Six months home
The last six months have seen amazing returns from financial markets. They have also seen us forego travel, eating out and attending social occasions. Efforts to beat or control the virus will continue for some time and this will weigh on the investment outlook. What is clear is that, just like with the climate crisis, the pandemic has created a further need to work towards a more sustainable future. That touches all aspects of life – work, leisure, what we eat, how we provide education and how we invest. Structural trends will largely determine where investment returns come from but within that the companies that have the best environmental and social profiles will be the most successful.
I would go out tonight....
This week marked the six month’s anniversary of the equity market bottom and the beginning of our changed way of lives. Lockdown began in earnest in the third week of March and, sadly, governments in Europe are once again tentatively re-introducing more restrictions on social activity and mobility. The headline number of reported new infections is rising again across Europe and even in the US, which was seeing reduced infection rates. Of course, things are different now than they were in March. There is more testing and more testing detects more cases. So far, hospitalisation rates have been modest, but it would be dangerous to be complacent about that, given the lags involved and the potential for the current surge to impact on vulnerable people. Healthcare is better prepared, there is more capacity and a broader range of treatments. However, as many people have repeatedly said during the last six months, a second wave is one of the key threats to the economic recovery. There are also doubts about ability of governments to keep on spending to counter the potential downside risks.
Increasingly, how we deal with Covid-19 is becoming part of the broader discussion around sustainability. The disease has highlighted weaknesses in society and the economy. For investors, there are numerous themes. There has been higher volatility and divergent trends within markets that have provided opportunities for more active investment management. Of course, there have been winners and losers and a degree of conviction has been required over these last few months. In my blog on 20 March I argued that high yield, which had sold off very aggressively in the preceding few weeks, would deliver strong returns going forward despite the likely increase in defaults. Since 20 March, total returns from the US high yield index has been just short of 22%. In a sense, this is a response to the swift action taken by central banks and governments to sustain the orderly working of markets and levels of economic activity.
Let's get social
There are more sustainability issues at play here. Companies have had to adapt to the pandemic by changing how they manage their workforces and supply chains. Investors are likely to reward those companies that are meeting the challenge of making their businesses more sustainable. Covid-19 has strengthened focus on all aspects of ESG investing. The social pillar recognises the importance of adapting companies to new ways of working, to taking care of the well-being of their people and to how they interact with their customers and broader society in a world of heightened uncertainty and anxiety. This will be under the spotlight as more and more investors look at their assets through the social prism. Measuring employee satisfaction, the ability of how companies can communicate on the robustness of their business with more people working remotely, and how companies have interacted with government over things like furlough schemes will be taken more and more into account.
I and my colleagues and many others have highlighted the positive impact that lock-down had on carbon emissions as air and road travel was severely curtailed during the crisis. Again, investors will look to companies to see how they respond going forward by structurally reducing business travel and optimising their supply chains. It is quite astounding how rapidly the carbon transition is impacting business strategy through the need to disclose more data on carbon emissions, to sign up to targets that align with the Paris Agreement and to use carbon pricing as a tool to properly reflect the economics of their business. Being able to demonstrate how Covid-19 has accelerated the carbon transition will be critical in the discussions between company managers and investors. It is difficult at this stage to see many parts of the service sector going back to 100% occupancy of office space and having business travel as a key expense.
In the current context, there are some businesses that potentially face the same risk. The newly imposed restrictions in the UK and elsewhere highlight once again the vulnerabilities of the travel, leisure and hospitality sectors, as well as the challenges for physical retail and commercial property. We are seeing job losses across those sectors and a need for either government support or radical balance sheet adjustments to stay in business. Some will not make it. Whether they are large businesses (I am sure we will see an airline go under at some point) or small businesses, there will be job and capital losses which will impact on shareholders, bond holders or credit institutions. These trends have not played out yet and there will be ongoing challenges for the energy sector (carbon transition), for parts of real estate and for travel, hotels and restaurants.
The biggest technical risk – from a mean-reversion point of view – is with global equities right now. To bring rolling 12-month returns back in line with the long-term average suggests something as much as another 10% correction. That is not a forecast, just a risk. But then overlay that with political uncertainty and potential disappointment that the Fed will fail to provide further information on how it proposes to evolve its policy took-kit in order to achieve its “average inflation target” and it could make for an interesting fall. Credit returns have eased back a little in the last month (US corporate bond returns were -1.2% in August), so they are somewhat less exposed to a performance set-back. A little portfolio re-balancing from stocks towards credit might not be a bad idea right now.
It is clearer in the context of energy how we adapt to a more sustainable future. The shift towards a lower carbon economy is well underway. It will get more challenging but investment flows and new technology, together with strong leadership from governments, will help that. For parts of economic activity that have been derailed by Covid-19 it is not so easy. Yes, we will always want to travel, we will want to eat in restaurants, shop in city centres, go to sporting events and enjoy the arts, and holiday. How do we restore those activities in the future? Some providers today won’t survive, there will be capital and goodwill lost. Yet there will be chefs who want to restart a restaurant business. There will be families that want to have their annual holiday in the sun. There will be sports fans that want to see their teams play in real life and not just on TV. A big challenge is to get the finance and capital in place to allow those phoenix businesses to emerge. Government support will be hugely important in this respect and the next phase of global policy stimulus should not only focus on green topics but also on supporting what are economically and socially important activities.
What if we have to live with the threat of viral pandemics going forward? If we do, the health aspect is vital to the ability of those activities to re-emerge and remain sustainable going forward. The development and deployment of vaccines and remedies to this and other illnesses is critical. Just as research and development is important in the energy transition, it is crucial in the healthcare and pharmaceuticals industries. To me, this remains an interesting and potentially rewarding sector to invest in. The earnings profile of healthcare is less volatile than in other more cyclical sectors and the growth potential is very strong, not least because pricing power is likely to remain strong even in the face of political efforts to reduce drugs prices. At the moment, consumers are still concerned about health risks so are not travelling, are not able to engage in socially engaged activities and are directing their spend online. A sustainable model for many industries going forward will be achieving the optimal balance between physical and digital engagement, customer care and the ability to meet what could be more demanding standards.
Tell the story
I don’t think there is one single shape to describe the economic recovery. Some activities recovered quickly; some will never recover. In the same way I think the outlook for equity markets is complex and dependant on the broader economic, policy, sectoral and individual company developments. Over time, businesses that have sustainable environmental and social profiles or enable that sustainability through their own products and services will be the ones that survive and prosper. The climate crisis and Covid-19 are accelerating the recognition of that and the ability of investors to respond by developing more responsible investment techniques. Data and transparency are crucial but not sufficient. Dialogue with companies in order to understand their business models and how they are adapting to changing market conditions is just as important. And for asset managers, being able to tell the story of their focus on sustainability along with the optimisation of asset allocation based on increasingly more informative data will help direct capital to promote better returns and a better future.
We must hope that the next six months sees further progress in dealing with Covid-19. Market performance since March has been nothing short of startling with some equity markets up as much as 60% from the lows. However, as we enter the northern hemisphere Autumn, returns are cooling off and investors are paying more attention to the material risks out there – set-backs to the recovery, uncertainty around the US election, Brexit and risks in geo-political relations. Against those risks the policy environment will remain supportive for markets. That should mean that if there any market set-backs, there should be investors willing to rebuild exposure to growth assets. While some things are changed for good, there is a human desire to rebuild and re-start and to invest for a more sustainable future. With interest rates on hold for a long-time, governments able to use low borrowing costs to finance recovery programmes and the ongoing recovery of growth and trade, 2021 could be a much nicer year.