COVID-19 vs The Fed

This is our first market update this month and marks the halfway point of a very turbulent 2020. In some ways it also marks the halfway mark of this crisis. We have passed through the eye of the storm and have had a few bouts of renewed volatility as predicted. Over the past few weeks, the VIX has touched the 40 level a few times. We have also had renewed selloffs of major equity indices (sometimes more than 4% in a day) which hadn’t happened since March. Despite some of the recent optimism on Wall Street, we are of the view that there are a few chapters yet to unfold. The second half of the year is unlikely to be much easier than the first as we grapple with economic realities, second waves and upcoming elections in the US.

Let us take stock of where we are: We had the most extreme selloff in market history in March, followed by an impressive, central bank led relief rally that lasted more than 2 months before finally cooling off. In retrospect both the initial selloff and the subsequent rally were possibly too extreme and partially cancelled each other out. However, there is no getting around the fact that most major stock indices are still down substantially year to date (FTSE100 -19%, Eurostoxx50 -15%, Dow -13%, S&P500 -7%). The clear winner so far this year is undoubtedly the tech-heavy Nasdaq which is up an incredible 12% YTD. Meanwhile investors, fund managers and hedge fund managers across the board are experiencing the toughest year of their careers.

It is important to point out just how influential central banks, in particular the Federal reserve, have been this year. There is no doubt that the financial system would be in a state of complete disrepair had it not been for the unprecedented action we have seen. The immense arsenal, much of which has now been deployed, is worth recapping:

• Zero rates followed up with forward guidance (a promise to keep rates near zero for long time)
• Unlimited quantitative easing (already well into the trillions)
• Multiple asset purchase programs including state and local debt
• Buying up of corporate bonds (initially indices, now even individual names) including high yield bonds
• Helicopter money, which literally means printing money and sending people a check in the mail (a highly controversial measure that takes credit for today’s cover photo)

But what will the long-term consequences of these actions be? While hard to pin-point exactly, it is certain that there will be repercussions. At the moment the theory is “we’ll fix this later”, presumably through taxes and austerity. The Fed may actually not even be done yet. There are 2 more fairly obvious and controversial strategies remaining: Negative interest rates, and direct equity purchases (In Japan the BoJ already does both). The Fed has shown that it will stop at nothing, so both of these measures are in the realms of possibility.

The short-term impacts of the Fed’s actions are easier to assess as we are already seeing some of them. The Fed has inadvertently created various text-book bubbles (let’s not sugar coat things), the most obvious one being in the equity sectors currently in favor (stay-at-home stocks, tech). The combination of the Fed’s actions and the increased pivot towards a more technology-driven world is a perfect explanation for the huge rally in tech stocks we’ve seen, and the very reason the Nasdaq is up in the midst of a crisis. Stocks that we love (and still own) are at frankly ridiculous valuations. Shopify (SHOP), which was our biggest individual holding last year, and which we have once again owned since early April is up 200% in less than 3 months. It’s never a good sign when investors are nervous about the rapid price increases of their own holdings. While hard to rationalise fully, Shopify has undergone a paradigm shift in the last 3 months and is arguably the biggest beneficiary of this crisis. The tech rally becomes a bit more disconcerting when we look at a company like Apple. Apple is up 60% in 2 months, and more than 20% YTD. Here is the problem: By literally any metric available, Apple is in worse shape than it was 6 months ago. So, when we look at this impressive Nasdaq rally, we do need to consider that it is being propped up by these types of dizzy valuations, and that it is not impossible for us to see a reversal at some point. This is not to say that we recommend shorting tech, certainly not. We have a fairly chunky allocation to tech, and various single stocks, in all of our portfolios, but we do not recommend being over-exposed.

