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No one (except maybe Bill Gates) could have predicted that a virus would cause the next big financial depression of the century. And indeed it was a surprise. The overall mood of investors entering 2020 was of another ‘boring’ year following the decade-long bull market. Yes, maybe they were prepared for less growth and some very overvalued companies to deal with, but nothing special. Clearly, the first quarter of the year was an interesting one. But as the title of this magazine suggests, now is the time to focus on the bright side, while being prepared for the worst. Here, we give a 360-degree view of how asset classes are faring to see where the sweet spots lie for investors and examine the role safe havens such as gold have played during the crisis so far. Finally, we ask advisors which sectors will likely survive and even thrive and whether some of them will need a total rethink. Hope you enjoy the read, and stay safe!
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STEPHANIE HOPPE At the start of the year, most investors expected the 11-year bull market to continue, but in the wake of Covid-19, global markets have shown record daily volatility. The spread of the coronavirus dealt a severe and unexpected shock to markets, leading to the greatest oil price decline in the Opec era, unprecedented central bank intervention and the biggest economic contraction since the great depression. The Dow Jones index fell from record highs to bear-market territory in a matter of weeks, while the VIX index spiked to levels last seen in the global financial crisis (GFC). Its sharp rise began in early March and was still at this threshold in mid-April – almost six weeks later. Price movements across different asset classes, with the exception of US Treasurys have been highly correlated, because the markets are dealing with uncertainty. Volatility has become the ‘new normal’ and is unlikely to abate until the magnitude and length of the new virus are better understood. At the time of writing, there were too many unknown factors for investors to predict precise economic impacts. But equity markets were strengthening, with major indices reaching their highest close in weeks (with the exception of UK’s FTSE 100), driven by consumer stocks and plans of resuming economic activity in countries with decelerating outbreaks. So, should investors wait on the side lines or is the next bull market already on its way?
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GAUGING FEAR The VIX, often referred to as the market’s ‘fear gauge,’ breached 50, indicating high volatility on March 9. Historical daily data to 1990 shows there were only three periods when the VIX passed this level, all of which were linked to the GFC in 2008 and 2009. But 12-month returns on the S&P 500 following these periods were strong, despite being muted in the short term. ‘This was particularly true for those who invested just as the VIX dipped back below 50. The average 12-month return of 32.4% was well above the S&P 500’s long run average annual return of 9% seen between the second quarter of 1990 and the first quarter of 2020,’ GSAM’s latest volatility report. Although the report looks at a limited data set, it seems to illustrate that, with a long-term investment horizon and a high-risk tolerance, now may be a good time to invest in equities.
‘We are all on “Covid time” now, as we’ve never seen as swift a change in society, culture and, of course, economy as that caused by the coronavirus,’ said Stephen Dover, head of equities at Franklin Templeton. ‘In a world where bond yields are at or below zero and there is massive fiscal spending, equities should outperform dramatically in relative terms. The recent indiscriminate equity selloff has left pockets of relative value for investors.’ Asian equities, particularly Chinese equities, have rebounded strongly and outperformed many other markets this year. The recent rise in the US dollar has also made foreign stocks relatively less expensive. ‘Global technology companies and Chinese internet companies should see their competitive market strengthen further as the entire world learns to both work and live remotely,’ Dover said. ON THE RUN Bond markets, meanwhile, remain down for the most part. Some of the ‘on-the-run’ government bonds have proved more stable, but the majority of government bond issues have underperformed. Short-dated government securities have benefited from a decline in cash rates, but with government yield curves steepening, the remainder are down in price. Liquidity across global bond markets remains poor, marked by wide bid-offer spreads, the difference between the price at which an asset is bought and the price at which it can be sold.
‘In the current environment, we would anticipate that yen currency exposure might start to offer some support to bond investors, along with selective short positions in emerging-market currencies,’ said Paul Brain, lead portfolio manager of the Global Dynamic Bond fund at Newton Investment Management. ‘We also believe it is wise to be increasing government-bond duration (sensitivity to changes in interest rates) and buying longer-dated US Treasurys, with an eye to reducing that duration as the full extent of the crisis feeds into markets.’
The US Federal Reserve stepped in and acted swiftly to implement a set of targeted credit programmes to lower credit spreads to levels that are hoped not to constrict economic growth. Essentially, the Fed provided a backstop for borrowers by increasing confidence in issuers’ creditworthiness. It also restarted quantitative easing (QE) measures, under which it will use newly created reserves to purchase Treasury and agency mortgage-backed securities (MBS). In a previously unprecedented action, the Fed created two new facilities that will have a big impact on the corporate bond market. The Primary Market Corporate Credit Funding Facility (PMCCF) will lend money directly to investment-grade companies. The Secondary Market Corporate Credit Funding Facility (SMCCF) will purchase investment-grade debt and investment-grade debt ETFs at market rates. The aim of these facilities is to create a powerful tailwind for corporate debt markets. Money market funds understandably are at all-time highs. To cushion the free flow in their incomes and cashflows, companies are strengthening their balance sheets. Earning projections, meanwhile, are difficult to predict in this environment. It’s highly likely that projections for the next two quarters are overstated and will need to be revised downwards. From an investor’s perspective, this means basing decisions on longer-term earning outlooks, balance sheet strengths and cash flow quality.
The Covid-19 recession is expected to be more severe than the GFC but many analysts also predict a faster recovery, pointing to both the scale and speed of unprecedented central bank intervention across the globe. With the Fed’s balance sheet expansion expected to rise to $4tn to $5tn or more this cycle versus $1.3tn in the GFC, policymakers seem to have learnt from some of the mistakes that were made during GFC by responding faster and at a larger size.
