The current situation is still very fluid.
We are more pessimistic than the general investor and we believe another leg of the bear market will be upon us.
Panic in the market has indiscriminately reduced valuations.
We are starting to build positions in high quality companies at reasonable valuations.
By now we are all aware that the Coronavirus is affecting the economy and the stock market. Below I summarize what we see as the next scenarios. We divide the effect in three time horizons.
Lockdowns clearly reduces consumption.
Shops, restaurants, most commercial activities are closed. Currently for two weeks but it might be (and probably will be) longer.
People are generally worried so even where lockdown is not implemented, they tend to consume less, stock up, reduce unnecessary consumption.
Holidays that were previously booked are cancelled.
Companies have to reduce working hours and lay-off employees.
Short to medium term:
Loss of confidence from companies and consumers reduces investments.
Less optimism means less cars sold, houses, holidays, electronics and so on.
Banks issue less loans, which in turn reduces consumption and investments even more.
The long term impact is still unclear because it depends on a number of factors we will outline below.
If the situation is resolved soon, the long term effect might be mild.
If the situation is not resolved soon, companies will start going bankrupt and unemployment will go up and GDP will decline long term.
In both scenarios government debt will increase.
All over the world, governments are pouring money into the economy. The U.S. has planned a $2T investment, equal to 10% of GDP. The UK £400B, equal to 15% of GDP. NZ is implementing a $12B package, equal to 3% of GDP. Europe is following a similar path.
Some countries such as NZ (21%) or Germany (62%) have low GDP debt ratio but other countries such as Italy (135%) and the US (110%) are already stretched.
At the moment countries don’t seem to be worried about their debt increase because Central Banks are buying their new debt issuances. Usually this increase in monetary base leads to inflation, but this didn't happen over the last ten years. Many theories are put forward for this new reality, but nobody knows for sure. And there is no certainty that this scenario will persist. Consequences of increasing debts and money issuance are hard to predict. We assume that debt will just be kept inside central banks’ balance sheets and will never be repaid (or cancelled).
If inflation picks up, the situation will worsen very quickly because long term bonds will be sold-off very quickly (they have started to be sold in the US over the last week), central banks will struggle to keep a balance between avoiding a recession and reducing inflation and so on. Cash will lose value, but so stocks and bonds. Probably real estate and gold should do ok, but it is hard to say.
The stock market is currently pricing in a short to medium term scenario.
Most investment banks are currently predicting 15/25% GDP decline in Q2, but then they forecast a rebound in Q3 and Q4. Goldman Sachs, for example, predicts that US GDP will decline 6% in Q1 and an astonishing 24% in Q2, to rebound in Q3 and Q4 with growth above 10% per quarter. According to their forecast, unemployment will quickly jump to 9%.
Around the world the situation is not much better, especially in Europe.
The only place that seems to be doing relatively well is China where the economic activity is restarting now.
We see a weaker scenario because we don’t expect this situation to fully reverse in just three months, and we expect indirect effects such as loan delinquencies to have a longer lasting impact. As we mentioned in our previous letters, we arrived at this moment with a stretched economy, and this will have a negative impact on our capacity to react and adjust (e.g. see oil industry). It might be that people will just get used to it, but it might also be that they start to react irrationally.
We don’t think the market has bottomed out yet.
We think we have only seen the first round of sell-off, and another round will come when companies and analysts will update their estimates, when some companies will start defaulting, and unemployment will go up. The picture below compares the current market fall with previous intense crises.
As we mentioned in our letter to investors three weeks ago (at that time markets were down 10/15% from their peak), we expected a decline between 30 and 50% if the situation was to improve quickly. So far the Dow Jones declined 33.5%, well within range of our first projection. However, we also said that if this was not resolved quickly, we expected a 70% decline, in line with previous significant crashes.
How the economic situation unfolds depends on two things:
Governments: As previously mentioned most governments are pouring a lot of money into the system and this should somehow cushion the impact. Different policies will also have different effects.
Medical situation: Clearly this started as a medical emergency. So how the medical system reacts and how efficiently it will manage to contain the virus will have a strong effect. Broader testing, the development of a vaccine (and how quickly it will be approved and distributed), as well as how individuals change their habits of cleaning and distancing, will all have a strong impact. Countries such as South Korea and China have done very well in this sense. Western countries don't seem to have the same behavioural changes necessary for containment.
At the moment, our base expectation is for a decline, from the beginning of the year, of 40-50%. This is because the medical situation does not look rosy and because, despite significant efforts from governments and central banks, they are not managing to stem the tide.
However, we have also noticed that everything is being sold indiscriminately. Even utilities and gold that are usually considered safe heavens in recession with low interest rates have been sold. This is offering opportunities. Over the last month we have started or added positions in the following companies:
Wix (platform to make websites): read our analysis here.
Waste Management (as the name suggests)
Visa (credit cards)
Illumina (DNA sequencing)
We are also trying to balance our positions with PUT options (on the index) and shorts (e.g. Uber). We will try to write on the rationale for buying each company in the coming days.
Our performance so far
Overall, despite the sell-off, our portfolios are doing relatively well. Our performance YTD is as follows:
- USD accounts: average of -3%.
- NZD accounts: +2%
- EUR accounts: -4.5%
- GBP accounts: +2.8%
Below we report a graph comparing our USD account performance with the SP500 (SPY) and Vanguard Total stock (VT; an index of Global stocks), over the last 12 months. Our performance suffered a bit when the market was climbing, but offered a very strong protection in the downturn.