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Intermission?

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Just as Covid-19 cases are coming down in the US, financial markets stumbled last week. Adding to uncertainty: those examining economic data for signs of direction could see whatever they were predisposed to expect. A glass half-full, with unemployment below 10 percent last month and half of the jobs lost in March and April regained. Or half-empty, with nearly 30 million Americans still claiming unemployment support and many facing eviction and hunger as benefits tail off. This is a good time to draw breath. Looking out to the rest of this Covid-19 year, three things are clear. The Fed is there to help – big time. Agreement on more fiscal support alongside easy money is unlikely any time soon. And the virus is not yet vanquished. According to Dr. Fauci, he does not expect the US to return to normalcy until perhaps late 2021, when it is likely that a vaccine for Covid-19 could be widely distributed.

Some see last week’s stock market moves as a sign of returning normalcy: tech stocks that soared during the pandemic economy turning down towards earth, with a rotation into some of the sectors that have been hardest hit by the pandemic. Others see it as a creeping recognition that even with the widespread reopening of locked-down economies, from the US and Europe to India, the global economy is in truly bad shape. Surely that will impact earnings and equities at some point, they say.

Observations and the takeaway for investors:
1. Returning to school?

There is widespread agreement, from governments around the world to businesses to families, that a return to in-person education would be a major, and welcome, step towards normalcy – provided it is safe. The data so far are concerning. At a minimum, experience suggests that steps to reduce infections, from mask-wearing to social distancing, are needed to keep the spread of infection under control. In some European countries that have recently begun the return, such as France, this is mandatory. In Scandinavia, schools have been open longer without a clear impact on infections. In Israel, by contrast, early reopening had to be reversed over the summer as infections surged. And a renewed attempt to open up earlier this month has now run into roadblocks, with the Israeli government announcing a series of lockdown measures for businesses, public institutions, and schools at least over the span of Jewish holidays from September 18 to early October.

In America, for many who long to return to normal work, whether for economic reasons or because working from home is stressful or inefficient, it is critical to have schools reopen. This is particularly true for parents of younger children, for whom online classes are barely satisfactory, and for women, who are more likely to take on childcare duties in comparison to their male counterparts. Perhaps businesses that would like to see their workers return to the office, even if part-time, should consider how to support childcare?

Parents and students alike would mostly also like to see colleges open for in-person instruction, not least to justify the cost of tuition. Private schools, colleges and universities without large endowments are nervous about their financial future, threatened by diminishing enrollment from overseas. But recent analysis by the New York Times is sobering: US counties with a high concentration of colleges show a steepening curve of new infections, in contrast to others (see chart above). The response by some institutions – to send students back home – has been sharply criticized by Dr. Anthony Fauci. Returning students may seed community spread wherever they return to. Financing and staffing isolation areas on campus for those testing positive may be a better solution. But who is to pay?

2. It is becoming clearer: the Covid-19 recession threatens to deepen existing divides in society


In a recession, the less well-off are typically hurt the most. In part, this is simply because those with lower incomes have fewer resources to fall back on if the job market worsens and are more likely to lose their jobs. A cascade of problems can then follow, including, perhaps most devastatingly, homelessness. The depth of the Covid-19 recession meant that its initial impact was felt by many. But as employment has recovered, jobs and incomes are being restored for the better-educated and better-off at a faster pace while many families at the lower end of the income scale are struggling to pay for food and rent, with breadwinners still out of work. Unemployment among Black workers has climbed more than that for other racial groups compared to the pre-pandemic lows. The gap with the jobless rate for white workers has more than doubled from 2.7% in February to 5.7% last month.

The dynamics going forward may worsen this trend unless the government takes swift action both to support the unemployed and help state and local governments. On individuals and families first: consumption held up surprisingly well among lower-income families during the spring and summer. Much of that was due to the additional income support for the unemployed in the CARES Act. Research shows that some 70% of the additional $600 a week, which expired at the end of July, was spent within two weeks. Without that extra money, unemployed families face difficult times.

