COVID-19 Update

My assessment is broadly unchanged from what it was in January when I issued my first warning. Start of the year the threat was being ignored almost completely which was an UNDER-reaction. As a result my recommendation end of January was to either get into cash or hedge, but definitely to reduce risk assets. For pensions that quite simply meant 100% allocation to cash (which is what I did personally as well). For more complex, less linear portfolios that meant unwinding directional stocks and putting on hedges. In my portfolios I opted to buy SPX puts 7% out of the money (3030 strike at the time) which would protect portfolios against significant downward moves. Those puts cost 3.65 cents and at the time of writing are valued at 32 cents. As a result my portfolios are roughly flat YTD.

Where we are now: I believe the market is playing catchup over the last few weeks – we’ve gone from pricing virtually no risk to re-pricing every asset class. Yesterday we saw multiple standard deviation moves across multiple asset classes and the entire US treasury yield curve move below 1%. The ferocity of the sell-off in terms of daily move was more powerful than the daily moves we experienced in 2008. The reason for that is simply the catalysts that have developed through 10 years of stimulus and easing (markets melt upwards and downwards quicker than they used to). The moves we are seeing now aren’t an OVER-reaction as much as they are a catching up effect due to the aforementioned catalysts that will continue to amplify moves in either direction. By the time this crisis starts to settle, on average we will likely see the sort of correction commensurate with the level of impact.

How bad can this get?

As for the level of the impact, my assessment from the start of this outbreak in Jan was, and is still is:

• This will continue to get worse before it gets better, and large moves up and down for the coming weeks are virtually guaranteed.
• This is likely to be a 25-30% correction overall – that would make it the worst correction since 2008/2009, but not quite as bad in terms of overall sell-off. Bear in mind some indexes are only just entering bear market territory, and some haven’t even. We are coming off an extremely high base due to the unprecedented rally coming into 2020. For these indexes to fall 25-30% from their peak is in many ways not a particularly drastic phenomenon. I believe it is too soon to call the bottom.
• The overall time to reach the bottom (which is extremely difficult to pin down) will be shorter than it was in 2008. My base case is that in May/June we are pretty close to the bottom (barring any game-changers listed below), whereas in 2008 it took 6-9 months for real stabilization before the rebound happened.
• Is there a change that this is “the end of markets as we know them”. No. I’ve heard a few analysts on Bloomberg talking about this; they clearly need to take a chill pill. If one thing is guaranteed, it is that markets will re-bound from this sooner or later.

Similarities/differences versus 2008/2009

• In 2008 the world had a huge amount of structural issues – generally economies were on weaker footing than they are today, but more importantly the financial system had a huge amount of systemic risk – most notably within banks. While the initial catalyst was a sub-prime crisis then, contagion quickly spilled over into global institutions and liquidity seized up rapidly. Today the entire financial system is far more robust – there is almost no possibility of a major US bank going under which turned out to be the inflexion point in 2008.
• The problem had no quick solution – there was no silver bullet. Today’s problem hard as it is to rationalize right now, has an extremely simple, fast solution (potentially). Containment, fading of the virus or a cure/vaccine would virtually eliminate the problem over night (minus the fallout caused by the economic disruption experienced). That is a huge positive for today’s crisis versus 2008
• In 2008 stimulus was extremely effective as the problem was economic – today one can argue stimulus is in many ways pointless, unless it is very specific and targeted. Reducing the fed rate will not stop a virus from spreading. Deferring mortgage payments in Italy however will likely reduce panic and fear. Authorities need to get more creative than they were in 2008.
• Central Banks had plenty of ammo in 2008 (rates were high, QE was virtually unheard of compared to today) – all of this ammo was subsequently used. Today Central Banks have virtually no conventional ammo left (this has been the biggest fear of most sophisticated investors for a long time). Rates could be cut by 5% in 2008, today they can be cut by 1% in the US and not at all elsewhere in the world (ignoring the possibility of negative rates). QE has already been deployed aggressively for years. So the only ammo remaining for CB, is unconventional – targeted coordinated stimulus packages (which we can expect to start, and in size, soon). Is this the correct approach to take? Hard to say as it increases the “catalysts” in future again, however we can be certain that CBs and governments will fight this with every last tool at their disposal (authorize spending, cut taxes, suspend obligations, defer payments etc etc)
• On balance I believe taking into account the similarities/differences to 2008 – this is likely to be a less severe crisis when all things are said and done.

