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: If March marked peak fear, then April may be representative of peak complacency. However many other questions remain unanswered, we are fairly certain that the world is not going back to how it was. Rather, COVID-19 has accelerated the trend of deglobalisation and set in train a shift towards more centralist and protectionist economies. Narratives will correspondingly change. The accumulation of more debt will be solved through further moves into unchartered territory by Central Banks and Governments. Even if the full consequences may take years to play out, there is still no guarantee at this stage that the recovery in the economy will be either smooth or swift. Asset allocators therefore need to remain highly nimble. Even if correlations have increased, so must conviction necessarily . Favour active managers of equities and high yield.

Asset Allocation:

• Equities: The ~30% rally in the MSCI World from the March trough means that its current multiple of earnings (~18x for 2020, per Bloomberg) is back in-line with the Index’s 10-year average. Put another way, with many corporates withdrawing their financial guidance – and so making forward earnings almost impossible to predict – a lot of bad news, we believe, is already being discounted. At the least, we think it crucial that investors make a distinction, favouring active managers over passive strategies and their corresponding ability to undertake deeper scrutiny over business models. In this environment, businesses with attractive growth, healthy balance sheets and strong cashflows look well-placed.
• Fixed Income: Central Bank intervention has flattened the yield curve and with policy at the lower bound almost everywhere in the developed world, we see it being difficult to get too excited about Government Bonds. Where we have become more constructive, however, is within the high yield space. To the extent that history is relevant, as investors do get more optimistic they may return first to credit, forming higher levels of confidence about solvency and coupon stability than earnings streams and future dividends. The recent widening of high yield spreads has created some attractive selective opportunities. Even if bankruptcies occur in certain areas, much of the bad news is discounted, in our view.
• Gold: We remain positive on the case for gold and note that after March’s price volatility, the commodity has returned close to its recent highs. We believe that gold should benefit under most Central Bank and Government policy scenarios since it carries neither credit nor political risks and acts as a natural diversifier.
• Alternative Assets: We continue to see merit in owning real assets such as infrastructure, real estate and niche private equity. 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 clearly benefit from a weaker currency. Our preference is for safe haven currencies, especially the Japanese Yen.

What happens next?

Let’s begin with a spoiler alert: we don’t know the answer to this question – no one does – but we can at least posit some useful discussion points. It’s hardly novel now to observe that each day brings something different. This should not be surprising though given that never before have we seen the world effectively shut down, and then stay shut for a minimum of six to eight weeks. The ultimate length of the lockdown will, of course, determine the magnitude of the recession that then follows. To the extent that markets can be considered efficient, the rapid bounce of equity indices back into bull market territory (defined as a 20%+ upward move from their lows) that followed the most abrupt sell-off in markets ever witnessed would seem to suggest that a relatively roseate outcome is now being discounted. We are not so sure. If we can be confident of anything, then it is that further gyrations in all asset classes look likely. The full impact of COVID-19 on investor psychology, financial markets and the real economy, not to mention on human health and behaviour will take not even months, but probably years to play out.

What we do know is that there has been a significant near-term impact to the economy. If data showed a deep hit in March, then it has manifestly demonstrated a collapse in April. (As a side note, we can also not help but observe if ever a case study was needed to prove that there is no correlation between economic growth and equity market performance, now you have it). The OECD’s databank perhaps captures what’s going on best, with its composite leading indicators gauge showing its largest ever drop on record. For further evidence, take your own pick of the statistics. Of most note though must be what’s happening in the world’s largest economy: US industrial production saw its biggest month-on-month drop in April since 1946. Further, in the space of just five weeks through to 22 April, all the jobs created in the last decade (24.8m) have been wiped out by those making claims for unemployment benefit (26.5m). Against this background, economists seem almost to be falling over each other with the bearishness of their predictions: Goldman Sachs suggests a 35% contraction in developed world GDP in Q2; JP Morgan, 40%. Even the more sober IMF is calling this the worst financial crisis since the Great Depression, pencilling in a 3.0% contraction in global GDP in 2020. Back in January it had called for a 3.3% rise.