The same is true for many states and local communities. Business leaders last week called on New York Mayor Bill de Blasio to take action to improve the city environment. But New York, as other cities, counties and states, faces a cash crunch. Some community leaders suggested higher corporate taxes to bolster city funds and allow for spending on cleaning up, mending roads and improving public services. For now, with stimulus urgently needed, supporting new federal aid for state and local governments is the least that the business leaders could do. Debates continue among business leaders on the responsibilities of corporations. It is now 50 years since Milton Friedman’s seminal essay “The Social Responsibility of Business Is to Increase Its Profits” was published in the New York Times Magazine. Now, the New York Times and Andrew Ross Sorkin’s DealBook are revisiting the topic with economic and legal thinkers of today.


3. Covid-19 pushed climate concerns aside: wildfires and storms are reminding Americans of its dangers

Terrifying scenes of wildfires spreading across California, Oregon and Washington are a reminder that Covid-19 is not the only global challenge. Our own colleagues living in Oregon needed to evacuate from home over the weekend and had difficulty finding refuge from the fires. The urgency and speed of scientific advancement on Covid-19 has not been matched in the field of climate. A slower moving crisis is harder for politicians and citizens to react to, and easier to ignore or deny. For many years, a false choice of “climate versus the economy” – perhaps similar to the “health versus the economy” debate this year – also dampened enthusiasm and political support for action in many countries.

As with the pandemic, international cooperation is essential – and complicated. Real progress on climate requires the US and China – the two biggest emitters – to work together. Poorer countries that have not contributed much to global warming and emissions look to others to act. But, as we see in the US, phasing out fossil fuels produces losers as well as winners and those who stand to lose are strong advocates against regulations to curb emissions. At the same time, coal plants – known to cause deaths through air pollution as well as contribute enormously to global warming – are still being built, mostly in Asia and mostly by China. In Europe, policymakers have said that stimulus measures will include “green” plans. There is an opportunity here as well. It is good to see that in today’s changing world, investors who have paid attention to sustainable impact investing are already reaping some rewards.


4. Remember Brexit?

As the European Union has shown signs of coming together, notably agreeing on joint borrowing to support individual member nations in need, the same is not true across the English channel. Boris Johnson’s originally botched performance on Covid-19 led Scotland and Wales to implement separate policies to contain spread across their borders. Now the UK government’s threat to violate terms of the withdrawal treaty that enabled agreement with Europe on a phased, rather than sudden, withdrawal is giving more life to Scottish nationalism and upsetting the balance in Ireland.

Most commentators expected Johnson to find a way to compromise with the EU to allow a smooth withdrawal and continued close trading relationship. In his words last year, he wanted to take the issue of Brexit off the front pages, with no more dramatic news stories of dire shortages and job losses to come as trucks backed up at new customs points and European firms moved production out of the UK. In the event, Covid-19 did the job for him, pushing Brexit concerns aside and out of the headlines.

Government actions have now put the issue back in the news. European willingness to continue a close trading relationship with the UK – which is more important to the UK economy than to the EU – rests on two key and connected elements. The first is largely political: preserving the open border between Northern Ireland and the Irish Republic which has been integral to peace and the Good Friday agreement. In effect, as the UK acknowledged in signing the Withdrawal Treaty, allowing the free flow of goods across Ireland means some form of border controls between Northern Ireland and the rest of the UK, anathema to many in the Conservative party. The second reflects the importance in today’s world of standards and regulations rather than tariffs as barriers to free trade. Europe’s single market requires a “level playing field” with common rules on state subsidies, standards and regulations to preserve fair competition. Johnson’s government last week staked out a position against Europe on both these issues, thus violating the Withdrawal Treaty and international law. The reaction from Europe was fast and furious – and some of Johnson’s own backbench supporters expressed their unease this weekend.


5. Investor Takeaways

Brexit. Investors also pushed Brexit aside for much of this year. No longer. Fixed income and currency markets are moving to reflect growing awareness that a hard break between the UK and Europe could be imminent, Betting that this outcome would encourage the Bank of England (BOE) to be more accommodative, to shield the UK economy, investors have pushed down interest rates and the Pound this month.

On rates, 2yr and 5yr yields dropped further into negative territory while yields on 10yr and 30yr maturities fell even more sharply – though remaining positive for now – flattening the gilts curve. Overnight swap rates are now pricing in a reduction in the BOE policy rate to zero by year-end and investor expectations are that the rate could turn negative by early to mid-2021. Meanwhile, Britain sold its first-ever six-month treasury bill with a negative yield. Investors will hear more of the Central Bank’s intentions on September 17th but market consensus is that there will be no further action until November – after the new October 15th deadline which the Prime Minister has set for agreement with Europe.

