Looking through the fog

First and foremost, before we discuss recent market behaviour, I would like to wish you all well. I know the past few weeks have been immensely challenging for everyone.

We must also recognise how deeply upsetting this global tragedy has become and the many difficult days ahead. We are clearly living through a remarkable period in history and we are all being asked to cope with a great deal of uncertainty.

As investors we must accept this uncertainty and focus on what is knowable.

Over the past few weeks, we have spent a great deal of time talking to investment professionals, across assets classes, in order to better understand what is happening and how current events compare to the seismic events of the past.

From our many conversations, it is apparent that there has been a great deal of panic in financial markets of late.

Indeed, by some measures the recent level of panic and fear in equity markets has only been seen twice before; during the great depression in the 1930s and the financial crisis in 2008/9.

We have also observed with great interest how the banking sector is acting today. It is obvious that this crisis is very different from the 2008/9 financial crisis, with banks in a much better position today, and it was very encouraging to hear that banks seem open for business and prepared to lend. There is an expectation of, and a desire from, banks to be part of the solution rather than the problem as the world confronts this challenge.

This is a critical difference between now and the financial crisis. It appears that the extraordinary moves by central banks, around the world, have essentially removed the risk of a systemic crisis.

Another major development since our last note has been the emergence of detail on fiscal supports for the economy. I want to be succinct here, so I shall spare you the detail, but safe to say the magnitude of the fiscal response has been truly enormous, with the US stimulus amounting to c.10% of GDP.

Whilst European leaders are yet to work out the full details of further measures to support the Eurozone economy, I think we can now say that central banks and governments have acted very quickly with a remarkable package of supports.

Will it be enough? We don’t know but these measures will go a considerable way to helping people and businesses get through this period and, if necessary, the political will seems there to do more.

Indeed the phrase “whatever it takes” that was so effective in calming fears over the Eurozone debt crisis in 2012 has become a mantra to be chanted by finance ministers and central bankers the world over.

This is not to say that every business will survive, unfortunately it is probable that many won’t. However, the eventual economic recovery will happen quicker thanks to these measures.

Returning to the panic we have seen in markets, it was also striking to observe that over the past couple of weeks the gap between the cash flow yield on equities and the yield on government bonds reached the highest levels we have seen over the past 65 years.

This is pretty remarkable, with the free cash flow yield from the US equity market, on a trailing basis, almost 5% higher than the yield on the 10 Year US Treasury Bond. Now earnings and cash flow will clearly be under pressure this year but we should expect a recovery in cash flows over time.

Furthermore, over the longer term, cash flows from equities will grow, while the income from bonds will not, so this relative valuation shows you just how fearful investors have become.

What is even more striking is that the indicators of fear and panic we are discussing took many months to peak during the 2008/9 financial crisis, whereas this time around they have reached historically high levels in a matter of weeks.

So what does this all mean for financial markets and your investments?

Unfortunately we can’t know whether markets have bottomed or whether we will see a further decline.

However, we do know that we have witnessed levels of fear and panic that we have only seen twice before.

We also know that potential returns from equities relative to bonds have reached historically high levels.

Furthermore, we know that governments and central banks have enacted historically large monetary and fiscal supports, in order to help people and the economy get through this period.

Whilst there are differences in approach, it’s very clear that the world has turned the full might of its resources to tackling this crisis.

We believe these facts give us grounded reasons for optimism.

Of course, at is origin this is a health crisis, rather than economic or financial crisis, so until we have solved the health crisis the outlook remains challenging.

The world economy is in the midst of an unprecedented ‘shut down’ and economic data is going to be historically bad in the coming weeks and months.

However, this is now well understood and the question is no longer how bad it will be in the short term but how quickly we can recover?

At this stage we can’t know the answer to this.

It is plausible that the economy will bounce back very strongly, relatively quickly. However, it is also plausible that it will take longer, depending on how long it takes to solve the health crisis.

This is why holding high quality assets in a portfolio is so important.

Some of the world’s strongest businesses may, in fact, emerge stronger from this period, while some of the trends we have discussed over the past few years, such as innovations in healthcare, energy efficiency and ecommerce will likely accelerate.

There is no doubt in our minds that provided we own high quality, diversified portfolios we can look forward to a recovery over the medium term.

Furthermore, with truly historic levels of panic and relative valuation reached in recent weeks, we believe we can, at the very least, ask positive questions about the outlook for equity assets.

The natural conclusion from this note is that long term investors should remain invested in high quality assets and, where they have the capacity, potentially seek to invest further funds in the expectation of an eventual recovery.

As always, please do not hesitate to contact us to discuss our investment outlook in more detail.

Ian Quigley
T: +353 1 2600080
E: ian.quigley@brewin.ie

www.brewin.ie

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