Bulletin

13th May 2020

COVID-19 – Follow the science
Article by Patrick McIntosh, [email protected]

The virus and the way out, a road map to the future

Scientists in Oxford and AstraZeneca are confident that they will have 1 million vaccines tested and ready to go by September.  Both Oxford and Imperial will start trials of the vaccine in June.

Both groups have significant experience with MERS and SARS and so their track record makes them well placed for success. They hope to get to 100,000,000 vaccines by November.

These vaccines will first be used on the vulnerable and the exposed i.e. people in public services who need protection initially, and then more widely.

They will be looking to scale up to 9,000,000,000 doses across the world and this is going to be challenging!  We feel that this will lead to significant long-term economic slowdown as a consequence of lack of ability to move freely until we can be sure we are all safe.

Global co-operation may enable massive scaling-up at speed, but this remains an unknown possibility at the moment as each country seeks to create the vaccine.

How long can the vaccine last?

Based on the SARS evidence it could last for up to five years.

Experiments and experience from flu vaccines developed in the 1990s demonstrated two points.

The first is that the immune response in humans improves with exposure and with vaccinations, even if the vaccine slowly wears off. Remember the vulnerable have a new flu vaccine injection each year for this very reason.

The second is that as evidenced from work in the 1990s and before, the virus starts to weaken as time goes by.

In the 1918/19 influenza pandemic there were roughly 3 spikes, but with each spike the virus weakened until eventually it became a fairly standard flu type infection which humanity could cope with.  Much the same is expected with COVID-19.

In developing strategies to cope with outbreaks of the COVID-19 virus scientists are looking at the way in which they controlled smallpox. When an outbreak occurred, they contained the population and treated them all with the vaccine as quickly as possible. In this way the vaccine is used as efficiently as possible until we have got enough of the population of the world controlled at scale.

We believe that the Government’s immediate priorities are:-

1.  To manage the fear factor so that people remain respectful of infection, but not irrational in their ability to cope with it.

2.  To increase testing knowledge, blood sampling etc in all its forms.

3.  To have a tracking system on everybodys’ phone so that we know where we are and who we have been in contact with so that we can be isolated quickly and efficiently if we come into contact with the virus.

4.  To build enough medicines, ventilators etc to cope with short-term outbreaks that are bound to occur over the next 18 months to 2 years until the vaccines and herd immunity have controlled the virus.

5.  Finally, over the next 2 to 3 years the world will get vaccinated and herd immunity will evolve and the virus will mutate and weaken.

It will be very difficult for the globe to enter Into international travel outside high-level medical areas such as Europe as it will be so difficult to understand where, for instance, sub-Saharan Africa, India, South America, Russia etc, have got to and therefore be safe to travel there.

We should also note that in the USA 65,000 have died from COVID-19 and flu.  Last year saw 34,000 die of flu, 36,000 from road traffic accidents, 84,000 from diabetes and 480,000 from smoking!

Finally, this virus has absolutely nothing to do with AIDS which is a completely different type of virus and infection and should not be confused as being the same.  Both Oxford and Imperial have confirmed this fact and are very concerned about the conflation of information being circulated in ill-informed social media and the press.

Investment process

Linking this to the economics of global evolution the following is relevant:

Firstly, governments and central bankers are following the science and the key points previously detailed.

Debt will continue to escalate as we keep the global economy ticking-over until we can get back to a new normality.

Financial repression in all its forms may take place but it is very difficult to know which or how many of the different elements will be applied across the planet.

Equity markets could fall dramatically but equally will recover significantly.

The economic cycle from this point is probably about five years, albeit that there should be some significant evidence of economic evolution in a positive direction during 2021.  This will simply be down to how quickly the world becomes able to manage the virus and cope with this new Illness.

So long as you have enough cash to cover out-goings for the next two years and do not commit to any unusual or substantial expenditure then the following rules should apply:

We would not recommend reducing debt as it will be very cheap and may well be degraded by government action across the world. But pay the debt interest!

