Written By: Emma Powell
LAPF Investments

Emma Powell considers the fluctuations in global equity markets and shares the views of some practitioners that, despite the current uncertainties, the importance of ESG considerations may boost investment opportunities

In March, equity indices around the world entered bear market territory as investors braced for the economic blow dealt by the Covid-19 outbreak. The S&P 500 suffered its fastest descent into bear market territory on record, taking just 16 days to fall by more than a quarter from a 19 February record high. Meanwhile the FTSE 100 suffered its worst points loss in eight years that same month.

Investor nerves have been further strained by the collapse in oil prices, with the price of the US benchmark oil contract, West Texas Intermediate Crude, slumping below zero at the end of April, amid plummeting demand and a supply glut.

However, while the sharp sell-off in equities has hit stock markets across the globe, the extent of losses sustained by different indices has varied widely since the start of the year. The CSI 300 index, designed to replicate the performance of the top 300 stocks traded on the Shanghai Stock Exchange and the Shenzhen Stock Exchange, had regained almost all the losses recorded by the first week of May, which could be attributed to China being hit first by the pandemic and putting in place drastic measures in an attempt to combat it.

Yet the Brazilian Ibovespa has been the worst performing index in sterling terms, declining by more than half since the start of the year, as the real suffered a sharp devaluation and the collapse in oil prices weighed heavily on oil giant Petroba’s shares, one of the main constituents of the index.

A heavy weighting towards oil majors has also weighed down the FTSE 100, with sentiment towards former largest constituent Royal Dutch Shell worsening after it cut its first quarter dividend for the first time since the Second World War.

Unsurprisingly, fluctuations in emerging market flows more broadly have been extreme. In March, the discount applied to emerging market equities against US stocks moved to its widest point in history at 65%, according to the Institute for International Finance (IIF), based upon the average cyclically-adjusted price-to-earnings ratio.

Outflows from emerging market equity portfolios by non-residents surpassed levels experienced during the 2008 financial crisis to reach a record high, and concerns intensified around the high level of dollar-denominated debt held on many emerging market corporate balance sheets.

“While valuations at these levels are compelling from a long-term perspective, concern about the outlook for growth and commodity prices – coupled with the immediate threat of the virus for underdeveloped healthcare systems – will weigh on risk appetite,” said Sonja Gibbs, managing director for global initiatives at the IIF.

Flows have since recovered, following unprecedented quantitative easing from the Federal Reserve.

“Generally, emerging markets are going to have better growth prospects, but there is a high risk associated with that and currency is a big part of that risk,” said Barnaby Wilson, co-manager of Lazard Asset Management’s global sustainable equity select fund.

However Lewis Grant, portfolio manager on Federated Hermes global equities team, said: “While companies listed in more developed markets are often assumed to be safer or more defensive just because of where they are listed, determining the risk profile of individual companies is not always that simple.” Grant added: “Within the emerging markets, we are often buying the largest companies that are selling into developed markets.”

Searching for quality
The sell-off in global equity markets has since eased due to indications that the pandemic may have passed its peak in many large economies, and there were signs that relations between the US and China could be beginning to thaw. The MSCI World Index had gained almost a quarter since reaching a trough on 23 March. Although there has still been a high level of divergence in the performance of global equities due to country and macro-economic factors, according to Grant. “Some of the biggest winners have been the growth companies, which have traditionally underperformed in bear markets,” he said.

Yet while uncertainty pervades global markets, there is consensus among official forecasts that global economies are set for a severe downturn this year. The International Monetary Fund has predicted a 3% contraction in the global economy in 2020, which assumes that the pandemic fades in the second half of 2020 and containment efforts can be gradually unwound. “That makes identifying companies within your portfolio that will be able to withstand the ‘second order’ effects of economic stress even more important,” said Lazard’s Wilson. “If you can’t service your debt over the next 12 months, the long-term becomes irrelevant,” he said. “The strength of the balance sheet is really important.”

Companies that are not only operating within vulnerable sectors and facing challenges to their sales, such as airlines, but also have high leverage and low levels of interest cover are the most at risk.

However, given the broad-brush sell across markets there could be value on offer within global equity markets according to Grant. “There are opportunities in every sector,” said Grant. “That even includes the energy industry, particularly smaller companies that may become acquisition targets and benefit from a resultant boost to their shares,” he said.

ESG rises to the top
The fluctuations in global equity markets contributed to the aggregate deficit of the UK’s defined benefit schemes rising by £60 billion in March, according to data from PwC. That had recovered by £80 billion in April, to the same level it stood at in January.

UK pension schemes deserved a “pat on the back” for the extent to which funding levels have held up against tumultuous equity markets, said Pete Smith, principal and senior investment consultant at Barnett Waddingham.

“The work that has been done on diversification within pension funds and the move to a more global – and less UK – focus, has meant that asset valuations have held-up better than expected,” he said, “that has left schemes less exposed to poorer performing UK equity markets, and the weakening of sterling against some other global currencies.”

“Schemes have also moved away from relying primarily on equities for the growth element of the portfolio,” said Smith, “and increased allocations to alternatives and other private market strategies.”

The average UK equity exposure for the LGPS had declined to less than a quarter of total equity exposure by the end of March 2019, according to Pensions and Investment Research Consultants (PIRC), compared to around half 10 years ago. Meanwhile alternatives accounted for 11% of assets last year, up from 6% in 2009. However, according to Smith, given the uncertainty surrounding asset valuations, it is unlikely trustees would make many wholesale investment strategy changes at the moment.

“A bigger consideration for some schemes would be ensuring there was sufficient cash available to meet short-term liabilities,” he said, “but that is less of an issue for larger LGPS funds as employer contributions would provide enough income in the wake of investment losses.”

However, an April survey of administering authorities by the LGPS Scheme Advisory Board found that 5% anticipated issues around cashflow in 2020-21 due to loss of dividend income or delayed employer contributions, while a further 8% said they could be facing challenges in this area.

One clear theme that has emerged from the current crisis is the importance placed upon environmental, social and governance (ESG) considerations by investors.

“One of the recurring things is that sustainability is the opportunity at the moment,” said Federated Hermes’ Lewis Grant. “However, social issues, which had been ‘somewhat left behind’ governance and environmental considerations have also gained more attention in the wake of the pandemic,” he said.

Research by Fidelity found that while the S&P 500 fell by just over a quarter between February 19 and March 26, companies with an ESG rating of A on Fidelity’s metric performed on average almost 4% better than the market, while companies with the lowest score, E, performed on average 7.4% worse. That was reinforced by an S&P Global study of 17 exchange-traded funds that found 12 had lost less value than the 13.7% shed from the S&P 500 during the market crash, with the best-performing suffering only a 5.4% loss. “It’s a clear indication that companies realise that consumers and society want a relationship with companies that they can trust to act responsibly,” said Wilson.

Taking heed of sustainability issues and having good governance practices in place can mean that companies end up being very high quality in terms of profitability, and according to Wilson, the lesson from the coronavirus is that you need to prepare for the risks that you face.


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Published: June 1, 2020
Home » Global equity markets whipsaw but there may be opportunities

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