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: These are not normal times. Old rules are being upended in terms of the role that states must play. More central planning amidst a world of higher geopolitical tensions seems likely. Such actions may create major market inefficiencies and uncertainties. Regardless, investors seem content to accept the ‘whatever it takes’ platitude for now. For asset allocators, there are clear challenges ahead. With near-zero interest rates (and no prospect of inflation, for now), conventional 60:40 equity-bond allocation models simply won’t work. Further, if we can be sure of anything, then it will be further major dislocations over the near- and medium-term as many industries and businesses are forced to restructure. We believe such a backdrop only reinforces the case for active management across a balanced and highly diversified portfolio.

Asset Allocation:

• Equities: Active management seems the best way of reconciling the views of those who believe that equities have run too far, too fast (the MSCI World is up 34% from its March trough) and those who see there being no other major liquid asset class in which to invest. What does seem clear is that these are not normal times. The bifurcation between ‘winners’ and ‘losers’ (e.g. tech vs financials) continues to widen and mean reversion as a strategy is not currently working. Although the recent earnings season was not as bad as feared, calendar Q2 results may reveal a truer picture of the pandemic and provide a useful for reality check for equity investors. For context, even if earnings are currently depressed, the MSCI World trades on 20.9x 2020E P/E, a premium to its average multiple over the last ten years of 18.0x (per Bloomberg).
• Fixed Income: Some select credit opportunities are emerging as much as anything owing to the spreads available relative to owning conventional Government debt. With interest rates negative in many countries, we find it difficult to make a case for Sovereign Bonds as a diversifier or return generator, particularly since investors are de facto guaranteed to lose money on bonds with negative yields. In the corporate sector, against a context of growing credit downgrades and rising default rates, adopting an active approach is the most logical strategy.
• Gold: We continue to be positive on gold. It acts as a natural portfolio diversifier. Further, the best time to own the asset is when real interest rates are falling and/or negative, as is currently the case. Finally, do not forget that gold lies outside the banking system and so carries neither credit nor political risks.
• Alternative Assets: Real assets lagged not only in March’s market sell-off but also in the subsequent recovery. We believe that investors have been somewhat indiscriminate in their considerations. Low yields generally strengthen the case for private assets. Those with strong balance sheets in non-cyclical sectors (e.g. seniors’ housing or logistics REITS) should continue to prosper. We see certain opportunities in infrastructure, real estate and niche private equity.

On the other side

Optimism knows no bounds, it seems. Many asset classes continue to trade higher by the day, inching back towards pre- COVID crisis levels. We think we understand why: markets are forward-looking and the perception is that the worst is over; hence the stronger reaction to good news than to bad currently. Central Bank and Government support has provided a clear prop to markets, macro data has been ‘less bad’ than feared, COVID-19 cases are peaking and more countries seem to be opening parts of their economy almost daily. Many seem to have written 2020 off, giving companies (and their earnings) a ‘pass’ – since the event provoking such dislocation was exogenous and not potentially self-inflicted, as in 2008 – focusing instead already on prospects for 2021.

There have, of course, been clear relative winners and losers from the COVID crisis. Big tech has, thus far, been the major beneficiary, seemingly at the expense of sectors such as energy, financials, hospitality and airlines. Lest we forget, the upward progress of the S&P 500 Index since its March lows (equivalent to a 36.0% gain) is not indicative of the health of the broader economy. Perhaps the 16.5% decline in the Russell 2000 Index year-to-date (by contrast the S&P has lost just 5.8%) paints a truer picture. More broadly, equities are on a different trajectory to the economy.

More provoking to us is to consider what will the ‘new normal’ look like. We wonder what may be the outcome for financial markets if their reading of the current environment proves incorrect. The past is of little guide to the future simply given the unprecedented nature of the COVID-19 crisis. Since the pandemic remains highly unpredictable, the future is even more unknowable than might usually be the case.

After the excitement of Central Bank/ Government intervention, now comes the reality: lower nominal GDP for longer. The global economy will be – to all intents and purposes – worse-off post-COVID. Previous GDP growth won’t come back any time soon, especially in a world which had been planning for ever-higher growth. Consider the pre-COVID context: an over-build of real-estate, corporate over-leverage, under-saving by consumers – hardly an appetising backdrop. Corporate and household debt will likely become more burdensome as the economy shrinks, decreasing the possibility for new spending once any recovery gets underway. Expect a rise in business and personal bankruptcies long after the most acute phase of the pandemic has passed. Further, the ability for policymakers to revive growth remains constrained by near- zero interest rates. Do not forget that we are living in a deflationary world: one characterised by lower wages, lower oil, more digitalisation and forced deleveraging.