Be very wary of investing in debt and banks and cash (especially those offering higher rates of interest) because degradation of debt means inflation on the other side of the argument and significant pressure on banking survival .

Investing in future technology and the global economic recovery will be vital and essential to retain wealth and value.  There will be huge volatility in global stock markets.  We will come out of this but there is no short-term fix, and there is no simple solution.

As always, the only way to reduce risk is through diversification, ie maximum spread with minimum commitment in any one direction.  At KMG this is what we will continue to focus our minds on as we move through the summer. 

It is important to remember that: focusing too short term can be dangerous, we cannot assume the future will be like the past, and we should not fall into behaviour biases.  KMG continue to look not just at asset allocation, but sectors and themes combined with good fund managers that can deliver their fund objectives.  We should not ignore the importance of diversification!

Working from home during COVID-19
Article by Gemma Barker, [email protected]

KMG has been ready for the last 5 years!

We at KMG feel very privileged to work amongst the beautiful green surroundings of Surrey, but our little oasis comes with difficulties at times. We spent the first couple of months of 2020 directing you all to alternative meeting spots to avoid flooding and roadworks and many of you have experienced rescheduled meetings due to snow at some point.

Because of all this we have had to learn to be adaptable and ensure our systems were ready for any situation that may arise. The whole team have therefore been able to enjoy the flexibility of working from home on a regular basis for years. This meant that when COVID-19 hit we were in a fantastic position to almost “pick up our desks” and begin working from home, even down to wonderful June on reception being able to direct our landline calls around the South East to each of our homes.

All our files are held on secure cloud systems so we can access them from anywhere and we were already beginning to set up clients with “portal” accounts so that documents can be shared digitally and securely.

However, working from home once a week and working from home every day for seven weeks are two very different beasts. We wanted to make sure that we still felt connected with our colleagues at this difficult time, so we have taken to video calling each other using Microsoft Teams whenever we are working collaboratively during the day. We have even had a “relaxation night” over Teams from the comfort of our own homes, and there are now rumours of a KMG bingo evening coming up.

A KMG team meeting

You may already have had the pleasure of a Zoom meeting with one of the team, and perhaps you don’t know whether you were speaking to the Smallfield office, or perhaps someone in the Brighton or Greenwich “offices”!

We very much look forward to the day when we can share a coffee with you in person again, but some of these changes are surely here to stay and we are pleased to embrace them!

Strategy – Looking Forward
Article by Andrew Heath – Investment Manager

Investments and the future wealth creators in your portfolio 

This article is much longer, and more technical, than we usually write for you, but we hope you will enjoy reading in more depth about our thought processes during these uncertain times.  

In Patrick’s lead article we consider the effects of COVID- 19 and some of the possible outcomes.  So, what does this all mean for you as a client, and what are we doing with the investment strategy at KMG?

What have we changed so far?

In April we trimmed across all areas of our discretionary portfolios including fixed income,

alternatives, and equities, adding 10% cash to all strategies. Within fixed income we trimmed exposure to lower quality debt primarily as corporate defaults will likely rise over the coming months.

Within alternatives we reduced exposure to areas of the market that were designed to deliver income. Although a lot of these companies will continue to do so, the change in the environment means that  margins will be squeezed and thus dividends will be cut indiscriminately. We also focused upon liquidity reducing exposure to those funds that are invested in specialist areas of the market where liquidity is likely to be lower in the current storm.

Across our equity exposure we reduced some of our riskier and more cyclical names particularly exposed to the small and mid-cap areas of the market. We also added to large cap quality growth funds which will act more defensively during this volatile period.

This included increasing exposure to Liontrust Special Situations, Fundsmith Equity and HSBC American Index. The underlying companies are focused towards sectors and industries that are more likely to weather the storm with stronger barriers to entry, solid balance sheets and higher free cash flow.

Current Strategy

In terms of alternatives we remain focused particularly on infrastructure and alternative energy but remain mindful that liquidity is often lower in these areas. This includes social infrastructure such as social housing, doctor surgeries, hospitals etc, some of which are government backed structures which are much less correlated to the economic cycle.

