Investment Update

A path through the bear market

We don't have a crystal ball, but we do see a way ahead.

As global stock markets dive in the face of the rapidly advancing Covid-19 pandemic, we believe it makes sense to consider wading cautiously back into the equity markets for investors with suitable risk tolerance. There may be even lower entry points to come, but our analysis suggests that there is now, on a probability-weighted basis, some value on offer.

We are confident enough to do this, not because we have a crystal ball, but because we believe the risk of the current market correction evolving into a financial crisis is low. There is a susceptibility among people to anchor on relatively recent events, to think that they are more likely than they really are solely because they are front of mind. Behavioural economists call this the ‘availability bias’. Because the global financial crisis was the last major market blow-up, many people believe that a crisis of lenders and the whole financial system is about to repeat itself.

In fact, financial crises are relatively rare events. About 150 years of history suggests they have common precursors. They tend to be preceded by an extraordinarily rapid increase in leverage (of a speed that we have not seen over the past decade), often as a result of financial de-regulation (quite the opposite to today) and an overextension of credit to un-creditworthy borrowers as a result of imprudent lending standards, especially by weak banks with inadequate capital (again no systemic evidence of that today). This is so important for our decision to start buying into the drop because without a financial crisis economic recoveries tend to be V-shaped (a relatively quick rebound). Financial crises tend to lead to slow economic recoveries and protracted spells of depressed markets – their aftermaths are U or even L-shaped.

Weighing the threat

Before Covid-19 became a pandemic, we assumed three broad possible paths forward: (i) coronavirus and the associated disruption could be on the cusp of dissipating rapidly; (ii) it could continue to worsen into Q2, greatly disrupting profits, before the world gets back to normal in the second half of the year; or (iii) it may escalate into a full scale pandemic, with many tens of thousands of deaths and lasting economic effects into 2021. We are investors, not expert epidemiologists, so we cannot presume to know how the virus will unfold. Indeed, even if the disease followed the optimistic scenario (i), government action or press hyperbole could curtail consumers anyhow, hitting company profits. As such, we felt we must assign an equal weight to all three of these scenarios – the mathematical expression of "we don't know".

Now the World Health Organisation has declared a pandemic and condemned Western governments for inadequate medical responses and social distancing protocols. Public condemnation has spurred government action. Some measures, such as the US travel ban from the Schengen zone or the closure of Italian public services, will last into April. Meanwhile, the resumption of business as usual in China has taken longer than expected, albeit there is still progress. We now judge the probability of the optimistic scenario (i) has decreased significantly and the likelihood of scenarios (ii) and (iii) have increased.

Weighing the reward

Financial markets are probability-weighting machines, so part of our job is to assess if the market is over-weighting the likelihood of too rosy or too dark a future. One way to do this is to use a simple, tried-and-tested valuation framework to assess what each coronavirus scenario would mean for important inputs for an asset’s value such as cash flows, interest rates and the equity risk premium (the extra return investors demand for holding risky assets). Then we can compare the probability-weighted “fair values” to today's actual price. For US equities, in the most pessimistic scenario, we assumed that all cash flow to shareholders will be wiped out this year and 50% would go next year. We also assumed bond yields will fall by at least another half a percentage point, and that investors would demand an equity risk premium equivalent to what they demanded after Lehman Bros went bust (i.e. the highest on record). This worst-case scenario implies a ‘fair value’ of around 2,200 on the S&P 500 Index, depending on the level at which you assume earnings would start to recover. These are extremely grave assumptions, for an extremely grave scenario. And yet as of Thursday’s close, the market had fallen to within roughly 10% of this level.

Another approach to forecasting the worst possible case is to apply a standard price-earnings multiple to what 2020 US company earnings would be if we assumed that they fell by the amount that they fell during the financial crisis. This very simplistic approach would imply a level of 1,800 for the S&P 500. But assuming that a pandemic-induced recession would be as devastating as the global financial crisis is a huge assumption, given what we discussed above about the prevalence and provenance of financial crises. Assuming that company earnings followed a path of adjustment similar to that of the 1990-1991 recession would imply a level around 2,200 (coincidentally). At the time of writing, the S&P 500 was 2,480. A major global recession is far from certain, and yet markets are not far off pricing it in.

The path ahead

To stave off recession – or at least to minimise it to two quarters – firms need monetary easing to offset some of the financial tightening caused by higher bond yields. They also need targeted monetary policy, such as the nearly £600 billion of measures unveiled by the Bank of England (BoE) this past week, in addition to cutting interest rates by half a point. The European Central Bank (ECB) made a good attempt soon after, with more quantitative easing and similar long-term funding for banks. However, its impact was quashed by a press conference from ECB President Christine Lagarde that was bungled to the point of satire. Ms Lagarde inadvertently implied that the stimulus wouldn’t do any good, which is not the consensus among economists who have produced lots of new research on this over the last 18 months or so.