‘Two factors drive that faster recovery relative to the GFC. First, both the consumer and the financial systems were less leveraged going into this recession, which should mean a faster bounce back,’ said Andrew Sheets, cross-asset analyst at Morgan Stanley. ‘Second, the fiscal and monetary policy response is much larger in size and faster in deployment than in the GFC.’ Others are more cautious and warn that the modern monetary theory-style policies employed by governments and central banks aren’t concerned about the size of fiscal deficits. ‘The risk is that once these temporary policies are introduced, they may become permanent,’ Dover said. ‘When the economy starts to recover, there likely will be increases in taxes, including on capital gains. Investors should take into consideration the current low tax rates and likely future higher tax rates into their portfolio decisions.’ Fast forward to the potential shape of a recovery, we wade into an alphabet soup of predictions ranging between U, V and L, or inflationary versus deflationary pressures. A V-shaped recovery would be the best-case scenario, as it starts with a steep fall and troughs and recovers relatively quickly. But V-shaped scenarios have been more common in growth and corporate profits than in financial markets over the past 50 years. ‘If recoveries are equal to recessions in duration and magnitude, then the output lost in the downturn will be fully recouped during the rebound and asset markets might retrace as quickly as they slumped,’ said John Normand, head of cross-asset fundamental strategy at JP Morgan. ‘Hence, the always hoped-for and almost always delivered V-shaped profile. If the recession inflicts longer-term damage to balance sheets or labour markets, then the recovery of lost income will be slower and so might be the rebound in corporate profits and asset prices. That’s the dreaded U.’
Many fund managers and analysts believe the full magnitude of the demand shock by the coronavirus still remains underappreciated by markets and are therefore likely to reverberate for the remainder of the year. Much will depend on how quickly the US and the world go back to work and whether there will be a second spike of outbreaks if this move is engineered too quickly. Moving past the US presidential election cycle should shore up US capital investment in the shorter term. ‘We expect extremely easy monetary and fiscal policy to collide with significantly deferred consumption,’ Sheets said. ‘Our biggest fear is that 2021 repeats the mistakes of 2010 regarding fiscal tightening.’ As the medium- and longer-term effects of Covid-19 remain uncertain, adopting strategies that benefit from high volatility will help to enhance returns and serve investors best.
Bradford A. Evans Senior Vice President and Portfolio Manager, Heartland Value Plus Fund
Case for divestment There is a growing voice among asset managers that argues by avoiding unethical companies, we leave ownership and therefore governance to investors uninhibited by ethical considerations, thereby strongly promoting continued investment. Yet in modelling, building and managing portfolios, fund managers make choices every day on stocks they hold and divest from on financial grounds. It seems strange then that divestment on ESG grounds has become so contentious. Our imperative is to deliver long-term out performance by investing in superior companies that have a compelling investment and ESG case. Whilst sustainability is important – and we look for thematic plays that support our key strengths in education, health & wellbeing, social infrastructure and sustainable solutions - we always seek to ensure that these are also strong candidates in terms of business ethics, corporate governance, human rights and environmental management. Choosing not to allocate capital to companies exhibiting poor overall environmental, human rights and business ethics credentials is a perfectly valid risk-adjusted approach to ESG analysis and oversight. In what circumstances then would divestment support an ESG investment strategy? We apply the sanction to companies consistently failing to make progress in improving their performance in key areas such as climate change, or which have particularly poor records in fines, prosecutions, higher than average health & safety accident rates or pollution incidents. These factors reduce a company’s ability to achieve superior long-term performance, thus potentially justifying divestment. For example, we recently divested from Deutsche Bank, which has been implicated in multiple financial scandals. Due to poor internal controls, the company saw ballooning contingent liabilities and has been weighed down by prosecutions. However, our concerns centred around operational integrity, and where culture became severely challenged by the ongoing failure to restore trust. Finally, a severe misconduct crisis, which included LIBOR rigging, mis-selling and money laundering – with serious implications for the long-term prospects of the company – prompted our decision to divest. We also withdrew our investments in British multinational security services company G4S. The company was facing multiple ethical challenges over care and protection, including assault, use of non-approved restraint and more serious torture allegations in South Africa. Operating in a high-risk environment, there was mounting evidence G4S was failing to provide adequate care and custody. Our decision to divest was ultimately prompted by allegations of abuse at the Medway young offender unit.
A multi-layered approach We certainly endorse engagement, but there is the perceived danger among industry observers that the responsible investment industry has turned engagement – and the pursuit of it for its own sake – into an excuse not to take more decisive action when needed. The fossil fuel divestment campaign which emerged in 2010 has also had a growing influence, backed by studies suggesting client portfolios may incur significant ‘stranded asset risk’, given the world needs to transition to a low-carbon economy, by keeping unexploited fossil fuel assets in the ground. This has built a powerful case on moral and financial grounds for avoiding or indeed divesting from fossil fuels in order to align portfolios more closely to the Paris Agreement target – keeping the increase in global temperatures to below 2OC and limiting the increase to 1.5OC. EdenTree’s Amity Funds have taken an increasingly focused approach to being ‘carbon aware’ by avoiding thermal coal, oil & gas exploration and production and some high emitting industries and companies that are unlikely to transition. At EdenTree we invest for the long-term. We do not take the decision to divest lightly and always look constructively to engage with a company first, often over long periods of time. However, these efforts are not always rewarded and from that we may sometimes conclude that divestment is warranted. Since 2012, we have proactively divested from 10 stocks and fixed interest instruments specifically on ethical or ESG grounds. These range from systemic business ethics failures (corruption, money laundering etc.) to product quality and safety issues, incompatibility with our climate change stance, to pressing human rights and safeguarding concerns. We believe the balance between good stock selection and constructive engagement, but with the ultimate sanction of divestment, provides a robust process of risk assessment for clients. It also provides the reassurance that we have clearly established values with divestment red lines. Timely divestment can also protect client capital from growing legal and regulatory headwinds. Many of the stocks we divested from on ethical and ESG grounds still face systemic challenges including fraud related litigation and product safety. Some financial institutions are still recovering from headwinds sustained during the financial crisis a decade ago. Understanding these sometimes long-term impacts via our robust ESG due diligence process and acting on them, has, we believe, protected clients from reputational impacts and capital loss. For example, Samsung Electronics has been mired in controversy regarding corruption and poor employee engagement for some time, and we had strong concerns over cobalt sourcing and the integrity of human rights within the supply chain. Governance remained a real problem, coupled with a culture of impunity given rising safety challenges. After engaging with Samsung following the arrest and conviction of senior management for corruption, the company’s lack of reassurance left us no choice but to divest.At a time when financial services are suffering from high levels of mistrust, investment managers are under pressure to demonstrate active principles alongside wider ESG credentials. We believe divestment, deployed wisely, sits comfortably within a balanced strategy of focused engagement and research. Withdrawing client capital or taking profit from disreputable businesses provides ultimate reassurance of the overall process, and one we know is supported by clients who seek strong values-led action from their managers.
