Stock markets rose again in May as developed nations began reopening their economies. Politicians and investors are hoping the worst of the coronavirus pandemic is behind us. Central banks plan to pump more money into the system to support a return to stability, including a €750 billion recovery fund in Europe. In the UK, the Bank of England is actively reviewing negative interest rates. And tensions flared up between the US and China, this time over new security laws in Hong Kong.
Looking at Nutmeg portfolios, it seems global stock markets had another good month in May. Does that mean financial markets are more stable now?
That’s right, financial markets did have another good month on the whole and are continuing to show resilience in the face of some significant near-term economic headwinds. In fact, in the month of May we’ve continued to see volatility fall, and we’ve seen riskier assets perform well, buoyed by sentiment related to the reopening of economies, and by the continued efforts of policy makers – central banks and governments – to limit the long-term damage to economies.
In terms of returns, global developed market equities returned around 4.9% for the month of May, for once not lead by the US equity markets but by Japan and Europe, where markets returned around 6.7% and 4.9% respectively. UK large caps meanwhile underperformed their global peers, returning around 3.3%, while US large caps returned around 4.7%. Emerging markets continued to lag their developed peers, with performance of only around 0.6% on the month. Meanwhile, despite the economic challenges ahead, smaller companies as a whole performed well with small caps in Europe, Japan and the US outperforming their large cap peers for the full month.
A similar trend was also observed in fixed income assets – the riskier assets offering the greater returns. Government bonds, a traditional safe haven, delivered very muted returns of around 0.6% in the US and flat returns in the UK, while investment grade corporate bonds continued to deliver gains, with UK corporates offering investors a return of around 0.8% in May. But as I mentioned, it was really the riskier end of the fixed income spectrum that offered investors the greatest returns in May – assets such as high yield corporate bonds, which delivered returns of around 4.6% and emerging market sovereign bonds, which delivered returns of around 5.7%.
There’s been a lot of talk about negative interest rates here in the UK. What does this mean for investors?
That’s correct, despite the Bank of England stating only a couple of weeks ago that it was not planning or contemplating negative interest rates, in the past two weeks the governor of the Bank of England, Andrew Bailey, confirmed that they are actively reviewing the policy implications of negative interest rates.
When interest rates become negative, the result is that interest payments reverse the traditional course: that is, that lenders would have to pay the central bank in order to keep their reserves stored there, rather than receive interest on them. This also has a knock-on effect for savings and investment markets, with savers faced with the prospect of paying to save their cash, while bond investors will pay for the privilege of lending to governments or corporations.
Interest rates have been negative for some time in the Eurozone and in some other countries, such as Switzerland and Japan. But the UK central bank, the Bank of England, has until now refused to contemplate this course of action. However, in recent weeks the UK sold £3.8 billion in negatively yielding 3-year government bonds, the first time that UK government bonds have been sold at negative yields – that’s investors paying for the privilege of holding the debt should they hold to maturity.
So, will the Bank of England go negative on interest rates? We know interest rate cuts have a lagged effect on the economy – and therefore policy makers will be in no rush to venture into negative rates should they decide to consider it a sensible approach, especially with a Brexit conclusion on the horizon in the next seven months. That won’t stop the market taking existing bond yields negative if it believes that is the direction of policy however, but at the current time, market expectations put only a 25% chance of negative interest rates by the end of 2020.
Apart from the coronavirus crisis, what other big events are influencing financial markets at the moment?
Well we’re certainly never short of political news stories at present, and while the Brexit negotiations continue to proceed under the market radar, the familiar topic of global trade and in particular the relationship between the two superpowers of the US and China is never far from headlines.
This month we saw China move to enforce security laws in Hong Kong, which has led to another step-up in rhetoric between these partners. The move essentially violates a key part of the one-country, two-systems arrangement that has been in place since Hong Kong gained its independence from the UK, whereby Hong Kong manages its affairs in all areas except national defence and foreign policy.
In retaliation for this, the US has put in motion the process to remove the special trading status of Hong Kong – a key source of its competitiveness as a trading state and something it has enjoyed since 1992, when the US passed policy to treat the territory as a separate entity to China, once control of the state was passed back to China from the UK five years later. This means Hong Kong could no longer be recognised as a unique customs territory and drags the world’s third largest financial centre and eighth largest exporter and importer globally into the wider US-China trade spat. But both sides have much to lose here: two thirds of China’s foreign direct investment goes via Hong Kong; the state is the largest trade surplus contributor for the United States; the US consulate estimates 1,400 US firms have operations there; and US foreign direct investment totalled more than $82 billion as of 2017. So, this is another significant escalation in the trade disagreement between the two nations and while the special status hasn’t been revoked yet investors will fear with a US election on the horizon there is much room for increased escalation in the fall out of Covid-19.
