Avoiding demand destruction and investing in Global Leaders Equity Fund

The use of the word unprecedented in describing the current global situation is, well, unprecedented. Extrapolating at current rates of growth “unprecedented” is likely to occur at least once in each sentence by 2025, and by 2030 all sentences will be composed only of the word “unprecedented” simply repeated over and over. Efforts to contain and slow the spread of the Coronavirus (COVID-19) have resulted in spectacular reductions in economic activity with gross domestic product (GDP) declines of many countries estimated at 10 to 20% for the second quarter 2020. Unemployment in the United States (US) has risen to ten times the peak of the global financial crisis. Equity markets experienced their fastest fall in history. This is genuinely unprecedented.

There are dangers in extrapolating. Lockdowns are a temporary measure designed to reduce strains on health services. The length of these lockdowns are unknown, but our central case is that they are likely to end within one or two quarters. Governments are aware that prolonged period of economic inactivity would be more severe than the long period of austerity measures similar to those in place in many countries. Professor Sir Michael Marmot’s recent review 1 shows the negative impact austerity has had on much of the United Kingdom (UK) population, particularly the less advantaged. In other words, governments are aware that extended shutdowns to try and avoid a humanitarian crisis will in fact trigger humanitarian crises. Additionally, the longer that people remain unemployed, the more difficult it is for people and economies to reach their full potential. Given that the evidence2 suggests that the virus is much more deadly for the elderly and infirm, it would make sense for their isolation to be extended. Meanwhile healthy individuals of economically productive age are likely to be sent back to work by governments. The speed by which this happens will likely be determined by forecasting the ability of healthcare systems to cope with envisaged cases. Antibody tests for the virus promise much. These should help determine the proportion of populations already exposed to the virus. At the moment there is little data to know if populations are anywhere close to developing herd immunity. In an optimistic scenario, widespread testing might show that this is the case. As 80% of COVID-19 cases are thought to be asymptomatic this is a realistic prospect. Perhaps more likely knowledge of the extent of immunity will help forecast healthcare requirements to end lockdowns

Given the declines seen in equity markets then, surely this is an opportunity to buy?

Equities are long-term investments. In our view no decision should be made to invest in equities with a short term time horizon. Large market falls, however, tend to provide great entry points. So yes, we agree that it’s a good time to buy. We would, however, suggest that a higher degree of care is required when investing in the current environment than has recently been the case. Since the late 1990s under Alan Greenspan the Federal Reserve (Fed) have acted to support stock markets with lose monetary policy. This policy was continued by Ben Bernanke who reduced interest rates to counteract market falls. Almost all share prices benefited from this and index investors were prime beneficiaries. The era of the “FED put” may well now be ending. It seems likely that the cost of capital will permanently rise for some companies and changes in the economy means that not all corporates will be as equally successful. Indeed the depth and extent of the shutdown is likely to lead to some corporate failures, or need for government bail-outs. Overall, we believe we are likely to see a greater divergence in performance of equities looking forwards.

destruction or demand pull outOur focus on quality companies enables us to select those with balance sheets sufficiently resilient to withstand more difficult periods such as the one we are currently experiencing. Indeed around 35% of the Global Leaders Portfolio is invested in companies with net cash, virtually no net debt or credit ratings above that of the US Government. The time for quality to shine is in market downturns such as the one we have just experienced. While it’s not particularly sexy to lose less money than peers and the market in any particular period, over extended time periods this defensive nature preserves and enhances wealth.

The team have spent considerable time examining how the business operations of our holdings are currently being impacted by the economic shutdowns (see below for a summary of our major sector exposures), the likely long run effects on their businesses and what the “new normal” is likely to look like.

Key to understanding the current impacts is the concept of demand destruction or deferral. Some spending reductions are permanent while others merely push out demand into the future. We try and avoid those companies with weak balance sheets that have seen permanent demand destruction. Overall, we continue to have high exposures to companies who are relatively unimpacted by economic shutdowns and would be very well placed if they were to continue longer than we anticipate.

Geographically we envisaged that as the origin of the virus, China would be among the first to see an economic recovery. Shares in the US have bounced back strongly since mid-March. We are a little cautious that the US is not yet through the worst of the virus, but as the President there wishes the economy to get back to normal rapidly perhaps things will return to a new normal faster than we expect. Our thoughts and prayers are with all those impacted by the virus.

1. https://www.health.org.uk/publications/reports/the-marmot-review-10-years-on

2. https://www.thelancet.com/journals/laninf/article/PIIS1473-3099(20)30243-7/fulltext

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