What actions will we see over coming weeks?

• CBs will cut rates as much as they can as quickly as they can (Fed will cut again shortly almost certainly)
• Multiple stimulus packages, and hopefully coordinated action (in particular in Europe) – suspending mortgages payments, providing funding for specific initiatives, more QE etc etc
• All countries will gradually tighten the net on quarantine. Italy was first, other countries will follow with similar actions (unless Italy’s plan proves unsuccessful very quickly), there will be more travel bans etc
• I believe within a few weeks there will be some sort of negotiations on oil – difficult to predict in which form given the near break-up of OPEC last week. But it is possible that the Saudi’s accept that they have overplayed their hand.
• You’ll see more and more weird, opaque, and probably smart/creative stuff happening (like New York starting to mass produce their own anti-bacterial products). Supermarkets will start mass-supplying vital products (think less selection but plenty of supply). Stock-piling isn’t a terrible idea (I recommended that 4 weeks ago already and people laughed at me… few weeks alter the first riots in Australia were reported related to toilet-paper) although we shouldn’t be too concerned about actually running out of vital products)
• In the US massive stimulus packages will be announced (rate cuts, QE, etc etc)

Game changers – positive and negative

• It is VITAL that the virus naturally starts to fade in northern hemisphere regions with the onset of summer. All prior similar outbreaks followed that pattern. SARS, MERS etc faded and practically disappeared in the summer. It is important to note that no cure was ever found for SARS. That is not to say it wouldn’t have been possible, but the need disappeared as the virus wiped itself out. If Covid19 does not moderate over the summer, then this becomes a huge problem and all bets are off. Global recession will then be virtually guaranteed and this will be a bigger event than 2008, possibly much bigger. I believe this is unlikely however. My view is this thing starts to fade in June the latest.
• Countries are successful or unsuccessful with their containment strategies. China was successful so far, but China is a bad precedent for the rest of the world as it is a dictatorship. It is 10 times easier locking down Wuhan than it is locking down Texas. But China controlling the spread is a positive. Italy is the next important case to look at. Italy is accepting FULL economic disruption in order to pursue containment. If it works, then this is a positive. If Italy fails to contain despite this action, that would have to be considered a huge negative. If Italy contains, then similar action will work in Spain, Germany etc.
• Cure/Vaccine – not in the realms of possibility short-term (I won’t go into the detail behind why). Any cure/vaccine is 9-18 months away. So a cure is not a short term solution. However, given the magnitude of the problem a cure/vaccine at some point is highly likely – the timing is likely to be known much sooner than an actual rollout. It is possible that within 1-2 months there is a line of sight on a cure, and if so that would be a huge positive. Most likely it would cause the most rapid price rally in financial markets history. In terms of entry point for an investor, the chances of timing that are extremely low.
• Another possibility is that this virus cannot be contained, and countries eventually abandon containment efforts (no point taking economic hits if they don’t yield positive results). We come to accept that Covid19 is here to stay and we get accustomed to having an additional seasonal illness not too dissimilar to flu. Flu kills roughly 50,000 people a year in the states alone. If Covid19 ends up becoming an annual killer of 10-20k people in the US per year, medium to long-term that is something the world will become accustomed to.
• Africa being caught on the wrong side of this given they are heading into winter rather than summer. Equatorial regions are generally less of a concern given the high levels of humidity, however countries that have real winters could pose a problem given African countries generally don’t have health systems equipped to deal with mass pandemics. Personally I am just hoping and praying on this front that the virus doesn’t spread too aggressively in Africa.

