Probability is the only mathematical tool available to help map the unknown and the uncontrollable. It is fortunate that this tool, while tricky, is extraordinarily powerful and convenient for those who are able to deploy it. (Benoit Mandelbrot, the founder of fractal theory)
The substantial, and in many markets unprecedently-fast, falls in growth asset values in the month since the CoVid-19 crisis began unfolding has been disorienting for many investors. The event is a textbook “black swan occurrence” – a shock so uncommon that price mechanisms tend to ignore it rather than capture its probability, and thus markets over-react massively when it in fact transpires. This degree of market shock is exacerbated, because prior to the outbreak, investors were largely focussed on an improving growth and profit outlook for 2020 after the trade-war affected uncertainties of 2019.
Cautiously optimistic assumptions have however been de-railed as the bull market reversed into a bear market and commentators have been outdoing themselves in predictions about how deep the global contraction triggered by CoVid-19 will prove to be. For instance, there have been widespread statements about a multi-year recession and potential for economic depression which we consider at this point to be exaggerated. Similarly, predictions that the current shocks to the global system will be “worse than the GFC” need to be put in context for NZ investors. It is true that if no progress is made on virus containment, resumed business operations and re-activation of international activity, the hit to GDP growth is likely to exceed that in 2008-2009. All the same, it is important to remember what the GFC was, and what it did, to asset values – which, as can be seen in the main US equity index charted below, did not recover their prior peaks for over four years. Evident below is 2008’s drawn-out deterioration and then capitulation / collapse, which contrasts with 2020’s “bolt-from-the-blue” immediate reversal of the prior asset pricing trajectory.
In the northern hemisphere, everyday savers and non-institutional investors generally hold a relatively low share of their portfolios in real estate assets. While the collapse of the financial sector’s debt funding instruments in 2008-09 led to massive interventions to assist banks, mortgage institutions, and lending conduits, the hit to consumer wealth was mainly felt inside long-term pension funds that were in general, not immediately needed for day-to-day consumer survival. The prevalence of defined-benefit (DB) pensions in Europe and North America allowed the retiring cohort to draw reasonably decent incomes through the crisis years, as their payments were linked to prior finishing salaries. Housing prices collapsed in most markets, but once banks were nationalized (UK) or restructured (USA) the foundation was laid for poor-quality and excessive debt loads to be gradually worked through. Unemployment surged in the Great Recession years, and opportunities were particularly few for younger workers. However, many older workers retained long-term employment by bargaining with companies over reducing weekly hours, freezing salaries, or taking moderate income cuts for the crucial years of the downturn. Meantime, the fixed interest component of their pension funds gained substantially in value as the crises years dragged on, as central banks created “Quantitative Easing” (QE) and “Zero-Interest Rate Policies” (ZIRP). Arguably, the resulting distortion of risk signals that interest rates normally provide has led to the sensitivity in asset markets this time around, as they went into the CoVid-19 shock based on extreme valuations made possible by years of low yield signals from bond and credit asset markets.
It may not have felt so to residents of our own region, but NZ and Australia experienced a comparatively mild GFC when compared with Europe, the UK and United States. Excessive prior gains in real estate were wiped out, and lifestyle spending geared to house price gains ceased for a few years. However, Australia did not even enter recession and the major Australian banks, with the government at their backs, were able to inject capital into their NZ subsidiaries and keep them solvent while the NZ government bailed out some key non-bank lenders. Thus, there was no real full-scale asset fire-sale here, which would have led to the kind of widespread impoverishment in family spending power and mass destitution that the term” depression” implies.
In the current crisis, the NZ equity market has lost around 15 months of cumulative gains (falling back to the Christmas 2018 low as of today,) whereas the US market has lost around 3 years’ worth (having last been at its current level in March 2017.) This is why we have long highlighted the risks arising from a very expensive local share market and have kept our exposure to it at a prudent level in multi-sector funds. Underappreciated risks to earnings have hit the “defensive” market from left-field: few anticipated a shock collapse in visitor numbers and in airport and airline usage but these sectors have been hit hard by panicked investors. On the other hand, one of the most resilient domestic companies has been F&P Healthcare, a globally-active manufacturer of respiratory masks and healthcare equipment, Not a classic ‘defensive” stock by any standard, but one that has gained 78% over the last year and is trading at all-time highs through the current turmoil.