In the short term, infrastructure and logistics were areas of the market that saw significant drawdowns as investors realised cash. However, these companies have been oversold and are likely to recover. They include Tritax Big Box which manages a highly diversified portfolio of operational distribution centres, which have high quality tenants including Amazon. The business benefits from the structural change impacting consumers i.e. movement away from high street to online.

Within fixed income we remain focused upon higher grade credit and government bonds and continue to maintain a lower exposure to lower quality debt. Rating agencies will continue to downgrade sectors and names with many fallen angels, those pushed beyond investment grade, seeing yields rise significantly increasingly their debt servicing costs.

The dash for cash (selling your liquid assets to raise cash) has calmed down and overall liquidity in fixed income markets is better now. However, there are still parts of the market suffering from much lower liquidity such as leverage loans. There have also been liquidity concerns within government bond markets, particularly within the US Treasury market but the US government is now buying primary and secondary issuance as well as bond exchanged traded funds (ETFs).

New issuance across the investment-grade market is operating better. The secondary market is also back on its feet and functioning. There continues to be focus upon those fallen angels, and central banks has been quick to provide some support here.

The high yield market feels more exposed particularly within the energy market and defaults will certainly rise even with the US Federal Reserve and European Central Bank pledging to buy high yield ETF assets for the first time in history.

Although earnings numbers and economic data is likely to be terrible over the coming months, we still do not know the full extent of the damage. We do, however, know that typically larger companies with strong balance sheets and strong barriers to entry will survive, and we have exposure to many of these within the portfolios.

Companies are cancelling dividends and stock buybacks to absorb the hit to economic growth, which also threatens further debt downgrades and defaults. However, the next phase could suggest that the price swings between and within asset classes are more predictable and based on fundamentals which is a good thing.

On a sector basis we are more exposed to technology, healthcare, and consumer-related whilst there is much less of a focus upon energy/materials companies which are generally highly leveraged. Our financials exposure is more dominated across emerging markets where growth for deposit-based facilities continues to grow. These businesses are not immune to the heightened volatility, but better-quality names will survive the crisis and are less sensitive to GDP growth.

The Next Phase

What really matters is the length of time that the economic recession lasts, and that we do not know. This is where the US is so important, it is the largest and most influential economy in the world, the longer the lockdown, the greater the impact; more jobs will be permanently lost, debt will be higher, corporate profits will be lower. Better news on the health crisis is a pre-requisite for moving to the recovery phase but visibility on the extent of the economic and corporate earnings damage will not come before then.

The new cycle is being set and there will be new trends and new market leadership. At this point, it is impossible to identify all those trends, but at the very least, we appear to be in a new era of fiscal expansion.

At a high level we need to focus on digital/technological opportunities, healthcare advances, infrastructure and green and sustainable investment. Within these broad trends we need to maintain exposure to quality companies that are operating with good management teams and strong business models.

Digital World

The world has entered a new digital era with major technological innovations fuelling momentous change and creating high growth investment opportunities. This change was happening before the tragic Covid-19 virus, but the trend has been accelerated. People will increasingly work from home, shop online, socialise, and be entertained digitally.

Technology is moving fast and has become broad -stretching across many sectors and industries. It includes:

· Payment Platforms

· Artificial Intelligence

· Big Data & Cloud Computing

· Automation & Robotics

· Web Entertainment/Streaming/Gaming

· Healthcare Innovation

· Cyber Security

· Industrial electronics/software

We need to focus on what we think the world will look like in 3, 5, 10 years’ time and understand the new technologies and how they will impact our lives. Working from home, web-based entertainment, E-Commerce, virtual assistants, driverless cars, drone deliveries, unmanned factories, remote surgery, personalised medicine, smart homes will be common features. This transformation is profound and many of these industries are in their infancy.