The impact of the Oil price war:

• To complicate things further the current oil war is an overlay onto an existing problem – interlinked, but largely unrelated. Russia and Saudi Arabia have essentially decided that it is a good time to let prices drop and flush out competition. It is a full-on political move largely aimed at the the US. Shale producers were down 30-40% in a day yesterday.
• This can go a number of ways – potentially negotiations re-commence given the magnitude of the market reaction (medium to long-term nobody benefits).
• Base case I believe oil prices will stay low, and possibly go lower (into the high 20s briefly is possible) for a few months and recover back into the 30s and maybe above 40 later in the year.
• The violent nature of the sell-off yesterday was an ill-timed combination of virus related fears and massive demand destruction forces in oil – a true black swan event which nobody could have predicted

Recovery plays:

• Stay away from poor quality companies – don’t be tempted buying weak companies that have sold off 70-80%. There will be defaults as a result of this crisis, that is guaranteed. Companies with high operating leverage that cannot sustain cash-flow interruptions will not survive. FlyBe took 2 weeks to go bust as a result of Corona. Cruise operators are tempting buys, as are smaller airlines – I believe there is a risk some of them will not survive, so I would stay away
• High quality stocks that have been hit hard, with solid balance sheets are a fairly good medium term plays. Companies like VISA, MacDonald’s, Apple etc who all suffer from the disruption but have no risk of going under will perform well when things start to recover.
• Solid oil/oil-related companies (think BP rather than Halliburton) that can sustain a lower oil price for at least 6 months will do well over a 2 year horizon (I personally bought BP shares at 314 yesterday)
• Selling medium to longer term volatility on great companies that have had virtually no volatility to speak of until recently
• Getting back into vanilla equities, and solid equity fund managers with good track records (Fundsmith, Findlay Park etc). One can argue that these sort of funds can be held continuously throughout a crisis, but if you are in cash now then you have been granted a great entry point which comes around once every 5-10 years. You will likely need to accept some further downside and volatility in the short-term, but over 3-5 years these are fantastic buying opportunities
• Option strategies that allow you to leverage upside gains without over-paying for vol (outright calls will be expensive)

Timing

The timing of re-entry is difficult. As I have said before I think this gets worse before it gets better. What happened in Italy is likely to happen in other countries. The US almost certainly will reach an inflexion point where Corona becomes a major head-ache (we are nowhere near that point yet). The US is particularly badly positioned to deal with an outbreak like Corona (political system, lack of bordered between states, lack of healthcare etc). If you are sitting in cash and have already avoided the first 20% drop, then you don’t need to over-analyze your re-entry point too much. When is too late? I believe by June the latest thing will start to improve so you want to get in before that. Obviously any resoundingly positive news (line of sight on a vaccine, or sooner than expected fading) brings that timing forward. But right now we are mid-March – odds are fairly high that there is quite a bit more pain and volatility to come. Keep powder dry – if you want to deploy, think about doing it progressively on further dips over the next 2-3 months, but don’t over-committ or try to call the bottom. Think about lining up re-mortgaging to take advantage of lower rates.

Final note

We need to stay calm and keep perspective. Take China for example: 100,000 infections in a country of 1.4bn. 0.01% of the population. These press articles stating that 80% of the world’s population could become infected are utter nonsense. It’s hardly a horror movie. It’s significant and it has economic impacts, but there is no need to be overly stressed about it. The average death age is 81 – it is obviously not nice to take solace in the fact that the disease targets mainly the old, but it is certainly better than it targeting children. Stop worrying about your kids – they’ll be fine. You should be more annoyed than worried. You’re going to have to move holidays, work from home, potentially take care of your own children 24 hours a day if schools shut down (as my wife can attest that has been my greatest fear from day 1… 3-4 hours a day of quality time is great, 24 hours a day is hard work). The vast majority of us will be absolutely fine. Some of us will contract Corona, and 2 weeks later we’ll be fine. If this thing wasn’t called Covid19, but instead was just a strange relative of seasonal flu – and the headlines were “Seasonal flu derivative infects 100,000 and kills 3000 world wide” we would not bat an eye lid. This will eventually get better and go away. Stay calm and be ready to capitalize on the opportunities. As a result of this we will finally see the best opportunities since 2008. That is something to be excited about.

Greg Brandtner

CEO – Hurst Hill Ltd