The rapid shutdown of numerous major economies due to the COVID-19 virus has resulted in equities falling by roughly a third from their peak and corporate debt has also materially underperformed. The US economy alone is forecast by some to contract by circa 30% during the second quarter of 2020. Whilst the scale of the market falls are not unprecedented, the speed by which they have sold off is. The previous record for ‘speed of sell-off’ was set in 1929 but has been beaten in 2020 by some margin (according to Goldman Sachs). The COVID-19 ‘cure’ induced recession is unlike any other economic shock observed before.
Importantly, the shutdowns are working in that they are bringing COVID-19 infection growth rates down. Policymakers have clearly learnt the lessons of 2008 and have responded extraordinarily quickly to provide massive fiscal and monetary support designed to underpin confidence. Unfortunately, we know all too well that largesse today will need to be paid back tomorrow. This will mean that taxes will have to rise and austerity will need to be extended.
If this playbook, which we have seen before, becomes politically unacceptable lawmakers may move decisively towards the direct financing of infrastructure spend and subsidies for workers by authorising the printing of money specifically for these purposes. This is known as Modern Monetary Theory. Should this approach be enacted, the implications for markets are likely to be profound and may include the anticipation of a return of inflation and all that that entails. Whilst this is not currently our central scenario, we remain very aware of the possibility of such an outcome.
Dividends are being withdrawn pre-emptively, share buybacks halted, capital expenditure reduced and working capital shrunk in order to help companies conserve cash during this period of uncertainty. This hoarding of cash can become self-defeating as it directly impacts economic activity. Critical will be how lenders react to companies which are at risk of defaulting on their loans. Will the banks put such companies out of business or will they (or policymakers) provide the necessary liquidity to allow companies to trade through this event? We think the latter, particularly as banks are relatively well capitalised, political pressure will be intense to continue to lend and we know that the crisis is probably time limited in that a mass vaccination program is likely to be initiated in 12-18 months’ time.
Our base case is that the shutdowns work in western economies and developed Asian economies and the number of new infections falls substantially in these geographies as the second quarter progresses. These improving trends are likely to be taken well by market participants. Authorities will then move to a posture of continuing to shield vulnerable groups, whilst allowing a gradual return of economic activity whilst undertaking intensive testing and a much more rigorous trace, track and isolate program for those confirmed to have the disease.
If this is seen to work then international travel may well be opened up to those areas which have had similarly successful lockdowns. Unfortunately, would-be travellers from countries with less successful shutdowns will be prevented from travelling to those countries which have successfully managed to contain the virus.
Nonetheless, concerns will persist that the virus could return at any time before mass vaccination and so consumers and companies will continue to be cautious and will prefer to save rather than loosen the purse strings whilst the uncertainty remains. Following an initial surge of pent up demand post any hard lockdown we anticipate the recovery will be disappointing, unless fiscal stimulus is ramped up further still.
As companies act to shore up their balance sheets through equity issuance and the withdrawal of dividends and share buybacks, the recovery in confidence should be observed first in corporate debt markets. We are therefore focussing our attention at this time on increasing portfolio exposure to fund managers that specialise in credit and convertible bonds, as we are confident that these asset classes have return (versus risk) profiles which are both asymmetric and favourable.
This hasn’t prevented us from topping up those direct equity holdings which we believe have been sold down disproportionately relative to the risks they face.
We have also converted a significant proportion of our ‘near cash’ investments (generally, ultra-short dated credit investments) into actual cash in order to be able to move swiftly as and when opportunities arise.
Cornelian Investment Team
3 April 2020