We are witnessing profound shifts across all industries, with new business models and the disruption of the incumbents, from commuting to work to working from home, heading to the shops to buying from Amazon, Blockbuster Video to Netflix, Travelodge to Airbnb, Taxis to Uber, people filling factory lines to robots controlled by AI. How we work, communicate, express, inform and entertain ourselves, is changing rapidly. Smart Phones were not around 12 years ago, the internet was not widely used 25 years ago and now they are indispensable to more than half the world’s population!

Expect volatility along the way as there will be periodic sell-offs as valuations become stretched and people take profits, but if the secular growth story is intact and the company is still leading the way any sell off brings in a new wave of buyers keen to harness the long term growth potential of the sector.

Healthcare Innovation

Perhaps the most powerful investment theme is the desire of humankind to live longer and healthier lives. Healthcare is a prime focus now for obvious reasons, but technology is driving how we think about nutrition and exercise, how we interact with medical professions, and app monitoring. Of course, the ageing population theme continues to be important, and is interlinked with this innovation.

Healthcare has so far been reactionary: when we are ill, we seek solutions. New technology will be more proactive as gene sequencing can help identify how we might get ill and then personalise a solution. Even the 3D printing of skin, bones and organs is now possible as well as remote surgery.

The tragedy of the Coronavirus pandemic will increase the scale of the long term moves to healthcare innovation, from pioneering new vaccines to better diagnostics and more PPE. New trends emerging include mobile healthcare, with fitness and wellness monitors talking to apps with data interpretation leading to early prognosis. Also nanomedicine is assisting diagnostics, analytical tools and treatment therapies

Infrastructure

Infrastructure, like many of these themes, is extremely broad. It includes renewable energy, particularly wind and solar, healthcare including hospitals and GP surgeries, social housing, education, and logistic centres with tenants such as Amazon and Ocado. Often many of these provide long term visible income streams backed by government or a regulatory framework.

Companies often pay dividends based upon assets which are critical to society and which generate income regardless of demand, and are needed for society to function successfully, even during a recession. So far, our infrastructure funds have continued to pay strong dividends.

Sustainable Investment

The promotion of green investment has taken a back step in recent weeks, but the focus will return in a stronger manner. Once we move through this crisis investors will once again focus upon sustainable issues driven by the demand for better resource efficiency, improved health, and greater safety.

There will be more of a focus on the following:

· Efficiency in the use of materials and the desire to make industrial and agricultural improvements will persist. This will also be true for how we manage water and waste.

· Being forced to work remotely and finding it is a highly effective form of communication means people will do this more, saving time and resources.

· The desire to eat healthier food and exercise will persist.

· People will continue to demand improvements in local air quality for the health of their families.

· People will give up more of their time to help others, either through donations or volunteering.

· Companies will take a different view on how they run their business, and value will be seen in proactively managing staff and supply chain stakeholders. Society is watching how companies react and some brands will take a long time to recover.

· Demand for quality education will persist.

· Healthcare systems will be more supported and activity around managing diseases should be bolstered.

· Some climate-related initiatives, such as parts of the EU Green Deal and the climate crisis meeting COP26, have been delayed a year as COVID-19, rightly, stays at the top of the agenda. But this de-emphasis will be temporary.

These are not necessarily new trends but there will be a renewed focus on the way we live our lives. The process is based on the belief that in a fast-changing world, the companies that will survive and thrive are those which:

· Improve people’s quality of life, be it through medical, technological, or educational advances.

· Drive improvements in the efficiency with which we use increasingly scarce resources.

· Help to build a more stable, resilient, and prosperous economy.

These sustainable themes help identify companies set to make our world cleaner, healthier and safer. The impact of COVID-19 on our health, livelihoods and economies enhances the view that investing in these companies will see stronger growth.

Summary

We believe the portfolio is already well aligned to the structural trends likely to accelerate as a result of the current situation. However, there are always improvements to be made and of course the world and trends that follow continue to evolve at a fast pace. The objective is to identify and capture key structural growth trends that will shape the global economy of the future and then invest in high-quality companies whose products and operations capitalise on these changes.

