In this continually-evolving crisis, we update our investors again with a brief summary of how we are assessing the risks for our global equity portfolios.
The most important datapoint in determining the economic cost of this pandemic is its duration. This will dictate the length of time that consumers and businesses face restricted activities. Increasingly, it is looking likely that a vaccine will ultimately be required for economies to completely open back up. Estimates on timing are around the 12-month mark – but then manufacturing and distributing 7 billion doses will likely add significant time on the other side as well. For what it’s worth, America’s now famous Dr Fauci believes 18 months is the more likely timeframe for a usable vaccine.
Some have talked about herd immunity as a possible solution, but there is simply too much evidence now to suggest that either: (i) this will take longer than a vaccine to build; and/or (ii) may not even be effective, to the extent people can contract COVID-19 multiple times. Furthermore, an approach favouring herd immunity would result in many more fatalities than on favouring a vaccine.
The increasing evidence of asymptomatic carriers further reduces the prospects that economies can be opened back up without significant risk of a second wave. Even with increased testing, how does one know to test someone with no symptoms but who remains contagious to others? A second wave would obviously be disastrous for the global economy.
Naturally, governments need to try to open their economies back up as best they can with increased testing to try to isolate new cases before an exponential spread starts again. Much has been written recently about serological testing for antibodies as a path to economic reopening. The hurdles to overcome here include: (i) poor accuracy and lack of standardisation of serological tests; and (ii) simply too few have contracted COVID-19 (as a percentage of the total population: and (iii) increasing evidence that recontraction (or reactivation of existing COVID-19 contraction) is possible. For investors, as societies begin to reopen around the world, what probability do you place on a second wave occurring?
In the US economy today, US initial jobless claims are more than 22 million in four weeks – ten times the claims of the first four weeks of the 2008/09 GFC. At least 3 million businesses will likely close – and possibly many more. JPMorgan believes the US economy will contract 40 per cent year-on-year in the second quarter (by comparison the worst quarterly decline in the GFC was 3.9 per cent); and 20 per cent unemployment (double the peak unemployment rate post GFC).
In the euro area, ECB President Christine Lagarde pointed out last week that incoming economic data have started to show “unprecedented falls, pointing to a large contraction in output in the euro area, as well as to rapidly deteriorating labour markets.”
In China, the official GDP decline reported last week was 6.8 per cent year-on-year. Independent estimates put the true growth rate closer to a decline of 12 per cent. And while the Chinese economy has started to show signs of improvement, we are now starting to see a second wave of weakness stemming from declines in manufacturing orders from the US and Europe. And in a recent survey of Chinese households, more than 60 per cent said their income would likely decline in 2020 versus the previous year; and 42 per cent said they were planning to reduce their consumption this year.
And this leads us to the broader point. Even if COVID-19 was contained over the next couple of months (a low probability event in and of itself), there will be significant long-term repercussions from the economic contraction that is already locked-in for Q2.
At best, households will have a lower propensity to consume and a higher propensity to save post-COVID-19. And many will have to undergo a period of deleveraging to repay the increased borrowings required to survive this disruption.
Many surviving corporates will make it only through increased borrowings. Remember, in describing the various relief packages recently announced by the Fed, Jerome Powell characterised them as “lending powers, not spending powers”. As he points out: “The Fed is not authorized to grant money to particular beneficiaries.” These corporate balance sheets will need to be repaired after COVID-19, reducing cash flow for investment and shareholder returns.
And then there are government balance sheets. Take the US, for example. Even before the pandemic, the federal deficit for the year was projected to exceed US$1 trillion. The recently enacted CARES act will add another US$2 trillion (not to mention the enormous gaps that need to be plugged in the various state and municipality-level budgets). And the longer the economy remains disrupted, the higher this figure will go.
On the other side of this pandemic, will we see coordinated deleveraging between households, corporates and governments, in all economies, all at the same time? If so, what do global growth expectations look like then?
The equity markets
Let’s go back to, say, October last year – before COVID-19 had even been discovered. At the time, global growth was solid, unemployment rates low and leading indicators for growth in all major regions were improving. Interest rates were low and monetary policies were supportive. The outlook for equities was rather attractive.
And today, we not only have an economic contraction locked-in which is significantly more severe than during the GFC; we are also faced with a scenario – that carries a reasonable probability – of this contraction persisting in some form until there is a useable vaccine produced and distributed to every human on planet earth more than one year from now. And the longer this takes, the slower the recovery period out the other side as we enter the period of coordinated deleveraging, described above.
The price level of the S&P 500 today is the same as it was in last October. Or said another way, the market-implied expectations for future aggregate earnings is the same today as it was in October. Does this sound strange to you?
Our global portfolios
This COVID-19 crisis is a uniquely shaped risk for active managers and investors to deal with. And it is really forcing managers and investors to decide what they believe in. One of the primary tensions is the one between long-term absolute returns; and short-term relative performance.
In March, readers will know we moved to a highly-defensive portfolio position in our Montaka variable net strategy and our Montgomery Global long only strategy. We did this because we believed there was (and still is) a more severe downside possible scenario than what was being priced in by equity markets. Our belief was (and still is) that today is the day to preserve as much capital as possible – while the day to pounce on extraordinary investment opportunities remained in the future.
We also warned that if markets were to rally during this period that we would underperform in the short-term. And that is exactly what has happened. But chasing this short-term bounce would leave us exposed to the downside scenario that we believe remains very possible. By avoiding this possible downside scenario – to the extent it does play out – we can take advantage of great opportunities and, over the long-term, deliver strong absolute returns for our investors.
As such we continue to be defensively positioned in these strategies. Indeed, as equity prices marched higher last week, we reduced our exposure even more.
We believe equity markets are pricing in one of the most optimistic scenarios around COVID-19 and associated economic revivals – possible, though low probability, in our view. The risks around: (i) vaccine timing; (ii) second waves of covid-19; (iii) second-order economic impacts; and (iv) timing of economic recoveries, all appear to remain very much to the downside.
A better time to buy equities in size would be when equity markets were pricing in much worse scenarios for the above risks and could then surprise to the upside. If and when this time comes, we are very well positioned to take advantage of opportunities. In the meantime, we will remain focused on protecting our investors’ capital.
 (IMF) Statement by Ms Christine Lagarde, President of the European Central Bank, at the forty-first meeting of the International Monetary and Financial Committee (April 2020)
 (Brookings) Speech by Mr Jerome H Powell, Chair of the Board of Governors of the Federal Reserve System, at the Hutchins Center on Fiscal and Monetary Policy, April 2020
 Note: Our Montaka 130/30 Extension strategy remains fully-invested at all times, so is not considered to be defensively positioned