Loans effectively interest-free in the Developed world, and some now almost risk-free in NZ
Part of the reason to be less pessimistic is simply the size and scale of central bank responses, which are escalating by the day. One example overnight was the US Federal Reserve indicating that it is willing to conduct “unlimited” purchases of government bonds, mortgage-backed securities and even corporate debt, as well as lending directly to companies in some circumstances. This “whatever-it-takes” attitude is clearly meant to stop the free-fall in market sentiment, although the extension into potentially-limitless private entity financing departs from the traditional central banks’ operating limits. In becoming the buyer of last resort, central banks are quite likely to staunch the destabilizing outflows presently causing havoc in liquid asset markets. For now, the perils of this approach are less important than the merits of combating a shock to the global economic system that is caused by a pathogen, more than by risk-chasing investment decisions.
Along with the key central banks of the Developed Market nations, our own Reserve Bank (RBNZ) has joined in the emergency stimulus-and-lending operation with great alacrity and unprecedented ambition. Less than a year ago, it was accepted wisdom that the RBNZ would never engage in Quantitative Easing, by buying up government and other debt securities with its own balance sheet, in order to keep credit flowing. Short term, the RBNZ probably had no real choice. However, the fundamental reasons NZ had excluded this course in the past are still valid and may return to trouble the Governor in time. Today, the NZ government announced a three-year business loan underwriting programme whereby it will assume 80% of the credit risk on such loans, allocating 20% to the banks administering them. This is quite radical, to the extent that the NZ taxpayer is now ultimately answerable for keeping the domestic business world afloat through not just the crisis period but into the medium-term. It will be the responsibility of voters in future years to assess whether that obligation proves worthwhile.
For now, banking operations appear out of peril, which was the object. Business failures will be lowered as a result – but as more rational voices have noted (in a whisper) lack of cheap operating credit was not a constraint for business. As turnover hits the wall of CoVid-19 restrictions on public movement, business clearly needs emergency lines of credit. It will be of great interest, when the crises eventually subsides, for financial writers to assess whether the trading banks might not have sourced this emergency liquidity elsewhere? If the action was taken to support privately-owned banks’ own unwieldy balance sheets, fine – but arguably the public discourse on that point should be open and honest. Whatever the pros and cons, Developed Market banks are now able to lend, roll over and re-finance loans and protect their lending margins. So, unlike during the GFC, the financial transmission channel of deep recession has this time been dug more shallowly.
Is Salvation at hand?
These massive interventions by state institutions (details of which have been covered in our recent blog posts) may actually stem the selling in vital markets and allow continued functioning of the credit and cash-flow apparatus at the basis of capitalist systems. We believe at this point that the balance of evidence supports a slow-stabilization scenario. There will be major economic costs and adjustments ahead this year and next, but the fundamentals of asset markets should be robust enough to begin reflecting the unlimited support now extended by the institutions that control the global supply of funds. Where previously-downplayed risks are exposed and re-priced to reflect reality, this will ultimately be a positive.
However, it is important to stress that the CoVid-19 market crash has been unique in its speed, in market history. That means, there are very likely to be second and third-round effects yet to be felt around the world. The rapid rise in the US dollar against almost all world currencies has severe implications for global companies and countries that are servicing USD-denominated debt. The sharp increase in yields for most of the global corporate debt market also produces fundamental challenges to heavily-indebted firms. Investment funds, strategies, and even value propositions based on pre-crisis norms will be up for fundamental questioning. In the process, some unsustainable strategies will be exposed as such, and their issuers may be severely compromised – either by investor outflows or by the re-pricing of risk. In other words, some kinds of assets and asset-financing techniques will almost certainly be fatally compromised by margin calls, redemptions, investor cash-preference, or the collapse of individual Merger and Acquisition proposals or equity buy-back plans.