As of 3/31/2020, Heartland Express, Inc. represented 2.82% of the Value Plus Fund’s net assets, respectively. Portfolio holdings are subject to change. Current and future holdings are subject to risk. The statements and opinions expressed in this article are those of the presenter(s). Any discussion of investments and investment strategies represents the presenter’s views as of the date created and are subject to change without notice. The opinions expressed are for general information only and are not intended to provide specific advice or recommendations for any individual. The specific securities discussed, which are intended to illustrate the advisor’s investment style, do not represent all of the securities purchased, sold, or recommended by the advisor for client accounts, and the reader should not assume that an investment in these securities was or would be profitable in the future. Certain security valuations and foraward estimates are based on Heartland Advisors’ calculations. Economic predictions are based on estimates and are subject to change. There is no guarantee that a particular investment strategy will be successful. The Heartland Funds are distributed by, and the individuals mentioned above are registered representatives of, ALPS Distributors, Inc.
Neville White, Head of Responsible Investment Policy and Research at EdenTree Investment Management
While absolute and relative returns are the yardstick used to measure active managers over the course of an investment cycle, the numbers also serve as a proof statement as to whether a team’s actions match their words. In informal conversations with gatekeepers, a frequent complaint we’ve heard relates to managers who put up performance that is disconnected from the process and philosophy the team claims to follow. And while some variability can be expected in normal conditions, time and severe market stress tends to bring structural inconsistencies to the surface. NO TIME TO FAKE IT The chaos brought on by the COVID-19 to start the year is a case in point. The speed in which the virus spread and crippled the global economy left little room for on-the-fly adjustments. Instead, portfolio managers were left to battle the storm with the names their process led them too, presumably well before the economic threat from the pandemic was understood. For clients in the Value Plus Fund, that meant names that are financially sound, that are overlooked or unloved by the Street and those that have generated meaningful free cash flow. The results speak for themselves -- the Heartland Value Plus Fund Investor Class (HRVIX) outperformed its benchmark, the Russell 2000® Value Index, by more than 1200 basis points (12%) for the first quarter. Even more telling is the fact that stock selection was the overwhelming driver of results, meaning the numbers can’t be chalked up to a handful of sector bets that just happened to work out. We are heartened by the relative performance, and view it, along with the Fund’s outperformance during the Great Financial Crisis, as validation of a process that takes a holistic approach to evaluating opportunities. Names don’t simply make the cut based on one or two investment metrics. Instead, we dig into balance sheets looking at debt/earnings before interest, taxes depreciation and amortization (EBITDA) as well as EBITDA to interest. Free cash flow and the sustainability of those cash flows are additional aspects we put under the microscope. A COMPREHENSIVE APPROACH Our due diligence includes knowing our management teams and their approach to capital allocation. We aren’t seeking a single silver bullet that may or may not save the day if the markets tank. Instead, we are looking for interconnected threads of a web that we believe serve as a safety net in times of market stress. This approach, in our view, has shown during the most recent period as well as during the Great Financial Crisis to mitigate some of the damage from sharp selloffs. However, we believe this philosophy is just as sound in identifying names that should excel in more normalized backdrops. For instance, while the immediate focus on Wall Street has been whether individual businesses can survive COVID-19, the tide will turn eventually, in our view, and companies that are well suited to thrive in the aftermath of the pandemic will then take center stage. In that context, we view Heartland Express, Inc. (HTLD), a best-in-breed truckload carrier, as a unique opportunity that has the balance sheet to endure the current slowdown and a competitive advantage to help it excel during an eventual rebound. Due to the vital role trucking plays in delivering food and supplies, the industry has been able to mitigate some of the softness caused by the recent dramatic economic slowdown. The ability to continue to generate revenue during the current crisis should allow HTLD to maintain its strong balance sheet, without tapping into its net cash position. We believe when the economic recovery comes, Heartland, which has one of the youngest fleets of rigs in the industry, will be better positioned to gain market share while weaker competitors are forced either to make do with older, less reliable trucks or take on additional debt to replace them. Despite HTLD’s position as an industry leader, enviable balance sheet and long-term growth prospects, the company’s shares trade at just 6x EBITDA. WHAT NEXT? The economic disruption caused by COVID-19 as well as the size and scope of the response by global governments is unprecedented. While stimulus packages out of Washington D.C. will provide life support for some of the weakest corporate players, we believe it won’t be enough to stave off the inevitable fate for poorly run companies with excess debt and undifferentiated business models. As such, we remain focused on businesses that are poised to be disrupters in their fields and that have strong cash flows and a history of prudent capital allocation. As stimulus funds begin to hit the domestic economy, we expect a sugar rush of spending that should boost gross domestic product for a quarter or two. However, the heightened regulatory oversight that will be attached to money earmarked for the commercial economy is likely to have a lasting impact on businesses forced to accept Federal dollars. As such, we believe investors who show a willingness to overlook idiosyncratic challenges do so at their own peril.
