In volatile times, those offering opinions or projections have learned well that forecasting the worst of outcomes is a smart move. You hear most therefore, expounding pessimism.
The 3 levels
Working through the ramifications and implications of a set of circumstances is well achieved by following a process known as 3 Level Thinking: the highest level is the third; if you do the second you automatically do the first and the third encompasses all.
Level 1 is Analysis – What’s going on and Why? (No consequential analysis)
Level 2 is Synthesis- What can/will go on and Why (consequence and implication)
Level 3 is Transcendence – Anything can be and Why Not (imagining what does not exist)
So, the third level (whilst fascinating) and the realm of creative people is not useful in our case; we limit ourselves to attempting the move from level 1 to 2.
Second level thinking is an investment practice utilised by investors such as Howard Marks and has consistently and significantly helped to outperform markets.
In his excellent book ‘The Most Important Thing’, Marks explains that markets are reactive, which represents the First level of thinking:
‘This is a great company, it’s at a high price but markets like it, I’ll buy it’
The Second level is: ‘This is a good company but not great. So, it is overpriced. This will likely become realised in time, so value will likely fall’.
In essence ‘second level thinking’ is going beyond the general prevalent belief and asking:
‘And Then What?’
To put it more plainly, most investors are part of a herd which moves as a pack.
What we know today
So if we look at what is known currently.
We know that a Corona virus variant which presents a threat to life (primarily it appears to affect those older/less physically robust) is spreading through Europe and the US.
We know (from South Korean data) if strong measures are taken, it appears possible to control the speed of transmission to avoid severe Health Service overwhelm. The South Korean mortality rate is more than 80% lower than that of the Chinese (0.6% to 3.5%).
We have experienced a series of Corona Virus variants previously; most notably SARS in 2002 and Swine Flu in 2009 which were contained, although Covid-19 looks to be more infectious.
If the virus behaves as previous Corona variants, it SHOULD slow in warmer weather.
‘And then what?’
The primary question long term investors must ask is:
Does this virus cause a systemic change to our personal and economic way of life?
Is it a transitory disruption?
If the answer is systemic, the ‘And Then What’ question is impossible to answer but outcomes will likely not be good for a protracted period. We will over time adapt, and a level of previous normality will ultimately be regained, but disruption will be longer lasting and far more profound. Does this scenario look the likely case as things stand? It does not.
*George is writing an important companion piece which will examine in far more detail the how’s and whys of the Government actions and likely changes over time*
If transitory ‘And Then What?’
The decision by Western Governments to increasingly shut down parts of economies to reduce social interaction is amongst the more significant actions taken outside of war. China and South Korea are ahead of the West in this and look to have contained the spread of infection, slowly now relaxing restrictions. Europe looks to be at least 4 to 6 weeks behind in this process.
If the control of infection proves to follow a similar path in Europe and the US then the shock, although large, will be comparatively short lived in the main. There will however be significant disruption and economic trauma.
The orderly function of markets must be maintained, if they freeze up then much goes badly wrong. This lesson was well and truly learned in 2008. The robustness of systems is transformed from that last crisis. Central Banks are already quickly and decisively facilitating whatever is needed. We can therefore discount the likelihood of market function failure as a major concern.
Financial Protection For Individuals And Business
The short term hit to individuals who can’t earn, businesses with lost customers/orders or delayed payments is going to be big.
All Governments know this and will provide significant support, this was confirmed by the U.K. in the Budget on 11th March.
So, we can in all likelihood discount a looming wave of extreme personal hardship or large-scale bankruptcies.
Will global economies experience recessions?
If so, ‘And Then What?’
General and habitual fretting in financial markets around possible recession signals is simply the concern that the numbers relied on to attribute ‘future value’ to assets will deteriorate and so prices will fall.
Well, events over the past few weeks mean they assuredly will and they assuredly have, considerably.
A technical recession which is defined as two consecutive quarters of negative GDP is almost a sure thing, but ‘And Then What’.
Climbing out of a long deep recession can be a slow and laborious process. Much damage and dislocation has been suffered and the rehabilitation process is difficult and slow.
This is why Governments will now attempt to provide whatever temporary relief business needs, not only out of altruism but because it makes financial sense. If a business is lost to bankruptcy it pays no further tax and workers lose jobs. The domino effect causes others to fail in turn, so even less tax. Keeping them functioning if possible, is the smart move.
Further, if we believe the likelihood is that the Covid-19 disruption is short term and inflicts no major structural damage to the majority of business then a rebound in activity should be swifter and stronger.
Do we have historical evidence for this assertion; yes, we do, that’s how previous Corona outbreaks have played out. In fact, in all previous instances’ markets have been above pre-health scare levels within around 6 months. Does this mean it will be the same this time? There is no guarantee of that.
A Change to Policy
The classic response of Central Banks to an economic shock has been to cut interest rates significantly. The problem, especially for Europe (ECB), is rates are close to/at zero already.
‘And Then What’
It seems likely, due in part to this lack of interest rate flexibility, that several countries will seek to stimulate their economy by engaging in much higher fiscal spending. The crisis could well be the catalyst for this previously missing link to economic stimulus.
In the U.K. Budget on 11th March, fiscal stimulus was announced of £175 Billion for housing, roads, technology centres, public service infrastructure (40 new hospitals) etc. That’s game changing investment levels.
Why has infrastructure spending not happened before?
