We normally publish the newsletter monthly. Unfortunately, these are not normal times. This is an update on the fast-moving situation. In an effort to make it easier to read, we’ll use the Q&A format.
Q: What’s the latest with the COVID-19 spread and its economic impact?
A: As the virus spreads and is hitting peak acceleration of doubling every 2-3 days, the social distancing is the main deterrent. The toll on the economy is sever. Most major metropolitan areas and the states they’re in are in full lock-down mode. That means all non-essential businesses and travel are shut down.
Q: How’s the market reacting?
A: The US Equities have lost 35% a month after hitting the all-time high, which is both the fastest bear market ever and the worst month in history so far (not even 2008 or 1929 can compete). The credit markets are very fragmented, depending on the issuer and duration, with large portions holding up well. Commodities are also big losers, with the notable exception of gold. Most foreign markets are down, but emerging markets are holding up better because of the lower effect of the virus (so far) and China recovering.
Q: What’s the worst-case scenario?
A: It’s obviously hard to tell. CDC predicts the worst case to be 80% of Americans to be infected over the next 6-9 months, with over a million deaths. This is assuming no actions taken and the worst conditions, which we hope is extremely unlikely. The looming economic toll is very real and very close. As many businesses that have been ordered to shut down have no choice but lay off workers, the economists expect this week’s Friday new unemployment claims number to be around 2 million, up from around 200,000 two weeks ago. As the unemployed struggle to pay their bills, rent and mortgages, the financial system could very quickly come under the same stress as the healthcare. We’re facing an unprecedented, almost complete shutdown of the economy, and it won’t take long before a deep recession takes hold unless it’s addressed immediately.
Q: What’s the government doing about it all?
A: The local governments are reacting by issuing lock-down orders, getting hospitals prepared and taking other emergency measures, including limited financial relief. The Fed (FOMC) has brought the proverbial “policy bazooka” by dropping interest rate to zero and announcing the unlimited “quantitative easing” – buying back various bonds in the open market to provide further liquidity. While this is helpful to markets, the Fed can’t address the main underlying fiscal problem above – that’s up to the Congress. The bill currently in the works should address the gap between the start and the end of the lock-down, when the economy can expect to start getting back to normal. That includes four parts: funds for medical providers, suppliers and research, relief for individuals, relief and incentives for small businesses, and help and bailouts for large businesses as needed.
Q: Will the aid package be enough?
A: That’s the trillion-dollar question. Assuming the estimate of the necessary lock-down time is within the range that the funds are designed to cover, perhaps the meltdown can be avoided. If it’s longer but close, another stop-gap funding is possible. If the lock-down takes much longer than anticipated, all bets are off.
In the last newsletter we outlined three scenarios:
Scenario 1: Strict measures reduce the spread of the virus in the next 4-8 weeks or so (following the pattern in China), and economic activity returns, helped by global government stimulus. The dip in corporate earnings lasts 1-2 quarters. The market recovers relatively quickly and is already oversold.
Scenario 2: The virus spread gets worse causing major economic disruptions for months. Mild recession occurs for 2-3 quarters and the economy recovers with additional stimulus. The market drops 10-25% more and takes 1-2 years to recover.
Scenario 3: The health situation gets much worse (i.e., the spread of the disease happens faster, the virus gets worse through mutation, longer incubation period or drug resistance, etc.) and causes the entire economy to near-halt. Deep recession follows for the next 1-3 years. The market drops another 20-50% and takes 3-5 years to recover.
At the time the probabilities we assigned to them were: 60% / 30% / 10%. Sadly, we now need to reprice them as 20% / 60% / 20%, making the second scenario most likely outcome. The red line we identified was major urban area under quarantine Italian-style and/or ban domestic air travel, and we’re nearly there now. Of course, the Congressional aid package could be a game-changer if our elected legislators take five minutes to put their politics aside.
Q: What does it mean for my investments?
A: First, every portfolio is different, because every situation is different. It should be designed with your risk tolerance and time horizon in mind. If you’re an aggressive investor with a long-term horizon, you’ve probably done well over the past 11 years of the bull market and you should be prepared for market downturns. If your time horizon and/or risk tolerance is low, then your portfolio should have reflected it and contained low-risk investments and hedges that should have held up well.
Having said that, as we mentioned last time, this is a black swan event, with unprecedented risks. Many traditional hedges have not worked well because the situation isn’t traditional. A new example is the traditionally stead and unexciting utilities sector. It’s in a highly regulated market, with very predictable revenues and profits, passing a good chunk of them to investors. Unfortunately, a shutdown of so many factories and businesses mean a steep decline in revenue and consequently the stock prices. This was never a problem in the Financial Crisis or even the Great Depression. Another example is real estate, and it used to be one of the author’s favorites. Although some parts of it are fine, the commercial real estate risks never included a sudden and complete switch from the offices to the remote work force. If that trend continues and even if it does not fully revert (very likely), this part of the real estate market could be a big trouble.
Q: Should I just sell everything?
A: Well, that’s pretty much never a good idea. You only do this if you just bought your dream house or you’re about to board a private jet to a non-extradition country. Below is the comparison of the largest crises in the past 30+ years and recoveries that follow, as food for thought. If you sold, not only will you lose the eventual rebound. What would you do with the money? Keeping it in a bank or under the mattress will only erode its value due to inflation. There’s always a bull market somewhere, opportunities always exist, as long as you accept the risk. And if you can’t, there are investments with low risk that are better than cash.
Q: How do you (would you) manage my portfolio in current situation?
A: Well, given the extraordinary situation, we’ve been re-evaluating every portfolio. We have addressed two separate issues: which investments are vulnerable to continued significant downside, and are there opportunities created by this situation?
For the first test, we asked the following questions:
Can the business/industry/sector operate remotely?
Is there still demand for their products or services?
Can we expect full demand back when it's over?
Do they have working capital and debt coverage to survive 3-6 months?
The table below identifies these areas, which we’ve been attempting to mostly eliminate from clients’ portfolios in the past couple of weeks. Of course, certain areas may already be beaten down too much and actually represent a speculative opportunity instead.
For the second test, we used a slightly modified set of questions:
Can the business/industry/sector operate remotely?
Is there an increase in demand for their products or services?
Is that demand increase sustainable when it's over?
Do they have working capital and debt coverage to expand?
The table below identifies these areas with opportunities. We used to add to our lineup of motifs (managed portfolios) to have one used specifically as hedge against the COVID-19 threat to a portfolio and another one to take advantage of what we see as the new opportunities in the emerging post-pandemic economy.
Q: Is there anything else positive?
A: Ah, yes. Most people are missing some of the positive things this situation presents:
- ✓ Much lower oil prices will lead to lower prices at the pump. Some analysts expect sub-$2 gas nationally soon.
- ✓ Lower rates cause the mortgage rates to go even lower. Perhaps it’s a refinance opportunity.
- ✓ Fiscal stimulus should bring some immediate relief, and if you have to take capital losses you will use them to offset some of the gains in your tax returns.
- ✓ The carbon emissions and pollution levels are way down in the last month worldwide.
- ✓ The lock-downs are forcing us to spend more time with family and loved ones. Enjoy it!