We want to focus on companies with characteristics such as strong intellectual capital, high barriers to entry, pricing power across the cycle and an ability to invest and compound growth. These high-quality businesses will survive the crisis and are more likely to emerge in a stronger position afterwards as weaker competitors fall away.

Final Thoughts:

· The economic slowdown caused by the virus is temporary but the effect on society is permanent thus creating or at least enhancing some important themes.

· Central bank stimulus has been released in an unseen quantity. These figures are extremely difficult to quantify.

· Debt, demographics, and technological advances remain deflationary for now – the question is whether the stimulus will create inflation down the line?

· Bond yields continue to be held artificially low by QE for now.

· We need to invest in the structural growth areas such as technology, healthcare, infrastructure, and sustainability and only those businesses that are sensibly leveraged.

· Trends in ecommerce, virtual events, gaming, and automation will likely accelerate. For many businesses this will necessitate rapid adaption in order to survive.

· Avoid structurally challenged areas such as European banks, autos, high street retailing, traditional energy, highly leveraged businesses, and deep value stocks.

· Of course, in the shorter term there may be some additional areas of the market that may come under pressure such as high yield bonds, select emerging markets and certain income strategies

· We must think less of the concepts of value and growth and focus upon structural growth and the businesses that will be key players, perhaps regardless of price.

· Liquidity and price remain paramount

· Markets will continue to be volatile, but we are looking to the long term.

· In the future we can deploy the cash weighting to these areas of the market once we get more visibility on the virus and the economic effects.

In the coming weeks our Discretionary Portfolios will be adapted to the above themes to ensure we are prepared for the future changes we expect to see.

Financial Services in an uncertain world
Article by Jenna Duffett, [email protected]

Protecting you, protecting us. KMG is one of very few firms holding high level professional indemnity cover 

I am very pleased to be able to confirm to all clients that KMG carries full compliant cover for all the regulated activities we undertake. Our understanding is that our current professional indemnity insurer is the only one to offer full cover in the market, and in turn we are only one of approximately 150 firms in the UK they will insure.  This means we continue to be able to protect our clients fully; not something that most IFAs in the UK can say!

For many years, the financial services sector has been troubled by various issues such as rogue funds and Ponzi schemes, through to the Credit Crisis of 2007 and into 2008 where we saw banks no longer trusting each other.  The consequence of this lack of trust in who held toxic debt, (sub-prime loans), was the main driver for liquidity to dry up in the banking sector, and thus all financial markets became extremely challenged.  Money must circulate to allow the financial markets to operate and trades to happen.

During this period, we witnessed the failure of Lehman Brothers, and here in the UK Northern Rock faced “a run on the bank”.  The casualties mounted and one important consequence was the way in which the Financial Conduct Authority expected banks to capitalise themselves to ensure liquidity if this ever happened again.

One of the benefits of KMG’s experience is that we have seen many financial disasters over the years.  What clearly sets COVID-19 apart from the last financial crisis is that liquidity is not an issue, and so the wheels of financial markets continue to turn.  Indeed, if anything, the amount of liquidity that governments around the globe are pumping into the system means that we should not see the catastrophes of 2007/2008 again.  This perhaps was the biggest lesson learned: the system needs to keep working.

At KMG we never forget the past, nor do we believe that the future will be identical.  Past mistakes happen, but always with a different spin.  So we have, and always will, continue to scrutinise all the funds we recommend to you, even cash holdings!

Like banks we too are regulated by the Financial Conduct Authority.  Like banks we are required to have liquidity to meet any challenge.  Hand in hand with this is our requirement to hold Professional Indemnity insurance, and we are not allowed to operate without this.  Renewing this insurance has become ever-more challenging simply because the insurance market now has far fewer insurers than ever before. 

REMINDER – Secure access to your reports

In the current climate it remains ever more important that we can deliver your valuations and reports to you securely.  We continue to find postal delays are occurring and so if you have not as yet spoken to us about our client portal then please contact the team. 

We would be delighted to assist you with creating a secure log into our systems where you will be able to view and download your latest reports from us.