MAY 2020

Investing When There’s No Playbook: 5 Questions to Assess the COVID-19 Market Environment

Category: Managing Directors, Portfolio Management

By Doug Cohen, Managing Director, Portfolio Management

There is simply no normal playbook for a market defined by a pandemic that has shut down much of the global economy and that may or may not keep it that way for many months to come. The most bullish investors believe US corporate earnings could be close to flat this year relative to last year’s $8.2 trillion or so.  The most bearish investors believe US corporate earnings could be almost flat this year relative to, well, flat—as in zero (at least after the write-downs that the Street often ignores). Suffice it to say, that’s one heck of a delta in terms of expectations.

We don’t know when or if there will be a vaccine or an effective treatment. We don’t know how long the world’s largest governments will sustain their “whatever it takes” fiscal and monetary policies.  Nor do we know the longer-term implications of such unprecedented government spending. As Charlie Munger, Warren Buffett’s almost equally legendary partner recently said, “This thing is different. Everybody talks as if they know what’s going to happen, and nobody knows what’s going to happen.” All that said, the future is always uncertain.

Investing is primarily a function of the perceived probabilities relative to what has already been discounted in the price.  In that sense, we do know enough to assess the broad parameters of five questions that strike me as particularly pertinent right now:

1) At what point will a medical breakthrough render COVID-19 largely irrelevant?  An answer to that question would clearly dwarf any and all of the other questions.  Alas, like a Russian nesting doll, that one query leads to many more. When will a vaccine be identified? How long will it take to test, produce and distribute? Will the virus become less prominent in sustained warmer weather? Will potential mutations over time render a given vaccine only partially effective, akin to seasonal changes in influenza that limit that vaccine’s efficacy? Will any of the current, seemingly more promising treatments such as Gilead’s Remdesivir, Regeneron’s antibody-based therapies or Trump’s Hydroxychloroquine (kidding, really) prove effective? The prevailing consensus is that, although limited human trials are already underway, a widely available vaccine is unlikely to be available until at least early 2021. An effective treatment may come sooner, but likely for a limited subset of patients, such as those already facing advanced disease.

Going back to the original question, the phrase “largely irrelevant” is clearly key from an economic standpoint.  The implementation of a timely, accurate and efficient testing process will be important as testing is a cornerstone of most early-stage plans to send many Americans back to work. The widespread capability to identify those who have been exposed to the disease through serological testing for antibodies would be a major breakthrough.  Suffice it to say, the current testing capabilities fall far short of what will be required in almost all regards, but a testing “Marshall Plan” to complement the ongoing vaccine and treatment research could improve the outlook considerably. Any true semblance of economic normalcy beyond getting most folks back to work will be determined by the extent to which people are comfortable traveling, attending communal events such as sporting events or concerts, or simply eating at reasonably crowded restaurants.  We appear to remain far from that point both in the US and throughout most of the world.

What is the likely worst case? If all the wonders of modern medicine haven’t been able to prevent or cure the common cold, it’s conceivable that no breakthrough occurs.  Indeed, there has never been an approved human vaccine for a coronavirus of any sort. In that case, the likely default is herd immunity. That would require a 60% or higher total infection rate, something most scientists believe could take perhaps 24 months to take root in the US assuming some degree of continued social distancing and other means of prevention. Even then, more isolated outbreaks would still occur, although they could likely be ringfenced rather easily.  The key caveat related to herd immunity is that we currently have still have little idea what percentage of people may be asymptomatic or otherwise not captured in the number of likely infections. Nor do we know for sure what possible re-infection rates might be although the news out of South Korea on April 29 that, contrary to earlier fears, patients appear not to have been re-infected was a major positive.  Limited testing on well-controlled populations such as cruise ships and in some European cities imply that the COVID-19 penetration in the broader population could be many times greater than the reported number of infections.  This could be interpreted, somewhat perversely, as good news to the extent it allows herd immunity to emerge more quickly.

