The past couple of days both the Australian and global markets have seen us go into the red. The now apparently exponential rate at which COVID-19 is spreading and fears around a global pandemic have driven investors into safe-haven assets like gold and treasuries, pushing the already low yields further. So, we thought it might be pertinent to ask ourselves the question: What is next for markets? Where do we allocate?
These questions might seem disarmingly simple but the answer has to be nuanced. Investment, no matter how much the tragic quants like to make it so, is fundamentally an art and not a simple science. We are not of the opinion that markets are rational nor are they efficient in the short term, they are made up of people with their own motivations trying to price in their many and varied interpretations of risk and reward. And the markets have determined that the newsflow warranted a 1000 basis point sell-off in the Dow, and European equities, having close to $720bn AUD wiped off in value, the ASX never one to be left behind promptly followed suit with 129 Billion AUD in the red. This begs the question, how serious is this problem? For one, the numbers don’t seem to add up. According to the WHO, confirmed cases in China at last call stand at just above 77 000 with 2600-odd deaths while globally, excluding China, known cases stand at 2060 with 23 dead. It might be callous to say so but do these numbers warrant such a reaction from the markets?
We are by no means experts in the field of disease control nor do we have epidemiologists on hand to give us a better understanding of the facts on the ground. And the numbers are beginning to suggest an exponential growth, probably the most concerning aspect. Imagine if the spread was such that governments had to take on the same Draconian measures as those undertaken in China? Or the political ramifications? For example, the way the Japanese government handled their particular situation with regards to the Diamond Princess, whose passengers ended up bringing the virus to Japan, might have consequences for public opinion and the strength of the government. Suffice it to say, if we see continued problems (or even the Olympics being cancelled) this does not bode well for the Abe government. Furthermore, given the asymptomatic nature of the virus itself where the carriers do not actually exhibit symptoms for up to two weeks, this might be a bigger problem than we can currently know. Though the fact that we do not have community transmission outside of China should give us some semblance of hope. This comes with the caveat that this might not be the case for much longer. After all, there is no mass testing (at this stage) in countries such as Indonesia or most of the middle-east where there are only the odd-cases found in Iraq, Kuwait, Iran and Afghanistan.
The takeaway here is this, as it currently stands we certainly feel that the sell-off is disproportionate (this might seem a little unpopular to say given the seeming doomsday proclamations in the media) until we become aware of further ramifications both from political and consumer sentiment perspective. Another example of the political ramifications might be the Chinese citizenry becoming increasingly defiant of the government in getting back to work and actually giving interviews to western media such as the New York times about their discontent, something that would previously have been unthinkable. If this is the start of a trend that could see further instability, then we might start having to worry.
So what do we look for?
While we are suggesting that the sell-off is disproportionate to the facts on the ground as they currently stand, there is a counter-argument. We live in a world of historically high asset valuations, it might be a case of the markets looking for an excuse to have a risk-off trade. We have previously mentioned that the low-interest rate environment had unexpected consequences when it came to the amount of corporate leverage and lackluster capital reinvestment. In fact, if one were to pull up the statistics, the best-performing companies over the past ten years - since the GFC that is - have been those that had high debt-to-book ratios. While this might push up return on equity in the short-run, it is by no means sustainable in the long-run. So our view is that the sell-off is not solely the result of the virus but that it was the straw that broke the camel's back.
Purely from a portfolio perspective, we are firmly of the belief that, while there might be turbulence ahead from an equities perspective, it offers decent buying opportunities for the discerning investor. Factors that have gone out of fashion like cash-flow conversion, leverage and ROIC will start to matter a lot more even if the central banks counteract less than stellar economic data with further rate-cuts. We definitely expect the RBA to go 0-bound by mid-2021 and the Fed to expand the balance sheet further, especially with pressure from the Whitehouse.
From a purely sectoral perspective this means understanding that different sectors might perform well in different geographies. For example, Australian materials or airlines might not be the best performers but healthcare and even SaaS providers present decent opportunities (with the exception perhaps of the precariously valued WAAX stocks). Similarly, in Asia infrastructure plays that might benefit from governments desperate to promote domestic growth might benefit. The Chinese government, we expect, will stimulate and do so in a big way. Whether by building excess infrastructure capacity or stimulating credit growth again (PBOC is already well on its way).
Here is where one must hold a view. Fundamentally speaking one has to come to judgement as to whether the virus is inflationary or deflationary in nature. On the one hand, the disruption to supply chains and the decrease in productivity that might stem from short-term underemployment (i.e. people not going to work) could be intrinsically inflationary. On the other, if there is a marked decrease in consumer sentiment and spending as a result of uncertainty, then that would be deflationary.
If you were to believe that this creates an inflationary scenario then equities and precious metals would be the asset classes to be in. On the other hand, if you were to believe that we are likely to enter into a further deflationary period, then bonds would be the asset class to look for. Our view is simply that equities with some diversification across illiquid and low-beta (low correlation) assets are the way to think about allocating.
While one could make the argument that, given the uncertainty, it might be better to go to cash entirely, this doesn’t bode well in a low-interest rate environment especially if recent events build up inflationary pressures in the economy (thus a double whammy of low interest and inflation eating away the real value of money).
Despite the volatility and while it might seem like self-interest for us to say so, we continue to believe that it is better to stay invested but with reasonable diversification across geographies and asset classes. Yes, the markets are volatile and yes, Covid-19 could very well be a black swan event but maybe it would pay to go back to Buffet’s logic:
”If you had to choose one car and you could only have that car for the rest of your life, how would you choose it and how much difference would it make to your judgement.”
Our view, when thinking about portfolio’s, is like this. If one had to choose a portfolio and asset allocation that could ride through the next hundred years, what would it be? How would you think about it? We are not suggesting that everyone has a time frame of a hundred years but rather this exercise allows investors to wade through the noise and hopefully attain a little more clarity. Not being a victim to the swings or temprament of the markets. It is not necessarily about putting together a group of historically well-performing investments but asking how those investments perform in different contexts. So while a certain asset class or strategy might not perform well in a low-interest rate environment, others do well in the opposite (financials being the easiest example and infrastructure being the opposite).
Markets & Commentary
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TAMIM Asset Management provides general information to help you understand our investment approach. Any financial information we provide is not advice, has not considered your personal circumstances and may not be suitable for you.