Three critical issues for investors in the COVID-19 crisis
While I count this as the fourth major market crisis of my investment career (following the ’87 crash, the bursting of the tech bubble and the global financial crisis), it’s the first to be associated with such significant broad scale social disruption and cost in terms of human life. Also different is the unprecedented pace and scale of change. This applies to the spread of the COVID-19 virus, the adjustment to asset prices, the response of policy makers (in terms of monetary, fiscal and social policy), and the way we’ve adapted to work in this extraordinary environment.
At this point I want to slow things down and explain how we are thinking through this crisis and what we believe is important from an investment perspective.
Focusing on the critical issues
Starting points matter. We went into this crisis well placed, primarily because we thought markets were complacent and priced for perfection. Our valuation framework (which has not been without its critics) did what it does best and highlighted the embedded vulnerability of markets. However, as we’ve said consistently, price and value aren’t the same thing. While prices are lower across most assets, the extent to which value has been restored is less clear.
There are three critical issues to understand here.
First, the extent of the economic downturn and the profile of the recovery are difficult to predict. The nature of the shock, its differential impact across the global economy, the likely long-term destruction in some segments of the economy, and the extent to which substantial fiscal and monetary policy stimulus must interact with social and health initiatives, all combine to make forecasting the recovery profile even more difficult. While we’d all like a V-shaped and uniform economic recovery, our baseline is more a U or a W.
A second and related issue is that the key from an investment perspective will be the impact on corporate health and profitability. Our modelling suggests that profits globally could be down 30% - 40% this year, potentially more, and this will lead to corporate failure or at the very least some significant downgrades – particularly in highly leveraged businesses. We are concerned that deteriorations in credit standards, and the mispricing of credit risk generally through the various global QE programs, will hit home as profits collapse. Dividends may help in some areas but are unlikely to fully absorb the impact.
Finally, and like most people, we’d like to see evidence the COVID-19 virus is getting under control. We’re watching the COVID-19 curves closely to get a stronger sense of the impact but also the pace at which key economies can be taken off ice. While there are some positive signs that Australia is flattening the curve, the experience in the US and parts of Europe is more concerning and unlikely to be linear. Also, the potential for several waves of infection needs to be considered.
While opportunities are emerging, we’re not there yet
Our investment framework helps us select assets that make the most sense to own, with a preference for lower risk entry points to our preferred markets. In this context, ‘lower risk’ means assets where we consider the downside risks are largely reflected in the price and, as investors, we feel confident we are accessing good quality assets with an adequate risk premium to skew the likely outcomes in our favour.
On balance, we don’t believe we’re there yet. We believe market pricing reflects temporary recession, not a broader or more protracted and difficult environment where a high equity risk premium is ultimately required. Volatility remains high (big daily gains, big daily falls) and we think will for some time.
That said, there are some interesting areas that we are exploring. These are areas that have been hit hard and are potentially discounting a more severe downturn. We’d include infrastructure and REITs as well as some parts of the credit landscape.
Our portfolio position
On balance, we are treading cautiously but have nonetheless started to take advantage of the volatility in markets. During March we made several changes.
After cutting equities to 20% in late February, we increased our equity position in mid-March, adding about 5% to equity weights. This was on the basis that the extremes in volatility saw the market tactically oversold.
With some market participants selling good quality assets to raise liquidity, we stepped into the market to accumulate some higher yielding Australian bank (T1) paper at yields of around 9%–10%. While supply of securities was limited, this was a good example where we could use our cash holdings to provide liquidity and access good quality assets at discounted prices. Spreads have subsequently narrowed significantly.
A key position for us has been our long USD position versus the AUD. With the AUD temporarily falling below USD0.60 amid the volatility, we took some profits on this position, but overall remain long USD.
With the RBA cutting rates and joining the global QE club, while announcing it was targeting a yield of 25bps on the three-year part of the yield curve, we looked to extend our duration further out the curve.
These periods reaffirm my belief in the importance and role of flexible asset allocation approaches where the investment decisions are aligned with the underlying objectives of the investor – including liquidity, something you don’t need until you do! The order of returns matters, and this approach can potentially help us generate good outcomes (and sleep better at night) without the same level of risk as equity-heavy portfolios. We’ve written and spoken about this a lot, but it’s a message that can be lost when markets are on the up.
Equity markets plunged in March, albeit ending the month well off their lows. Australia was a relatively poor performer during the month (-21.5%). The US market posted losses of around 12.5%, while markets in Asia (including Japan) posted significant but more modest losses. Volatility was extreme during the month. The key VIX index peaked at 82 in March, where S&P index was 25% below its starting point for the month. For reference, this was above the levels recorded during the GFC. By month-end volatility had moderated but remained at an elevated 55.
From a sector perspective the weakest performers in the Australian market were energy (reflecting OPEC tensions and the collapse in global oil demand), real estate (reflecting the impact of the shut-downs on property demand and rents) and financials, impacted by the banks’ potential exposure to bad loans and expectations regarding repayment deferrals. Growth as a style factor outperformed value in March.
While overall value (and prospective returns) across the equity universe have improved, the impact on corporate earnings make the extent to which value has improved unclear. Notwithstanding this, Australia remains our preferred market, partly because it has underperformed, but also because we are seeing more positive signs around the containment of COVID-19.
Central banks globally adopted the “whatever it takes” mantra in March, cutting rates and embarking on renewed QE programs to inject liquidity and confidence back into markets. Notably, the RBA was among the most aggressive central banks, cutting rates by 50 bps to 25 bps and starting QE through direct bond purchases and yield targeting (predominately at the front end of the curve). While front ends rallied, there was significantly more volatility at the back end of curves as investors also sought liquidity in the sovereign market.
From a credit perspective it was clearly a very tough month. Credit appeared to lag equities during the last week of February but caught up quickly. Adding to weakness in credit has been the collapse in oil prices which has put substantial pressure on energy producers, who are well represented in the global high yield bond market.
We are starting to see some opportunities in credit and have begun adjusting our position accordingly. That said, we are yet to see the distressed pricing that would reflect the downside risks to global growth resulting from widespread shutdowns and make credit generally a more compelling proposition.
Currency volatility was also extreme in March as the safe haven attraction of the USD dominated. The AUD fell sharply (at one point briefly falling below USD0.56) before recovering towards month end.
We’ve been long USD versus AUD for a while now. While we did take some profit on this position, it remains one we continue to hold. While our Purchasing Power Parities calculations estimate a fair price in the mid to low 60s, with Australian rates now low and aligned with global rates, the RBA doing QE like other central banks, large fiscal deficits and high public sector debt for the foreseeable future, we still think pressure remains on the downside. As a result, we think the AUD could drop below USD 0.50 before this cycle’s over.
For more on how COVID-19 is impacting markets, click here.
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