2020 will undoubtedly be etched into the history books. The impact of the coronavirus on global health and economies has been swift and unrelenting. We must remember this is firstly a health crisis, and secondly an economic/financial crisis; and therefore, there must be a resolve of, or a better understanding of the health issues, before the economic issues may be properly resolved. Governments and central banks have been swift to react with a range of policies, and the speed and magnitude highlight the inferred seriousness. While the stimulus packages are at levels never seen before and providing a degree of confidence after one of the largest market meltdowns in modern history, the invisible and fast-moving coronavirus has caused many governments to put complete countries into hibernation. This is the most surreal situation.
It is true that many governments and professional investors have been caught off guard. The problem surfaced to the public during January 2020 and it was thought to be a localised issue that would subside within the boundaries of China. At an investment conference in early February 9 out of 10 smart investment professionals presenting were strong bulls and many even had emerging markets on the top of the investment opportunity list; however, there was one well-respected presenter that was extremely bearish, but he is known to be a perma-bear. In a matter of a couple of weeks, the perma-bear was so correct. A significant change to the landscape has occurred and we now need to think along the lines of pre-corona and post-corona. The dynamics of post-corona is not yet clear, and the situation remains extremely fluid. When every major sporting event is postponed or cancelled, the message becomes quite clear.
Three months on, Wuhan appears to be emerging out of lockdown and industry in China slowly returning to normal. Like much of the economic data emanating from China, the data relating to the coronavirus and statements about almost the full elimination of new cases and virus-related deaths may not be reliable. Korea, Hong Kong and Singapore are also countries where the virus seems to be in order, but all these countries are controlled economies.
In the more democratic countries, the numbers are totally scary. Italy was the initial epicentre outside of China and changed global views on the coronavirus. Later Spain, Germany and much of Europe went into lockdown as health systems were overrun. In the early phase, the democratic countries did not take the virus seriously and now complete countries are in hibernation (deep freeze). Australia seems to have identified the magnitude of the problem and gained a relatively better understanding of the impact and control of the virus. A large portion of our cases are directly attributable to cruise ships or returning overseas travellers.
The United States have been in denial, and with a poor health care system. This will be the new epicentre that really counts. Donald Trump has shifted from referring it to the Democrats “new hoax” in January; to one death in late February; and then a “pandemic” by mid-March. It is interesting how the various world leaders have dealt with this problem. The rate of growth of infected in the United States; the number of deaths; and the timing for the eventual subsiding of numbers of deaths in the US will be the most important data set to watch. Forecasts for deaths in the US are in the range of 100,000 to 200,000, but sadly without a supportive health care system, the mortality rate may be even higher.
We can all read the media. In the simplest terms, few have any idea of the degree of human or economic impact, or the timeframes involved. It is clear a vaccine is required to properly arrest this coronavirus, and, in the meantime, measures must be taken to limit the damage. There is little doubt the problem will be resolved over time and opportunities will present.
Thoughts from here
Government policy, the flow-on impact and financial market pricing is moving around each day. The reality is that at this stage no one knows the eventual outcome. The speed and quantum of stimulus, the draconian lockdown policy across the world, indicates the seriousness of the problem. As this is a health issue foremost, and it seems there is not enough hospital and health equipment in any country to properly support this crisis and ‘flattening the curve’ is seen by the experts as the most preferable solution. To achieve this, economies must go into hibernation to slow the rise of infection to a manageable level for the health system to cope, which is the China/Korea outcome, as shown in the chart below.
The western world is later into the cycle and the trajectory is following the initial phase (see chart below).
The OECD stated, “the increasing stringent containment issues needed to slow the spread of the coronavirus will necessarily lead to significant short-term declines in GDP for many major economies, according to new OECD projections.”
Following the GFC (a financial/banking crisis) in 2008 the economic world and financial markets experienced strong “V” shaped recovery. Consensus is, that the current crisis is broader and more severe than the GFC, and many are talking a “U” shaped recovery pattern. If we think along the lines of resolve, repair and recovery, with moderate time frames in each stage, the “U” shape makes sense. The third option is “L” shaped which would be a bad outcome.
Stimulus and support commitments from global governments and central banks to date amount to around $7 trillion, in the form of government spending and newly created money, as they work in a synchronised manner to keep the global economy from sinking into a depression. In Australia, the $130 billion JobKeeper wage support program has been a game changer. Westpac revised the forecast unemployment from peaking at 17% back to 9% by late June 2020 and then settle at 7% at year-end (down from 9%) following the announcement of the JobKeeper package. This would be an outstanding result, if the companies/businesses are able to survive in the interim. And yes, this will be funded by additional government debt, but at an interest rate of around 1%, it is 1/5th of what the government borrowing cost was following the GFC.
Australia has the capacity to fund the stimulus and support packages at this stage without putting undue pressure on the balance sheet, with debt to GDP currently around 41%.
Trying to look through to the other side
Is it different this time? Yes, in many ways, however, markets are markets in a capitalistic world, and in that sense, we would assume that markets will eventually recover and the strong companies that remain relevant will prosper. We need to think pre-corona and post-corona. The chart below highlights the numerous significant events that have affected markets. The global economy is most likely to continue to follow the pattern and continue to grow.
During the middle of March, volatility (VIX Index) peaked at levels similar to those of the GFC. Panic selling had peaked, and as volatility subsided in latter March, when investors were beginning to make a more fundamental assessment.
Equity markets cavitated during March with most markets down 25% to 30%.
A significant change that has occurred over the last ten or twenty years is the growth of passive investing. Low cost spreadsheet trading with low/no fundamental input.