Andrew J. Fleming Vice President and Portfolio Manager, Heartland Value Plus Fund
Source: FactSet Research Systems Inc., Russell®, and Heartland Advisors, Inc. The inception date for the Value Plus Fund is 10/26/1993 for the investor class and 5/1/2008 for the institutional class. Data sourced from FactSet: Copyright 2020 FactSet Research Systems Inc., FactSet Fundamentals. All rights reserved. Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell Indices. Russell® is a trademark of the Russell Investment Group Past performance does not guarantee future results. Performance represents past performance; current returns may be lower or higher. Performance for the institutional class shares prior to their initial offering is based on the performance of the investor class shares. The investment return and principal value will fluctuate so that an investor’s shares, when redeemed may be worth more or less than the original cost. All returns reflect reinvested dividends and capital gains distributions, but do not reflect the deduction of taxes that an investor would pay on distributions or redemptions. Subject to certain exceptions, shares of a Fund redeemed or exchanged within 10 days of purchase are subject to a 2% redemption fee. Performance does not reflect this fee, which if deducted would reduce an individual’s return. To obtain performance through the most recent month end, call 800-432-7856, or visit heartlandadvisors.com. In the prospectus dated 5/1/2019, the Gross Fund Operating Expenses for the investor and institutional class of the Value Plus Fund are 1.18% and 0.95%, respectively. The Advisor has voluntarily agreed to waive fees and/or reimburse expenses with respect to the institutional class, to the extent necessary to maintain the institutional class’ “Net Annual Operating Expenses” at a ratio not to exceed 0.99% of average daily net assets. This voluntary waiver/reimbursement may be discontinued at any time. Without such waivers and/or reimbursements, total returns may have been lower. An investor should consider the Fund’s investment objectives, risks, and charges and expenses carefully before investing or sending money. This and other important information can be found in the Fund’s prospectus. To obtain a prospectus, please call 800-432-7856 or visit heartlandadvisors.com. Please read the prospectus carefully before investing. The Value Plus Fund invests in small companies that are generally less liquid and more volatile than large companies. The Fund also invests in a smaller number of stocks (generally 40 to 70) than the average mutual fund. The performance of these holdings generally will increase the volatility of the Fund’s returns. Value investments are subject to the risk that their intrinsic value may not be recognized by the broad market.
GARETH PLATT It’s a maxim as old as the markets themselves: when things get choppy, head towards the golden light slicing through the fog. Gold has, since time immemorial, provided a haven for investors spooked by collapses in riskier markets. It can’t go bust, post financial losses or make bizarre executive decisions – it is, after all, just a lump of metal – and this steadfast reliability has offered investors a haven in even the roughest of storms. When the rest of the market is sinking, gold tends to survive. Even in the early 1930s, the jagged teeth of the Great Depression, the price of gold rose by $15 an ounce. But will gold weather the storm this time, with the howling headwinds of a pandemic hammering into its hull? So far, the signs are promising. After all, its price has just burst through $1,750 an ounce, a seven-and-a-half-year high. With the coronavirus driving the S&P 500 to a three-year low, it’s easy to reach the conclusion that gold will, once again, provide sanctuary. But beneath the surface lustre, the figures aren’t so reassuring. In March, gold experienced its largest weekly fall since 1983. Although the subsequent recovery has been spectacular, the sense of volatility remains. Vast gaps have opened up between the Comex and LME prices, caused by disruption to gold supply chains. The Cboe Gold ETF Volatility index, which measures the market’s expectation of turbulence, is currently showing double its pre-Covid-19 value.
Gold bugs brush off the recent losses, saying they’re simply a ripple effect from tremors elsewhere. Investors, rushed by margin calls, needed a quick supply of cash to plug gaps in their portfolios. Gold, the most gooey of all liquid instruments, priced in dollars, provided an easy out. By enabling panicky investors to limit their Covid-19 losses, advocates will tell you that gold actually did its job. To critics, however, the recent downturn only highlights an inescapable truth – that gold is no longer the bullet-proof survival bunker it once was. They’ll point out that, since Nixon severed the Fed’s ties in 1971, the markets have had a new king. All other asset classes orbit around the almighty dollar, and can rise or fall with no guarantees.
The March rout may have made alarming headlines, but it isn’t the first time in recent memory that gold has been dragged down by alternative assets. When the S&P 500 nosedived in early 2018, gold went with it, shedding 14% of its value in just seven months before rising in line with the equities market. As critics will point out, this kind of market-shadowing is precisely the thing gold is supposed to not do. Alastair McIntyre, president of Malagash Metals and one of the pioneers of gold trading in China, said: ‘When the world went to hell a couple of months ago, gold dropped like everything else. The dollar and US Treasurys didn’t. There’s your answer to where the real safe haven lies. ‘When equity markets were off by 30-35%, gold was off by 15%. In relative terms, against the equity market, it did perform a little bit better. But still, it fell.’ But will gold overcome its recent jitters and provide the haven that its advocates demand? Naysayers will say that the gold market is bulging with recent supply (of the 190,000 tons of gold mined throughout history, the majority has been extracted in the last 50 years) – any contraction in demand could wreak havoc. At the same time, the rise of multi-asset funds means gold is now less ringfenced than it was before. ‘Multi-asset funds are definitely a factor. The same investors are working across asset classes now, so gold is getting pulled in to other classes,’ Don Casturo, CIO of Quantix Commodities, said. ‘This feeds into a wider point. If a meaningful percentage of holders are consolidated entities that have funding needs in times of stress, then gold can be much more correlated.’
