Limited is licensed and regulated by the Guernsey Financial Services Commission. Its Jersey Branch is licensed and regulated by the Jersey Financial Services Commission. Brooks Macdonald Asset Management (International) Limited is an authorised Financial Services Provider, regulated by the South African Financial Sector Conduct Authority. Registered in Guernsey No 47575. Registered office: First Floor, Royal Chambers, St. Julian’s Avenue, St. Peter Port, Guernsey GY1 2HH. This document contains data attributed to a third party which is the property of that third party and is licensed for use by Brooks Macdonald, subject to the below terms of use.

MSCI INDICES

The MSCI information may only be used for your internal use, may not be reproduced or re-disseminated in any form and may not be used as a basis for or a component of any financial instruments or products or indices. None of the MSCI information is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. Historical data and analysis

should not be taken as an indication or guarantee of any future performance analysis, forecast or prediction. The MSCI information is provided on an “as is” basis and the user of this information assumes the entire risk of any use made of this information. MSCI, each of its affiliates and each other person involved in or related to compiling, computing or creating any MSCI information (collectively, the “MSCI Parties”) expressly disclaims all warranties (including, without limitation, any warranties of originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential (including, without limitation, lost profits) or any other damages. (www.msci.com)

More information about the Brooks Macdonald Group can be found at www.brooksmacdonald.com.

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US Government 10 Year Bond Yield

US 12-month forward Equity Earnings Yield vs US 10 Year Government Bond Yield

Source: Re�nitiv, MSCI: please see important information. Data to 30 June 2020.Past performance is not a reliable indicator of future results. Investors may not get back the amount invested.

MSCI USA 12-month forward Earnings Yield

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Has coronavirus reinforced a preference for equities vs bonds?

As we balance our investment outlook across asset classes, a key consideration is the expected return.

As was the case before the coronavirus pandemic, we continue to observe a significant difference between the expected earnings yields available on equities compared to that available on government bonds. As we noted earlier in discussing the sharp rise in US money market funds so far this year, some of this money might represent investors keeping cash on the sidelines. However, the question remains, should those investors in this position choose to move back into risk assets, will they choose to buy US Treasuries where

10 year benchmark bonds are yielding less than 1%, or will they be tempted to look at equities where, for example, the expected 12-month forward earnings yield for US equities (which is the inverse of the Price-to-Earnings ratio) is over 4%.

We should keep in mind that the earnings yield gap between equities and government bonds do not provide a timing mechanism. Nonetheless, it offers a longer-term roadmap as to how we might look to position our asset allocation.

Looking forward, post-coronavirus and beyond