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Letter to investors

Investment outlooks / Q3 2020

Control is key

  • The short term does not look bright – yet the equity market has kept rallying, leaving future potential equity upside limited
  • The options for investors wanting to participate in the new bond issuance market at the government level are also limited
  • We choose what business models, what geographic markets and what consumer base we have exposure to – that control, together with active management, will be key

There was a sting in the tail at the end of Q1 with the start of economic lockdown across the developed world. We entered the second quarter expecting equity markets to decline further with lockdown expected to persist across much of the developed world as we entered into Q1 earnings season. We witnessed some of the worst economic data ever recorded in a number of countries around the world. Despite many companies refraining from providing any forward-looking guidance and the macro situation continuing to deteriorate, global equity markets marched higher on huge inflows of liquidity and stimulus plans that dwarfed anything that was announced in 2008 – although the economic impact of Covid-19 due to the consumer lockdown was much more significant.

Click chart to expand. Source : FactSet, Refinitiv Datastream, Dolfin; July 2020

With interest rates being taken down to essentially 0 per cent or below across the developed world this is going to have a longer-term impact on expected returns. The desire by governments and central banks to avoid recessions is leading to larger and larger injections of liquidity into the financial system which appears to be creating bubbles across multiple asset classes.

The growing disconnects between the underlying fundamental economic picture, company revenue and earnings combined with current stock market levels is alarming. The ‘bad news discounting’ is at extreme levels and the phrase ‘priced to perfection’ is particularly apt as we are already seeing second waves of Covid-19, companies announcing job cuts or going into administration, and lockdowns/quarantine being reintroduced in a number of cities and areas around the world. The future, in the short term, does not look particularly bright – yet the equity market has kept rallying and pushed valuations to extreme levels – meaning that future potential equity upside from here is likely limited.

Click chart to expand. Source: Dolfin, Bloomberg, July 2020

Liquidity has been a driver of a rapid market rally that we have seen – to the extent that markets have pushed higher than can fundamentally be justified. James Gutman in the macro section delves much deeper into some of the relationships between the price/earnings ratio and the historic relationships between price and industrial production that appears to have broken in 2008 – which coincidentally is when we had the start of quantitative easing introduced – and the markets have got hooked on lower interest rates, negative real yields and cheap money.

Click chart to expand. Source: Dolfin, Bloomberg, July 2020

One of the issues with pumping trillions of dollars of liquidity into the markets is that it has to go somewhere. Adrian Van den Bok has been looking in more detail in the fixed income section at the share of government bond issuance that is purchased by central banks – and consequently what is left for investors. Other than the US – which is providing plenty of issuance for foreign investors to purchase (which generates the next questions of who is going to purchase all of the debt that they are issuing to fund their stimulus plans) – there is little new government debt being supplied into the market. Keeping in mind that a lot of the German and French debt is negative yielding – the options for investors wanting to participate in the new issuance market at the government level are limited.

Click table to expand. Source: Dolfin, Bloomberg, Goldman Sachs July 2020

Looking ahead rather than in the rear-view mirror – the path looks bumpy from current levels. Markets look to have run out of steam, at least in the short term, with limited fresh stimulus measures introduced. This has led to the S&P500 trading in a wide range over the last month and something that we expect to continue as we move through the second half of 2020.

Q2 earnings season – now upon us – is expected to provide us with insight as to what companies are expecting to happen. The dispersion of estimates is significantly wider than normal given the relatively few companies that tried to provide guidance during Q1 earnings. Within our discretionary model portfolios, we continue with a few key beliefs:

  • The macroeconomic environment has bottomed but growth will be sluggish moving forward with consumers tentatively returning to some version of ‘normality’.
  • Control is key in both stock and bond selection. We want to choose what business models, what geographic markets and what consumer base we have exposure to. Some of our core views – the rise of video games and the power of the EM consumer have strongly contributed to our portfolios in 2020.
  • Active management is required in a rangebound market. Buying and holding broad based ETFs is unlikely to generate the returns that clients expect – especially with the incredibly low interest rates and consequently yield that is available for investors.

Whilst bubbles can continue to get bigger – eventually they all pop. The additional consideration for this bubble is that it is fairly all encompassing and by not participating in the bubble you are running the risk of missing out on the potential of substantial upside in the short term. By participating in the ‘bubble rally’ there is the risk of the bubble popping and experiencing a significant market drawdown and volatility.

What we have seen in 2020 to date has been historically significant – from a market movement, societal restraints, economic impact and stimulus measures announced. It seems that nothing is off the table now by governments as they continue to try to generate new measures to stimulate growth, stop businesses going into administration and encourage consumers to start spending again.

After three and a half months spent almost entirely working from home, the investment team here at Dolfin has adapted well. In the last quarter we produced a number of videos looking at investment opportunities, market movements, strategies and themes which are all on our website. This is our second Quarterly Investment Outlook written entirely  ‘from home’ and we have now hosted a number of monthly update webinars to ensure all of our clients, counterparts and intermediaries stay up to date with what we are doing.

I cannot see this environment changing substantially until there is a vaccine available – so even at this early stage I anticipate that our next QIO will also be written from home.

We remain here to discuss our latest ideas, deployment strategies and updated performance numbers with you. Please contact your relationship manager if you would like to arrange a call or video meeting. In the meantime, I hope that everyone continues to stay healthy and safe and we look forward to catching up over the coming quarter.


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, July 2020.

For more information please read our disclaimer.

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