TOUGH CONDITIONS What’s more, we’re facing a set of market conditions that may prove grueling for gold. The US dollar appears set for a prolonged period of buoyancy as investors scramble for greenbacks, which may make gold prohibitively expensive for traders in alternative currencies. Then there’s the sudden collapse of physical demand. Central banks have spent much of the past decade buying gold to diversify their currency reserves, but now their purchasing power is being squeezed. The problem is particularly acute in Russia, one of gold’s best customers, which is now reeling from the flatlining price of oil.
At the same time, retail demand in China and India, where the burgeoning middle classes have become the bedrock of the world’s jewelry market, has evaporated, increasing the likelihood of further friction. Hiren Chandaria, head of Indian business at digital UK gold provider Goldex, told Citywire that, while physical demand will eventually go up again, in the short term, we may see a gap between physical and digital prices. LONG-TERM RELIABILITY But, as any student of market history will tell you, we’ve been here before. Gold struggled at the start of the last financial crisis, too. By the end, it was nudging all-time highs. If we zoom out of all the sensationalism and consider the wider panorama, the value of gold has remained unerringly consistent. To take just one example, its value against the euro has increased by 85% since 2000. If that’s not eye-catching enough, consider this: during the selloff in mid-March, commentator Ryan Giannotto pointed out that the metal had outperformed the S&P 500 over a full five-year horizon. Yep, that’s right. An inanimate object that produces no income and has no intrinsic value has consistently outperformed an index of the world’s most powerful companies, whose returns have increased by 40% over the same period. It’s a remarkable statistic, which highlights the fact that while gold may occasionally weather bouts of instability, it usually comes through the other side.
What’s more, it appears the current turbulence may soon start to create tailwinds for gold. The imminent injection of $2tn into the US economy is likely to significantly weaken the US dollar and thus make gold more competitive, while dampening confidence in the currency markets. One gold bull, Charlie Hyett of Amplify Trading, even suggested to us that the stimulus flood may sever the traditional gold-greenback correlation and fortify gold as the dollar rises. As part of the same stimulus package, the Fed is likely to hold interest rates at zero for several more months, which removes the opportunity cost of gold. Although it doesn’t offer yield, neither will commodities or fixed-income assets, scrubbing out a key negative at a stroke.
But perhaps the biggest single tailwind is the imminent arrival of earnings season, coupled with key US economic data. For equity traders, the early snippets are far from encouraging. On April 15, US industrial output had registered its biggest fall in more than 70 years, while retail sales figures plunged 8.7%. Fears are mounting that the US will soon record 20% unemployment, nearing the peak of the Great Depression, and there is no evidence that the picture will improve anytime soon. As Bernard Dahdah, senior commodities analyst at Natixi, said: ‘We don’t have a vaccine. We don’t currently have a concrete, long-term solution to tackle the virus. ‘In the US, millions of people don’t have healthcare benefits, and if those people go bankrupt, you might end up with a sub-prime crisis. We believe it’s more likely than not that we see another stock market crash. Generally speaking, the tendency is for greater bullishness on gold in these conditions.’ Tim Marlow, a Manchester-based corporate finance partner and passionate gold follower, believes that gold’s attractiveness is already rising. ‘The risk to equities is now significant, given the lack of current earnings data. The FTSE 100 is currently trading at about 15x earnings – but that is based on old 2020 earnings data. With an unknown hit to earnings, that could push the FTSE price-to-earnings ratio into uncomfortable territory – in spite of the current c.25% fall of the index since January 2020 highs. This is much the same picture across any index you look at worldwide.
‘Cash also feels less secure. With massive fiscal stimulus comes inherent risk to a country’s economy. Speaking personally, I think UK government debt will exceed GDP for the first time since the 1970s, based on predicted borrowing for a three-month lockdown. Sovereign risk, then, de-stabilizes the various currencies of the world as people fear failure. ‘Long-term inflation will re-balance the books and erode national debt in real terms. But short-term, precious metals seem the best hedge. In fact, once quantitative easing and the subsequent inflationary pressure really kicks in, precious metals will be the last true store of value.’
OVERALL VIEW The critics are still unconvinced. Don Casturo believes the rush to gold will eventually create a market with nowhere to go. ‘The fundamental issue I have from gold is that it’s not consumed. Its utility, if it’s only as a safe haven, is only good when there’s a desire for safety. When that desire for safety is over, it’s not like oil or food. With gold, you still have that asset and you need to sell it back. ‘When this ends, you’re going to see $100 declines in gold, potentially for multiple weeks.’ However, it appears that the majority of investment professionals (at least those sampled by Citywire) believe gold, for all of its recent wobbles, remains very much a haven. The broad consensus was summed up by Tim Marlow: ‘Gold has been the store of value for over 5,000 years, and this status has, in my opinion, never been more secure. Its insurance-like qualities against Black Swan events is unquestionable.’ This optimism will be a crucial asset for gold in the months ahead. So much of its appeal, after all, lies in reputation. Investors flock to gold for its long track record of shoring up more rickety asset holdings. For now, this confidence is shining as brightly as ever.