Governments annually borrow part of their expenditure as most don’t receive enough from tax receipts. This extra borrowing comes at the cost of increasing interest charges it pays. Have too much debt and markets will potentially make it more expensive by demanding higher yields on new debt. Argentina as an example must offer far higher interest rates if they wish to borrow, compared to Germany or the U.K.
So, as major infrastructure spending needs to be financed with big borrowings, governments haven’t wanted to go there, partly for the reasons above and their general wish post-economic crisis to be viewed as prudent and careful custodians.
But, not only can major countries now issue debt at less than 1% yields over 10 or for some 30 years, but markets are hungry to own it. Also, and importantly, the existing cost of debt servicing has and will continue to reduce significantly as maturing bonds are replaced at fractional comparative yields (partly how the U.K. Chancellor has balanced his books with the huge extra investments being made).
Fiscal expansion rather than cutting interest rates is the alternative way to stimulate economies. As rates can’t be cut further, fiscal stimulus is highly likely.
‘And Then What?’
Rates at zero, massive and economically stimulative fiscal / infrastructure spending, recovering global economies. That’s a heady mixture for risk assets.
For investors, probably the biggest conundrum medium to long term, is the arrival at zero yields on much of the Fixed Interest complex. No Government debt (Gilts, Treasuries, Bunds or Japanese Bonds (JJB’s)) will have a yield more than barely positive, if at all. Corporate Bonds will offer some yield but we’re talking about 1-2% for higher quality so just about mitigating inflation. The yields can’t obviously go much lower either, so there is no prospect of capital appreciation.
In short if you don’t have to own them, why on earth would you?
*NB* investors using fixed interest actively managed funds will have an AMC (annual management charge) of around 0.7%. If the yield on the fund is at 2% that’s a cost of 35% of the return. Expect Managed Bond Funds to expand their remit to invest in other assets such as equities, because they won’t make any sense otherwise.
‘And Then What?’
So, investors who want or need income will have to look beyond cash deposits and fixed income. This is where investment opportunities may present.
The 5% plus yield on high quality Global Property REITs is going to look mouth-watering, as are 3-4% dividends currently paid by International companies with excellent balance sheets.
Infrastructure funds with high levels of contractually guaranteed recurring income paid as dividends will also be attractive.
Borrowing costs for property purchase (both domestic and commercial) are going lower, which will be stimulative to domestic and commercial property markets.
Investment, as post 2008, will be pushed into risk assets because of T.I.N.A: There Is No Alternative.
I wrote about this last week but I think it bears repeating (and I’ve expanded the comparatives):
An investor who does not know what has happened in markets previously asks for options to invest £250,000.
They are told that they can invest in say a suite of Gilts of between 2-30-year duration and the return will be around 0.6% pa: no capital growth.
Alternatively, they can invest in a mix of commercial property, infrastructure funds and high-quality shares with a dividend of 3-4% pa and additional capital growth of 3-4% pa potentially over time.
Which do they choose?
As an aside, the rush last week by investors into Gilts, the ‘safety trade’, made sense. If you sold stocks at the beginning of the week thinking they would fall and bought gilts which would rise, you were right and did great.
But the longer term return for Gilts is just going to be awful, so these buyers of gilts either must hold longer term and see their money gradually dwindle, or sell and buy back into many of the assets they sold out of in the first place.
An interesting question is, when do they take that decision and when they do, are they buying them back at a lower price than they sold them? The problem will be that if they are waiting for certainty, prices will have rebounded. It is important to remember they paid 20% tax on gains to get out initially.
If a company share price is valued at 20 times its earnings (price to earnings ratio) then mathematically, the value of one year’s earnings represents 5% of the value of the share. This sounds odd but is correct. Paying a multiple of 20 means each year’s earnings are valued at one twentieth of the total value.
So theoretically, if a company said, we would make no earnings the year after purchase but then return to previous earnings levels year 2 onwards, that should only cause a 5% reduction in the share price.
Disney is down 34% YTD, Nike is down 25% and Simon Property is down 43% (and a best in class REIT but has retail property)
From these falls it can be inferred that the market has calculated the earnings of Nike to be totally lost for the next 5 years due to Covid-19.
*note* Actually, it’s more extreme for Nike as they trade at 30 times earnings as a world class business. A 25% fall in share price represents the expectation of no earnings for the next 7.5 years.
It is possible even so early in this situation to look back and ask “why didn’t I/we act more decisively with investments when Covid-19 was first apparent?”
The answer I think is partly an accumulated deafness to the “concern du jour”, from media incessantly and hysterically trumpeting the new reason to be fearful (media click bait).
This though was coupled with a slightly more thoughtful analysis of past experiences with Corona virus shocks, none of which were remotely as impactful on everyday living.
The disruption will obviously last for a time and the summer weather will likely help. There are strong scientific reasons to believe that as many people catch the virus and fully recover, natural immunity will build and resultant outbreaks if suffered, will be less severe. It is not likely therefore that this level of disruption keeps repeating. This of course assumes no vaccine is created (which we anticipate there will be, as recent developments in Canada have shown) and that was achieved for both SARS and Swine Flu.
Markets are behaving now as they do when they have no sense of the shape of the future. They are trading almost completely on emotion which will cause volatility. Last week’s 2,000-point rise on Friday in the S&P 500 being an example.
When emotion is the primary driver for selling price, either in bubbles or sell-offs then those prices over/undershoot their real values either too high or too low.
It is reasonable therefore to assume that with historic levels of fear in the market, the current prices are not representative of the true reality of value.
Note: This is written in a personal capacity and reflects the view of the author. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.