Lockhart Capital Management Market update – 20 March 2020

Since our note last week, the news on the progress of Covid-19 has unfortunately got worse.  The policy response however is finally improving, and quite rapidly (though not yet rapidly enough), and with resulting measures that are positive from a public health perspective, but negative in terms of economic outcomes.  Hopefully this can be contained to the relatively short term, and without too much long-term structural damage being done.  The better news is that the monetary and fiscal response, while unable to cure a virus, does give the chance of a strong rebound out of this phase, and in a superior manner to the weak recovery post the Great Financial Crisis of 2008.


It is worth remembering that after the 1987 stock market crash, many investors moved to cash, where they remained for several years, missing the early stages of the greatest bull market of all time.  Something similar was true post 2008, and the subsequent “most hated bull market of all time”, with investor and portfolio manager surveys during 2009 being sceptical of the rally (emotional scars run deep), although now everyone swears blind that they were invested through it!


The lack of “places to hide” this time around means that to some extent it has not mattered that much what your portfolio was like coming into this period (most everything is down), but it will be much more critical what it looks like coming out the other side.


To get to that “other side” it is likely that the market will need to have seen a peak in the number of new cases of the Coronavirus, and, perhaps even more importantly, wide-scale testing that will allow investors to attempt to quantify the situation, and the market to put in a bottom.  There are two other key factors to getting beyond today’s chaotic scenario.  Congress needs to hurry up and pass the economic relief package (c.$1trn), and secondly, the Federal Reserve Act needs to be amended to allow the Fed to buy corporate bonds and US municipal bonds, as suggested by Ben Bernanke and Janet Yellen in the FT this week.  Jay Powell had previously stated that he wasn’t looking to get the Act amended, which was a mistake and roiled markets further, although we don’t want to be overly harsh as the Fed had done well in the commercial paper and money market arenas, moving swiftly and in size.


Of course, positive news on some sort of imminent cure for the virus would also help stabilise financial markets and allow for a rebound.  However, given the current state of investor psychology, another piece of genuinely bad news, such as the rapid increase in US unemployment being even worse than had been anticipated, could lead to one final lurch down.


The crisis has served to bring closer the inevitable fork in the road for the Eurozone.  As we anticipated, Christine Lagarde has not been able to “throw Italy under the bus”, now suggesting instead that “there are no limits”, and an aggregation of Eurozone government debt behind one transnational issuing authority, and behind which every member state stands, is a logical way forward.  This will go down better in some countries and less well in Northern Europe.  The march to Federalism would get a real shot in the arm here.  Fiscal union is inevitable, or they all have to go their own separate ways.  Indeed, Spain has called for a common European-wide fiscal response.


In any event, even Germany is now loosening the purse strings, and there is a clear effort on the part of policy-makers to protect “main street”, after the PR nightmare of 2008 and the (correct) perception of bailing out bankers at everyone else’s expense.  That is simply not going to be repeated, and money will be printed on a vast scale, to tilt the ratio back the other way this time around.  Deficit spending and variants of Modern Monetary Theory look as though they will be here to stay, as we had suspected, and this has positive implications for the ability of equity markets to recover, and, longer term, for Real Assets.  As an example, Australia has just launched its first ever bout of quantitative easing.


A quick word on sterling.  We have seen extraordinary weakness of the pound versus the US dollar, but it should be recognised that most “risk on” currencies (e.g. the Australian dollar) have also been very weak against the US dollar, while “risk off” currencies (such as the Swiss franc and Japanese yen) have gained, as one would expect.  It is also true that some investors are currently willing to sell anything to hold US dollars, often because they have funded their investments by borrowing dollars in the first place.


The UK has also been at the vanguard of the fiscal and monetary policy response to the crisis, and which necessarily has a weaker currency as a by-product.  That said, if there was a particularly strong recovery, then the Bank of England might be expected to take back its interest rate cuts (currently lowest rate in its 325-year history) rather rapidly, which would then support the currency.  Nevertheless, the market has been a bit sceptical about the UK’s initial political/healthcare response, which also softened the pound.


Supply and demand have got completely out of kilter over the last week, with vast amounts of unwinding from leveraged investors and forced sellers.  This has moved on to hit bond markets, with corporate bonds now performing as badly as in 2008 (Microsoft bonds are 20% cheaper than a week ago!?), and even government bonds were sold down.  The US stock market fell 16% in a week and yet the yield on the 10-year US Treasury doubled.  This is unprecedented, and entirely illogical, but is part of the scene until all these trades and emotion wash through.  It is not helped by well-meaning but counter-productive legislation post the last crisis, and market-makers acting more as agents than principals.


Anything that is “exchange-traded” has also been hit by waves of sell orders.  So, the Gold ETF was weak, even while precious metal dealers were selling out their inventories of gold and at huge premiums. There was hence effectively a difference between “the gold price” and “the price of gold”. NB The US mint has sold out of Silver Eagles too.


So, there are all sorts of anomalies and disconnects at the moment, and it is important not to panic.  The advantage of a sensibly-constructed portfolio is that you should not be forced into trading in extremely volatile (and dangerous) conditions, rather be patient as the car hits the patch of ice, and only seek to change direction or speed when beyond the worst of it, and initially with just small adjustments to the steering wheel.  We have some ideas in mind where the risk/reward trade-off has skewed favourably in our direction, and subsequently will look to build out the Real Assets element in portfolios further, as planned.


We can’t say when the market will bottom, but it is usually several months before a recession actually ends, and probably on the day when the outlook is darkest (almost by definition).  There is no need for us to be heroic in portfolios right now, and there will be internal signs of improvement in the health of markets that will give one more confidence in due course, even before a price bottom.


In the meantime, given that we have not added meaningfully to risk assets since 2011, we observe that smaller companies are as nearly oversold as they were in 2008, that the Japanese Topix Index is trading below book value, and that India is at 2.5 times book, which is cheap by its standards.  Gold and Gold Mining Companies remain compelling, and we would welcome the chance to top up our Infrastructure exposure.  So, there will be plenty for us to do in due course, and, in some cases, we will be averaging down on the book cost of purchases.  It is always worth remembering that as prices fall, expected future returns rise, and that the market has recovered from every downturn, bar none.

Andrew Wilson, Chief Investment Officer, 20 March 2020

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