The US Federal Reserve (Fed) has made an enormous amount of liquidity available to banks, and extended the maturity of the bonds it buys as part of its normal day to day operations. However, we believe the Fed needs to do more when it meets on 18 March. There also needs to be a strong response from the US government: tax relief for small businesses, providing an incentive for firms to hang onto staff, and helping households who may be worried about lost wages. Again, the UK led the way in this fiscal response, and unfortunately we don’t hold out much hope of Europe following suit. And US stimulus may take another week, which could continue to unnerve markets.

Democrats have an incentive to delay and water down President Donald Trump’s stimulus proposals – our research suggests that a weak economy will likely derail Mr Trump’s previously strong re-election chances. However, they cannot be seen as playing politics with the nation’s health, so they should ultimately agree to stimulus. The Democrats have a stimulus package that is working its way through the House of Representatives, but Republicans have indicated they will vote it down. The White House will likely need to table its own package.  There’s a lot of common ground: there’s already a $760bn infrastructure bill with Congress, for example. Even though it’s another Democrat bill, Mr Trump has recently expressed willingness to capitulate on the Democrats’ preferred method of delivering it.

There is some discussion about whether the consumer will dictate the extent of the coming economic slowdown, as opposed to businesses and ‘the supply-side’ of the economy. In which case, the extent of the slowdown and the ability for it to spring back will be determined by the extent to which unemployment rises. We will be monitoring data on corporate layoffs and leading indicators of firms’ employment intentions. We note that global skills shortages over the past two years may encourage firms to keep their staff in place if they believe that any contraction in profits will be transitory.

If fiscal and monetary policy does begin to arrest the tightening of financial conditions, and firms don’t start to position for a protracted crisis, at that point we believe it would be sensible to take on greater exposure to stock markets. This is also conditional on the spread of the pandemic: South Korea has proven that an admirable policy response – even after a bungled start – can arrest the spread of the virus. If European economies follow a similar curve, we could see new daily cases peak in the final few days of March. Of course, this remains highly uncertain, and the coming week is likely to see a parabolic rise in cases, which could unnerve markets.

If the transmission and morbidity profile worsens in Europe, and/or adequate stimulus in the US fails to get passed, it may make sense to reduce equity exposure, depending on where valuations are at the time, because the risk of a prolonged recession would have increased.

Financial risks remain

All of this is not to say that there aren’t risks to the financial system, risks that may make the economic fallout greater than it would otherwise have been. We are concerned about the liquidity and quality of corporate bonds, an area that has come under particular pressure during this correction.

But banks don’t hold these assets on their balance sheets in the same way they do loans. This matters because financial crises are co-ordination problems: banks stop lending to other banks and depositors withdraw their deposits because they become wildly concerned that the banks aren’t good for the money. This time round, banks appear more than good for the money: capital levels are three times higher than in 2008 and non-financial corporations appear to have enough cash to meet short-term liabilities (in aggregate circa 75% higher than in 2008).

Compared to more normal conditions, in a recession a high level of corporate debt and problems in the bond market are more likely to increase the level of corporate defaults. But the evidence doesn’t suggest that it will cause a financial crisis this time around. Our gauge of financial stress, which pays particular attention to short-term funding markets, such as commercial paper or eurodollars, remains under control. Indeed it signalled more stress in 2016, and an awful lot more in 2011 to 2013. There is, however, scope for credit spreads (the extra interest a company has to pay above the government bond yield) to rise further, which may have other, unforeseen effects on the economy. We are monitoring this area closely.

One more immediate problem is that the turmoil in the bond market may induce fire sales of good assets, particularly considering the unprecedented role of bond exchange-traded funds (ETFs) in today’s markets. Historically low interest rates have precipitated an unprecedented hunt for yield, which encouraged many ‘tourist’ investors into corporate bonds in general, and passive ETFs in particular. ETFs offer instant liquidity to investors, yet the fixed income assets within them are relatively harder to sell, creating a liquidity mismatch that is straining the sector.

Although implied default rates in investment grade bonds are already high, we are concerned that bond values could fall much further. Liquidity is half what it was before the financial crisis, as brokers no longer trade on their own account, but instead mostly look to match buyers and sellers.

A plan, but not a crystal ball

To be clear, equity markets have a tendency to overshoot and there may be even better entry points presented tomorrow. However, we don’t have a crystal ball. We can’t know what will happen in a few days or a few months.

But we are long-term investors. We asked ourselves, “would we regret missing an opportunity at these levels in two years’ time?” The answer, given the information in front of us, was yes. Unless we believe that the world will definitely enter a recession in 2020 and that 2021 will not follow a V-shape but an L (as a result of a financial crisis, perhaps), today looks a good entry point to realise long-term value.

We felt the US market was pricing in too high a probability of the bleakest scenario unfolding. Acting now makes sense.

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