Apparently, there are more index funds and ETF’s on the US boards than companies. Quite bizarre! Passive investing works well when markets are rising as momentum propels pricing and valuation in an accelerating manner. However, in a sell-off in the magnitude that we have just experienced the multiplier turns into the divider, and the rate of fall in market pricing is also accelerated. But worse, there is no fundamental thought of what is being sold and how the valuations of many high-quality companies have changed from reasonable to cheap, when index funds or ETF’s are contracting in size, as sell orders are transacted on the market. The same can be said for algorithm-driven trading – no fundamental assessment. An example to consider, China’s iron ore demand projected to lead to Australia’s first commodity to top $100 billion export earnings.
As markets are sold off, heavily influenced by a lack of proper fundamentals, a dislocation occurs between good and poor quality companies. This is where a good active manager earns the fee. There are companies that will do better post-corona compared to pre-corona and they are the ones that investors should want to own.
The chart above shows the equity markets for the year from April 2019 to March 2020. The US and Australian markets followed a similar path, with peak drawn down around 30%, with a slight recovery during the latter period. In contrast, China was mostly flat during the last year, falling only 10% during the corona period and starting to show signs of rising during the last couple of weeks of March.
Equity markets are driven by economic activity. Sending communities into sudden hibernation cause production to fall off the cliff as can be seen in the charts below.
China, albeit a controlled economy, is showing signs of increased economic activity. This will be driven by fiscal stimulus directed towards infrastructure. That is a positive for Australia, in particular, the engine room of the nation, Western Australia.
Westpac expect the Australian GDP will now contract by 8.5% in the June quarter, followed by a 0.6% contraction in the September quarter and a 5.2% lift in the December quarter. Overall, the economy is expected to contract by 5% through 2020. This is in sharp contrast to the pre-corona GDP growth forecast at +2.3%. The OECD are forecasting that global growth will be -2% for every month of hibernation, so 3 months equals -6%. There is no question the impact of the coronavirus will be severe, however, with significant government intervention being supportive of recovery.
Interest rates at such low levels are also supportive of recovery. As mentioned earlier, Australian interest rates were around five times current levels post the GFC. The low-interest rates also point to the fact that the problems of the GFC have not gone away; they have merely been kicked down the road.
The chart above highlights the volatility that appeared in bond markets during March. The chart below shows the interest rate movement for the US 10-year government bond. What was happening? These are safe, liquid, defensive assets. This was a mixture of panic selling and the urgent need for liquidity.
We have been banging on for over twelve months about risks associated with credit and corporate bonds following the changes that have taken place over the last twenty years. In round terms, investment grade credit and lower has grown now two to three times over twenty years, while the quality government bonds on issue has reduced by 50%. When government bonds recently went into a spasm, credit markets froze.
The chart below shows investment grade and high yield peaking at 1160 basis points over swap. That is an eye watering 11.6% over swap. Many of those companies will not survive so the guess is; what the default rate may be? The good news is that late March spreads contracted but only back to 8.6% above swap. No doubt the spreads will continue to contract over time, if markets become more rational. Returning to the conversation about passive. This is a time to invest with active fixed interest funds where the manager is both competent and cares, and understands the fundamentals of the specific underlying securities in a portfolio. It is not possible for passive funds and ETF’s to achieve this objective.
We are now witnessing what happens to credit when there is a significant equity market sell-off. The bottom line is that some of the investment product has been marketed as defensive or liquid assets. Some product is not and have never been such, except the consumer drive for yield has created a demand that has been filled by this type of product.
By the nature, private debt and private equity are not priced in transparent markets. This can be good, in that volatility is reduced, which supports a lower total portfolio volatility and more consistent performance. However, pricing transparency is limited and often in the hands of the portfolio manager. The growth of private markets over the last twenty years has been staggering. Twenty years ago, there were 9,000 companies listed on US equity markets, and now it’s around 4,000. So only 4,000 companies report to a regulated market in the US. The growth in listed market capitalisation and the reduction of the number of companies would suggest the growth in private unregulated markets is substantial.
So, we have the new phenomenon. Unfortunately for all of us, and more so, owners and employees of these establishments; restaurants, gyms, clubs, pubs and other fun places, are now closed. There are the fortunate ones, where technology developments have allowed offices to be emptied and many businesses to operate remotely from home. If the coronavirus occurred 10 years ago many other businesses would be crippled if it was not for technology developments that emerged during the dot-com boom (followed by the dot-com crash of 2001). So many are now working from home for a while and let’s hope the habits do not deteriorate.
It is an amazing world that we live in. And that is why it is important for us all to get through to the other side with as little damage as possible. We normally include lots of charts in the Economic Update showing various aspects affecting normal economic activity and trends. At this stage they are all in the pre-corona stage. We must look and think forward to the post-corona period and look to capitalise on the opportunities that will present, and work hard to make back the lost investment dollars.
This is the most difficult period many investors and advisers have ever faced. It was unpredictable, thought to be a localised China problem, and did not relate to any specific financial market event.
The nature of equity markets is that they follow and
anticipate economic growth. Government stimulus from many of the key centres will work hard to ensure the problems of a depression and such, are avoided. The great unknown is the extent of damage and the timing before we pop through to the other side. I have been impressed with the way Australia has made strong and decisive decisions to look after people, and to an extent business.
It feels like there may be another leg down due, which will be influenced by data emanating from the United States. However, large investors have now had time to assess fundamentals and we may see some more balance come into the markets, which may also limit any further downside. No one really knows the answer.
For superannuation style investing, the time horizon is 5 to 10 years and more. The diversified style of portfolios reduces the downside risks that are inherent in many single asset classes and they also provide exposure to the upside on a risk-controlled basis.
It is important to retain high levels of liquidity to take up opportunities, should they present. There will be a time to rebalance and re-weight, but we would prefer to wait to see if there is a further leg down. For new money, dollar cost averaging may be considered.