Coronavirus Commentary 19th March 2020

I sincerely hope this will not become a permanent weekly Commentary but I want to update you on the latest developments in economies and markets.
Full panic mode was reached early this week as investors and companies belatedly cottoned on to the fact the best way to prevent the virus spreading was to follow the procedures taken by the Asian countries who have already had some success in that respect. Although the virus was the initial catalyst for market moves, the latest ructions, in my opinion, are due to over leverage in some parts of the financial system which has once again caused participants to question counter-parties. This, in turn, has led to a craving for US Dollar cash at the expense of all else, despite the US being way behind most international peers on efforts to actually control the spread of the virus.
Although I retain my view (in light of developments in Asia) that the financial markets will rebound (like China) as soon as people think the virus is under control the last week has probably signalled two massive regime shifts that will be multi year in their impact. The first is that the era of austerity is officially over. The following is a quote from the UK Chancellor.
Meanwhile US Treasury Secretary Steve Mnuchin said ”this is not a time to worry about the US Budget Deficit” (and the US hadn’t been that worried pre virus).
And for once it hasn’t just been talk. The UK has already pledged £32 billion in immediate relief plus another £330 billion in loan guarantees. The US are proposing over US$1 trillion in relief including direct payments to families. Mortgage and rate relief is also being introduced.
This is why the normal safe havens of government bonds have seen a sharp sell off this week simultaneous with the sell off in equities and commodities (there is supposed to be a negative correlation in such times). This is the second multi year theme. It is dawning on investors that budget deficits and government debt to GDP is going to balloon in many countries as authorities ”do whatever it takes” to provide liquidity during the downturn and ensure a subsequent rebound. Therefore the one way bet nature of government bonds is rightly being called into question.
Central Banks are doing their bit to ease liquidity in financial markets too. On top of the significant moves made last week the ECB announced a €750 billion Pandemic Emergency Purchase Programme whilst the Federal Reserve announced the Money Market Mutual Fund Liquidity Facility.
As mentioned above, severe technical malfunctions in the bond markets, not valuations or fundamentals, are responsible for much of the gyrations of late. That is why the Central Banks have moved in so forcefully.
The good news is that, in my opinion, governments and central banks have (at great cost) virtually guaranteed the liquidity of the private sector in the West and, more importantly, its ability to participate in the inevitable recovery. This is very much what happened in 2008-09 and sowed the seeds for the dramatic recovery that commenced in markets from March 2009 (much later for the real economy). Thus far there has been nowhere near the level of panic in Asia although the dollar shortage issue needs to be alleviated.
One way we have been able to take advantage of the malaise is investing in a fund which benefits when volatility is very high and unlikely to accelerate much further. The fund has low correlation to both equities and bonds and does not need equities to go up, it just needs a levelling off in volatility. As you can see the in following chart volatility (VIX) has soared to multiples of historic levels and is approaching 2008-09 peaks. It could very well stay high for a while but that need not be a problem for the fund. The reason for that is, much like an insurance company, when big events happen and it suffers then the subsequent premiums it takes in go up a lot (this is an analogy not an exact comparison).
We also managed to buy back Unicorn UK Equity Income after selling in anticipation of Brexit malaise (it initially fell, subsequently soared before falling back again). The text below is from the company about their investment philosophy.
We have also added to (or initiated for some portfolios) Franklin UK Equity Income. This is a fund which retains a conservative core and aims to (and has) delivered steady returns versus peers. It does not aim to be heroic in its position.
In order to keep risk levels from rising too much we financed by selling some Europe as in anything but the very short term Sterling is simply too cheap.
Finally, on to the virus. Whilst investors obsess with Europe and the US we are actually seeing continued containment and even improvement across North Asia. Please see below for South Korea and China. The latter chart depicts the relative performance of Chinese Equities as the number of cases peak. Japan, Taiwan and Singapore are also controlling the spread well.
It is obvious now that the West is not going to look to Asia as an indication of how the virus develops (even though there is a clear pattern) but rather wait until we see some signs of peaking in Europe and perhaps even the US.
However, it is clear the authorities are doing everything possible to both backstop the financial system and provide liquidity to the real economy during the months (not quarters) of shutdown.
When one steps back and considers that a company is valued on the sum of its discounted cash flows over a number of years plus a terminal value then the loss of one or two quarters profits should not be a big deal. However, investors always over react and especially in times of widespread macro fear as exist today. This has created the opportunity for us to add incrementally (on at least seven different dates and therefore price points).
Corporate and High Yield Bonds are now becoming interesting but credit analysis is critical. The need for further due diligence on that plus our long standing concerns about the liquidity and inherent leverage within the market have prevented us executing as of yet.
We haven’t been able to find a suitable property vehicle for years and therefore have escaped the latest round of fund closures.
So in conclusion it has been another torrid week designed to torment even the most experienced of investors. My first full year in the markets was 1987 and therefore I had a baptism of fire, The Tech Wreck and Corporate Debt bust of 2000-02 followed before the Lehman Crises erupted.
The lesson from all of these times was that if one focussed on balance sheet quality and didn’t try and be a hero then buying judiciously always yielded long term rewards.
Just consider from a personal point of view. In 4-6 weeks time when we are given the all clear pubs, restaurants and aeroplanes do you think you and your friends will continue to stay away or will you be raring to make up for lost time? I know what camp my friends and I are in! I can see what is happening in China (Apple reopened all shops, but not for drinks!) and that is what gives me confidence this painful episode is an opportunity to be taken advantage of.
Yours sincerely
Ian Brady
Chief Investment Officer
19th March 2020

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