Q1 2020 Market Commentary

Q1 Overview: How Permanent Is The Damage?

One analogy we sometimes use for investing is that it is like taking a dog for a walk across Hyde Park. You walk on a steady (but not necessarily straight) path in your intended direction. The dog, however, often has different ideas. Sometimes a long way ahead, sometimes a long way behind but, at the end of the walk, you both end up together at the park gate. For reasons you will be very familiar with, in Q1 our investment dog tore off a way behind us. How long will it stay there?

The answer depends – and here we will have to abandon our dog walking analogy – on the time horizon you are thinking about. For shorter term investors (which I would define as being two years or less) then the worry is that markets have fallen far and fast enough that you do not recover today’s losses before you need the money. Unfortunately, this may indeed be the case today. Table 1 shows data from the 2019 Barclay’s Equity Gilt Study (which use long term data starting in 1899) showing the probability of beating cash over different time horizons.

If you have a 2 year time horizon then historically there is a 30% chance you do not beat cash. The 2 years from 2020 may indeed be one of those periods. However for longer term investors the odds become better. At a 5 years’ horizon there is an almost 80% chance you beat cash and for 10 years this rises to over 90%. This is of course one reason why we discuss investment time horizons with all our clients and why we trust that most, if not all of you, are thinking longer term.

The same equity gilt data also shows long term annualised returns of around 7% for UK equities (or about a 5% real return over inflation). And by long term here we mean long term. For the record, the 120 years since 1899 is a period that includes World War 1, the Spanish Flu of 1918, the Great Crash of 1929, the Great Depression, World War II, the stagflation of the 1970s and more recently the 2008 financial crisis. So crises and economic shocks are in a sense a normal part of markets and in many ways the real surprise is when (as for the last 8 years or so) these events don’t happen. The long term returns we use for our client projections come from a different source but are consistent with these long term results.

All this does not mean that the economic impact on your portfolios is not real however. It is worth remembering that investing is, in essence, buying a claim on a productive part of the economy. This could be shares in a company (equities), lending money to that company (credit) or lending money to the government (government bonds). It could also be a share in a productive asset (like a wind farm say or commercial property). Either way, your return, at heart, is geared to the return of the (these days global) economy. Right now this economy has (intentionally) been put into a coma to protect us all. This will probably lead to the sharpest recession ever seen in developed market economies. And in a sense a small part of your investment has truly been lost. To the extent the economy has stopped then businesses will be operating with much lower sales and profits, rents on property may not be paid and some companies will not be able to pay their loans back. Some of these profits and rents ultimately flow back to you as returns on your portfolio and for a while at least they will be lower because of the crisis. Though the impact of crises such as these is built into our investment assumptions, that does not make the impact of them any less real.

Still, say it takes 2 years for the global economy to return to its pre-crisis level, which is the current central estimate of the economists we follow. There will be some real economic losses. For instance, vacancy rates and arrears might rise on a property portfolio. However, assuming you are diversified (as you are), the true economic cost is normally far less than the sharp falls we see in many risk markets. In part this is because the shorter term emotions of markets push prices either above or below the true economic value of an asset (the dog wandering all over the park in the analogy we started with). However, it is also because uncertainty over the future course of the economy is particularly acute right now.

Say you have a business that can survive without sales for 3 months in a row but no more. Will this be enough? Will the government aid be able to help if the slowdown goes on longer than that? What will its markets look like when business activity re-opens? It is a cliché that markets hate uncertainty. One way of explaining this is that many businesses (such as airlines, hotels) are priced today like they might not make it through this. History shows that most will, one way or another, survive (and we will of course need airlines and hotels in the future!). Once the shutdown is over, the tail (worst case) risk reduces and these businesses will start trading at normal valuations again. Just this journey from a “normal” valuation to “might not make it” and back to normal is enough to see very large swings in equity prices for individual companies in the short term. This explains why markets often move faster and further than the true economic impact of an event would suggest and why high levels of uncertainty (which we have today) push asset prices down.

