The decline in equity prices since February has been the fastest we have seen in a generation. We have an unfolding global pandemic, alongside a major plunge in the oil price on fears of a potential oil war. Markets have been driven down precipitously, primarily due to concerns around global economic contraction resulting from the spread of the Coronavirus (COVID-19). In turn, this caused a shortage of market liquidity and a potential business funding crisis.
The natural response is to compare the current circumstances to history and see what lessons can be extracted from previous virus outbreaks and market crashes. A Severe Acute Respiratory Syndrome (SARS) virus hit China in 2003, infecting at least 8,000 people and killing around 800 - roughly 10% fatality rate. The effect on the market was material but short lived and it subsided in around a month. This pattern of swift recovery, less than six months, was repeated for outbreaks of Swine Flu, Ebola and Zika, however the major difference today is that China’s gross domestic product is four times the size it was in 2003 and the globe is far more connected than it was almost two decades ago.
The global financial crisis (GFC) was essentially driven by over extension of credit that ultimately resulted in a stock market crash and a major economic contraction. This time things are switched around, the concerns around the virus are resulting in a material reduction in economic activity, which will ultimately lead to a meaningful output contraction. While it isn’t our base case view, the likelihood that this eventually spills over into a financial crisis if authorities do not appropriately manage the situation cannot be ruled out. Governments and Central Banks, as in the words of Mario Draghi during the European financial crisis, are already “doing whatever it takes”.
Despite the unusual nature of this market disruption the experience of previous market dislocations is proving invaluable in remaining composed amidst adversity. We understand that such times can be troubling for investors.
Our portfolio management approach hinges on forming a view of the most likely outcome given the prevailing circumstances, what we term our “base case” scenario. In our assessment, the current market and economic turmoil is likely to be transitory in nature and we expect it to subside towards the end of 2020, (although precise timing is very uncertain). This base case is predicated on strong, coordinated global fiscal and monetary policy response to alleviate the stress created from the impending economic contraction and to avoid further degrees of financial stress in the system.
It is also prudent to consider that in circumstances as uncertain, unprecedented and as fluid as those we currently face, the risks to our base case scenario are material. As such, we construct a stress scenario whereby the required fiscal stimulus is insufficient and/or the combined impact of the virus and oil crisis is much worse than anticipated, resulting in the financial system becoming increasingly stressed. In this scenario, the result would first be economic contraction, which then leads to a financial market crisis. While the likelihood of this occurring is currently quite low, considering its possibility allows us to adequately prepare our portfolio responses for such a scenario.
Our positioning is being rigorously debated and reviewed on a daily basis given the current high levels of market volatility. We are reassessing our base case, not losing sight of the stress case and are well prepared to adjust our portfolios accordingly.
The following summarises our current house view portfolio positioning:
- Our portfolios remain well diversified and in quality blue chip equities that have sufficiently strong balance sheets to withstand an economic shock such as that we are experiencing
- Our bond exposure is diversified across US Treasuries, investment grade, and short duration credit (less sensitive to cyclical factors)
- Within our equity exposure, we are underweight in highly economically sensitive or cyclical businesses (e.g. basic materials and industrials, and consumer stocks) and overweight staples (e.g. health and household), pharmaceutical and technology – namely those companies that have recurring revenues, (e.g. food retail)
Efforts to reduce the spread of the coronavirus will decrease economic activity for some time. The investment team focusses on the underlying impacts that such disruption will have on the investments made. It is worth remembering that the prices of equities are determined by the marginal buyers and sellers. The underlying value of the companies themselves depends on the future cash generated by these businesses. In normal circumstances, the companies held generate returns in excess of their cost of capital, meaning that their intrinsic value is increasing.
Veteran investor Ben Graham introduced the world to the concept of Mr Market, who can be incredibly pessimistic and incredibly optimistic at times. We believe that the extent of market pessimism over the Coronavirus is likely very high. Government and central bank efforts to support markets have already been substantial. We believe that peak fear is close.
The world is first and foremost facing a major public health crisis and our thoughts go out to those affected by this human tragedy. The response by authorities to contain the spread will undoubtedly be negative for the global economy. The magnitude and duration of this is uncertain and will depend on a host of factors which need to be closely and consistently monitored.