Markets, optimism & COVID-19

As global economic fears are escalating, we thought it timely to update our network on our views.

11 March 2020.

As global economic fears are escalating, we thought it timely to update our network on our views. We wish to highlight four points:

• We are not viral disease experts and are not qualified to predict the ultimate health impact of COVID-19.

• However, we have been concerned about extended market valuations, the chase for yield and investor complacency for some time and therefore have been positioning portfolios defensively in anticipation of a potential shock**.

• Our ethical positioning, and particularly the exclusion of oil companies, has bolstered our returns relative to the market.

• We are continuing to monitor the market and economic impact of COVID-19 and will provide updates on our views so long as the extreme market volatility persists.

The World Health Organisation (WHO) declared COVID-19 a Public Health Emergency of International Concern (PHEIC) on 30 January 2020. This is defined as, “an extraordinary event which is determined to constitute a public health risk to other States through the international spread of disease and to potentially require a coordinated international response. This definition implies a situation that is:

• serious, sudden, unusual or unexpected;
• carries implications for public health beyond the affected State’s national border; and
• may require immediate international action.”

For the first time since the onset of symptoms of the first identified case of COVID-19, WHO has reported more new cases by countries outside of China. This merits serious concern, but it is exceedingly difficult to predict the ultimate economic impact. However, we do hold the view with some conviction that the supply-side shock, caused by the shutdown across China, along with a breakout of the virus across every continent will have a lasting economic impact. How this translates into company earnings remains difficult to predict.

For some time, we have been aware of the susceptibility of extended market valuations to negative news flow. With stock market indices recently hitting record highs and investor confidence seemingly immune to the prospect of anything denting the continued rally, the scope for a shock to markets was evident.

Much of the unshakeable faith has been led by the decades’ long intervention by global central banks to keep interest rates low in an attempt to stimulate investment and demand. While the strategy has been successful in pushing interest rates low, so low that in a number of major economies interest rates have been negative, the stimulus to the real economy has been muted. In turn, it has resulted in only moderate earnings growth which begs the question, how have stock markets managed to rally so hard?

This is perhaps best explained by reference to stock market valuations. Using the US S&P500 as the ultimate bellwether of global risk appetite, we can see how expensive the market had become over recent years. This effect was replicated across most major stock markets, including Australia’s own.

Source: Factset, 10 March 2020

This chart illustrates the point. The blue line tracks the index movement which has risen sharply since the last sell-off in December 2018. The red line is the aggregate level of earnings per share which records an actual fall in earnings over the same time period. Of concern has been the market’s continuing rise in the face of declining earnings. This has resulted in the common valuation measure of price to earnings ratio rising to a peak of 18.5 times*– an extreme level when viewed in a historical context.– an extreme level when viewed in a historical context. This suggests markets became unsustainably expensive.

*PER here referred to is of S&P Index over latest EPS-NTM, 3 February 2020.

While not immune to absolute falls or volatility, we do believe our portfolios should perform relatively well against the broader market and companies held will have limited exposure to supply side shocks as manufacturing and services around the world are restricted in their activity.

We are actively watching the state of markets and monitoring the situation closely. Should we see a deterioration in the current outlook to suggest a permanent destruction of capital, we shall update and communicate our views accordingly.

Mathew Browning, CEO

**The market commentary reflects U Ethical’s position at the time of publication and is subject to change. U Ethical reserves the right to make any adjustments to the investment strategy or outlook for all products at any time to reflect major disruptions or changes in the financial markets, as allowed by the relevant governing documents, Product Disclosure Statement, Information Memorandum, or Offer Documents. Past performance is not indicative of future performance. All investments carry risks. There can be no assurance that any U Ethical product will achieve its targeted objectives or rate of return and no guarantee against loss resulting from an investment in any U Ethical product.

Important information:

U Ethical is a registered business name of Uniting Ethical Investors Limited (ABN 46 102 469 821 AFSL 294147).
U Ethical Enhanced Cash Portfolio is issued by UCA Cash Management Fund Limited ABN 41 075 948 444 (UCA Cash). U Ethical Growth Portfolio is issued by UCA Growth Fund Limited ABN 39 075 948 435 (UCA Growth). UCA Growth and UCA Cash rely on the exemptions under section 5(1) and 5(2) of ASIC Corporations (Charitable Investment Fundraising) Instrument 2016/813. UCA Cash and UCA Growth are required to notify investors that the debentures in the
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