Closer to home, European nations appear to be making progress on a further support package for the economy. The European Commission built on Franco German plans and announced a proposed €750bn recovery fund, worth around 5.7% of EU GDP over four years, where the European commission would raise funds externally in public markets and distribute these via grants to the most affected sectors and regions. This raises the prospect of a response that is funded at a common level as part of the EU budgetary expenditure, and despite the fact that this funding would not be available until 2021, it is a significant symbolic move that would serve to counter recent Euroscepticism. However, we are likely to see a familiar sticking point – which is that all 27 EU governments will all need to agree for any plan to take effect and there are several northern European states who have been less favourable on the idea of debt funded at a common level.
So how did the Nutmeg fully managed portfolios perform during the month?
Given the strong performance we have seen in global financial markets in the month of May, all portfolios finished the month in positive territory. Returns in the fully managed portfolios ranged from around 0.9% in the lower risk portfolios, through to around 4.6% in the highest risk portfolios. The strong performance on the months means the typical Nutmeg medium risk fully managed portfolio has now recovered over 60% of the market losses incurred in February and March volatility.
Given everything that’s happened lately, have you made any changes to the Nutmeg fully managed portfolios?
We made a number of strategic adjustments through the month in order to keep portfolios in line with our medium-term investment views, but also to manage risk in the near term. The first was with our government bond exposure, and here we reduced our exposure to long maturity US government bonds. These are assets that have performed very well in the challenging market conditions we have had so far this year. Through the end of April, they had delivered performance of almost 24% year to date and so with fiscal expansion underway at a significant pace in the US, the fiscal risks for long maturity bonds have been rising. We keep broadly the same position in duration terms, but we reduced our exposure to longer dated securities due to this risk and the performance they had delivered thus far.
The second change we made was another adjustment to portfolios to manage risk and rebalance a successful position. We trimmed our overweight in Nasdaq stocks in those portfolios that own them – Nasdaq is the high growth index in the US, and this position again has performed very well relatively since we increased our exposure back in March. Given the strong performance, and recognising the increased risk of crowding into these companies, we have rebalanced some of this position into globally focused socially responsible stocks. We also trimmed our US exposure in portfolios that do not hold Nasdaq, again rebalancing a small portion of the position given the performance of the US market. We remain overweight the US and overweight the technology sector.
And finally, we also shifted some of our European Monetary Union (EMU) exposure to a socially responsible focused approach in Europe. This is a theme we are embedding for the medium term in our portfolios. This approach ensures a greater exposure to companies with strong environmental, social and governance alignment, avoids exposure to those companies undertaking controversial activities and offers a lower carbon intensity, which in turn lowers the carbon intensity of the portfolios overall. Following these changes, Nutmeg fully managed portfolios have on average around a 15% exposure to the SRI theme within their respective equity allocations.
This month’s customer question came to us during one of our recent webcasts. A viewer with the username AC asked, “Does Nutmeg have a view on the crypto market and would you see that as a potential expansion area for Nutmeg’s offering in the future?”
For those who don’t know much about cryptocurrencies, they are a form of digital payment that uses a decentralised currency. They come in various forms, each with their own unique characteristics, but Bitcoin and Ethereum are among the most popular and widely known.
Because these assets are relatively new (they’ve been invented in the past 10 years) they lack the track record of other investment assets and are typically difficult for investors to analyse and value. In fact, much of the perceived value of cryptocurrencies relates to their potential future use, rather than their current commercial use. There is little in the way of fundamentals to analyse and we don’t truly understand how they might perform in different stages of the economic cycle. They are yet to receive regulatory support, or be integrated into global payment systems in a way that legitimises their use.
Because of these reasons and further issues around fraud, custody and security, cryptocurrencies typically exhibit high volatility versus traditional investment asset classes such as equities or bonds.
Currently, they are not regulated by the Financial Conduct Authority and due to their relative lack of liquidity, narrow access to market and typically high volatility, we do not consider them to be suitable for Nutmeg portfolios.
As the market matures, moving towards greater transparency and accountability, we may revisit the decision not to include cryptos in our portfolios, but for the foreseeable future we do not envisage including them.
About this update: This update was filmed on 3 June 2020 and covers figures for the full month of May 2020 unless otherwise stated.
Data sources: Bloomberg and Macrobond.
Risk warning: As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past performance or forecasts are not reliable indicators of future performance.