Market report May 2020
There is an ongoing debate about which of the two investment approaches, active or passive, are more effective. In recent years, the popularity of passive investments has increased, and assets in publicly traded funds (ETFs) and index funds have outstripped assets in actively managed funds for the first time in history in 2019.
What is active investing?
Active investing is a strategy of actively buying and selling securities by a fund. In this style of investing, investment managers evaluate a wide range of securities and choose which to buy and sell in order to get better results than the index, eg Morningstar Global Equity Index (generating “alpha”). In actively managed funds, fund managers decide on investments based on their research and opinions. Managers will invest in a mix of assets in line with the fund’s objectives, adjusting the weight of shares, bonds and alternative risk management methods. In the long run, asset allocation will be managed in line with the fund’s strategic asset allocation. In the short term, the fund manager can make minor adjustments to take advantage of attractive investment opportunities. These short-term adjustments are known as “tactical” asset allocation. Fund managers keep track of the latest market trends, news related to the global economy and any other events that may affect the results of investment in the fund. Those who invest actively believe that they can achieve better performance than those who follow the index or the market.
What is passive investing?
Passive investments can be called the management of index funds. Fund managers are trying to match returns on a specific market index or benchmark. They do it with exactly the same investments that are in the selected index. In the case of passive funds, fund managers do not actively evaluate investments and do not make decisions regarding which securities to buy and sell.
Active or passive investing: what is right for you?
To assess which investment style is right for you, it’s worth looking at the pros and cons of active and passive investing.
Advantages and disadvantages of active investing
The main advantage of active investing is that it enables fund managers to take advantage of attractive investment opportunities. For example, if the sector or shares appear to be undervalued, the investor may seek to allocate capital. This means that there is potential to exceed the reference level or index. Another advantage of active investing is that it gives investors more control and flexibility. For example, if a fund manager wants to avoid a particular sector or action for ethical reasons, he can do so. Active managers can also apply security strategies. It is a form of risk management in which the investor takes an offset position through a “short position” or options. Hedging can help minimize the likelihood of a large loss. On the other hand, one of the disadvantages of active investing is that fees are generally higher than fees for passive investments. This is due to the costs of research and active trade. The manager may outperform his passive counterparts and may also perform worse.
Pros and cons of passive investing
One of the key advantages of passive investing is that fees are generally lower than active investment fees due to the fact that less human supervision is required. The simplicity of passive investments is another benefit. Investors often feel more comfortable with passive funds because they know exactly what they are getting – investment in line with the market index. Many investors also like the fact that index funds have a higher level of transparency, because it is always clear what assets are stored and it is refreshed every day. The downside is that due to passive funds there is less potential for higher returns. By definition, a passive fund will never beat the market. Your investment is also on the market without active down protection in the event of a downturn. When it comes to which investment style is more appropriate, a solid investment strategy can include both active and passive investment styles. When markets are volatile, investors can benefit from an active management style because fund managers may be able to minimize losses. However, there are cases in which passive funds potentially outweigh active funds, and then you save on generally higher costs associated with active investment. An investment plan should always start with financial goals and risk assessment.
American money market, negative interest rates
If the US economy readings remain weak until 2021, the Fed will have to increase quantitative easing. Since short-term interest rates are already at zero and quantitative easing (QE) is fully clear, it is not clear what other tools the FED will use. Until the next steps of the FED become clear to the market, investors have no obvious way to value additional mitigation measures.
That is why the market seems to be obsessed with setting negative interest rates. It is, in fact, a way of expressing the view that the FED will need to do more to support the US economy over the next few years to return to the right post crisis trajectory. In this way, the logic of pricing in the FED’s transition to negative rates makes sense to us, even if we think market negative rates alone are unlikely.
Statements from the beginning of May of the chairman of the FED, Jerome Powell, specify several key reasons why the FED may reach the point where he will have to go deeper into the monetary policy toolkit:
- The FED has learned that it can and must work more strictly on the labor market than expected. The seemingly trivial relationship between unemployment and inflation, based on recent experience, makes this possible. And those at the bottom of the income distribution will only benefit from economic expansion if the labor market is hot.
- The economy, in order not to lose ground when lifting people out of poverty, should recover in the shape of the letter “V”. A central bank study found that 40% of all households earning less than USD 40,000 per year lost their jobs in March and April. It has taken many years for these households to take advantage of the benefits of recent expansion, and if they can’t get back to work quickly, the need for return could be repeated, with enormous social and economic costs.
- The Federal Open Market Committee (FOMC) expects the economy to recover quickly, but not in the shape of the letter “V”. While Powell expects unemployment to fall rapidly this year, he also sees several years before the US economy returns to its previous level.
