Finally, much uncertainty remains around vaccination and immunity. Most experts seem to agree that a vaccine could be twelve months or more away, and there is no consensus on how long immunity might last for people who have recovered from the virus. SARS, for example, confers immunity for two years on average. If that is the case for COVID-19, we are looking at the need for regular booster vaccines – and that is assuming that the virus remains relatively stable.
On the economic front, last week I described the progress of economists’ downgrades to growth forecasts as a “race to the bottom”. That race is still on, but nobody can see where the finish line is. The latest crop I have seen suggest 2020 GDP falling around 2% globally, but with most of the damage confined to the second quarter. The risk is that isolation has to continue in some form for longer than most people’s current estimate of three months. The UK’s Deputy Chief Medical Officer has not ruled out as long as six months. And the longer it goes on, the more companies and individuals will find themselves stretched financially.
A Professor of Supply Chain Management has suggested a lot of the world’s logistics capacity will not be in the right place when world trade starts to ramp up again, slowing the recovery.
I also heard an interesting view last week from a Professor of Supply Chain Management. He suggested that a lot of the world’s logistics capacity will not be in the right place when world trade starts to ramp up again, slowing the recovery. He likened it to turning up at the supermarket to find all the shopping trolleys scattered around the car park instead of neatly lined up by the door.
This all translates into extreme downward pressure on aggregate company earnings. Many companies have withdrawn their guidance for the year, and analysts are struggling to arrive at precise estimates. Strategists have a freer hand, and expected falls of 40% or more at index levels this year are not uncommon. However, it is also expected that there will be a rapid recovery in 2021.
Looking at a 2020 forward price/earnings ratio is meaningless. 2021 might be more appropriate, but for now we might have to rely more on longer term estimates of, for example, sustainable returns on capital versus price-to-book ratios. This sort of analysis proved useful in picking winners during the financial crisis.
I touched last week on the risk to dividends, and that is even more apparent now. It appears almost inevitable, for example, that banks, who tend to be big payers, will be told to hold back all payments to preserve capital. Our initial projection for 2020 suggests a 30% reduction in payouts, so be very careful about relying on historical yield data.
This will obviously raise challenges for clients who rely entirely on dividends for income, but at least will be mitigated to some degree by the fact that discretionary spending is currently much reduced. However, we highlight the risks to future returns and income-generating capability that will be created by supplementing income by dipping into capital at current levels. It might be better to hunker down for a while if at all possible in anticipation of more normal times in 2021.
Finally (and with apologies for the longer text than normal, but I think there are extenuating circumstances!), onto portfolio rebalancing. This was another component of last week’s rally in equity markets, and might be a feature over the next few days too, given that it tends take place at month ends (and especially quarter ends). Most professionally-managed portfolios adhere to some sort of strategic asset allocation benchmark based upon the trade-off between expected returns and risk (as measured by volatility).
When markets move sharply, as they have recently done, portfolios have to be brought back into line to maintain the risk/reward balance (unless the manager explicitly changes the tactical asset allocation). The recent falls of equities relative to bonds created the largest potential rebalancing demand for equities on record.
We, too, are rebalancing portfolios, especially as we see better long-term value available now, even if that does involve “looking through” the current crisis. Having said that, we are not calling the bottom. There is plenty of volatility ahead. Even so, in last week’s GISG and AAC meetings, we did see sufficient value in one segment of the market to suggest adding further to positions, and that was corporate credit. Both Investment Grade and High Yield corporate bonds have been hit very hard in this downdraft, with the falls exacerbated by reduced liquidity.
Yield spreads over government bonds, while not at all-time highs, are within the highest few percentiles ever recorded. Yes, there will be casualties, but persistently high rates of default are now being priced in. Furthermore, central banks appear more willing to provide a liquidity backstop, as well as there being government-backed measures to provide support.
The closing message, at a time of apparently unremitting gloom and doom, is that we are already starting to position for a world after this COVID-19 outbreak. And if we experience further dislocation we will be looking to take advantage of more attractive long-term opportunities.