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Are equities disconnected from the real economy?

22042020_Global portfolio update

Are equities disconnected from the real economy?

In this continually-evolving crisis, we update our investors again with a brief summary of how we are assessing the risks for our global equity portfolios.

The coronavirus

The most important datapoint in determining the economic cost of this pandemic is its duration. This will dictate the length of time that consumers and businesses face restricted activities. Increasingly, it is looking likely that a vaccine will ultimately be required for economies to completely open back up. Estimates on timing are around the 12-month mark – but then manufacturing and distributing 7 billion doses will likely add significant time on the other side as well. For what it’s worth, America’s now famous Dr Fauci believes 18 months is the more likely timeframe for a usable vaccine.

Some have talked about herd immunity as a possible solution, but there is simply too much evidence now to suggest that either: (i) this will take longer than a vaccine to build; and/or (ii) may not even be effective, to the extent people can contract COVID-19 multiple times. Furthermore, an approach favouring herd immunity would result in many more fatalities than on favouring a vaccine.

The increasing evidence of asymptomatic carriers further reduces the prospects that economies can be opened back up without significant risk of a second wave. Even with increased testing, how does one know to test someone with no symptoms but who remains contagious to others? A second wave would obviously be disastrous for the global economy.

Naturally, governments need to try to open their economies back up as best they can with increased testing to try to isolate new cases before an exponential spread starts again. Much has been written recently about serological testing for antibodies as a path to economic reopening. The hurdles to overcome here include: (i) poor accuracy and lack of standardisation of serological tests; and (ii) simply too few have contracted COVID-19 (as a percentage of the total population: and (iii) increasing evidence that recontraction (or reactivation of existing COVID-19 contraction) is possible.  For investors, as societies begin to reopen around the world, what probability do you place on a second wave occurring?

The economy

In the US economy today, US initial jobless claims are more than 22 million in four weeks – ten times the claims of the first four weeks of the 2008/09 GFC. At least 3 million businesses will likely close – and possibly many more. JPMorgan believes the US economy will contract 40 per cent year-on-year in the second quarter (by comparison the worst quarterly decline in the GFC was 3.9 per cent); and 20 per cent unemployment (double the peak unemployment rate post GFC).

In the euro area, ECB President Christine Lagarde pointed out last week that incoming economic data have started to show “unprecedented falls, pointing to a large contraction in output in the euro area, as well as to rapidly deteriorating labour markets.”[1]

In China, the official GDP decline reported last week was 6.8 per cent year-on-year. Independent estimates put the true growth rate closer to a decline of 12 per cent. And while the Chinese economy has started to show signs of improvement, we are now starting to see a second wave of weakness stemming from declines in manufacturing orders from the US and Europe. And in a recent survey of Chinese households, more than 60 per cent said their income would likely decline in 2020 versus the previous year; and 42 per cent said they were planning to reduce their consumption this year.

And this leads us to the broader point. Even if COVID-19 was contained over the next couple of months (a low probability event in and of itself), there will be significant long-term repercussions from the economic contraction that is already locked-in for Q2.

At best, households will have a lower propensity to consume and a higher propensity to save post-COVID-19. And many will have to undergo a period of deleveraging to repay the increased borrowings required to survive this disruption.

Many surviving corporates will make it only through increased borrowings. Remember, in describing the various relief packages recently announced by the Fed, Jerome Powell characterised them as “lending powers, not spending powers”. As he points out: “The Fed is not authorized to grant money to particular beneficiaries.”[2] These corporate balance sheets will need to be repaired after COVID-19, reducing cash flow for investment and shareholder returns.

And then there are government balance sheets. Take the US, for example. Even before the pandemic, the federal deficit for the year was projected to exceed US$1 trillion. The recently enacted CARES act will add another US$2 trillion (not to mention the enormous gaps that need to be plugged in the various state and municipality-level budgets). And the longer the economy remains disrupted, the higher this figure will go.

On the other side of this pandemic, will we see coordinated deleveraging between households, corporates and governments, in all economies, all at the same time? If so, what do global growth expectations look like then?

The equity markets

Let’s go back to, say, October last year – before COVID-19 had even been discovered. At the time, global growth was solid, unemployment rates low and leading indicators for growth in all major regions were improving. Interest rates were low and monetary policies were supportive. The outlook for equities was rather attractive.

And today, we not only have an economic contraction locked-in which is significantly more severe than during the GFC; we are also faced with a scenario – that carries a reasonable probability – of this contraction persisting in some form until there is a useable vaccine produced and distributed to every human on planet earth more than one year from now. And the longer this takes, the slower the recovery period out the other side as we enter the period of coordinated deleveraging, described above.

The price level of the S&P 500 today is the same as it was in last October. Or said another way, the market-implied expectations for future aggregate earnings is the same today as it was in October. Does this sound strange to you?

Our global portfolios

This COVID-19 crisis is a uniquely shaped risk for active managers and investors to deal with. And it is really forcing managers and investors to decide what they believe in. One of the primary tensions is the one between long-term absolute returns; and short-term relative performance.

In March, readers will know we moved to a highly-defensive portfolio position in our Montaka variable net strategy and our Montgomery Global long only strategy. We did this because we believed there was (and still is) a more severe downside possible scenario than what was being priced in by equity markets. Our belief was (and still is) that today is the day to preserve as much capital as possible – while the day to pounce on extraordinary investment opportunities remained in the future.