Eric Schoenstein Managing Director, Jensen Investment Management
Disclosures: The information presented is intended as an illustration of Jensen’s investment approach. It is general in nature and not intended to address your investment objectives, financial situation or particular needs. The mention of specific securities should not be construed as a recommendation or offer to buy or sell any security and or designed or intended as a basis or determination for making any investment decision. The specific securities identified and described above do not represent all of the securities purchased and sold in the Jensen Quality Growth Strategy and it should not be assumed that investment in these securities were or will be profitable. The information contained herein represents management’s current expectation of how the Jensen Quality Growth Strategy will continue to be operated in the near term; however, management’s plans and policies in this respect may change in the future. In particular, (i) policies and approaches to portfolio monitoring, risk management, and asset allocation may change in the future without notice and (ii) economic, market and other conditions could cause the Strategy and accounts invested in the Strategy to deviate from stated investment objectives, guidelines, and conclusions stated herein. Jensen Investment Management, Inc. is an investment adviser registered under the Investment Advisers Act of 1940. Registration with the SEC does not imply any level of skill or training. Although taken from reliable sources, Jensen cannot guarantee the accuracy of the information received from third parties. Graphs, charts, and/or diagrams cannot, by themselves, be used to make investment decisions.
What factors should investors focus on in highly volatile markets? Investors should seek out investment managers who have a deep understanding of their companies. Investment managers who really know what they own. At Jensen, we look for high-quality companies with high free cashflow, returns above the cost of capital, and consistent deployment of that free cashflow into the business, with any excess being returned to shareholders. Ultimately, it is a combination of all three factors that helps dampen volatility. Jensen Quality Companies have a demonstrated ability to constantly generate tremendous amounts of free cashflow over a long period of time (15% ROE for each year of the last 10 years at a minimum). This allows them to organically fund their business and grow in a sustainable fashion. Not only does this lead to higher returns that are typically above the cost of capital, but it also saves companies from having to rely on lenders to help finance ongoing operations. High free cashflows also favor reinvestments to further enhance competitive advantages and allow businesses to pay out dividends to return capital to shareholders while they wait to see their investments appreciate. How have you positioned yourselves for market volatility and the unprecedented market reaction to Covid-19? In times like these, it is critical to maintain a long-term view. While no strategy is going to completely protect anyone from the financial impact of the pandemic, Jensen’s “Risk First” mindset has been critical to our longevity in both bull and bear markets for the past 32 years. In evaluating business risk, pricing risk and security specific risk as a starting point for investments, we can construct resilient portfolios built upon a strong foundation of quality. How can you identify high-quality businesses in the current market turmoil? How do you separate market noise from business reality? Our process remains unchanged, to qualify for our high-conviction portfolios, companies must have generated a 15% return on equity each year for last 10 consecutive years. This leaves us with about 230 firms that can demonstrate the consistent business performance we want to see for the Jensen Quality Growth portfolio. We then try to find companies that we think are best positioned to maintain their current strong fundamentals in the future. Consistent with our investment discipline, Jensen continues to make buy and sell decisions based on our fundamental research. While we have not made many changes to the Jensen Quality Growth portfolio in reaction to market turmoil, we do aim to take advantage of pricing disconnects as they present themselves. Given the current volatility, we are focusing on companies that cater to somewhat inelastic customer demand and are therefore less susceptible to the difficulties that more financially sensitive firms might encounter. Becton Dickinson (BDX) is a good illustration of a current Jensen Quality Growth portfolio company. Becton Dickinson is a US health technology provider, whose business is built upon diagnostics. The firm has recently partnered with another business to produce their own version of a COVID-19 test that will run on their diagnostic systems. Since COVID-19 is a worldwide pandemic, Becton Dickinson should benefit from increased global demand for its products. Microsoft (MSFT), another current Jensen Quality Growth portfolio holding, is benefitting greatly from the shift towards working from home. The firm’s online and cloud services are critical to business function, especially in the current decentralized working environment. We have recently added Automatic Data Processing (ADP) to the Jensen Quality Growth portfolio. A provider of human resources management software and services, ADP gives large companies access to outsourced management capabilities, which enables them to keep their costs low while conserving cash in other areas.
Eric H. Schoenstein, managing director and portfolio manager at Jensen Investment Management, discusses the surge in market volatility and explains how his firm is dealing with the impact of COVID-19.
ABOUT JENSEN INVESTMENT MANAGEMENT Jensen is a 30+ year-old active equity manager with an unwavering commitment to quality. The firm focuses on businesses derived from a select universe of companies that have produced a long-term record of persistently high returns on shareholder equity. Jensen seeks to provide clients access to the long-term success of the portfolio companies via two strategies, Jensen Quality Growth and Jensen Quality Value.
TIM COOPER The Covid-19 pandemic is testing investment sectors to the extreme. While short-term potential for upside performance is limited, some industries have the potential to be long-term survivors and even winners, say advisors. Unsurprisingly, defensive sectors have held up best so far, with consumer staples, healthcare and utilities losing the least. Communications companies should also prove resilient as people switch to working from home, as should other technology firms such as video game providers. These short-term survivors could turn into long-term winners if they use the situation to build more customer loyalty. There are other opportunities, too. In its latest market update, UBS said the recent selloffs in the oil and gas industries have created opportunities with high-quality names that can buffer against a prolonged crisis and benefit from an eventual recovery. Furthermore, it sees opportunities in Asian stocks, which are relatively cheap, and those that are buffered from the virus by other factors, such as the 5G rollout in Asia. In an update, Raymond James CIO Larry Adam also predicted that home improvement and e-commerce firms will have resilient earnings. But the technology sector is more divided, with streaming, gaming and cloud services potentially offsetting weakness in other product areas. KEEPING UP New York-based Avani Ramnani, director of wealth management at Francis Financial, said technology will be a key factor in coming out of the pandemic in good shape. ‘Companies that can adapt quickly to providing services online are finding traction,’ she said. ‘For example, coaches and fitness instructors might open group sessions on Zoom. People need to adapt fitness routines to small spaces and skeletal equipment. Adapting systems this way may allow more people to use the offering.’ Efficient distribution will also be key to survival. ‘Amazon, for example, seems to know exactly where products are in its supply chain and distribution network,’ Ramnani said. ‘Many other companies have had no idea.’ She added that communications and public relations professionals could also do well, adding value as more communications move online.