The currency has also taken a hit on the prospect of lower interest rates and damage to trade and growth from a hard break with Europe. Since the Pound’s recent high on September 1st, it has weakened some 4.4% against the US dollar and 3.8% versus the Euro. This may provide a useful tailwind for export-oriented companies, but international investors will have to weigh that against the erosion of returns caused by a fall in Sterling. As much as a third of the FTSE 250 Index dollar return of 27% in the five months to end-August was thanks to a strengthening currency.

Technology Stocks. As mega-cap technology stocks led the US markets down last week, investors again debated: when will the rotation into small-cap, cyclical and non-technology sectors begin?  The Russell 2000 Index is so far having its best month relative to the Nasdaq 100 in more than two years. Investor sentiment – fickle at best these days – shifted accordingly last week. The QQQ – a fund tracking the Nasdaq 100 – saw more than $3.2 billion of outflows, the worst week since Feb 2018.

The US is not the only place where technology stocks have been driving the performance of equity markets – and not just in 2020. If the top technology-related stocks are taken out of US and Chinese indices the numbers look quite different. And even in markets that do not have much technology representation, such as South Africa, the few tech names have had outsized importance.
Interestingly, Russia stands out as one of the only non-tech dominated markets that has kept pace with global equity markets. With its record low P/E and one of the highest capital payout ratios in the world, Russia has been able to attract foreign investors at a surprising pace despite less than inspiring headlines over the past half-decade. Read more about RockCreek’s views on the Russian market here.

Market Trends. Globally, the case continues to be made by some market participants for an eventual rotation away from technology into financials, industrials, and other cyclical exposures. Positive capital flows into Japan and Europe suggest investors are starting to look towards more value-oriented markets where technology is a less dominant player. The 7+% correction in the Nasdaq so far this month highlights the need for diversification in sector exposure and geography.

Softbank was recently “outed” as the ‘Nasdaq Whale’, making waves with its purchase of $4bn worth of options on tech stocks, a notional value of an astonishing $30bn. Retail investors have spent almost $40bn in US equity purchase premium on call option trades since mid-August. Indeed, trading volume for call options on the top five S&P 500 stocks is up more than four-fold from a year ago. Indicating the amount of speculation in the markets, these options are increasingly of shorter duration – a week or less before expiration – and highly price-sensitive. A future unexpected or sudden drop in demand for call options would force dealers to empty their inventories, putting more downward pressure on the technology stocks that have been carrying the US market.

However, dispersion and selection across the technology sector remains a place of hidden value. Take as an example, robotics software providers that have close ties to traditional industries and are well placed to benefit from a vaccine driven recovery – yet largely ignored by the market. We are also monitoring the high correlations that have persisted until very recently between US and China technology companies. Recent pressures on Chinese tech companies with US ADR listings have already resulted in diverging market dynamics. And if the world divides between two technology ecosystems, look for these correlations to weaken further.

Given the question of risk appetite in markets more broadly we also took a closer look at the VIX and what it can tell us about fear in the markets. Read more here.
RockCreek Update
First of all, we want to send our thoughts and best wishes to all the families touched by the devastating wildfires that have raged across California and the Pacific Northwest – including to one RockCreek team member and her family who are seeking temporary shelter after being evacuated.

More generally, the RockCreek team continues to move seamlessly between working from home and in the office as we adapt to what is – at least for now – the new normal. Our team has been working hard to generate returns and help our investors navigate through these times. We are especially excited to announce our newest partnership – working with the Equality Fund Initiative supported by the Toronto Foundation, Equality Fund and Government of Canada. The Equality Fund Government Pool, which RockCreek is managing, shows the remarkable commitment from Canada to support gender equality globally by investing through a gender lens. RockCreek and its partners on this Initiative are hopeful that this investment portfolio will attract global capital that will be impactful and move forward advancements in gender equality. We will be targeting companies, company founders and fund managers that are aligned with the Equality Fund Initiative’s gender lens themes.

To learn more about gender lens investing, watch a discussion moderated by Afsaneh Beschloss at the Center for Global Development, which gathered 900 participants, to hear how development finance institutions (DFIs) are implementing gender equity strategies and results from the first-ever Gender Equity in Development Finance Survey. The report provides an interesting comparison on the progress DFIs have made on investing in women-led companies as compared to the private sector.

Team RockCreek

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