2) At what point could “don’t fight the Fed” no longer apply?  There’s a good chance that a snarky millennial you may know has the phrase “you had only one job” somewhere in their lexicon.  (A quick web search seems to credit that line to 2001’s Ocean’s Eleven, but any Met fan knows it pertains to Carlos Beltran taking three called strikes in a row to end the last playoff game ever at Shea Stadium).  In the aftermath of the Great Financial Crisis (GFC), don’t fight the Fed—more specifically, do not underestimate the Fed’s desire to keep interest rates very low to fuel a “wealth effect” from rising asset prices—has been the single most important thing for investors to keep in mind.  And unlike in Fight Club, there was no attempt to keep the rule secret. Ben Bernanke spelled it out as clearly as possible in the Washington Post in 2010.  The unprecedented size and scope of the recent crisis-related rescue actions significantly transcend those implemented during the GFC.  While the DC-led largess has aroused the predictable criticisms ranging from “they favored Wall Street over Main Street” to “a capitalist society should allow those who took too much risk to fail”, I’d give Congress and the Fed high marks for doing what was necessary to give the economy the best chance to ride out an epic storm.

Still, I think we all know there simply must be unintended consequences from this kind of money printing. The post GFC era gave the world trillions in anomalous negative nominal interest rates even as the general market structures and levels were orderly and high.  I suspect the consequences of the recent actions will be more profound, not necessarily over the next few months but within the next few years. Does inflation finally resurface? I’ve been in the camp that the Phillips Curve (lower unemployment leads to higher inflation) had become passé in the Amazon era but I’m no longer confident about that.  Does the US dollar weaken significantly? I’m still not sure what major country has a much better overall outlook but if ever gold was going to re-emerge as perceived store of value, this seems like a good time.  Are taxes headed significantly higher? That seems like a given, particularly in regard to corporate taxes, the next time the Democrats are in power. Could the explosion in public sector debt have adverse consequences far beyond what the Modern Monetary Theory proponents have proposed? It sure seems that way to me, especially when interest rates finally reverse course and head higher.  That seems highly unlikely in the near-term, but this is probably a good segue to question number three…

3) Does a new paradigm emerge from the current period?  One of the more senior, well respected leaders of a major credit-oriented investment firm told us on a private call circa March 5 that (paraphrased) “in two years hardly anyone will even remember this coronavirus period.” Our eyebrow still hasn’t completely descended since that comment, although from both an equity and a fixed income index perspective, he still may end up being right.  More broadly though, if we were ever on the cusp of a paradigm change—especially coming off the longest economic expansion in US history, eleven years defined by moderate growth, low inflation, low interest rates and rising government debt—this seems like a pretty good time.  In that sense, we harken back to our comments inspired by Bridgewater’s Ray Dalio last July.  Here’s what we wrote:

“As per Dalio, the intermediate stage is the “bubble” stage where debt grows faster than income, equity markets rally and the yield curve flattens. These three conditions have been prevalent in recent years. But as you get later in the cycle it takes more and more debt to drive growth. From a ratio of 1:1 it now takes $5 of debt to generate an additional $1 of GDP growth. In China and the U.S., the ratio is hitting a wall at 0.20-0.25. Near zero interest rates, low risk premia on risk assets in general and on equities in particular, central banks running out of gas, decelerating productivity growth despite being in the midst of a digital revolution, and anaemic GDP growth despite interest rates being so low are all powerful indications that we are not only coming to the end of the current debt cycle; we are very close to the end of this debt super-cycle. Policy makers all over the world are being “grotesquely complacent” when it comes to debt management.  Dalio believes that the eventual bursting of the debt bubble is likely to exacerbate the inequality issues that are fueling a new and highly unpredictable surge in populism that could have profound effects on both global politics and economics.  He concludes that the potential monetization of rapidly rising global debt could usher in a new era of currency depreciation that would alter many of the patterns that investors have embraced in recent years. He strongly advocates for investors to own gold.”

