View From the Top

Opinions expressed whether in general or in both on the performance of individual investments and in a wider economic context represent the views of the contributor at the time of preparation.

View from the very top: within the space of a month, the world has changed more than any of us could have imagined possible. Beyond the human toll, there will be clear political, economic, social and investment ramifications. Even with the considerable monetary and fiscal stimulus promised, it may be hard for the world to avoid a severe recession. Already-high debt levels could also compound problems for certain sectors. Nonetheless, it is important to try and remain level-headed and consider what may already be reflected in the valuations of all asset classes. If history teaches us anything, then it must be that the best time to buy is on peak fear. It is important to stay nimble. Clear opportunities will emerge. For the long-term investor, the strongest of returns are often built on diminishing bad news. Deploy dry powder tactically yet still keep some cash in reserve.

Asset Allocation:

  • Equities: Global markets may have declined by over 20%year-to-date (27% before there bound), but this retrenchment places them only back at 2018 levels. For context, the S&P 500 rose from its 2009 trough by 393% before peaking in mid-February. Although the multiple derating witnessed globally from peak-to-date is comparable to that seen during both the bursting of the TMT bubble and the Great Financial Crisis, further downgrades to estimates seem likely. Against this background, there has never been a stronger case for active management. Growth as a style continues to outperform value.
  • Fixed Income:There has been a natural and instinctive bias towards safe havens and their perceived ability to offer a buffer against volatility. The entire US Treasury curve now trades under 1% for the first time ever. A similar pattern can be seen in other developed markets. Unconventional policy actions may create inflationary risks over time, but these currently seem remote, with deflation remaining the order of the day. Within the corporate space, credit risk in certain sectors (e.g. energy) is a major concern. Nonetheless, opportunities may be emerging within the high yield space, where spreads have moved significantly.
  • Gold: Recent moves in this asset have shown that even gold is not immune to market volatility. Nonetheless, we see a continued logic in owning gold; it is defensive, carries neither credit nor political risks and acts as a natural diversifier. Current government and Central Bank actions should also be very supportive for the gold price in the medium-term.
  • Alternative Assets:We continue to see merit in owning real assets such as infrastructure, real estate and niche private equity. The recent sell-off in many areas has been indiscriminate. Businesses with strong balance sheets in non-cyclical sectors (e.g. seniors’ housing or logistics REITS) should continue to prosper. Illiquidity premiums do still matter in a low-rate environment.
  • Currencies: Investors continue to flock to the Dollar, even if it looks over valued relative to its history. The US economy would also benefit from a weaker currency. Our preference is for safe haven currencies, especially the Japanese Yen.

All change

The beginning of March feels like a different – and now quite alien – era; one where we sat at our desks in offices to work, visited friends in restaurants, shopped and went to the cinema. To say that the world has changed almost beyond recognition

would be an under-statement. We may never return to quite those halcyon days of the early part of the year, or if we do, it will not be for some time. Countless headlines and expert views have appeared on the topic of COVID-19, but to summarise the current situation in two words, nobody knows. Simply put, this is why there have been such extreme moves in all assets classes both to the upside and downside on an almost daily basis. Economic experts seemingly and suddenly have become experts in healthcare, but the economics of fear is hard both to predict and model. Events have and can take on their own momentum.

It is important to remember that COVID-19 is a novel disease and so the rules are almost being made up as we go along. Before contemplating any impact to the broader economy and investment outlook, the very real human toll needs to be considered before almost anything else. To the extent that anything looks ‘certain’, we would argue the following are likely: there will be a severe global recession; the tools that have worked in previous crises may not work this time; and, regardless of the above two points, immediate, large and decisive policy action is required (and has mostly been promised). Below we attempt to answer the four key questions which we believe matter most currently:

What might be the impact?

It will likely be some time – years, most likely – before the full extent of the economic blow from COVID-19 can be estimated with any confidence. As ever more of the global economy enters a prolonged shutdown, it seems increasingly clear that the world is facing a drop in output unprecedented in its breadth and intensity; or, as the United Nations Secretary General puts it, “a recession perhaps of record dimensions is a near certainty.” Arguably, the biggest risk is if short-term quarantine measures turn into a longer-term isolation, with ramifications that affect economics, industries and societies.

The pattern in China could hint at what is in store elsewhere. In the first two months of 2020, all major indicators were negative. Industrial production was down 13.5% (with the Purchasing Managers’ Index recording a record low of 35.7), retail sales fell 20.5% and fixed asset investment dropped 24.5%, all on a year-on-year on basis. Economic consensus is that GDP may have fallen by over 10% relative to the same period a year prior (all data per Bloomberg). The context also matters given that China is the world’s largest manufacturing economy, biggest exporter and second larger importer of goods.

