Bank Holiday Digest

Posted 1 September 2020

Overview: September begins with all eyes on America While tensions have continued to escalate in American cities, US equities continue to push at all-time highs, having recovered everything lost in March’s frantic sell-off – and then some. If the stock market soaring to new heights while the world languishes in its deepest ever recession isn’t staggering enough, we also note the US is accelerating away from its global peers. While the S&P 500 has gained an incredible 56% from its March lows, the UK’s FTSE 100 has barely moved in the last few months – seemingly locked around the 6000 level. European and most other markets look similar, with US and global investors all giving the world’s largest economy – and it’s big tech superstars in particular – an overwhelming vote of confidence.

That market optimism continues to be backed up by an abundance of liquidity. The biggest market event last week was the speech from US Federal Reserve (Fed) Chair Jerome Powell, which indicated a significant break from past Fed policy. The announcement – that the Fed will allow inflation to rise above the 2% target for short periods of time – changes nothing right now, but it confirms what investors have suspected for some time: easy monetary policy is here to stay, even when the US economy starts whirring again.

Given the deep global recession we are in, an easier Fed does not mean that the dollar will weaken tomorrow, or that US Treasury yields will spike anytime soon. But it does make the Fed the most flexible and accommodative central bank in the world right now – which should lead to a weaker dollar in the long run. It is also clearly a positive for the US as a whole, which might justify markets’ American optimism.

The other beneficiary from all this optimism could be Donald Trump. Trump clearly wants to convince undecided voters that he is the ‘Law and Order’ option at November’s presidential election – painting a Biden presidency as route to violence, anarchy and moral decay. But for all of that strongman rhetoric, the President will be well aware that economic optimism – backed up by an accommodative Fed – is m most crucial to his re-election hopes.

Are US bankruptcies a welcome sign of natural selection?
Large corporate bankruptcies in the US are running at a faster pace than ever. So far in 2020, 157 US companies with liabilities of more than $50 million have filed for Chapter 11 bankruptcy, beating the record-setting years after the dotcom and financial crises. While insolvencies among bigger businesses – those with liabilities over $ 1billion – have not yet reached the 2009 peak, the rate of the bankruptcy filings is running quicker than 11 years ago, with 45 big companies becoming insolvent already this year, and analysts expecting more to follow.

Clearly, a global pandemic and an economic shutdown makes normal operation difficult for any company, but the wave of bankruptcies we are seeing – despite trillions of dollars being poured into the economy through government aid programmes – speaks volumes about the lasting impact of Covid-19. And with President Trump now set to cut the government’s $600-a-week emergency unemployment support in half, bankruptcy filings are unlikely to let up anytime soon – especially if virus cases continue to spike across the US.

One of the main concerns with governments’ blanket support measures has been that they would allow failing companies to carry on without a sustainable long-term business model. The pandemic may have been the nail in the coffin for firms such as Hertz and JCPenney, but both companies were struggling long before the first virus case arrived on America’s shores. The fact these companies have been allowed to go under suggests creative destruction is still working.

For an economy to show dynamism and growth, some level of ‘creative destruction’ – where unproductive or unsustainable companies die out and make room for more productive ones – is needed. For years, analysts have bemoaned ‘zombie’ companies, kept afloat only by the cheap credit that the world’s central bankers created since the global financial crisis. Many also cite this as one of the reasons for the sluggish productivity growth seen over the last decade. Chapter 11 bankruptcy is not the end for a firm, but a reorganisation of its finances and business affairs. In fact, American businesses filing for Chapter 11 are often able to carry on trading, sometimes even coming back stronger than before.

From an investment perspective, this productivity and focus on effective corporate structure has benefitted US markets. US corporate earnings growth have outperformed other regions over the long-term. Allowing companies to go bankrupt – but restructure operations to become more sustainable – could be a big part of this. As such – and as long as bankruptcies stay in the big business world rather than the small – a little creative destruction is nothing to be scared of.

Is it time to move beyond price-weighted indices?
Yesterday Apple split its shares by a ratio of four to one, meaning holders of Apple stock now have four shares trading at a price of $125 instead of one share at the price of $500. This is Apple’s fifth stock split, aimed at making the stock more accessible to new investors. But this seemingly normal corporate housekeeping has had a major structural impact on America’s oldest price-weighted stock index: the Dow Jones Industrial Average (Dow). The Dow has a mechanism to deal with stock splits. However, Apple, and the booming US technology sector it leads, had become so dominant that the mechanism was inadequate, and a substantial index shake-up became necessary. To offset the Apple change, three stocks (Pfizer, Raytheon and ExxonMobil) have been kicked out of the index, replaced by Amgen, Honeywell and Salesforce.com.

Although price weighted indices may have been useful at one point, many investment professionals now see such indices as unrealistic – and outdated – ways of measuring the market. An accusation that is perhaps not surprising, given the original methodology began in 1896. Changing the constituents of a concentrated index like the Dow – based not on a company’s performance, but on its decision to deliberately lower its share price – brings into question the value of the index as an indicator of economic health. What it also highlights is that the stocks in leading indices are not selected by algorithm, as one might expect, but by committee. The 30 companies in the Dow are decided by committee and their selection does not seem to follow any consistent process, making it difficult to forecast what the committee will include.

The domino effect of Apple’s change will trigger all the investments that track the Dow to automatically trade the affected stocks. The well-known downside to passive funds is that, while active managers fail to beat the market on average, passive funds can never beat the market, owing to their lack of flexibility or ability to react. It is also possible that the rise in passive funds has contributed to the outperformance of large stocks, which have larger weights in portfolios than active managers. As flows continue towards passive funds, the big stocks are supported, keeping their performance strong, creating more flows and so on. This is likely one of the reasons that America’s tech superstars – Apple, Facebook, Amazon, Netflix, Microsoft and Alphabet (Google) – now account for more than a quarter of the entire S&P 500. That is an astounding level of stock market concentration. To return to the Dow, this is exactly the sort of performance it struggles to account for, given its price-weighting.