US dividends and share buy-backs have exceeded corporate cash flow since 2013, so buy-backs have replaced capital expenditure, which has dropped markedly in the USA since the Trump corporate tax cut in 2017. Firms have borrowed USD 4 trillion on the capital markets, and bought back a comparable quantum of their equity, in value terms. The value of repurchased shares amounted to at least 20% of the S&P 500’s market capitalisation, yet retired only 0.7% of the broad equity market’s total share count per year. Now, the eight main US banks have suspended their buy-back programmes and this may become a condition placed on emergency financing from governments. If so, a major prop to equity market gains over the last decade will be eroded until the buy-backs resume, or (longer-term) until capital investment and profitability gains begin to be visible to newly-cautious equity holders.
What it all means for portfolio strategy?
This suggests to us, that while a powerful market rebound is entirely possible when the epidemiological outlook improves sufficiently and money moves out of present panic-driven Cash and Government bond allocations again, there are still more fundamental problems that remain to be properly addressed in equity capital markets. Thus, while we may adopt short-term positioning to take advantage of very beaten-down asset prices (in cases where the asset and balance-sheet quality satisfies our standards) in general, we will take a cautious approach to the growth asset classes in subsequent quarters.
One example is likely to be Global Listed Infrastructure. These assets are of high quality, have defensible and stable cash-flows and structural demographic support that will endure for many decades to come. Consequently, a portfolio of companies with consistent real cash flows and real pricing power supporting good and sustainable dividend paying should outperform most strategies.
In spite of their exceptional recent price returns, those underlying qualities in Infrastructure have not shielded their listed prices from the “sell-everything” ethos in the last month. This sort of “alternative growth” asset type we see as safer over the medium term than undifferentiated broad equity market exposures. Put simply, “Quality counts more than ever.”
The quality-first ethos also applies to our preferred Corporate Bond holdings. Investment Grade securities, while they have done considerably better than their lower-rated peers in recent market turmoil, have not yet differentiated themselves sufficiently in terms of attracting a greater relative reward for their credit ratings and much more solid balance sheet metrics. We therefore retain confidence in the capability of our active managers to continue to differentiate between viable and less-viable corporate debt issuers and their marketed securities. Again, the crucial factor will be, we strongly believe, intelligent scrutiny and a great degree of active management to minimize risks of loss.
What will all this mean for benchmarks? Arguably, the over-benchmark aware portfolios of recent years may need to be progressively replaced with thematic, outcome-oriented and quality-focus list style investment mandates where possible. Risk should (sensibly, in our view) become less obsessed with benchmark tracking and more focussed on true commercial robustness, ethical achievements in company operating externalities, or the development worthwhile investment activities such as sustainable and community housing, the greening of energy provision, cutting-edge medicine, AI, and above all, quality education. These activities either have vanishingly-low benchmark weightings and thus are usually forced into minor portfolio allocations, or are at times outperformed in price appreciation terms by more geared or crowded investment styles (e.g. buying into market capitalization favouring the “size factor” has been a winning strategy in many markets, but its logic is ultimately circular).
In sum, for the investors willing to use the current drastic re-pricings of global securities as the chance to introduce fresh thinking in portfolios and even to ask, what asset management really means, we are confident that we have developed a range of evidence-based and enduring answers. The CoVid crisis will not be the end of the world, serious though it is. We however predict it may be the beginning of the end for a certain world-view, based on the discount imperative and consequent de-skilling of investment choices.
This blog post has been prepared to provide general information and does not constitute 'financial advice' for the purposes of the Financial Advisors Act 2008 (Act). An individual investor should, before making any investment decisions, consider the information available in the relevant Product Disclosure Statement and seek professional advice. While every care has been taken in the preparation of this document, AMP Capital Investors (New Zealand) Limited and the AMP Group (together, 'AMP') make no guarantee that the information supplied is accurate, complete or timely and do not make any warranties or representations in respect of results gained from its use. The information is not intended to infer that current or past returns are indicative of future returns. The views expressed are those of the author and do not necessarily reflect those of AMP. These views are subject to change depending on market conditions and other factors.