All of the above said, data are backward looking and forecasts just that. At this stage, there is an incredibly wide range of forecasts and opinions, both in terms of the depth and length of any economic/ financial set back. Nevertheless, we believe it is hard for all of us to overcome cognitive biases: by nature, we are optimists, and programmed to believe things will get better. Consensus currently seems to discount a poor second quarter (and maybe third too), but still assumes a bounce back after that. Because most recessions in the recent past – most investors’ career lifetimes – have been short and shallow, so the ‘easy’ thing to believe is that this may be the case once again. Unsurprisingly, then, there is an inherent tendency among most investors to treat all pullbacks as temporary and reversible.

What if things are different this time?

The world does not turn on a dime, to employ a simple but effective Americanism. Put another way, recoveries don’t happen overnight. Indeed, the longer the world remains shut, the more disruption there will be. At this stage, there is no guarantee that the world will go back to normal by the year end. The putative openings of some economies may quickly go into reverse if there is a resurgence in cases. And, a vaccine may be months away, notwithstanding any debates about scenarios of mutating and/or multiple strains of the diseases. But, if there were a reason for hope, then consider that for the first time ever, the world is united against a common enemy. Over 100m scientists, technologists and engineers globally are working to solve the problem of COVID-19 (per ‘The Economist’ newspaper) and information sharing as never before.

In any scenario, we have to consider the virus as a turning point in history. Narratives will change. Large segments of the population are currently experiencing fears of unemployment and inadequate (and/or inaccessible) healthcare. The COVID-19 pandemic is the second major economic trauma in a decade, after the Great Financial Crisis. Maybe people might now seek to make sure they are never again financially unprepared for a crisis. Consider that at present some 40% of American citizens do not have savings to last more than three months if they lose their jobs, while around 25% of small firms do not have enough cash on hand to last more than a month (per the University of Chicago). This implies greater caution. Perhaps the recovery will not be as V-shaped as many hope if people are reluctant to return their old ways.

Furthermore, the impact of COVID-19 will also likely be highly significant in emerging economies, perhaps more so than in the west. In contrast to previous crises, support from the developed world is likely to be more tepid this time around owing to problems in their own geographies. Many emerging economies will additionally face a greater healthcare crisis owing to weaker infrastructure.

How to respond

We believe that a structural shift to more centralist and protectionist economies is already underway. Globalisation was already in reverse prior to COVID-19 – thanks Donald – but the pandemic has only accelerated it. Going forward, we should expect an effective merger of Central Bank and state power, with Governments accumulating more control. Intervention will increase immeasurably, and things may never go back to how they were before. Extraordinary powers (lockdowns have to be thought of as measures of last resort), once put in place, are rarely removed.

We have already witnessed massive amounts of stimulus, both of a monetary and fiscal nature. The G7 Central Banks purchased $1.1tr of financial assets in March. Over $2.3tr of fiscal aid in the US alone has been promised, with support for small and medium enterprises as well as local governments (a ‘Main Street’ plan). Furthermore, the Federal Reserve has committed – for the first time – to purchase sub-Investment Grade debt. All companies are now deemed effectively ‘too big or small’ to fail. Central Banks and Governments are pushing further and further into unchartered territory. The state is becoming more enmeshed in the private sector, effectively decreasing corporate and shareholder power (consider what is happening to planned dividends and share buybacks at present). With inequalities widening, the shift from wealth accumulation to redistribution will only likely gather momentum.

The full consequences of such a structural shift will take many years to play out. Not only do we worry about the creation of moral hazard, if consumers and businesses are now effectively being backstopped into perpetuity by centralised authorities, but also, more debt is accumulating. Per the IMF, gross government debt as a percentage of global GDP will rise to 122% by year-end, up from 105% currently. If lockdowns last for longer, the load will only be greater. The extent to which this debt will burden societies for years to come, of course, depends on what is done with it. That which was once considered radical – first quantitative easing a decade ago, soon yield curve targeting (aiming for a certain long-term interest rate through bond purchases and sales) and before not too long modern monetary theory (where countries can theoretically never become insolvent if they just print more money) – is becoming normalised. At least we don’t have to worry about inflationary pressures for now. Rather, deflation seems the order of the day, a function largely of demographics but compounded by the currently weak oil price. That’s a problem we’ll save for a future discussion.

Alex Gunz, Fund Manager, Heptagon Capital