How should you think about cash?
One of the biggest questions facing equity investors today is when and how to deploy surplus cash that they may have available. This is a question we have studied extensively in recent weeks, and while we can offer no definitive answers, some tentative conclusions may help to inform this decision. With that in mind, we set out here a summary of key points coming out of our analysis of the COVID-19 pandemic to date, and some thoughts on what might lie ahead.
Firstly, the outlook in the near term, we think, is grim. Probably more so than markets yet appreciate, and we expect to see more bad news than good news in the coming weeks and months. However, we also see some glimpses of light a little further down the track, and some possible tailwinds to recovery.
Starting with the near term, by now nobody needs to be told that COVID-19 is a critical health emergency whose management has profound economic implications. Some of the drivers of this are worth reiterating:
- It has proven to be highly contagious. With asymptomatic patients able to transmit the disease it has also been able to hide in the shadows and spread largely undetected. In countries where it has gained a foothold, daily case growth rates in the order of 20-30% have been the norm, and compound growth at these rates turns small numbers into large numbers very quickly.
- It appears to be about an order of magnitude more lethal than seasonal influenza. It is too early to accurately assess case fatality rate, but expert opinion sits at around 1%, and our analysis leads us to fear that it could be higher still. Even at 1%, it has the potential to become a leading cause of death in the foreseeable future.
- Further, fatality rate is very much a function of the sustained growth rate of an outbreak. If healthcare systems get overwhelmed by rapid case growth, an inability to care for serious cases pushes the fatality rate quickly higher.
This combination of features mean that if it is allowed to get out of hand, the human toll could compound in a terrifying way. As a result, governments have little choice but to pursue draconian measures aimed to limit growth – the so called “flattening of the curve.” These measures, of course, are highly disruptive for some sectors of the economy, and will likely result in a sudden surge in unemployment and business failures. Government stimulus and support initiatives will soften the blow, but will come at a steep, and currently unknown cost, and will inevitably address only part of the economic damage.
Not only will the control measures be onerous, it appears likely they could be with us for quite some time. Global resources are being thrown at the “silver bullet” of a vaccine, but expert opinion suggests that 12-18 months may be the best case timeframe. We might hope that urgency and application of resources will accelerate these efforts, but at the same time, widespread deployment of a novel drug that has not been exhaustively tested for safety is a science experiment that should not be taken lightly.
This means that we could be in crisis mode for some time, and sustained economic disruption is its own form of contagion. As businesses in one part of the economy fail, their problems are quickly spread to other businesses who previously regarded those businesses or their employees as customers or debtors.
We note that some store has been placed in the idea that warmer weather might slow the progress of the virus, leading to more rapid success in containing it. However, while many respiratory infections including the seasonal flu and some coronaviruses do show strong seasonal patterns, this is far from guaranteed in the case of COVID-19. Some viruses, including some of the more recent zoonotic viruses, do not show a seasonal pattern, and published research we have seen does not support the idea that climate has played a significant role in the spread of COVID-19. Our own analysis of case growth rates across different parts of the globe similarly gives us no comfort that seasonal effects are having much impact.
Another argument for a more positive outlook is the apparent success of containment efforts in places like South Korea, and particularly in China which is further along the path than any other nation. While we agree that there are some encouraging signs there, for several reasons it is not clear to us that we should take too much comfort from these observations. These include:
- It is not clear that a Chinese-style containment program can be implemented within the constraints of Western government and culture. Particular features of the Chinese system that may have aided success include an absence of privacy laws that enabled the movements of an entire population to be tracked, and an ability to apply harsh sanctions to enforce quarantine and social distancing. Informing the Party of a neighbour’s non-compliance may be the norm in China; dobbing on a mate in Australia is not. At least not yet.
- Even if these sorts of containment successes can be repeated elsewhere, we are yet to properly understand what happens when those containment measures are relaxed. As China progressively returns to a more normal mode of operation, we may find that hidden problems re-emerge. Similarly for South Korea. It is also worth noting that many European countries are following a trajectory closer to that of Italy than South Korea, highlighting the challenges involved.
- We are also inclined to be a little wary of the Chinese case data. On analysing the data from provinces outside Hubei, we find that the case experience has been surprisingly benign and consistent. While the points raised above may help explain why China has been able to effectively control new cases outside Hubei, they do not explain why the speed of recovery and rate of fatality appears to be significantly better in those provinces than (for example) in South Korea. The Chinese data also a shows consistency both across regions and through time that we would not expect from a naturally-occurring data set. We also see the Chinese Communist Party in the process of exercising tighter control over the COVID-19 narrative; a process that coincides with the expulsion from the country of significant numbers of Western journalists. All things considered, while the Chinese data offers some encouragement, we are reluctant to assume it tells the full story.
Drawing limited encouragement from the climate argument and the Chinese data, we anticipate that the coming weeks and months are likely to contain more bad news than good news. Possibly a lot more. Accordingly, even though equity markets have already fallen significantly and offer better value than they did, we are cautious about deploying the surplus cash we hold on behalf of clients.
Any forecast, of course, is highly uncertain, and a case can be made for some buying today in case the near term holds better news than we anticipate, but it appears to us to be too soon to move aggressively.
