Mid Monthly Update – September 2020
Look Both Ways
When you cross the road, you look both ways. Focussing on looking to the left may mean being hit by something coming from the right. In investing, many or most investors concentrate on looking left. Let me explain.
Below is a graph of bell curve distribution patterns. Just over two-thirds of the time, returns are within one standard deviation. Ninety-five percent of the time, returns are between two standard deviations. What everyone seeks to avoid is the five percent of time when returns are beyond normal distribution and in particular, sharply negative. Known also as left-tail risk, investors tend to focus on looking left more than looking to the right. This is quite understandable as good stewards of investors’ capital should be concerned about capital preservation. However, preservation of capital is also about preservation in real terms – above inflation, therefore investment risk needs to be taken.
What tends to happen is what happened earlier this year. The four standard deviation event happens once a decade, or so it would seem from recent history. It is usually something that was almost impossible to foresee. When that event happens, it causes great anxiety and market volatility – often reflected in the VIX index*. Such was the case in mid-March during the week beginning 16 March 2020 in response to economies closing down in response to what was to become known as Covid-19. The VIX index spiked before subsiding as can be seen from the chart of the VIX year to date overleaf, sourced from Yahoo Finance.
*The VIX Index is a market index traded on the Chicago Board of Exchange (CBOE) reflecting US S&P 500 equity index volatility. It measures 30 day, forward looking US equity market volatility and is also known as the ‘fear index’.
What can happen when the ‘fear index’ is at its most elevated, is that investors hunker down and avoid taking risk. Quite understandable. The vast amounts of liquidity provided by central banks coupled with substantial economic support from governments helped to stabilize risk markets. Investors could then be fearful of a right-tail risk event as markets rebounded strongly in response to central bank and government interventions. Few did.
Ultimately, cash burns a hole in investors’ pockets and FOMO (fear of missing out) takes over. Stocks rally (especially tech or digital economy stocks), credit spreads narrow and a right tail or V-shaped recovery in many risk assets happens – quickly. Those assets then become vulnerable, despite better than expected earnings and economic data. Similar to a couple of days in June, the Nasdaq index which contains the big ‘winners’, has hit something akin to an air pocket so far in September. While that raises fears of another left tail risk, the VIX had a small spike up, the froth has been removed from a buoyant stock market, but the major US equity indices have merely given back their August gains.
As thematic investors, geography is a derivative of our preference for identifying the key themes to be exposed to. From March this year, the focus was sharpened in favour of the digital economy and remains so although this does not mean large exposures on look-through to the ‘big tech’ names such as Amazon and Apple. However, cloud computing and cybersecurity, for example, will be in demand for some time. Rather, the focus of the managers we invest with is to look for the next beneficiaries of the digital economy.
Politics have loomed large in September on both sides of the Atlantic. Nervousness over the outcomes of the US Presidential Election in November and Brexit discussions, which should give some clarity by mid-October, have increased investor concerns. The decision of the UK Government to raise the stakes by threatening to amend the terms of the withdrawal agreement as an exercise in brinkmanship, has understandably affected the value of Sterling to the downside.
Option market activity in the big tech names has increased the volatility of those equities. A recent FT column has put this at the door of the Japanese owned financial institution, Softbank (in the news this week for its sale of UK chip manufacturer, ARM to Nvidia). However, their activity has been substantially overshadowed by US retail investors’ appetite for buying short-term call options just out of the money, forcing the writer of those options to buy the underlying stocks to cover their positions. This has also been referred to as ‘pump and dump’. The result has been increased volatility in stocks like Apple and Tesla. The latter of those also suffered from not gaining entry to the S&P 500 index as widely anticipated. Investors who had anticipated substantial buying of Tesla from passive, index funds, became sellers.
Ups and Downs
Tesla is something of a marmite stock, not unlike its founder – you like them or you don’t. For context, Tesla started the year at $86, hit a low of $72 on 18 March before rallying to $498 at the end of August, closing at $372 last Friday. That’s some ride (pun intended). Pundits talk about the winners and volatility but not everything has recovered to be up year to date; the FTSE 100 index started the year at 7,604. At the time of writing, it’s just edged back above 6,000. For the broader FTSE All Share index, the numbers are 4,231 and 3,385 respectively.
From the end of July, we have top-sliced the winners and built up cash in both funds, cognisant of the potential for a pullback in risk asset prices. In response to the amount of central bank and governmental support for economies, we have held gold as part of cash and as an alternative currency. Cash and gold have represented double-digit percentages in both funds for a few weeks. Recent economic data has surpassed forecasts in the major economies leading to brighter outlooks for economies into 2021, politics notwithstanding. Of course, Covid-19 infection rates are on the rise in Europe although mortality rates have not followed the same path thankfully. Students returning to universities may generate increased infection rates too. More testing is taking place as well.
We can see some rotation in favour of a broader economic impetus and have made a small increase in our exposure to industrial metals – from gold in Growth and from cash in Dynamic.
As Sterling based investors, any non-Sterling positions are both an opportunity and a risk. As Growth is a global equity portfolio, it naturally has a significant foreign currency exposure. Dynamic, being a multi-asset portfolio with a UK inflation plus 3% objective, is less likely to have substantial non-Sterling exposure. We are not currency speculators and feel Dynamic’s current Sterling weight of close to 70% is appropriate.