We also warned that if markets were to rally during this period that we would underperform in the short-term. And that is exactly what has happened. But chasing this short-term bounce would leave us exposed to the downside scenario that we believe remains very possible. By avoiding this possible downside scenario – to the extent it does play out – we can take advantage of great opportunities and, over the long-term, deliver strong absolute returns for our investors.

As such we continue to be defensively positioned in these strategies[3]. Indeed, as equity prices marched higher last week, we reduced our exposure even more.

We believe equity markets are pricing in one of the most optimistic scenarios around COVID-19 and associated economic revivals – possible, though low probability, in our view. The risks around: (i) vaccine timing; (ii) second waves of covid-19; (iii) second-order economic impacts; and (iv) timing of economic recoveries, all appear to remain very much to the downside.

A better time to buy equities in size would be when equity markets were pricing in much worse scenarios for the above risks and could then surprise to the upside. If and when this time comes, we are very well positioned to take advantage of opportunities. In the meantime, we will remain focused on protecting our investors’ capital.

[1] (IMF) Statement by Ms Christine Lagarde, President of the European Central Bank, at the forty-first meeting of the International Monetary and Financial Committee (April 2020)

[2] (Brookings) Speech by Mr Jerome H Powell, Chair of the Board of Governors of the Federal Reserve System, at the Hutchins Center on Fiscal and Monetary Policy, April 2020

[3] Note: Our Montaka 130/30 Extension strategy remains fully-invested at all times, so is not considered to be defensively positioned

INVEST WITH MONTGOMERY

Andrew Macken is the Chief Investment Officer of the Montaka funds and the Montgomery Global funds. He established MGIM in 2015 in partnership with Montgomery.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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4 Comments

  1. Hi,

    Given that various lockdowns are continuing – it is what it is – I would agree that the markets are reflecting a most optimistic scenario and therefore it seems to be somewhat divorced from the real economy. As you rightly say, the duration of these lockdowns is key.

    Perhaps time will tell which government approach was appropriate. Those governments that have called for lockdowns, are essentially betting (and in my view that is the right word, “betting” or “speculating”) that “possible” infection rates are more important than the “absolutely certainty” of economic Armaggeddon for the lower- and middle economic classes. Those governments that did not promulgate lockdowns, like Sweden, are either saying the medical data is not sufficiently clear to call for a lockdown in the first place, and/or it is saying the economic cost does not justify a lockdown.

    Montgomery/Montaka are known for their market-implied-expectations-vs-your-own-view approach to investing. I think it is a great way to approach investments. That also means your teams are used to think in probability-weighted scenarios and what not. Good on you.

    So my question, if you wish to have a go at it: Even though little information was available 4 weeks ago when most lockdowns were started, would you nevertheless have thought there was a sufficient “margin of safety” to bet a whole economy and the economic lives of so many people on the possibility (and even today no one knows the real “probabilities”) that x number of people would not only get sick, but actually die of covid-19? The equation should include the certain cost of closing economies down for y days. Take also into account that a lot of this is unfalsifiable, meaning governments can’t afterwards claim their approach worked, because the numbers could be low because covid-19 turns out to be not as lethal as originally thought. Not sure you want to have a go at it (can probably only get in trouble for doing so), but it seems to me some sort of probability-weighted approach is better.

    I hope Sweden’s approach work.

    • Jaco,
      This is such an awesome thought/question.
      I want to think about it a bit more.
      You touched on something I’ve been thinking about recently, which is the concept of unobservable counterfactuals.
      And it’s something politicians (and investors) face often.
      So for covid, Australia and NZ have done a pretty good job of containing the outbreak. So people naturally ask, was the action too severe given the outbreak was not nearly as bad as expected? Or was the outbreak not as bad only because of the severe containment action?
      And when the cost of severe action, as you rightly point out, is a signficant economic downturn, one opens themself up to even more accusation of overreaction.
      This is why climate change is such a difficult issue politically: it also represents a tail-risk in that there exists a non-zero probability of catastrophic consequences. Now imagine if a signficant economic cost was incurred to ensure no tail risk at all. Life would seem the same – and some would inevitably ask the question: why did we hurt the economy when climate change turned out to be a non-issue? But was it the action that led to the economic costs the reason climate change became a non-issue?
      These unobservable counterfactuals make life very difficult for political leaders. At a minimum, I think everyone will agree with that.
      Many thanks again and all the best,
      -AM

  2. Enjoyed your article Andrew and although I don’t entirely agree with all your levels of probability analysis, your process is clear and I thank you for the explanation. I do however have one query with regard to your analysis of risk associated with this recovery. Does your decision tree challenge the severity of this virus (in terms of deaths) against the yearly seasonal flu? And if so what is your analysis?
    Keep up the good work.

    • Hi Lester,
      Appreciate the feedback and thoughtful question.
      With respect to the comparison between covid-19 and the regular flu, I must admit that I was initially skeptical of the economic impact of covid-19 because there are such large numbers of hospitalizations and deaths that occur every year from the regular flu. So covid-19 would need to be significantly incremental to these numbers to have a major impact. On further analysis, however, it became clear that covid-19 spread much more quickly and in a way that was difficult to track, than the regular flu. Even today, medical researchers believe they have discovered the existence of those who have had covid-19, have been contagious, and yet had no symptoms at all. These unusual characteristics meant that covid-19 was going to require far more drastic lock-down measures to contain than for the regular flu. And, of course, it is these measures that are impairing economies all around the world.
      All the best,
      -AM

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