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Equities | Core: Summary

Investment outlooks / Q2 2020
  • The economic rebound we were seeing at the beginning of this year has been dramatically reversed as Covid-19 continues to create extraordinary price moves in global markets
  • Rallies will be temporary and further downside moves will follow in the coming weeks and months
  • As a result, we look to re-establish our exposure opportunistically and at lower levels for our core equity component

We often find ourselves focusing on the ‘known unknowns’ (future earnings, growth, changing consumption patterns). It is however, the ‘unknown unknowns ‘that always catch the market by surprise. Often these are dismissed as ‘white noise’ but this was not the case this time round due to the global impact of Covid-19. With people staying at home combined with the substantial increase in unemployment, there has been on both the global supply chain as well as demand

In order to take a step back and look at things in chronological order, the S&P 500 and MSCI World indices managed to reach their all-time highs in the middle of February with prints of 3393.52 and 2434.95 respectively. Around a month later on 23 March, both had declined in the region of 34 per cent. The size of these drawdowns illustrates some of the problems with a buy and hold approach and this has been felt across the industry in recent weeks. In a zero-interest rate world, it becomes even more difficult to cover the equity market declines given the low contribution to portfolio return that comes from fixed income holdings.

Being absolute return focused allows our model allocations to not be pegged to any kind of benchmark and as a result, we have had the flexibility to navigate through these markets effectively.

As at end 2019, we had zero equity exposure for the core and around 5 per cent exposure for the satellite parts of our discretionary portfolios. The main reason for such conservative positioning was stretched valuations which we discussed in previous outlooks. Within our Macro, Valuation Sentiment and Technical (MVST) approach, the valuation factor along with the macro factor are two of the most important structures for the core part of our equity investments. The sentiment and technical factors only provide guidance for short-term investment decisions around timing.

The last quarter is a good illustration why systematic algorithm and mathematical based models are not always easy to have risk management oversight. This is particularly good for navigating through the crisis – especially when the world around us is filled with unknowns. We question the  theoretical odds of the S&P 500 registering the deepest decline since October 1987 and that too three days after having experienced the previous deepest decline since that same date. But when markets are losing ground due to extreme uncertainty, we see liquidity drying up quite quickly.

These are the two main reasons for the sharp decline in March.

The first is the uncertainty caused by the implemented measures related to Covid-19 undertaken by governments to reduce infection rates as much as possible. Measures which are designed to save lives will at the same time cause a deep global recession. The market at that point, was discounting the potential expected impact on corporate earnings caused by the inevitable global downturn. Not surprisingly, due to the reasonable chances of corporate bankruptcies in most affected industries like airlines, tourism and industrials, some companies saw their stock prices decline by 80-90 per cent within a month. One example, Cineworld Group, the UK’s largest cinema operator, lost more than 80 per cent within a month and Royal Caribbean, one of the world’s leading cruise operators, declined by 75 per cent. One of the issues from an investor’s perspective has been the lack of clarity regarding the duration of the shutdown, the severity of the impact on corporate earnings and how quickly consumption could return to normalised levels once the shutdown finishes.

The second reason is liquidity issues. There were articles in the press and speculation that some large financial institutions were experiencing extraordinary liquidity pressure. As a result, the US dollar was exceptionally strong with GBP, EUR and many other currencies declining to significant lows. The US Dollar index gained 2.8 per cent for the quarter. Despite the Fed cutting the key interest rate by 1.50 per cent, USD liquidity remained constrained and even restarting QE did not successfully hit pain points immediately.

The MSCI World index lost 20.9 per cent for the quarter. In the US, the S&P 500 lost 19.6 per cent as at end 31 March 2020 and finished the quarter at 2584.6. It managed to outperform the other indices due to its high exposure to recession resilient sectors as information technology, healthcare, consumer staples and communication services, all of which represent 62.95 per cent of the index.

Click table to expand.

Other equity markets with a lower share of recession resilient sectors also underperformed. These were namely the Euro Stoxx 50 and FTSE 100 indices which lost 25.3 per cent and 24 per cent respectively. In Japan, the Nikkei 225 lost 19.3 per cent for the quarter. Looking specifically at emerging markets, the aggregate loss of 23.6 per cent resulted in the MSCI Emerging Markets index underperforming MSCI World due to their high exposure to global growth and commodity prices. The remarkable exception however, was the Chinese market, which managed to cover its earlier losses with the MSCI China index losing a moderate 10.2 per cent.