California-based David Bahnsen, managing partner at The Bahnsen Group, said fundamentals such as strength of balance sheet, cashflows and business model will dictate which companies survive. Social distancing may make some sectors attractive for a short time, but market prices reflect these things very quickly, he said. ‘The effects of distancing are priced into stocks such as Zoom, Amazon, Netflix and Peloton but that will not always reflect a reasonably-priced, sustainable trend,’ Bahnsen said. ‘We favor more consistently durable companies – such as Verizon, Walmart, McDonald’s, Coca-Cola and Merck – with safe business models, some benefits from circumstances, and financial strength to sustain them.’
The research firm lifted earnings estimates for healthcare distributor Owens & Minor. This company is ‘one of the best-positioned healthcare distributors thanks to the exponential demand for personal protective equipment in the US,’ Hardy said. Having its manufacturing facilities mainly in the Americas is a distinct advantage, he added. This plays into a wider trend towards reducing reliance on Chinese suppliers. CFRA sees the virus outbreak as a near-term negative for the life science tools and services sector. However, it thinks Thermo Fisher and Illumina are well-positioned as they have been working closely with governments and hospitals to develop testing kits and sequence the genome of the virus. ‘We also see the recent Qiagen acquisition, a provider of life science and molecular diagnostic solutions, as a positive catalyst,’ Hardy said. ‘Qiagen’s test kits have delivered fast results in China.’ Tschosik favored those firms looking for a cure for Covid-19 the most. ‘Those working on a vaccine category will do best in the future as that has to be the ultimate answer,’ he said. ‘For example, Arcturus Therapeutics, BioNTech and Moderna all have something in the pipeline.’ TECH TALK Moll said broadband providers, IT security providers, internal corporate web portal design and maintenance, and cloud-based customer relationship manager tools could all benefit from the move to working from home. Meanwhile, John Freeman, vice president of equity research at CFRA Research, said he likes video game publishers more every day. Electronic Arts, Take-Two Interactive and Activision Blizzard all have large net cash positions and will emerge as winners, not just on a relative basis. ‘Also, by the end of 2020, Microsoft and Sony will launch consoles, starting the first major console upgrade cycle since 2013,’ Freeman said. In a podcast, Mike Wilson, CIO of Morgan Stanley, said that, as central bank stimulus is directed at SMEs, they could outperform from here. ‘However, expectations remain more elevated in large-cap technology stocks, which suggests more downside risk to these compared to out-of-favor sectors,’ he said. Technology stocks appear more vulnerable based on their earnings revisions to date. ‘Our advice is to buy the dips from here, but don’t favor former leaders,’ Wilson said. But Tschosik said large technology names such as Facebook, Apple, Netflix, Microsoft, Amazon and Google will continue to offer some shelter to investors. ‘They have strong balance sheets (except Netflix), lots of cash and relatively low debt to asset ratios,’ he said. ‘When the market was selling off, these names held up well. They can survive any prolonged downturn better than some of the consumer names.’ Millennials will use Amazon more as their income grows, making that company a winner even after the virus goes, Tschosik said. ‘Facebook and Google were hurt more because much of their revenue comes from small and medium businesses, but that will come back,’ he added. ‘They are survivors and, after all the dust settles, people will come back to these big names.’
Los Angeles-based Gene Goldman, CIO of Cetera Financial Group, agreed that consumer staples are pricey now, but said they will continue to do well because people will only spend money on necessities for some time. ‘Countries like Austria have shown that we can’t flip a switch and go back to work or to restaurants - it’s a gradual process,’ he said. He added that, post-pandemic, financial stocks will be a big opportunity due to massive support from central bank stimulus. For example, banks will do well from their small business loans. ‘Industrials, such as those involved in construction and machinery, will also benefit as the next stimulus program will focus on infrastructure,’ Goldman said. ‘Technology will do well but only in certain areas, such as consumer-driven home technologies.’ Goldman also predicted the US will lead the global economy out of recession. ‘Asia is coming back too, but Europe has more complex issues,’ he said. ‘We like emerging markets as valuations are cheap. In the US, we would start to increase allocations to small-cap as the pandemic eases. We are also slightly overweight value versus growth. One effect of the pandemic is that the narrow focus of the bull market – for example, on a few large technology stocks - will widen.’ Todd Moll, CIO of Provenance Wealth Advisors, disagreed, saying small companies will struggle as their funding becomes exhausted. Consolidation will heat up, and the big will get bigger, he said. RETAIL AND DINING Garrett Nelson, senior equity research analyst at CFRA in New York, said defensive retailers Walmart and Costco should benefit if Covid-19 results in a prolonged downturn. ‘We expect them to post record sales and earnings thanks to consumer stockpiling,’ he said. ‘Walmart is the largest US grocer, giving it more cashflow stability than most retailers. ‘The stock has a long history of outperformance in bear markets and recessions. Its US e-commerce sales have also been strong. We expect this momentum to continue as Walmart expands grocery pickup and delicatessen services aggressively. Distress among other retailers could also lead to longer-term market share gains.’ Nelson said Costco has significant exposure to more recession-resistant products such as fuel, pharmacies and optical centers. Its large membership model and high retention rate give it high earnings stability. Costco opened its first store in China in 2019 and expects major growth there in the coming years. It has a strong balance sheet and has increased its regular dividend for 15 years. Costco should also increase market share in a prolonged downturn, Nelson added. Arun Sundaram, equity analyst at CFRA Research, said supermarket chain and drug retailer The Kroger Company is also a good prospect. In terms of e-commerce, retail giants such as Amazon and Walmart often overshadow Kroger. But the retailer is expected to benefit majorly from stockpiling. ‘Kroger’s leverage is within targets,’ Sundaram said. ‘It has been investing in click and collect and home delivery. Since many consumers are now trying grocery e-commerce for the first time, Kroger can build more customer loyalty and gain market share.’ But how long will grocery retailers benefit before we return to old habits? Illinois-based Patrick Tschosik, US sector strategist at Ned Davis Research, said: ‘As we come out of isolation, people will start to eat out more, initially at fast-food restaurants, as they will re-open first. Chipotle Mexican Grill might be a good example. Then, finally, we will move back to dine-in restaurants, so they will be the last to benefit.’
