There has been what can only be described as pandemonium in financial markets this week, the fastest ever bear market (20% decline), from all-time highs, and the worst individual day for equity markets since October 19th, 1987. This has been predicated on the progress and spread of the Coronavirus, the unfortunately timed oil-price war (Saudi vs Russia vs US), and the bungled responses from global governments and policymakers.
Financial markets have been “rioting” as they feel that the policy response has been woefully inadequate and disjointed, and that much more is required. The dysfunctional nature of Washington DC has been revealed again, and bureaucratic systems have not covered themselves in glory.
The obvious examples of this were the address from President Trump, which failed to announce a detailed fiscal plan (although did announce banning of flights from continental Europe), and Christine Lagarde yesterday, failing her “whatever it takes” moment, and rather throwing Italy (and EU harmony) under the bus.
That said, markets shouldn’t necessarily always be given exactly what they want, and the ECB is clearly trying to put more pressure on governments to provide fiscal stimulus around Europe. It is also true to say that plenty of helpful and appropriate measures have already been enacted across the globe, and of significant size. Indeed, there were huge monetary and fiscal stimuli announced in the UK this week.
The issue is rather that we haven’t (yet) had a “shock and awe” moment from policy makers, where there is a combined and integrated global effort. We suspect that a plan for global economic stimulus will appear today or over the weekend, and that the US Federal Reserve will cut rates to zero, likely no later than at its meeting next week. Markets hate uncertainty, and hopefully there should be steadily less of that, if policymakers do indeed get their act together, as they are being encouraged to do.
The crucial question will then be whether the virus starts to come under control in a couple of months, as it has done (seemingly) in South Korea and China. Indeed, we now hear of clients returning to Hong Kong to escape the UK.
For our part, we have avoided (fortunately) adding to risk assets during this period, even though all the Lockhart risk profiles have ample scope to do so. We prefer to buy assets when they are “dirt cheap and with a margin of safety”, and that hasn’t been the case, although valuation is starting to come through in some areas.
More interesting, for now, are the assets that have sold off simply because investors have had to raise capital, or because they are wrapped up in an exchange traded vehicle, which has seen them caught up in an indiscriminate fire-sale. This is particularly the case in the Real Asset space (e.g. Gold Producers, Timber & Forestry, and Global Property Securities), where we were anyway looking to continue building out our position, as previous readers will already know, and inflation hedges are now on sale.
So, this has proven rather serendipitous, from that point of view, and we are currently considering reducing our exposure in the Alternatives sub strategy (which has held up well), to fund this increase, and will likely rebalance the portfolios at the same time. Prices and valuations are down in Real Assets, and yet the opportunity and level of supportive backdrop has increased. There is now more chance of greater inflation and debasement of paper currencies, and sooner than might have been anticipated. In any event, the opportunity to trade against someone whose time horizon does not extend far beyond the end of their nose (at such moments), is a chance to “arbitrage time”, and a key part of our diversification.
Finally, a word on market action and the behavioural angle. A fast-falling market contains a “certainty discount”, where many investors need the certainty of cash (or a reduced level of risk) and will accept almost any price to attain it. Indeed, they are often forced to, perhaps by their own portfolio rules. This exacerbates all downturns, and especially with the current “microstructure” of markets, to which we often refer. There is very little liquidity these days, and it dries up at the first sign of trouble.
The more extreme a market event, the greater the level of herding and groupthink amongst investors. At times of greatest uncertainty (and “pain”) one can see why humans are the most imitative creature that have ever lived. The worst weeks of selling out of markets and mutual funds have been when markets are at or near their lows (often having halved). Yet, on the contrary, risk can be least when it is most visible, and the market will bottom, almost by definition, when things seem the worst. Rallies can then start, on just the absence of any further bad news, or even on simply a slowing of the rate of increase of bad news.
We have highlighted that we expect a huge policy response to the next downturn, and now here we are, with recession breathing down all our necks, and the kitchen sink will absolutely get thrown at this. It is for this reason, and as part of our strategy, that we have been maintaining a level of risk assets (albeit reduced), as one will want to participate during that phase.
At some point the policy measures will gain some traction and the news on the virus will get a little better (less bad), which will allow for a potentially explosive recovery in (some) asset prices. Nevertheless, our thesis is that this will then evolve into a time when real assets perform better than financial assets, that inflation returns, and that Modern Monetary Theory (or variants of) becomes the norm, and with all that this implies for cash, every other asset class, and the protection of the real purchasing power of wealth. To that extent, and despite the optics of the last couple of weeks, we remain on track.
Andrew Wilson, Chief Investment Officer, 13 March 2020
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