Now consider the western world. Images of deserted streets have become familiar; perhaps not surprising, given that around 25% of the world’s population is under some form of lockdown. Meanwhile, some 170 countries have closed their borders to some degree (per BBC News). Purchasing Manager Indices across Europe, Japan and the United States have shown declines more severe than during the Great Financial Crisis. Initial projections from economists suggest that the GDP drop in the second quarter of the year could be in the region of 20-30% year-on-year for the western world. Each recession is unique but every recession is also the same: you can never know how long it will last and what sort of scars it will leave.

What to do?

The biggest challenge facing policymakers is to address the immediate cashflow stress for directly impacted households and corporates. Monetary and fiscal policy may help provide liquidity for financial markets, but it may not work if many businesses have furloughed their workers and people staying at home cannot go out and spend. Even if the promise has been made of effectively limitless support, it remains the case that the Federal Reserve and its global peers per se cannot stop the spread of the virus. Policymakers are, arguably, still using a playbook designed for liquidity problems, not public health problems.

Nonetheless, the greatest lesson from the Financial Crisis was to act decisively and to act big; to demonstrate to markets, businesses and households that policymakers are serious about dealing with the slump. There is also a clear element of psychology at work here; if delivered right, institutions may end up doing a lot less than they had actually promised. The good news is that we have got decisive and coordinated actions. The Federal Reserve (as a proxy for other Central Banks) has said it will buy government and mortgage debt in unlimited quantities. Meanwhile, fiscal stimulus plans approved to-data are large; equivalent to 10-15% of countries’ GDP and over double the level delivered during the last crisis.

Where might the problems lie?

The current economic reset may be compounded by the unwinding of leverage and hence a liquidity shock – as evidenced by growing stress in the short-term funding market. Quantitative easing policies helped paper over many cracks. If credit markets do close up, then this could be very negative for low-quality businesses, particularly in sectors such as energy, construction and retail. Global companies generally, are dangerously unprepared for a sudden decline in profits, given record-high debt levels. Corporate net debt to EBITDA has trebled since the peak of the last crisis, with businesses (excluding financials) carrying over $74tr of debt, equivalent to 92% of GDP. This compares to 84% in 2009 (all data per the Institute of International Finance). Much of this debt is in the more risky format of high yield and/or leveraged loans.

Also, don’t forget the precarious health of the consumer. This matters particularly in the US, where consumer spend is equivalent to some 70% of GDP. Total consumer debt of $14tr stands at its highest-ever level in America, with credit card delinquencies at levels not seen since 1980 and auto delinquencies at record levels (per the New York Fed). COVID-19 may serve to expose inequalities in all countries to a greater extent than previously, particularly given the relative disproportionate impact felt by many workers in the tourism, retail, hospitality and gig economy sectors.

What are the causes for optimism?

The fall in equity markets from their highs is larger than the median historic correction (per JP Morgan), creating an asymmetry to the upside. Similar observations could be made regarding other asset classes. Against this background, it is important to remain level-headed and consider what may already be reflected in prices. Often the best time to invest is on peak levels of fear; the strongest of returns for long-term investors are built on diminishing bad news.

Also consider the practical. First, look at China. Some 90% of its factories are now operating at pre-crisis levels and its stock market has been the ‘least bad’ of the major indices in performance terms year-to-date. Next, there is much more governments can do too. Consider that the government budget deficit in the US is just 1.9% of GDP. In the 1940s, it reached 27% of GDP (the figures for the UK and other western economies are comparable). With bond yields so low, issuing money is clearly easy to do (even if there may be unintended consequences that arise from such actions). Beyond staying healthy, it is important for investors also to stay nimble. Out of the current situation, clear opportunities will undoubtedly arise.

Alex Gunz, Fund Manager, Heptagon Capital

Disclaimers 

The document is provided for information purposes only and does not constitute investment advice or any recommendation to buy, or sell or otherwise transact in any investments. The document is not intended to be construed as investment research. The contents of this document are based upon sources of information which Heptagon Capital believes to be reliable. However, except to the extent required by applicable law or regulations, no guarantee, warranty or representation (express or implied) is given as to the accuracy or completeness of this document or its contents and, Heptagon Capital, its affiliate companies and its members, officers, employees, agents and advisors do not accept any liability or responsibility in respect of the information or any views expressed herein. Opinions expressed whether in general or in both on the performance of individual investments and in a wider economic context represent the views of the contributor at the time of preparation. Where this document provides forward-looking statements which are based on relevant reports, current opinions, expectations and projections, actual results could differ materially from those anticipated in such statements. All opinions and estimates included in the document are subject to change without notice and Heptagon Capital is under no obligation to update or revise information contained in the document. Furthermore, Heptagon Capital disclaims any liability for any loss, damage, costs or expenses (including direct, indirect, special and consequential) howsoever arising which any person may suffer or incur as a result of viewing or utilising any information included in this document. 

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