Themes For March

5 April 2020

It goes without saying that March saw an unprecedented level of volatility as financial markets struggled to come to terms with the impact of the global pandemic COVID 19 virus. As mentioned in our recent “Coronavirus Conundrum” report, the quandary for markets is exactly how to value securities in an environment where the global economy has been deliberately shut down as a necessary step to slow the spread of the virus and stay within the critical care capacity of the health care system. In the short term, the variables that usually drive markets such as earnings forecasts and economic data are effectively meaningless as economic conditions are contrived rather than organic. Cash and bond rates have been manipulated lower by central bank policy, which has encompassed interest rate cuts, massive quantitative easing and liquidity support programs. To backstop the economy during the period of shutdown, governments have introduced broad ranging support measures for individuals and businesses, which are designed to maintain solvency rather than stimulate demand. In Australia, the aggregate of fiscal support packages announced so far are equivalent to an incredible 16% of GDP, which will increase our debt to GDP ratio from 28% to 40% which, although uncomfortably high, is much better than the US and other developed countries.

The State of the Virus

Due to the nexus between the virus and financial markets, investment professionals (such as your humble correspondent) have had to take a crash course in epidemiology to make sense of it all! The shape and duration of the economic recovery is inextricably linked to the spread of the virus and the measures being adopted to manage this. While polices have varied somewhat around the world, countries where the virus has hit most severely, such as China, Italy and the US, have adopted strict lockdown policies to contain the spread and limit fatalities in the short term. Countries with recent experience from the SARS epidemic in 2003, such as South Korea, Singapore and Taiwan, mobilised more quickly and adopted a more tailored approach involving mass testing and more targeted quarantine measures emphasising the vulnerable sections of the community as well using “contact and trace” methods to identify and isolate those infected or exposed to infection. Australia has not adopted the most severe lockdown policies but still implemented strict policies to limit the movement and grouping of people though “social distancing” measures, while still allowing mobility for exercise and essential work. The good news is that rates of infection and mortality around the world appear to have peaked and are beginning to fall with most hospital systems coping with peak load critical care cases. In other words, the curve is flattening and being maintained below the dotted line of hospital capacity. Importantly, during this time of economic hibernation, the health care system has built capacity in critical care beds, ventilators, N95 masks and protective equipment to treat the most critically ill patients and reduce mortality rates. A cautionary note however, is that once return to work policies are relaxed, expect a second spike in infections as sheltered people emerge to once again become exposed to the virus. For this reason, we could see a series of peaks and valleys in infection rates over the next 12-18 months and possibly a rolling series of hibernation measures as well which will contribute to on-going market volatility.

State of the Cure

There is a globally concerted effort to develop a vaccine with up to seven different pharmaceutical companies entering clinical trials already, however the human testing phase is necessarily a long and meticulous process, so realistically the best-case scenario is this will be available in 12 months. Of greater short-term importance however, are positive signs for anti-viral treatments used for other conditions such as malaria and lyme disease which are showing promising anecdotal results in treating seriously infected patients. In addition, there is a blood plasma anti-body test that will be available shortly which will help determine who has been exposed to the virus and recovered and therefore (in theory) immune from reinfection in the short term at least. Germany is about to embark on a mass anti-body testing campaign and are floating the idea of issuing “immunity passports” to people that have fully recovered from the virus so they can move freely in the community. Sweden has adopted the controversial and risky “herd immunity” approach which quarantines the elderly and vulnerable, but allows more liberal movement of the healthy population to allow a faster spread to develop a “herd” of immune people to starve the virus of available hosts. The end game for the virus will be either an effective vaccine, treatment medication or the development of herd immunity such that people will feel safe to move freely in society without fear of either catching or spreading the virus.

State of the Markets

The recent volatility indicates a disorderly and at times chaotic market. Forced selling from investors deleveraging, wild speculation from hedge funds, safe haven buying of government bonds, the USD and a huge dispersion in estimates of earnings have made the market next to impossible to read in the short term. In our opinion, it is much more relevant to look across the valley into 2021 and assess the state of play once more normalised economic conditions return. Investors that have attempted to profit from trading in this kind of market are relying more on luck than good judgment. We have a strategic long-term focus, which relies on sound judgment and therefore we have stood aside from the mayhem to let markets find their new equilibrium. In more recent days, we have been encouraged by a more positive tone as markets have been buoyed by positive signs on declining infection, hospitalisation and mortality rates and optimism that a gradual reopening of the economy may occur over the next few months. It is highly unlikely we will see a sharp recovery in activity however as this process will be carefully staged while maintaining social distancing measures which themselves will reduce the capacity of industries such as travel, entertainment, restaurants, transport and will prevent mass gatherings at sporting events, theatres, concerts and conferences for the foreseeable future.

The market has exposed flaws – yet again!

For the second time in 12 years, a severe market shock has exposed weaknesses in product structures and investment strategies. In particular, the failure to correctly manage liquidity risk has plagued some of the country’s largest Industry Superannuation Funds prompting one of them to seek a bailout from the RBA to meet unforeseen redemption and switching demands. It is uncanny how often the market exposes a flawed strategy or product design and it’s disappointing that many industry professionals failed to heed the clear lessons on liquidity management from the GFC in 2008. In constructing portfolios for our clients, we apply the strict screening criteria of liquidity, transparency and cost efficiency for any investment to be considered. This leads us to favour securities traded in liquid secondary markets, which have both market-based pricing and can be cash settled within a few days. At all times our clients know what their portfolio consists of, what it is worth and that they can be converted to cash if required relatively quickly. The flip side of is that we deliberately eschew illiquid unlisted asset such as the popular “alternative assets”. These have been heavily sold for their diversification benefits, which are largely illusory due to the use of infrequent and non-market based pricing mechanisms, which give rise to lower price volatility, which is incorrectly used as a proxy for risk. In liquidity crunch events like COVID-19 and the GFC, these assets cannot be readily sold and will restrict or even freeze redemptions for many months during which time assets are heavily written down in value to reflect market pricing. In our opinion, these are expensive and flawed product structures, which do not serve the client’s best interest and will therefore never feature in portfolios we recommend.