Looking in detail with regards to specific sector performance, US technology, US and European healthcare, consumer staples and utilities stocks outperformed the broader market while still declining between 6.6 and 13.5 per cent over the quarter. On the opposite side of the performance spectrum, US and European energy, financials and industrial stocks lost between 27 and 50.7 per cent.

We maintain our conservative approach. Our prime focus is the implementation of recession resilient plays from our thematic investment ideas that also hold resilience to the virus.

In our discretionary portfolios, we maintain our conservative approach. Our prime focus is the implementation of recession resilient plays from our thematic investment ideas that also hold resilience to the virus. In the middle of March, in anticipation of a market rebound, we increased our equity exposure by an overall 8.5% via a basket of recession resilient blue-chip companies. The equity market rebound has been driven primarily by technical and sentiment factors and as a result we only deployed a relatively small amount of capital.

Looking forward, the main question now is whether the markets will continue on this path to recover or whether this is a temporary rally prior to a larger downside move. We believe that it is the latter and therefore, we hold zero per cent equity exposure for the core part in our global discretionary portfolios. We used this market rally to further de-risk our investor visa portfolios by selling stocks that have exposure to the financial sector. This sector is especially vulnerable as companies are already setting aside provisions for impairments and in turn, leading to a further deterioration of credit portfolios.

Looking briefly at the macro picture, going forward we expect a deep but short-lived global recession as a base case scenario. For our core equity component, we are focusing primarily on US stocks as being the most resilient to a recession. An order of magnitude for the economic decline is yet to be determined. The market expectation, according to Bloomberg, is an annualised decline of 34 per cent in US GDP for Q2 and an increase in the unemployment rate by 14.7 per cent in Q3. The expectations for the macro data have been highly dispersed and this illustrates not only an order of magnitude for the global recession ahead of us, but also how inaccurate the market is in estimating its impact. As a result, we think that it is not prudent to call the bottom ahead of economic data releases for March and Q1 corporate earnings.

At the 2800 level, we think that S&P 500 is expensive if we factor in “fresh” earnings estimates. After the rally, US stocks remain with a 19 forward price-to-earnings ratio, similar to the level it had on February 2019 at the all-time high.

Click chart to expand.

Sentiment and technical factors are also signalling the increased probability for stocks to decline. Market participants are turning bullish as put to call ratios for US and European stocks are staying around 1 standard deviation below the average numbers. Technically speaking, the S&P 500 completed its rebound as the 2800 level corresponds to the point where it covers half of its decline from 3393.52 to 2191.86.

Click chart to expand.

Click chart to expand.

The optimism and the market rebound were driven by two reasons. Firstly, there were signs of the epidemic stabilising in Europe with a key focus on Italy and Spain. In Italy, the number of new daily cases of Covid-19 has not risen since 21 March. The same is true for Spain since the 26 March. Secondly, governments around the world have kept feeding the markets with new and increasingly more ambitious policy responses on both the monetary and fiscal side. The upcoming earnings season is incredibly important and while we expect limited useful forward-looking guidance, we believe that we will at least get a glimpse into how badly some companies have been impacted. This will allow us to carefully assess the impact of quarantine measures on corporate earnings and help to make decisions regarding further investments for both core and satellites parts of our portfolios.

To conclude, we prefer the US market more and primarily consider US stocks to form a core part of our discretionary portfolios. After the rally, US stocks managed to recover half of their losses and now their valuations are staying near the point where they had been at all-time highs. The macro side remains extremely uncertain with Q1 corporate earnings to be revealed in the second part of April. This will hopefully give us further clarity as to how the macro downturn is filtering into earnings numbers. A low put to call ratio shows that investors are bullish which we treat as a contrarian indicator. The combination of these four elements skew equity risk to the downside.

Consequently, we continue to keep focusing on our long-term thematic investment ideas for the satellite part of our portfolios and look to re-establish longs by buying dips opportunistically in tranches for the core equity component.


Past performance is not a reliable indicator of future returns. Forecasts are not a reliable indicator of future returns. If the information is not listed in your base currency, then the result may increase or decrease due to currency fluctuations.

If not otherwise indicated, all graphs are sourced from Dolfin research, April 2020.

For more information please read our disclaimer.

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