As I write this update to my last blog, there are tentative signs that the COVID-19 virus is plateauing, with the increase in new infections no longer following an exponential curve. However, while market volatility has calmed down, it is still elevated.
As investors and stewards of clients’ capital, we have two issues to consider:
- What the market is thinking/reflecting, and
- What is happening to fundamentals.
Time, then, to reassess the things we know and the things we don’t. Here is a snapshot of the matrix I have been using to think through this volatile situation with some points (not an exhaustive list), which you may recognize from my previous blog:
|What we know||
Treasury market is very illiquid. Bid-ask has blown out.
Credit under stress (operating expense + other).
Equity players have derisked.
We are seeing panic in markets.
Many asset allocators are unable to rebalance to equities because of the lack of liquidity in the bond market.
Travel demand has collapsed.
Energy demand has collapsed, supply is increasing.
Companies are drawing on lines due to economic uncertainty.
COVID-19 cases likely continue to ramp up in North America, following the patters we have seen in Asia and Europe.
China has been recovering towards normal.
|What we don't know||
How much of the treasury market malfunction is technical (poor positioning by levered funds) vs. fundamental?
How long dislocations will last.
What central banks can do to stop the panic.
What they will do ($1.5 trillion repo operation announced today)?
The ultimate response by companies and governments.
The ultimate economic impact.
The ultimate infections and deaths caused by COVID-19.
Ultimate level of hysteria around the virus risks.
How long will Saudi Arabia and Russia continue to oversupply the oil market?
What will the bond market dislocations do to availability of funding for companies?
Could this burst the private equity bubble?
There is good news! We now have clarity on several of the uncertainties from a month ago. Let’s go through a few of them:
Fundamental uncertainty #1: What will governments do to respond to the virus?
From a fundamental perspective, governments around the world have moved to lock down their economies to prevent the spread of the virus and have ramped up the testing and treatment ahead of further waves of infection.
Certainty is important to be able to decide what to pay for assets, and we now know there will be a significant economic impact at least through the second quarter of 2020. Of course, the duration is still uncertain and the range of outcomes is huge; from the hope of beginning to reopen the economy by mid-May through to 18 months of restrictions until we have a vaccine(more on this later).
This is both good and bad news. We know the governmental response to the virus (broad restrictions) is working to slow the growth of infections and preventing more health care systems from being unable to care for those in need. The bad news is that we still don’t know the long-term economic impact or the duration.
Fundamental uncertainty #2: What will governments do to respond to the economic fallout from the virus?
Check out this chart:
Source: Cornerstone Macro
Governments around world have now committed a combined $15 trillion of stimulus, split roughly 55/45 monetary/fiscal totally over 17% of global gross domestic product. Monetary stimulus is focused on the functioning of the markets (supporting asset prices). The fiscal stimulus is focused on the labour market and small and medium-sized enterprises (SMEs), with more to come.
What is interesting about this is the focus on who the crisis impacts the most; SMEs and individuals. There has been political pushback on bailing out large organizations and even private equity-owned companies through this crisis. Something to think about going forward.
It's great to see such immediate massive support (especially for those of us who remember the failure of the Troubled Asset Relief Program bill in 2008). I believe these actions will really help small businesses and employees in need. This event has been such a massive shock for so many people and is extremely positive in my view.
Fundamental uncertainty #3: How long with the Saudi’s and Russians oversupply the oil market?
Recently, the Organization of Petroleum Exporting Countries (OPEC) and other large oil exporters negotiated an agreement to cut 9.7 billion barrels of oil production. Of course, this doesn’t offset the demand reduction we have seen of nearly 20 million barrels a day. Canada, the U.S. and Brazil have also committed to a reduction in production of 3.7million barrels per day, which will be driven by declines and reductions in production.
So we certainly have some good news. The bad news is the market is still oversupplied. In fact, we saw West Texas Intermediate grade oil trade at negative prices on April 20. A step in the right direction, but we’re running out of storage and supply is still outstripping demand.
So with a commitment from the U.S., Canada and Brazil for lower production, if we see investment in these basins in the future, does that give OPEC the license to increase production again and create another shock? Something to think about.
The main question really is: What can (and will) the central banks do to stop the panic in financial assets?
As we have seen above, central banks have provided next-to-unlimited amounts of monetary support. The federal balance sheet has increased by $2 trillion (+46%) over the last two weeks alone! This has been good news for asset prices.
This clearly addresses the other two uncertainties: How much of the treasury market malfunction is technical (poor positioning by levered funds) vs. fundamental, and how long dislocations will last.
The good news is over the last month we have achieved a lot of certainty. Markets have gone on a wild ride over this month, down 20%+/- over the first week and a 25% recovery since then to end flat. Remarkable.
Now let’s update our table:
|What we know||
Central banks have committed whatever it takes to support asset prices and stabilize markets.
Positioning remains risk off.
Restrictions are working
OPEC has cut production 10million barrels a day.
Jobless claims have increased dramatically.
Individuals and companies are having difficulty paying for their loans/mortgages/debt.
|What we don't know||
What sectors/factors/companies will appreciate from here?
What happens to valuations going forward?
How long will this shock last?
What will the ultimate recovery be?
What will the stabilized growth rate be?
Could this burst the private equity bubble?
How will politics play in the distribution of stimulus?
It’s clear we have achieved a lot of certainty in the markets column over the last month, and most of the outcomes have been positive. We have seen spreads tighten, better functioning of markets and a federal government willing to do whatever it takes. While we have achieved some certainty in the fundamentals, I would say on balance the outlook is negative and we are positioned with that view. While we have seen fiscal support for those directly impacted by the virus, we continue to have significant uncertainty about the duration of this shock as well as what a recovery may look like.
As mentioned in the last letter to investors, we came into the crisis with enough flexibility to capitalize on the opportunities. We took advantage of dislocations to add to quality businesses at attractive prices over the last month, our cash positions coming down across the portfolios. Of course things are changing rapidly and we will continue to actively manage our portfolios as uncertainty and prices change.
We are all living through an unprecedented situation with the coronavirus pandemic. I do believe we will continue to see opportunities in the future as this crisis plays out through the fundamentals, so we continue to have flexibility in our portfolios to take advantage of these opportunities as they come.
Again, I would love to use this platform to answer any and all question you have. Please don’t hesitate to reach out.
Principal and Chief Investment Officer
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Published April 27, 2020