Simply put, if one viewed Dalio as credible but perhaps early back then, the timetable may have accelerated considerably. With real rates firmly in negative territory, gold has a good chance to surpass its $1923/oz all-time high from 2011.  Low interest rates may well come to be seen as a net negative for US equities, much as what seems to have occurred in Europe and Japan. If nothing else, once the proverbial dust settles, we expect to see less of the high correlation “risk on/risk off” moves that have generally aided passive investors since the aftermath of the financial crisis and more opportunities for idiosyncratic active managers.  Reduced globalization should also result in more differentiated performance across most asset classes. And taxes of all kinds are surely going up over time. That may happen less quickly at the federal level if Trump wins a second term, but the rapidly growing hole in many state and local government coffers will need to be filled. Current Senate Majority Leader McConnell has made it clear that may be an acrimonious issue going forward.

4) How should one assess fixed income opportunities in a period of near-record low interest rates and near-record high economic uncertainty? To be fair, one could argue that much of the prevailing economic uncertainty is largely offset by the aforementioned massive Federal Reserve backstop, particularly in most portions of high quality commercial paper, investment grade corporates, student loans, auto loans and credit card loans—along with portions of the municipal, mortgage backed and high yield markets. Still, even if the Fed backstop holds (a seemingly good assumption), given the likely credit deterioration to come, one could reasonably argue that prospective fixed income returns have not been this unattractive since Paul Volker essentially broke inflation’s back nearly forty years ago.  Athena’s underweight stance on the asset class is consistent with that view.  Near zero rates and a flat curve argue for taking little duration risk while rising debt makes us cautious regarding longer term Treasuries. At the risk of Dalio overkill, here’s what Ray said earlier this month: It would be “pretty crazy to hold bonds. If you are holding a bond that gives you no interest rate, or a negative interest rate, and they’re producing a lot of currency and you’re going to receive that, why would you hold that bond?”

All that said, one should probably avoid painting with too broad of a brush.  While Treasury and other cash-like returns are clearly low, they remain positive and can therefore help to preserve capital, at least on a nominal basis. More broadly, there appear to be some attractive opportunities in credit-sensitive areas such as short duration, investment grade municipals and investment grade corporates (yes, even Dalio professed some interest in corporates). The opportunities in distressed debt—with all the inherent risks—appear to be far more interesting though.

5) What do market technicals imply?  I know that many readers will instantly recoil at the notion that this would land in our top 50 questions, let alone the top five. Technical analysis is often viewed as the domain of Wall Street carnival barkers, the kind of folks who are more likely to require Head and Shoulders than to be able to correctly predict that pattern’s supposed future implications for a given stock or index.  I’m far from a true technical believer but admit to being dazzled by many of the mathematical curiosities associated with almost all things Fibonacci.  The simple reality is that there are enough savvy market professionals that do assess moving averages, volume patterns, and all the other tricks of the technical trade that the patterns do take on a certain significance.

In the current environment, most investors are trying to make sense of the unprecedented speed and depth of the initial late February to mid-March S&P 500 decline of over 35%, as well as the nearly as unprecedented ~30% recovery. The resulting 55% or so net retracement from the high (it was fun trying to show my teenage daughter that down ~35% and up ~30% only gets you a bit past half the way back) is almost exactly in-line with conventional bear market rallies.  The technicians we’ve looked at are generally bearish. “Nothing in my toolbox, price indicators or breadth indicators shows a single positive indicator” is how The Wall Street Journal quoted Libertas Wealth Management Group’s Adam Koos in mid-April.  The constant barrage of headlines about massive job losses, looming bankruptcies and a recovery that will be meaningfully hampered by health concerns continues to be reflected in heavily negative investor sentiment.  Our sense is that an overwhelmingly large consensus expects the next sizable market move of say 20% to be down not up. The latest American Association of Investors poll for the week ended May 6 found 53% of respondents as bearish for the next six months—near an historical peak—versus a long-term bearish average of 31%.   As Barron’s recently noted, 83% of the prior bull markets’ gains were given back in the subsequent bear market (implying that the S&P 500 would plummet to 1135 during this cycle). Bear markets accompanied by recessions typically last 11 months, according to Bank of America. With all the prevailing dislocations and those that are likely to linger for months if not years, could the full bear market have been fully captured in just 23 trading days?  Of course, a contrarian can’t help but be intrigued when the conventional wisdom seemingly has almost everyone on one side of the boat.  That strikes me as probably the most bullish element of the current market backdrop.

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