Another day, another gentle uptick in the UK and US stockmarkets. Like many, I slightly struggle to explain why investors are so optimistic, especially in Europe where earnings (and thus dividends) are collapsing. Just today for instance the European equities team at Morgan Stanley report with the current European earnings reporting calendar picking up speed “limited 1Q results tracked so far point to a YoY EPS decline in the region of 30%.”

To be fair the backward-looking numbers for Q1 don’t look too bad for the 61 companies tracked so far by the Morgan Stanley analysts. “40% of companies have beaten EPS estimates, while 32% have missed so far, giving a net beat of ~8% of companies. Weighted earnings have beaten by 3.4% (on limited numbers), and the median stock has also surprised positively so far (+1.9%). “

The problem of course is that these numbers are hopelessly out of date due to the lockdowns – thus the Q1 numbers are really just an artefact of an old’ ‘normal’. Cue the prediction of an EPS contraction of close to 30% YoY. We’ll get a better handle on these numbers between now and 8th May when analysts expect to hear from over $2.5tn of Market Cap on 1Q results, after which time the reporting pace will slow materially.

Contrast that with this useful info nugget. “The S&P 500 in the US is now just over 15% below its all-time high, which is impressive given it was down over 35% at one point. The index has been helped by a recovery in technology stocks”, according to Rachel Winter, Associate Investment Director at Killik & Co.

This is the subject of my Citywire column this week – out later on today here 

For me there’s an important new narrative emerging which goes something like this.

Central banks have flushed vast amounts of money into the system, some of which will end up being invested in risky assets by investors who frankly don’t need the cash but have to invest. They face three choices.

  • Sit on the cash earning no income at all, waiting for another entry point.
  • Invest in more classic cyclical stocks that will rebound sharply. But the challenge here is that 15% fall to date doesn’t seem big enough a margin of safety in case the economy relapses later in the year. Frankly for many classic cyclical stocks we need a 50% plus readjustment
  • Or invest in the new “defensives”, called tech stocks who seem to be sailing through the crisis.

My sense is that option 3 is proving popular with dollar investors and that is good news for the one stockmarket brimming with tech growth stocks, the US  – and its bad news for most other markets stuck with classic cyclical stocks.

If I had to peer into a crystal ball, I’d suggest that this momentum push into ‘defensive tech’ might even intensify from here and we could see a big melt up to insane valuations for many defensive stocks. On this analysis we could see another 10 to 20% rally hereon in for many of these stocks before they begin to run out of steam. Sensible, no….rational, maybe…understandable, yes.

Talking of defensives…structured products

I am one of the few investment observers who admits to quite linking structured products. That said, for full disclosure I write a market overview for the industry association, UKSPA, and know many of the providers in this space.

If we go back to the last great financial crisis, structured product issuers found themselves in the doghouse. Regulators then waded in and the industry was forced to go through a long process of rehabilitation, with most of the better issuers focusing exclusively on building IFA relationships.

My own sense is that many structured products now provide a very worthy alternative for defensive investors. Too much money has gone into terrible absolute returns strategies and funds, and some of that money could find a more sensible home in sensibly structured, returns by contract, SPs. They don’t work for everyone but for those willing to take the time to understand how the products work and their risk/return trade-offs, they are perfectly mainstream alternative investment class.

Crucially they can also provide real protection in a big market sell off. That sounds a tad counter intuitive because one of the key features of structured products is that they can put capital at risk if a barrier is breached. But that barrier usually has to be observed at the end of the plan not during the duration of the contract i.e they are what’s called European barriers. Also the barriers are usually set well below current market levels, usually between 30 and 50% of the relevant index level (usually though not always the FTSE 100) at strike. Obviously a declining underlying index might nix the annual payout but on paper the original investment should be safe?

In the middle of this month – April 15th to be precise – Tim Mortimer, Managing Director, at consulting and research house FVC put out a useful note looking at the products in the market and how they might be impacted by the sell off. You can download the report here 

According to Mortimer, there are currently 315 capital protected products currently active in the UK market, mostly issued as deposits. As I mentioned before, almost all capital at risk structured products have a single “European” barrier level. This means that if the underlying asset is above this level at maturity then investor’s capital will be repaid in full, and potentially with a growth element if markets have recovered. Most structured products issued in the UK are linked to the FTSE-100 only.

Crucially Mortimer found in mid April that looking at the current products in the market, the highest “barrier level (indicating the product closest to danger) is at a FTSE-100 level of 5331, [but] this is still 9% below the current level [on April 15th] and as can be seen from this chart below it is many years away, in fact in June 2028…..The first active barrier level is in February 2021, still nearly one year from today. Additionally, we note that the highest barrier level for any product maturing before January 2022 is at 4173, nearly 30% below the current level.”. The chart below nicely sums up the dispersion of barriers.

The bottom line here is that many structured products provide real, and valuable, downside capital protection even in turbulent markets. The upside – say through an autocall – might become challenging but for many defensive investors what they really, really want is that capital preservation with the chance of some upside potential. And on that score, most structured products seem to be delivering on their promise. Obviously, all bets are off if markets stumble aggressively again in the next few months and years – perhaps dragging down the big investment banks who are counter parties to many of these products. But I think the risk of new 30 to 50% declines in the level of the stockmarket is small though not impossible.