Another unwanted consequence of the Fed’s action is further exacerbation of the rich/poor divide. Sure, many people have been sent a token check in the mail, but without a doubt this crisis has hit the less well-off the hardest. I am often asked how it is possible that we are printing trillions of dollars without creating inflation. Well, inflation is a matter of definition. Yes, oil prices and wages aren’t going up, but we have created a hell of a lot of inflation in the wrong places. The trillions of dollars printed are not directly benefiting those most in need, but are instead largely being channelled directly back into the most powerful companies on the planet. Bezoz and Gates have become better off this year. That is no dig at capitalism, it is just the pointing out of an undeniable bi-product. At the same time low-middle income workers have lost their jobs and are on the brink of financial ruin. The problem is that there is no viable alternative. We are in the middle of a highly complex crisis and any potential solution is bound to be flawed. This phenomenon is not dissimilar to what happened in 2009 (if you need reminding: a couple of bankers lost their jobs, but millions of people took the better part of a decade to recover).

One of my biggest concerns is the long-term impact this is going to have on social divides globally. The problem goes beyond communities of different tiers within developed countries. In the developing world entire countries are being left behind because they simply don’t have the same fire power as the world’s most powerful nations. While countries like the UK and the US are in the privileged position of being able to attempt to print their way out of this mess, the likes of Brazil, India and South Africa don’t have that luxury (certainly not to the same extent) purely due to the prevailing construct of international markets. Any way one looks at this, a country like Switzerland is less vulnerable than a country like South Africa, and any wealthy family within either country is less vulnerable than a poorer family. That may sound obvious, but this crisis has amplified that general rule massively. We have chosen to save lives by switching economies off, but in the process we need to accept that we are disproportionately compromising the long-term livelihood of the neediest. When you lock down entire countries for months, create vast unemployment in the communities that depend on it the most, synthetically transfer wealth from the poor to the rich, and then throw in some toxic racism it isn’t hard to understand why millions are rioting. We are seeing the effect of millions of people feeling ostracised and disenfranchised playing itself out in the streets. I do firmly believe that governments everywhere need to get a lot more creative in order to ensure that this crisis is dealt with more equitably.

As we move into the second half of the year COVID-19 remains a factor. It has been our view since February that 2020 will largely be defined by COVID-19. We are currently seeing renewed spikes in cases, in particular in the US and various emerging markets (most notably Brazil and India). South Africa, which lies close to my heart, is only now reaching an inflexion point. Our concerns about lack of leadership and lack of coordination within the United States have also materialised. In addition, we are now dealing with the fully-fledged economic backlash (which we always believed would take longer to play out). We are also rapidly approaching the US elections which would have brought with them significant volatility even in a non-COVID year. Bottom line, we do not expect plain sailing in the second half of the year.

Our advice remains consistent with what it has been for months: Don’t try to time bottoms. Take advantage of volatility when its elevated. Don’t bank on binary outcomes. Be prepared for continued bobbling around within broad ranges. Be sceptical of analysts with constantly changing views (they are a dime a dozen). We have steered clear of the battered high beta names. Looking back over the last 3 months this was probably the right call. Easyjet as an example looked like it may have been great buy for a few weeks, but there was very little to support the trade fundamentally. If you owned Easyjet in the last 2 weeks you would have lost 30% of your capital. The company has years (not months) of significant challenges ahead. In a more extreme example retail demand for now virtually bankrupt Hertz was so strong that the company obtained approval for a new stock sale. Investors were told that they are welcome to buy shares, but they are likely to lose their money. The controversial sale has since been suspended. The point here is: If you are going to punt penny stocks be prepared for the possibility of serious loss. A share price dropping from 20 to 1 doesn’t automatically make it a buy. This is not what we consider investing.

We will be publishing a full performance update on hursthill.co.uk in the coming days. We are proud to report that our defensive portfolios are up 2.24% YTD while our more aggressive portfolios range from -2 to +3% YTD. In both cases we have outperformed the market substantially in both 2019, as well as the first half of 2020. We have generally been positioned a lot more defensively in 2020 than in prior years and this strategy is paying off so far.