First Quarter 2020 – Quarterly Commentary

Is it safe to look yet?

After a relatively sanguine start to the year, with equity markets looking set to drift higher on the back of an improving economy and supportive monetary policy, the world woke up one morning to a new terror – COVID-19.  At first equity markets shrugged off the “Chinese” problem, but as the days passed it became increasingly evident that this was not a Chinese problem, but a global one.

Bad Things Come in 3’s

The global economy has now suffered three shocks in a space of approximately six weeks, any of which on its own would have been sufficient to cause a stumble in equity markets.  The first was an anticipated supply shock as China, the manufacturer to the world, went into a state of lockdown as it tried to cope with COVID-19, bringing production to a sudden halt. 

Without parts from China how could iPhones and other “critical” merchandise make it to anxious Western consumers?  Little did we know that the inability to manufacture computer components and car parts would be the least of our concerns, and that within a few weeks hand sanitizer, face masks and ventilators would become the critical merchandise.

 In general, the concerns over a supply shock from China have likely been overestimated.  China is now ramping back up after approximately 49 days of quarantine and most estimates suggest that approximately 75% of production is back up and running.  However, with demand now suppressed by restrictions in the rest of the world, the shortage of consumer product seems likely to be mild.  That overhang was reflected in the Institute of Supply Management (ISM) Manufacturing and Non-Manufacturing surveys released at month end.  Both indices bounced back into “expansion” territory during the month, following the most dismal readings in history for February, despite ongoing weakness in orders for export purposes.

Through this period (please enjoy the irony), based on estimates generated by the French bank BNP Paribas, U.S. exports to China declined by approximately twice the value of Chinese exports to the U.S.  So, Donald, are trade wars really that easy to win?
 
As we wrap up 2019, there are indications that a “phase one” trade deal between the U.S. and China can be accomplished and may result in the rollback of some tariffs. Having travelled this path a few times in the last twelve months, we are loathed to put a probability on the success of this deal.  Equity markets have taken relief in the prospect of such an event, which of course leaves the risk of disappointment. 
As the proposed trade deal is expected to leave the most difficult issues unresolved, if a phase one deal does get completed, does it really mean anything or is it primarily political posturing?


A U-Turn by Global Central Banks

The trade war was not the only cause of a slowing economy.  Throughout 2018 the U.S. Federal Reserve and the Bank of Canada were pushing interest rates higher, supported by strong economies, full employment and a desire to create some cushion in the monetary system in recognition that a low interest rate environment would leave little flexibility should another recession occur.  Higher interest rates are designed to slow growth by making it more difficult to borrow.
 
The process of raising rates came to a sudden halt in January, as the U.S. together with almost 20 other central banks around the world (albeit with some grumbling about how the central bank shouldn’t have to bail the country out of a decline triggered by a trade war) began the process of cutting their respective benchmark interest rates with the goal of stimulating the economy, creating essentially a full reversal in short term interest rates.
 
This raised some alarm bells.  As of August, it was estimated that there was $17 trillion of debt trading at negative yields (yes, that means you get paid to borrow money).  With so many central banks cutting interest rates, that number was destined to spiral higher, wasn’t it?  Once more, expectations and reality diverged and by year end the amount of negative-yielding bonds outstanding had dipped to around $11 trillion.

The second shock came with the rapid spread of the virus through Europe, with Italy taking an exceptionally heavy hit.  We cannot underestimate the human tragedy as a shortage of critical equipment forces doctors to choose who to try and save and who to leave to die. 

Events in Europe incrementally woke up the rest of the world to the crisis looming on their doorsteps, and governments began to implement their own restrictions to try to protect their citizens.  At the time of writing residents in most of the developed world are in some form of self-isolation, creating a demand shock to the global economy.

The third shock came as the OPEC+ (essentially Saudi Arabia and Russia) agreement to reduce oil supplies fell apart.  Saudi Arabia promised to increase production and began selling oil to its customers at steep discounts, attempting to gain market share.  The additional supply met a market where demand was declining quickly as air travel, manufacturing and driving came to a virtual halt.   Global oil prices plummeted, with prices for Western Canadian Select dropping as low as $5 per barrel. 

