This is the third major market crash that we have seen over the last 20 years; the other two being the aftermath of the technology bubble and the global financial crisis. Each of these had very different underlying reasons and effects on markets. The technology bubble was a massive misallocation of capital which saw share prices hugely inflated in technology-related sectors, but when the bubble burst, other sectors of the market were far more resilient. The financial crisis of 2008/9 was more akin to what is being seen today, given that it has broadly affected economies and therefore almost all risk assets. This included supposed diversifiers such as gold, which proved a very poor investment in 2008 as it is an alternative currency and investors used it as a source of cash when they could not generate liquidity elsewhere. The financial crisis was so fundamental as it was a huge liquidity shock to the economy.
With the current crisis we have seen an element of supply shock during the initial phase when China was shut down and there were concerns about the effect this would have on the global supply chain. We are increasingly seeing China return to normality and this concern is receding (and indeed restocking of inventories will be one of those factors which likely pushes higher-than-expected global growth in the second half of this year and 2021).
It is also causing a demand shock as the restrictions on people’s movement is altering and affecting the way that they can consume goods. However, there is unlikely to be any fundamental lack of demand longer term within the global economy, especially for basic products, even if discretionary spending may be curtailed in the short term. Distribution channels may change. To that point, Amazon is looking to hire an additional 100,000 workers in the US and Ocado’s online grocery trade is working at full capacity to deliver fresh food and staples, its CFO recently noting it had received more orders in one day than it normally expects in seven.
Governments and central banks around the world are increasingly putting significant measures in place to support businesses in the short term so they can get through this. There will be casualties, but most of those will be weaker companies and not the ones in which we would normally invest. Historically, recessions have been a natural clearing process that allow economies to cull weak companies and move forward. It does mean that there will be a continuation of the very polarised world that we have been in since the financial crisis, in terms of the winners and losers.
Unfortunately, in periods of high volatility the good gets hit with the bad: it is usually only after the event that quality wins out. When credit markets are also very weak and investors are forced sellers, the tendency is to sell equities which can be more liquid.
In terms of fund maintenance, we are looking at which companies will be the long-term winners tempered by short-term risks both in terms of earnings potential and valuation. To that end we are in the process of speaking with the managements of all the companies we hold to learn what they are seeing “on the ground” and are engaged in good housekeeping practices: reducing positions where we feel the fund may be overexposed or where valuations may not take into account earnings growth contractions and increasing other positions where current valuations look highly attractive even in relation to reduced earnings growth estimates. Turnover in the fund has been elevated but the majority of the portfolio remains intact.
This current downside event is extreme. The VIX indicator of equity volatility has a historic average of around 15: its previous high was a spike up to 60 during late 2008 when the whole global financial system was in danger of collapse. This week the VIX hit an all-time high of 82. Europe is now the frontline and the VDAX, the European Equity market fear gauge, hit 93 on Monday, also the highest reading in history.
As evidenced in Asia, we know that social distancing sharply slows the advance of the virus. Europe has now embarked on a social distancing strategy. Like in Asia, this ought to slow the spread. Investors are worried about the sudden stop in economic output. Rightly, the question is whether liquidity shortfalls will lead to solvency problems. We believe that the solvency risk is now more than discounted given the details of the recent ECB announcement and recent political commentary. We do not view the ECB announcement as inadequate. Similarly, the UK has pledged £330bn to shore up businesses and the Bank of England is currently involved in a £200bn purchase scheme having also reduced interest rates from 0.75% to 0.1%. Europe is attempting to provide a giant bridge loan to the economy to ride out the lockdown period. Governments are promising to provide loan guarantees to banks for this funding. With the right guarantees, bank loans will arrive where needed and the economy should remain liquid.
The ECB has also provided significant capital forbearance. Banks no longer need to hold their Pillar 2 Capital Requirement, or their Pillar 2 Guidance top up. This gives European banks at least €200bn of excess capital that can be used to assist with this crisis. This means there will be no need for capital raisings even in a dire macroeconomic circumstance. Germany’s state-owned development bank, KFW, will lend as much as €550bn to support the economy.
We are also beginning to get more details of the European fiscal response.
One US economist/strategist that we follow uses a capitalised economic profits model to assess US market levels. A key variable in the model is the yield on the 10-year US Treasury Bond. Assuming the 10-year yield goes back to the 1.6% level it stood at before the crisis, the model says that the current US market level is indicating US corporate profits will fall by around 60%. If the treasury yield stays at its current level of 0.8%, the US market level is indicating a near 80% fall in profitability. The actual fall in US corporate profitability during the financial crisis 2007-09 was 46%.
These statistics are mentioned to give some context to just how volatile markets are at this point and why we are seeing such an increase in risk and drawdown for portfolios compared with what we would have seen in 2000 and even 2008. The global cases have just reached around 220,000 with some 86,000 having recovered and sadly 8,983 mortalities at the time of writing. However, we struggle to square the level of panic compared to previous pandemics. In the 2009 swine flu pandemic, the US alone saw 60 million people contract the virus, with 12,000 deaths and with less market reaction. We believe the market concerns around Covid-19 have been excessive. China has shown that it can be contained. While there will be severe economic repercussions over the coming months and the action being taken by governments and central banks in the rest of the world will provide a measure of stability to markets even if the daily disruption remains significant and extremely challenging for frontline workers in the health and public services. We are hoping for some signs that new daily cases in Italy have plateaued as we believe that this, in addition to the China experience, would really help provide clarity for investors on the timeline.
The response of the pharmaceutical industry has been phenomenally fast but even so it seems unlikely that a vaccine will be available before the year end. Drugs that help boost the immune system, including ones previously developed for Ebola and HIV, will potentially provide short term assistance to those already infected. Treatments being trialled include US drug maker Abbvie’s Kaleta, a combination of two anti-HIV drugs.
Mass testing seems the best short-term hope: as the Financial Times reported this week, one Italian town has reduced new cases to zero through a widespread testing programme. Testing would significantly reduce the need for widespread ‘stay at home’ policies.
The market is oversold and will recover but it is painful short term. Trying to ‘time’ the turn is difficult so we will be looking to hold onto the majority of the fund in the knowledge that it is comprised of quality growth businesses that will come through this dislocation stronger both competitively and in terms of their internal operations. It is worth remembering statistics like the following: $10,000 invested in the S&P 500 at the end of December 1979 would, over the 40 years until the end of last year, have increased to $867,457; but if you had missed just the 50 best trading days during that 40 year span you would have made only $75,473.
History has shown that when there is massive government and central bank action going on, it is ultimately wrong to sell quality assets. China’s experience in controlling the virus (not to mention Hong Kong, which has coped admirably) is also encouraging. Since the fund’s inception in 2008 historic drawdowns have lasted no more than 30 months and we would hope this time it will be shorter. But, come what may, this episode is an opportunity for long term investors to buy quality assets at much reduced prices.
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