HEALTHY EARNINGS Sel Hardy, equity analyst at CFRA Research, said Johnson & Johnson and its over-the-counter (OTC) consumer healthcare franchise could be a near-term beneficiary of Covid-19 as consumers have been stockpiling preventive care, digestive health and oral care products. Johnson & Johnson has also been working on a Covid-19 vaccine, which it expects to have available by quarter one of 2021. If the vaccine is the first to market, the company will enjoy considerable financial success, Hardy said. CFRA also expects stronger quarter-one results from Perrigo and Prestige Consumer Healthcare due to their focus on OTC pharmaceuticals.
Matthew J. Bartolini, CFA Head of SPDR Americas Research, State Street Global Advisors
¹Source: Bloomberg Finance L.P. as of 3/18/2020. Calculations by SPDR Americas Research. The views expressed in this material are the views of Matthew Bartolini through the period ended March 19th, 2020 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Investing involves risk including the risk of loss of principal. Past performance is no guarantee of future results. The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor. All material has been obtained from sources believed to be reliable. There is no representation or warranty as to the accuracy of the information and State Street shall have no liability for decisions based on such information. The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without State Street Global Advisors’ express written consent. SPDR, S&P and S&P 500 are registered trademarks of Standard & Poor’s Financial Services LLC (S&P), a division of S&P Global, and have been licensed for use by State Street Corporation. No financial product offered by State Street or its affiliates is sponsored, endorsed, sold or promoted by S&P. 3004850.2.1.AM.INST
Like many of you, my daily routine has been upended. Rather than checking the box score from the prior night’s Celtics game, I now search for the latest information of COVID-19. Rather than commute into the city, I move from room to room while on phone calls trying not to disrupt the homeschooling going on. Nightly conversations about what happened at work have been replaced with what might happen next in the world and how we are going to keep the house “light.” My typical commentary is filled with pop-culture references to make the financial markets a little more entertaining. Now, however, those references don’t feel appropriate considering the gravity of our situation. TRYING TO EASE NERVES This unprecedented time will no doubt spark furious academic debate, both from a humanitarian as well as a financial markets perspective – akin to the research that followed the great financial crisis and post-dot-com bear markets. Currently, I find myself cultivating rich data sets to help put market movements in context and chart how ETFs are performing. Of course, showcasing how ETFs are being used in this market will do little to quell the stress in our lives stemming from having our daily routines upended. However, hopefully my observations might ease any anxiety investors may have related to ETFs. 1. Low stock and bond volumes from the ETF primary market activity should not be seen as exacerbating market moves. Coming out of the crash of 1987, ETFs were created to allow investors to participate in the market, while limiting the impact on the securities held by the funds. Based on these levels, the same market impact holds today. As shown below, gross primary market activity of US equities, high yield bonds, and investment-grade bonds as a percentage of their underlying market’s trading activity has averaged less than 6% since February 21, 2020. For US equities, I took any ETF with a geographic focus and compared it with the total volume of all Russell 3000 stock volumes. For the fixed income analysis, the underlying market is represented by FINRA TRACE data. In addition to the average figures, the daily max and min are also placed in the chart. Only for high yield did this metric surpass 10% on a single day. 2. Trading volumes have increased across both equity and fixed income ETFs, hitting records. ETFs are being used to make real-time asset allocation decisions and provide liquidity at a time when investors demand it most. With the uptick in volatility, investors have gravitated toward ETFs as a result of their onscreen liquidity, leading to a heavy increase in trading volumes across a multitude of market segments. Both equity and fixed income ETF trading volumes have increased since February 21 and hit records, as illustrated in the chart below. Equity ETFs have traded, on average, $200 billion in the secondary market versus the normal average of $60 billion. Fixed income ETFs have traded an average of $37 billion – three times their normal average daily volume. Taken together, ETFs have represented 37% of all US exchange volume, versus the typical average of 26%. 3. The rush to defensive ultra-short term government bond ETF exposures is outpacing 2018 levels. In this market selloff, there has been a lack of information, and therefore, no information advantage. As a result, we have seen broad-based de-risking across many asset classes and a gravitation toward defensive areas. From a positioning perspective, we have seen investors uniquely favor ultra-short and short-term government debt. To date in March, $17 billion has flowed into the ultra-short and short-term government debt ETF category, with inflows every day of the month. Inflows, in particular, picked up pace once key technical indicators (i.e., last price versus 200-day moving average) used by traditional trend-following equity strategies were breached, triggering a defensive shift. The chart below depicts the rolling 30-day fund flows for this group of ETFs, and the most recent 30-day period, not surprisingly, outpaces the timeframe from 2018 when the S&P 500 fell close to 20%. STAY SAFE — AND INFORMED The new normal — sharing drinks with friends over FaceTime and building a few Lego police cars with your new officemates over lunch — is likely to be here for a few more months. These are uncertain times, so it’s important to stay safe and informed. I am not an epidemiologist, so providing my thoughts on the spread of the virus will be nothing more than repeating news headlines. Like the recent information on fixed income discounts and best practices for trading, we will continue to provide honest, data-driven insight to help investors make better-informed investment decisions at a time when uncertainty is so high.
In the new normal, ETF trading volumes have hit records across equities and fixed income. The rush to defensive ultra-short term government bond ETF exposures is outpacing 2018 levels.
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