Since my last update the spread of the virus has come under control, to varying degrees, in much of the world although some outliers remain (e.g. Russia). This has led to an easing of total lockdowns and a measured restart of physical economic activity. Again the degree and pace varies by country.
Markets have been further bolstered by massive amounts of both fiscal and monetary stimulus. Actual real economy data has set several records for its awfulness, especially in the Western World, but as economies were largely shut these numbers have been considered inevitable and thus of not much relevance to investors. How the recovery evolves from here is of much more importance.
I don’t often say this but I do have to commend the institutions investing in the UK on their ability to finance what they consider to be solvent long term winners amidst a liquidity crisis. By late April Man GLG estimated that 10% of the UK market had raised capital to enhance their liquidity through the pandemic. This is actually a case of markets doing what they should be doing!
The tricky part is now assessing what economies and thus company profits will look like going forward. Markets could easily assess that with lockdowns, travel bans and social distancing, leisure, retail and travel related companies would be worst hit, followed by energy companies (who had a brief price war to contend with as well). There are likely to be more shocks to investors as second derivative effects kick in. These are unlikely to come from the sectors mentioned above.
China and indeed other parts of Northern Asia are seeing sequential improvement but we must accept social distancing there was imposed earlier, was perhaps adhered to more thoroughly than in the West and ‘track and trace’ is tolerated more than it may be in Western societies too. We should also be aware that the recovery thus far in Asian economies has actually been held back by the lockdowns in the West because demand for Asian exports has collapsed. As the West comes back, Asia will actually be a tailwind not a headwind for many Western exporters.
Chart 1. Consumers are back: Auto sales recovering
Source; Matthews Asia
At this point I must make an apology. Although the virus in North Asia has tracked almost exactly as I expected, I said in my first COVID note in late February that the virus was unlikely to hit the West as hard as it had Hubei Province as we had much more time to prepare. Never did I think that the developed world would do next to nothing during this six to eight week window. As a result of this inactivity we have been hit even worse than Hubei in terms of casualties and fatalities (if we take all the numbers at face value). In turn this has meant lockdowns have been longer and economic damage more severe than in Asia.
However, the policy response has been commensurate with the economic damage inflicted. Please see the updated chart below highlighting the extent of Government support.
Chart 2. Fiscal Stimulus
Source; National Sources, HSBC
We have done very little over the last six weeks as we had already bought in several tranches as markets fell in March. We did lock in the profit on the incremental position we took in Japanese Equities and recycled this money into a short duration high yield bond fund. Traditionally high yield has exhibited less than half the volatility of equities, has a yield pick up and usually recovers faster coming out of a downturn. Although yields have fallen from the extremes of March they are still at very attractive levels. The fund we have bought has exhibited far less volatility than the sector over its lifespan to date.
There is near unanimity now that a second wave of the virus will occur and that “risk markets” will have another swoon, even if ephemeral and not quite to the lows of March. Certainly the rally we have seen, although pronounced, has not been as broad as to indicate widespread optimism about the future (it has been led by mega caps and companies less exposed to the first round effects of the virus).
Whilst another swoon will once again be uncomfortable we have more scope to take advantage of such developments by committing more to investments around the globe at what will be even more compelling prices than exist even today. We have the firepower to do so. Once again we will do so in an incremental manner. Furthermore, given the ubiquity of the expectation there is no certainty such a sell off will occur, or if it does it will be as widespread as the last one or that the shape of it will be the same.
The other scenario I am wary of is that if there is an unequivocal medical breakthrough. Then in one day risk assets will have a rise of ‘biblical proportions’, particularly those who are set to garner market share in the most afflicted industries as we come out the other side of the COVID emergency.
Although still early days, there have been indications of progress towards developing a vaccine from Oxford University/Astrazeneca and antibody tests being produced by Roche and Abbott should help facilitate the easing of lockdowns.
Whilst I noted above the rally has been a relatively cautious one in terms of participation so far, there are a few examples and anecdotes of how companies are potentially changing to the ‘new world’ (don’t like that phrase) and how quickly investor sentiment can change. Ed Leggett of Artemis states that at 50% capacity utilisation Wetherspoons (pubs) could add £1million profit per week by adding 10p to the price of a pint and 10p to a meal. Bowling Alley Company Ten Entertainment Group (who had been growing very nicely and profitably until February) now expects to break even on a cash basis at only 60% capacity utilisation. Budget Airlines are another example where an additional £5 or £10 per seat net to them (depends how much governments take in tax) could transform the profitability, even at much lower load factors. Whilst not an immediate problem pricing in consumer areas is something we will need to keep an eye on. Particularly in afflicted areas, the weak will most likely perish, conferring market share gains and hitherto unthinkable pricing power to the survivors. Pricing has a much more magnified impact on profit than volume (much less cost of goods sold to put the price up rather than sell an extra unit). Obviously this will occur over time and not all afflicted industries will have the same power to enact such.
The example of how quickly things can change is cycling (and motor repair) company Halfords. Already going through a restructuring of some duration and mostly high street based, this company was in the eye of the storm and the shares fell precipitously as shown below.
Chart 3. Year-to-date share price performance of Halfords
Source; Google Finance
They cut the dividend and utilised available funding to, at least in management’s eyes, get them through the crisis. Then a government minister announced the walking/cycling to work drive with attendant funding pledge of £2billion. The shares then soared such that all the loss for the year was erased in only 7 weeks. Whilst an extreme example it is one that, pre the rise, a fund manager included in a list of ten holdings he had (out of a total of 50) which could at least double and still be below their average historical valuation. Obviously it is highly unlikely all will but it does demonstrate the widespread latent upside. The above are UK examples but our Asian managers in particular have shared similar sentiments (or wishful thinking).
Obviously risks abound and here in the UK, as in the US, we have to deal with a government which has struggled to talk and act coherently regarding medical strategy and execution (although both score well on economic policy response). This risk is exacerbated short term as we have the next Brexit related deadline up at the end of June. The currency market and several commentators are suggesting no extension will be sought and that a reversion to WTO rules will start in January next year. This, in my opinion, is not an optimal outcome. The offsetting factors are that at least companies will know what they are dealing with and be able to respond accordingly. Secondly we will be in the midst of massive stimulus instead of having to cope with both Brexit and austerity as we did last time round. Sterling is also 15-20% below 2016 levels so the impact should not be as pronounced, excepting perhaps an initial knee jerk reaction. Let us hope people are being too pessimistic but I have to acknowledge the fact that the probability of a hard Brexit has increased.
The other big, but not totally unexpected risk is that anti Chinese rhetoric gets out of control and damaging actions ensue, further damaging corporate confidence and investment. President Trump has an election to win and China is the perfect fall guy to deflect from his handling of the health crises. Again I am hoping someone will inform him of the damaging impact on the economy. However, he may decide that it is too far gone to rescue by November and that rallying round a nationalist anti China campaign is the best bet for re-election.
So in conclusion we have seen the worst of the current stage of the health crises and have been shown a path back to some kind of normality, even if that path looks more winding and hilly than expected back in February. We have seen massive policy action, with promises across the globe of more to come, in order to steer us along that path. We have seen many examples of corporations adapting very quickly to the new environment and all this augurs well for the medium to long term. Even the oil price war seems to be over, removing at least in part a deflationary threat.
So we will continue to bob and weave with short-term volatility with the aim of fully participating in the resumption of economic activity to levels close to historical levels.
Chief Investment Officer
18th May 2020
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