Investment Commentary and Outlook as of April 16th
What we are seeing on the virus front:
- Rates of case growth are slowing wherever people have complied with implemented social distancing protocols, whether voluntary or involuntary across the developed world
- Emerging market countries are much more of a mixed bag as some have done little to try and mitigate growth and are now seeing more extensive outbreaks
- Testing capacity is still a major issue, particularly in the US, as many “re-open” strategies rely on testing to keep virus growth in check
- Developed Asia and China remain bright spots in terms of virus control, but both Korea and Singapore have had to re-introduce restrictions due to flare-ups in both countries
What We Are Watching
The US Federal Reserve unveiled extensive new programs to reduce the potential for major companies to declare bankruptcy, including essentially lending directly to companies that were rated investment grade as of March 22. The extent of support provided by the Fed and Congress now reaches almost 20% of US GDP. Globally, support from central banks and governments is equivalent to about 15% of GDP. Governments and central banks have also signaled that they will do “whatever it takes” to mitigate the potential for mass defaults of major companies, as well as providing significant support for individuals and smaller companies. What we have termed “Phase 2”, financial support, has progressed as quickly as anyone could have hoped six weeks ago (see our prior updates here).
The actions of central banks have recently superseded focus on containment of the virus. However, we are still very focused on this as it is obviously the critical issue which is still to be resolved. It is now clear that extensive social distancing works to get new case growth under control. Some parts of Europe are starting to lift restrictions now, though we note that even with this relief they are still locked down more than most of the US. The end of Phase 1, getting the initial virus outbreak under control, for Europe and the US is now more clearly in sight.
What we are calling Phase 3 is what we are starting to focus on now: what do life, the economy, and financial markets look like once the strictest restrictions are lifted?
In our view, the best-case outcome for Phase 3 is to have a robust test/trace/isolate program in-place that ramps up as shelter-in-place restrictions end. However, in the US and in parts of Europe it looks like restrictions will be lifted before widespread testing is available. We believe that this will lead to a relatively shallow rebound in activity as many people will choose to continue with most social distancing protocols, including avoiding crowds and close contact (such as public transportation), and that most people will continue to wear masks in public. People will not trust that the virus has been contained without strong evidence, even if only locally or regionally, that a robust test/trace/isolate program can provide. This means that many of the businesses that closed due to government order, such as restaurants and bars, will stay closed due to limited demand. We already see evidence of this in many parts of China. We also believe that travel, business meetings, etc. will remain very limited without proof that individual risk is low. This means unemployment will stay high.
There is no indication that the US Federal government is going to implement a national test/trace/isolate program, though several states have started to take some early action on this front. However, we remain concerned about patchwork controls in the US and to a lesser extent in Europe. Europe has restricted the free movement of people between countries – the US has not, and likely will not, do the same between states.
We do not see Phase 3 as a “V” recovery (i.e. one with a sharp rebound), at least not for a few months. We could get a much more robust outcome, but only with a massive ramp up in virus mitigation capacity (which would also put many unemployed people to work). The longer economic activity remains weak, the more support that governments and central banks will need to provide. This support, mainly in the form of loans, may lead to a necessary period of de-leveraging on the part of companies, individuals and governments which could weigh on economic growth over many years.
We have a running checklist of the concrete steps that will aid in getting markets to a stage of recovery:
- Declaration of a national emergency and rally the populous.
- Implement firm social distancing policies nationwide (work from home where possible, non-essential business closures, no crowds, limited public transit, etc.).
[Update: Done – virus growth is coming under control in most of the developed world]
- Government agencies working with the private sector to build significant capacity to treat COVID-19 patients (e.g. convert convention centers or hotels into treatment and quarantine facilities).
[Update: The pace of virus growth has slowed enough in many places such that immediate pressure on hospitals is easing, and capacity is being added everywhere]
- Congress passing an appropriate aid package for individuals directly affected by the economic slow-down. This will indirectly help companies and so it may not be necessary to do massive corporate bailouts as well except in unusual circumstances.
[Update: Done – the Fed has also stepped up to multiply the impact of relief provided by Congress]
Even with most of the items on our checklist completed or in progress, we continue to have concerns about emerging market countries as oil prices have continued to fall. Many of these countries are not well equipped to handle the worst that this virus can throw at them and many are very tourism dependent. The IMF will step in to provide support, but there are questions about whether every country that may need a bailout will be able to get one.
How Are We Positioned?
On the back of moves by the Fed we have begun adding credit risk back into portfolios. The Fed’s level of direct support to companies goes well beyond what was expected, making it very unlikely that a major investment grade company goes bankrupt in the short term. It will be very tricky to navigate how this support will eventually be unwound, but that is a problem for a future date.
We have not jumped into lower-rated high yield bonds, with the exception of those that were previously investment grade (i.e. fallen angels), as the support is not there and, at this point, a significant number of defaults, particularly of energy companies, looks likely.
We have not yet re-risked into equities. While large cap equities have had risk of default reduced, they have not had the risk of poor earnings over multiple years reduced and this may not be fully priced in by markets. Small cap equities have had neither default risk nor prolonged poor earnings risk removed at this point. Currently, large cap equities have outperformed small cap equities.
We are now at the “end of the beginning”. We have seen massive change in the past several weeks and we expect the pace of change to slow down now. This is not a problem that is going to be solved quickly and life for most people is not going to snap back to normal quickly (barring a very effective therapeutic). However, people, companies and markets, continue to adapt.
To discuss your current situations with our team of experts contact us at USA@riverandmercantile.com