The reality is that each historic turning point – and we have to consider the pandemic in this context – creates aftershocks and trends that will only come to be seen fully once the initial crisis has passed. Bear in mind, global human development (a broad measure combining education, health and living standards) will decline this year for the first time since 1990, when the index was initially created by the United Nations. Further, we cannot yet know whether rolling lockdowns may become a regular feature of the world – the World Health Organisation recently warned that COVID-19 may never go away. Policymakers will therefore continue to face the trade-off of how to rebalance health priorities and restart their economies. Beyond the epidemiological crisis, expect potential geopolitical reverberations too.

For now, though, it is easy to embrace the “whatever it takes” platitude. Consider just how aggressive recent Central Bank behaviour has been. For context, the Federal Reserve was buying $75bn of US Treasuries every month during its QE2 programme (which began in November 2010); currently it is buying the equivalent amount per day. Put another way, it is throwing everything it can at the system, especially since the Fed’s purchases now encompass junk bonds and mortgage- backed securities too, which was not the case in 2010. Sceptics may justifiably wonder what might happen were such stimulus taken away. Excess intervention would surely be preferable to a run on corporate bonds? Nonetheless many economists – particularly those of the Austrian school – would contend that once unconventional monetary policy begins in earnest, it must continue exponentially in order to prevent an asset price collapse. Were there a second wave of COVID cases in the US, it is not even inconceivable that the Federal Reserve may (be forced to) revisit its objections to negative interest rates. We should perhaps then wonder whether low/ negative interest rates are less a panacea, and rather, more of a disease.

This debate is also being played out against a broader backdrop of accelerated deglobalisation and its corollary, more centrally planned economies. Governments seem to have eschewed cooperation and, instead, have embraced more aggressive competitive stances. Unfortunately it seems that nationalist and populist tensions are intensifying. Further, neither the US nor China has hardly covered itself in glory during the current crisis. The chances of misunderstanding and miscalculations between these two nations seems only to be growing, particularly ahead of an impending American Presidential election. The growing mutual distrust dwarfs any previous trade tensions. The implications do not auger well for the rest of the world.

At the least, more central planning will introduce more market inefficiencies. Surely, rather than seeking to domesticate supply chains – which concentrates risks and forfeits economies of scale – the solution is to diversify them? Nonetheless, bigger government looks like it is here to stay. What this likely means is that there will be a further shift from wealth concentration to wealth redistribution, particularly given the widening inequalities that the crisis has exposed. For context, 40% of Americans in households making less than $40,000 annually lost their jobs in March (per Bloomberg) – and almost certainly more since. Expect some potential payback for consumers. Larger businesses have clearly benefited at the expense of smaller ones. This may mean more taxes and/or possibly greater regulation in certain sectors somewhere down the line. Remember when the break-up of the mega-cap tech companies was mooted only a few months ago?

‘Someone’ will have to be there to pick up the tab for all the debt that is being currently created. The US fiscal deficit is already the highest it has been since World War Two and double the levels witnessed in the Great Financial Crisis. Likewise, even at the end of 2019 the $13.5tr sum of total US corporate debt was also two times higher than a decade prior (data per Fitch). Investors seem to be buying the story that more debt is fine for now, given how low interest rates are and that deflation is the order of the day.

This view, of course, ignores the decreasing productivity of the debt: each new round offers diminishing returns. It also increases disincentives: bad financial behaviour is effectively rewarded if financially unsound/ insolvent businesses are allowed to survive. Alternative scenarios are perhaps even harder to conceive of though, since inflation seems an unimaginable prospect currently. Do not, however, bet against policymakers resorting to this solution (via even more unconventional strategies) at some stage, particularly since it would disproportionately benefit the most indebted.

The biggest implication of all the above is to expect ongoing dislocations in all asset classes. This requires different investor positioning both to that deployed in the past (a conventional 60:40 equity-bond portfolio just simply won’t deliver the returns to which investors have been historically accustomed) and during the recent indiscriminate sell-off witnessed in March. These are not normal times and so do not expect mean reversion. Whole industries will be forced to restructure and many businesses to de-lever. If ever there were a time for active management, it is now. Stay nimble and be diversified.

Alex Gunz, Fund Manager, Heptagon Capital