With governments and central banks throwing the kitchen sink at the current crisis caused by CCOVID-19, where does this leave us? More specifically, we will try and focus on where we see the biggest risks.
This week we begin with an old saying often attributed to Lenin, “There are decades where nothing happens, and there are weeks when decades happen.” The past few weeks have proven to fit this old adage (in financial circles at least). Again, the newsflow moves ahead beyond a rational rate of consumption. Starting with the biggest recorded monetary intervention in history by the Fed, a fiscal stimulus that was almost quite literally the throwing of the kitchen sink - $200bn AUD and counting (that’s somewhere between 0.5bn and 1.5bn low-mid range kitchen sinks, if you were wondering) - at home, another $2tn USD ask by the White House (which is well on its way to the $6tn USD scenario that we previously guessed), not mention a rather tense face-off between the Italians and the Germans on the other side of the planet. So where does this leave us? More specifically, we will try and focus on where we see the biggest risks.
Risk 1 - The Japanification of the Planet
When we first wrote about the likelihood of further non-conventional (and now everso conventional) monetary policy and fiscal deficit blowouts last year we posited that it would likely lead to the so-called “Japanification'' effect. Taking a walk down memory lane, the blackswan event that led to the BOJ initially taking their particular course of action was the Kobe earthquake of 1995. What was meant to be a short-term fix, including the slashing of interest rates to 0 and QE, became a much longer lasting phenomenon (i.e. 25 years later we are back where we started). That being said, to be fair to the Japanese, the introduction of a yield-curve and a gradual unravelling process was started before recent events got ahead of policy makers.
We think it likely that we see interest rates close to absolute zero and even negative for the foreseeable future. The nascent liquidity issues that we first wrote about in September of last year, starting with the Repo markets, are now the new norm. Where central banks take the traditional place of the banks and act as lenders of last resort to corporates outright. Case in point being a whole soup of swap lines extended by the Federal Reserve, ranging from Primary and Secondary Market Corporate Credit Facilities. This is a trend that the European’s seem to have perfected in recent years with their bond buying program. Thankfully Australia has not gone down this path yet with most of the RBA QE being limited to the buying government debt issues and treasuries in order to keep the yields low at 1.5%. We are not too sure about this remaining the case on a longer time horizon though. The most immediate targets in local markets are likely to be airlines, like Virgin, and Residential Mortgage Backed Securities (RMBS).
From an investment perspective, look at it this way, the key will be in determining whether the expansionary monetary policy and blow out in fiscal deficits will calm consumer sentiment enough to overcome the uncertainty around earnings and growth trajectories. If one was to take the affirmative case, then (on a reasonable basis) we might have already hit peak fear and it might make more sense to start sequentially allocating with the expectation that there will always be a knight in shining armor. If you take the alternative view then it might perhaps make sense to wait for more clarity. There is no point in trying to pick a bottom in a free-fall scenario. It might make more sense to wait until reporting season to see how big the impact is, in terms of actual numbers. Even if it is to the downside, at least we know what prices to bid at.
The best thing here might be to look to Japan post 1995 to see which sectors performed relatively well to get an idea about where to allocate. At the risk of sounding like a broken record, we will be looking at infrastructure and to lesser extent technology (first on the way down and first on the way up). Also, be on the lookout for zombie companies which are just liabilities.
What to watch for? Spreads on high-yield debt & leveraged loan ratios.
Risk 2 - A Non-Recessionary Recession
One of the most hazardous sayings in finance, and indeed life in general, is the old “this time it's different.” But we must admit we have not seen anything like the past month in our investing lifetimes. So we thought it might be pertinent to do a little more digging and look through history.
The easiest comparison that most people draw is to the GFC, but we do not think this is an appropriate comparison. The GFC was a liquidity shock which, although non-linear in its impact as all recessions are, had an element of rationality behind some of the movements. The market was trying to price in what growth was going to look like, in essence front-run the business cycle. Due to the feedback loop the markets can give an indication of what the real economy might do and recover before the real economy does. This time around it is not the case, this is what one analyst, Louis Vincent-Gave of Gavekal Research, termed ‘an exogenous shock’. The more apt comparison here might be the first Gulf War or, going further back through history, Pearl Harbour in 1941 or after WWI where the markets followed the real economy. He uses the example of WWI, where they closed the markets for nine months after which the re-opening became a positive shock rallying through much of the war period till 1918. In the case of the Gulf War, the markets didn’t turn upwards until Desert Storm. Again, we would like to reiterate, markets are a function of probabilities, not uncertainty.
Why is it different this time?
For one thing, it is the unprecedented response. We have had the Spanish flu, the Asian Flu of 1957 and the Hong Kong flu, all of which did not see the same draconian responses from governments. In fact, if one were to take a rather laissez-faire approach to it all and let it run its course, we would daresay that the economic cost would not be anywhere near as heavy as the measures now being implemented to prevent the human catastrophe that could be (much like the Spanish Flu).
What we are trying to grapple with is a black-swan that essentially created a cliff-edge moment for the real economy. There are two ways out of this scenario and the real impact of both are vastly different.
The first scenario is to create what is effectively a wartime economy, whereby governments around the world take draconian measures but force-feed growth through spending. Whether it is supply-side through infrastructure projects or on the demand-side through debt write-offs. It might sound like lunacy but we are inching ever closer to this scenario with proposals for things like student debt write offs where the Fed would buy the student loans and write them off. In terms of government debt, we do not foresee a scenario where governments actually pay the debt back. It is rather more likely that central banks let the debt on their balance sheets go to expiration without a call (debt monetization). In this instance you would see a rather quick recovery once the real economy opens up again with suppressed demand creating a sugar high during the initial stages. Unfortunately this will also be exceptionally inflationary.
The second scenario is one in which governments get through a 6-month timeframe and monetary policy gets gradually reset over a period of time. From an investment and real economy perspective, this seems a much harder route and one which we don’t see much chance of occuring because of various electoral cycles and policy constraints.
Our thoughts are that we would rather be prepared for the first scenario as a base case. One in which 1) the real value of debt gets eaten away through an inflation tax (tax but not tax); and 2) risk-parity constraints.
Risk 3 - Risk-Parity Trade
For the regular readers, we might once again sound like a broken record but this is where we see the biggest risks for the market. For those of you unaware of what an institutional risk-parity trade is, it is the traditional bond and equities portfolio mixture. Where assets would be allocated on the premise that bonds and equities have an inverse correlation and hence act as a natural hedge to each other. What we have unfortunately been seeing is that this correlation has somewhat broken.
For one thing, we are consistently seeing a scenario in which bonds and equities go up at the same time and vice-versa. Why is this an issue?
Firstly, in the event of a liquidity squeeze, it has the potential to create a vicious cycle. Where there is effectively no cover and, in a downturn scenario, all asset classes sell at the same time. However, if we had to choose and assume our base-case scenario of inflation coming back into the equation, then we would rather stick to equities. With allocations to bond proxies, including utilities, energy (not time yet but certainly will find a bottom before the rest of the market), gold and, from a regional allocation perspective, Asia which is less encumbered by debt and has seemingly broken its volatility in risk-off scenarios during recent times. The strong consumer stands in stark contrast to many western nations including Europe and even to a lesser extent the Americas.
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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.