12 Month Outlook: When Will Uncertainty Fall?

By definition, then, we will need today’s very high uncertainty levels to fall before markets can start to settle and recover. What might that look like? Here is what we are focussing on:

  1. The virus stops accelerating. We think we are close to or at this inflection point today given the lockdowns that have been put in place in the US and Europe and we think this is behind the bounce in equity markets we have seen in early April.
  2. There is a credible roadmap for re-opening the economy. Here, already things start to look murky. Though there is a plan, governments (understandably) do not want to take the focus off today’s lockdown measures. Also, the extent of the re-opening depends crucially on the availability of testing, hospital capacity and how many of us have already had the virus without realising it. There are just too many unknowns here to start to make solid predictions.
  3. There is some evidence that government support programs are working. We wrote in a previous update about central bank bond buying. We think this has been effective in calming the panic selling we saw in March and stabilising fixed income markets. The various government programs are impressive in their size but how effective will they be in keeping companies going? When we emerge from this how different will the economy look in 6 months, 12 months? Again, without any real meaningful historical precedents, it is hard to say today.

The bull case here is we are able to re-open quickly (say in 1-2 months from now). The virus stays contained and fiscal and central bank support leads to a proper post-crisis boom. The bear case is that the damage to the underlying economy is real, consumers and corporates remain cautious after this and we get a demand-shock led follow on recession lasting the rest of the year and beyond. Of course, there are plenty of scenarios in between. One description of where we are today that we have seen is that it is too late to sell but too early to buy. We would broadly agree.

Our Strategy For Q2

Unfortunately, “uncertainty remains very high today” is not a very useful investment strategy. At times like these we are reminded of the work of Charlie Munger, the long-time business partner of Warren Buffet. His approach to risk management is simple (which came from guiding pilots in World War II): do everything you can to avoid the risk you really do not want to happen. If this sounds trite then we think we are really faced with two investment “risks” today:

a. The market continues to go down and our equity and credit positions lose more money.


b. The economy heals, markets recover, and we are overly cautious and miss some of the rally by sitting in cash.

Which of these “risks” is the one to focus on avoiding? We come back to the time horizon point we started this discussion with. If your time horizon is a year or so then there is a good chance things get worse before they get better. Our focus would be on preserving wealth and cash looks a very attractive asset here.

However, as we discuss above, our time horizon for our clients is not 12 months but much longer. If you look at the history of financial markets (including all the wars, financial crashes, pandemics and recessions) it always pays to back human resilience and ingenuity in the long run. This too shall pass, our freedoms will return and economies will start to grow again. With this mind-set the risk to avoid is missing the recovery. This is therefore our focus. Having bought some equities on the way down we feel we have enough exposure today to capture the short sharp upswing that will happen if the more bullish scenarios play out. If, however, the rally we have seen since mid-March proves to be short and sharp and is then followed by a slower more prolonged sell-off (as you often see in bear markets) then we have the cash and a plan to continue to adding risk on the way down. In short, we are trying to maximise your returns over a longer time horizon than thinking exclusively about next quarter. This is pushing us to keep our risk levels constant even though the level of uncertainty we have about the future is far higher than normal. We remain focussed on capturing the recovery rather than missing shorter term volatility.

Finally, we have raised cash from some of our lower risk, absolute return style investments and are looking to deploy this as and when opportunities arise. One general sector we are looking at closely is corporate credit. As recession risk has risen, so have the returns on corporate credit. Part of this is, of course, justified. As an example, WTI crude oil traded briefly below $20 a barrel in March and is below $30 today. At these sorts of prices much of the US shale energy sector (financed in part by high yield debt) is insolvent. Here some of the high headline returns on offer look illusory to us. Other sectors do though look to offer more value. European banks were at the heart of the 2008 financial crisis. Today, however, they are very much part of the solution. Many European government support programs run directly through the banks. Capital constraints are being relaxed and it is a focus of regulators that they remain open for business. Subordinated bank capital debt is on offer at 15% or higher returns. This looks to us to be an attractive return for the risk involved.

Of course, in markets such as this opportunities can emerge quickly and outlooks can change fast. We will continue to update you as and when our outlook changes. For now, however, our focus remains on keeping risk levels sized so that we capture our fair share (or more) of the recovery as and when it comes.