After updating friends and family (and investors too) regarding performance and views regarding the Corona Virus at the end of February, we have been fielding a consistent stream of emails and phone calls regarding market volatility. We thought it would be prudent to put our thoughts down on metaphorical paper and return to publishing on our website during these very unique times.
The ferocity with which we saw the end to the longest bull market in recent history has many investors on edge believing that we may be facing a recession on the scale of 2008; at least that is what they have been led to believe by the recent swath of aggressive surprise rate cuts. The fact is that a decade of prosperity and relatively easy lifts on the investment front have softened many memories. The better way to examine the virus in a historical context is the combination of the turn of the century tech bubble bursting followed by the fallout from 9/11, but in reverse order. We have a specific event causing people to be concerned of their safety and the potential for escalating fallout which has drawn attention to some of the glaringly obvious disconnects between markets’ dangerously precipitous valuations and real economics.
The potential for recession is not one truly brought on by lack of demand, but the barriers brought on temporarily by COVID-19. The rational question to ask is if the virus were gone tomorrow, how would markets react? As I write this, the world has ground to a halt. Chinese manufacturing has dropped by double digit percentages, major US cities have shut down and global airlines are whispering the forbidden word of bankruptcy. Russia and Saudi Arabia have decided to play a game of chicken that neither can reasonably win. In fact, it has shifted their own fortunes to consumer countries such as the USA and China who will hoard and stockpile oil in their own reserves and has put on display how weak Russia and Saudi Arabia’s own hands are implying that both countries are already in the midst of recession. The Federal Reserve, the last backstop to any economic contraction has brought a bazooka to a baseball game, wasting precious ammunition on a hair trigger that never should have been pulled. Instead of reassuring markets, it has been misconstrued as a lack of confidence by the Fed regarding the economy causing investors to interpret it as signs of the worst potential scenario rather than a pre-emptive strike. If a vaccine or new infections evaporated miraculously by tomorrow, we would probably have a sharp V like recovery. But with a loss of confidence and dwindling flow of capital through the economic machine, as time goes by economic impact will grow lock in step as businesses shut down in the face of dwindling revenue, unemployment growth and future demand for goods and services declining and cycling through as the world tightens its belt. This grim reality relies solely on the actual viral fallout, and more specifically the fear surrounding the viral fallout.
COVID-19 has proven virulent and highly contagious. But let’s examine the facts. The virus maintains a higher mortality rate than the flu, but much lower then historical epidemics (H1N1, SARS, etc) with a susceptibility weighted towards geriatrics with compromised immune systems or pre-existing conditions. It has similar properties to the common cold and the flu in terms of infection rates but seasonality as well hypothesized by documented temperature sensitivities. This has led to some experts believing that we would see a reduction in viral progression as we enter spring/summer months, but that like the flu, we would see annual occurrences. We would suggest that the best way to examine the viral life cycle is to observe its progress in China and other Asian countries as they have reached a certain level of containment. Similar levels of containment may take an extended period of time in the western world, but with growing efforts to quarantine and limit the spread, we should see eventual progress.
The true test of weathering this market is to be able to separate market fear and economic reality. Market fear will be our guide in the short term; it will dictate markets and cause ongoing volatility as we have seen with double digit swings in major market indices as of late. As we examine these swings, we need to frame them in the context of economic reality. Do these moves make rational sense? Do they represent a true change in economic activity, or are they more representative of market mentality and investor confidence? As we examine market movements under this lens, we can position tactically to not only preserve capital and lessen the volatility of our overall portfolios in the short run, but to profit from the reactionary investing of others. As we observe longer term impact and market stabilization, we will find opportunities to invest in themes, sectors and companies at valuations that appear only once a cycle. The key is to be rational and nimble in the immediate.
As my wise and brilliant mother always likes to remind me, “This too shall pass”. Markets will eventually shrug off much of the overhang that the virus has caused. Confidence will return to markets, companies will recover lost revenue and the economic machine will start up once again. I cannot guarantee that we will emerge unscathed; we have spent the last several years urging investors to recognize how the underlying risks in the market were not being appropriately priced into asset valuations. Geopolitical tensions, isolationism, cash burning unicorns and persistently low interest rates have been constant red flags as we position our investments. As investors take stock of their current portfolios, I strongly endorse more prudent examination of investments. There are many companies who do not have the balance sheet let alone the business model to re-emerge from this routing of the market and global economy.
Even as we deal with the current volatility at hand, we have become more concerned about the eventual next roadbump we face with interest rates back at their lows. With persistent low interest rates, the tendency is for investors to deploy even more capital into markets. But as that capital floods back into traditional assets and drives valuations back up, this capital will begin to trickle back down to riskier asset classes as we saw with the deployment into emerging markets (I’m looking at you Argentina), cryptocurrencies, and cannabis in recent years. We will again face an overvalued and overheated market that could again topple for a number of black swan like events that are financial in nature rather than pandemic. Monetary policy will be unable to stimulate during these periods as we have spent the bullets prematurely and ineffectually in the wrong scenario yielding a very Japan style economy in its aftermath.