Looking beyond the near term, however, we do anticipate a recovery. On a 12-18 month timeframe, the successful development of a vaccine might be viewed as a back-stop, allowing a return to more normal conditions over a corresponding horizon. In addition, on a shorter timeframe we see some reasons for optimism that may not yet have drawn much attention. In particular, we see learning curve effects offering real potential to mitigate the social and economic damage during the remainder of 2020.
Currently, COVID-19 is an entirely new threat to our health and our economy and we start from a zero base in terms of our knowledge and experience in fighting it. As time passes, however, all aspects of our approach to dealing with it will improve. To give a few examples:
- Treatment protocols will improve. While a “silver bullet” vaccine may be some time away, there is a good chance that we will identify existing drugs and therapies that can shorten recovery times and mitigate against case seriousness; we will learn how to manage cases more effectively and without putting at risk health care workers, as happened in the early part of the outbreak;
- Production of protective equipment, medical consumables and other supplies necessary to the fight will be ramped up and export restrictions currently being applied around the world will be relaxed;
- Our understanding of social distancing and other non-pharmaceutical interventions will improve. We will learn which interventions offer the greatest health impact at the lowest cost, and community compliance will improve as the measures become more familiar;
- Importantly, testing methods will improve, as they have already begun to do. Tests will become cheaper, faster, more sensitive, and more widely available;
- Our capacity to track and manage the prior contacts of those who do test positive will improve, allowing further spread to be contained more quickly and reliably.
To appreciate how significant these learning effects may be, consider for example the current border restrictions in force and their devastating impact to airlines and travel companies. In a world where testing for COVID-19 is cheap, accurate and readily accessible, it could be feasible to lift travel bans, subject to a requirement that all travellers first test negative.
It is impossible to predict exactly what advances may be made in the months ahead or to what extent they might ease the health and economic burdens, but we can be confident in expecting that improvement will come. Once case numbers are manageable and we are confident they can be kept there, economic recovery can be given greater focus.
Accordingly, while we anticipate further bad news in the near term, we are optimistic about an improving outlook over a slightly longer timeframe. As events unfold, we will be watching closely to try to discern the signs of a turning tide and ensure that clients are not left behind when recovery does come.
Thanks Tim for sharing the excellent analysis. The impact of COVID-19 is well understood by now. The worst case is It lasts 1-1.5 years with fatality of 1-2% of population (similar to Spanish influenza) . The more unknown is the impact on the finance system. Look at the 08 crisis. It started from the subprime mortgage one, which OZ didn’t even have, and grew into global financial crisis. In some way, finance system is similar to virus. The problems grow exponentially. Most people don’t understand until it is too late. That is why Einstein called exponential growth the eighth wonder of the world. “… He who understands it, earns it … he who doesn’t … pays it.”
With more and more quantitive easing, and money being debased all other the world, how to you view ‘gold’ in the equation?
I am not enamoured with it as an investment. Gold will mostly be a speculative bet on the fear of others.
There is some evidence supporting high temperature and humidity reduce the reproductive number. This study was undertaking using China’s situation and analysed temperature/humidity differences across China’s cities. Refer to the paper.
Hi Peter. It wouldn’t surprise me if there were some temperature and humidity effects on transmission, but I’m wary of drawing conclusions from the Chinese data which was used in that study. I note that the US and UK Governments have now reached the view that China has manipulated the data to conceal the true extent of the epidemic there.
Hi Tim, just wondering how cash in the fund is impacted by the declining value of the market. Is it increasing as a percentage, I think Roger said recently it was at 30%, or has the fund been buying to keep cash at 30%? Cheers… JG
Hi Jon. This is something that we are thinking hard about. On the one hand, value appears to be present; on the other, we can see some possible sources of further bad news. Cash is still in the region of 30% for now.
Hi, excluding banks what are the top 5 equities that are in buy territory now? Cheers
Thanks for your reply. A mass produced vaccine should help bring the world out of hibernation but I fear the length of time this recovery is going to take. Take care.
What are your thoughts on this being bigger than simply a economic / business cycle downturn. A 75-100 year debt deleveraging cycle looks a possibility. With so much of the worlds population to be living off government benefits, I struggle to see where the demand for a rebound is going to come from. Also fear what the geopolitical fallout of this is going to be. I feel there are to many unknowables to call the bottom of the market simply on the heath issues.
Fair points Brad. There could well be lasting impacts that are extremely difficult to predict, and we certainly aren’t calling a market bottom. However, we do see a path to recovery over time, and aim to find a measured position that balances risk and reward.
Great analysis as always, but has the virus spread to pandemic levels in any warm climates? In any case it doesn’t seem it requires much of a spread for us to shut down.
Cheers, Phil. The numbers suggest that once case numbers start to grow, there is no obvious correlation between growth rate and climate. Given it grows exponentially, the size of an outbreak today is mainly a function of when it started to grow, and what the government did to respond.
Informative summation of the Covid-19 health situation and TMF’s sensible investment strategy. Good to know TMF team is sitting on the sidelines for now holding cash reserves for future opportunities.
Tim, this analysis seems spot on – cash is no longer trash (at least for the near future).