The GFC trajectory may mean that the FED will need more tools
Our forecast for the baseline scenario is probably not much different from what the FED expects. Rapid rebound as bank activity resumes and stimulus strokes, GDP growth stabilizing at around 1.5% on an annual basis as the fiscal stimulus disappears, unemployment decreasing rapidly (unlikely previous lows) and economic activity below the previous peak until 2022. A slow economic recovery path would leave many Americans behind and risk long-term employment prospects, which in turn would require more stimulus. Tax authorities are willing to maintain a deficit of 10% of GDP or even higher during crises, likely to exacerbate the reins as the cycle progresses. When the fiscal stimulus disappears, the FED will have to take over the baton to give expansion sufficient impact on the economy. This was the GFC trajectory. If we are to repeat it, we should watch the FED in the next quarters. This is one of the reasons why we think that the chairman of the FED strongly supported more incentives. Powell may be concerned that if the recovery is not solid enough, the FED will want to do more in the coming quarters. The stronger the recovery now, the less the FED will have to do later.
The FED expressed a comfortable position in the face of its tools. In our opinion, these tools effectively limit the risk of a deepening economic decline, they are not particularly effective in stimulating growth. And this is what we believe the Fed will want to do if this stimulation has a moderate effect. Guidelines for future policy making (forward guidance) and QE are no longer unconventional policies. Can you expect them to stimulate growth this time when they didn’t do it last time?
Is “fallen angels” the right choice?
Chart: Expected rise of ‘fallen angels’:
Source: Bloomberg Barclays, ICE BofA, JP Morgan, Moody’s, RCieSolution. Historical analysis does not guarantee future results. As at March 31, 2020. American companies represented by Bloomberg Barclays US Corporate.
Given the sudden emergence of liquidity challenges and limited access to capital in today’s environment, we estimate that 8.5% of the US investment class corporate market will be lowered below investment level. This is close to experience from previous crises, the 2002 recession (10%) and the great recession (8%). Because today’s corporate investment market is four times larger than in 2008, the forecast value of the “fallen angels” market is around $ 450 billion. To date, in 2020 the value of this market has already exceeded USD 150 billion. The scale of the value of “fallen angels”, which can roll through the high yield market, has put pressure on lowering both BBB- and high-yield bonds with the highest rating. The wave of rating downgrades from the investment level to the high yield level may result in losses in the case of investment strategies limited to the investment rating level and cause a revaluation of prices on the high yield bond market. For investors who can hold them, having “fallen angels” can make sense. This is because fallen angels tend to overestimate below their actual value. This was especially the case after a significant increase in the volume of “fallen angels”. For example, the Great Recession caused a large increase in the number of “fallen angels”, in 2009 the total return on „fallen angels” exceeded 60%.
Changes in the pattern of global trade caused by the Covid-19 virus
The strongest fall in Q1 in trade in goods since the first quarter of 2009 is only part of the current market narrative. The reserved Trading Moment Index shows that in the second quarter there will probably be an even stronger decline. World trade prices in USD fell even more in March (3.6% MoM), lowering their value in the first quarter to -6.2%. Trade in services, which probably saw an even stronger double-digit decline in the first quarter.
We expect the energy sector to suffer the most in 2020 (export losses of USD 733 billion), metals (USD 420 billion) and transport services related to car manufacturers (USD 270 billion). While suppliers of machinery and equipment, textiles and cars will lose less in absolute value, their export value will drop by more than 15%. The only intact sectors should be IT software and services (export increase by USD 51 billion) and pharmaceuticals (+ USD 27 billion). The stock market also values significant damages in the sectors we identify: year by year, MSCI Energy lost -37% of its value, the automotive sector -18%, transport -16%, and metals and mining -11%, while the aggregated global MSCI index lost 12%. Banking sector shares also lost -39%.
Chart: Change in exports by sector (USD billion) and total export share in 2019 (%)
Source: UCNTAD, Euler Hermes
This year, almost no country will see an increase in exports compared to 2019. The largest value of export losses will be recorded by the largest exporters: China (USD -275 billion), the United States (USD -246 billion) and Germany (USD -239 billion). We assess countries according to the absolute export losses and their share in total exports in 2019. Those who could record high absolute losses in absolute terms as part of their total exports are: Russia, Great Britain, Mexico, Spain, UAE, Belgium and Saudian Arabia.
Chart: 2020 Change in exports by country (USD billion) and total export share in 2019 (%)
Source: IHS Markit, Euler Hermes
Global stock markets
Global stock markets, respectively, in terms of 1 week (1 WEEK), 1 month (MTD), calendar year (YTD) and the last 12 months (1 YEAR), are shown in the table below:
The table includes rates of return in terms of pound sterling (GBP), local currency (Loc.) And relative (Rel.) as at 26/05/2020.
Source: RCieSolution Research
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The views expressed in this document do not constitute research, are not investment or commercial advice and do not necessarily reflect the views of all management teams. They change over time.