The reaction in the energy sector was swift, capital spending and dividends have been slashed as the sector struggles to survive.  This is a serious wound inflicted on an already weakened Canadian energy sector.  Without a new agreement between the OPEC+ partners, we expect there will be many bankruptcies in the industry.

It is questionable how long Saudi Arabia and Russia can hold out at current oil prices.  The International Monetary Fund (IMF) estimates that the Saudi Kingdom requires $83 oil to balance its budget.  The Saudis may also have underestimated the price shock in the current environment as demand weakened simultaneously with their planned supply increase and filling the budget hole from a $20 oil price to $83 may be more than they reckoned for.  Most OPEC countries will turn to a combination of borrowing and drawing on their Sovereign Wealth Funds (the government piggy bank) to meet the shortfall. The drawdowns from these rainy-day savings funds will likely exert additional selling pressure on equity markets as liquid securities are sold.  Russia may be somewhat better positioned as the IMF predicts they require only $40 oil to meet their budget needs.   Needless to say, this was not a shock the world needed while trying to deal with COVID-19.

At the time of writing, some faint glimmers of hope had been raised for the sector, with President Trump tweeting about a prospective deal between Saudi Arabia, Russia and potentially the U.S.  Is this a realistic hope?  It is difficult to be certain whether this is wishful thinking by a President that thinks out loud through his twitter account, or a reflection of serious negotiations.   China also announced that it would use this period of weakness to double the size of its strategic petroleum reserves, creating an outlet for a portion of the excess supply. 

Deja-vu?

Not to be dismissive of the human cost of the coronavirus spreading rapidly across the world, but our focus is on the economic impacts of the disease.  As in any panic, the world (and Facebook) are filled with misinformation, ranging from harmless claims such as one of our daughter’s asserted that the virus is spread exclusively by younger siblings, to more detrimental statements such as a claim that it can be cured by untested malaria drugs.  We will strive to be as factual as possible.

In some ways, it feels like we have been here before.  Financial markets face a drought of liquidity as panic sends investors to the sidelines.  Credit markets have tightened at the same time companies are aggressively trying to tap the market to shore up their funding, with March marking a monthly record in new global bond issues.  In other words, companies want access to cash and aren’t that worried about the price to be paid to access it.

Although the catalyst is different this time, the fears and market functions have significant similarities to the Great Financial Crisis (GFC), as it has now been named, in 2008/09.  To emphasize how much liquidity in financial markets has dried up, it was estimated by JP Morgan that on one day the ability to execute a large trade had declined by a whopping 92%!

Of course, in the midst of a crisis you can always count on a few reputable prognosticators to fuel the fire.  A few reminders of the expectations in the midst of the 2008/09 crisis may help give perspective to some of today’s more dramatic assertions as well.

Early in the GFC, Alan Greenspan, who had retired as head of the U.S. Federal Reserve in 2006, stoked panic when he indicated “the U.S. was in a once in a century financial crisis that has yet to run its course.”  The same article went on to make many comparisons to the crash of 1987.  We would note that the media has made similar comparisons to the crash of 1987 in recent weeks.

Our favourite was when Harvard financial historian, Niall Ferguson predicted in February 2009 (just before markets recovered) that “the global recession would create blood in the streets, civil wars and topple governments.”  The story in the Globe a Mail became the best-read story in the newspaper’s online history to that point.

Our favourite was when Harvard financial historian, Niall Ferguson predicted in February 2009 (just before markets recovered) that “the global recession would create blood in the streets, civil wars and topple governments.”  The story in the Globe a Mail became the best-read story in the newspaper’s online history to that point.

So, what does “out” look like in the coronavirus crisis of 2020?  We don’t know for certain, but there are a few things we can point to that should help financial markets recover.

1) Central Banks around the world are pulling out the big guns. We thought monetary stimulus following the GFC was massive, well it looks like a chihuahua compared to the mastiff-sized stimulus we are experiencing today.

The U.S. Federal Reserve is promising open-ended stimulus, which may end up reaching $5 trillion dollars, with programs to reach into every corner of the economy, from the banks right down to the dry cleaner on the corner.  By comparison, the first wave of Quantitative Easing (QE) during the GFC was approximately $1 trillion.

Closer to home, the Bank of Canada is getting into the QE game for the first time.  And even the exhausted European Central Bank is ramping up again.

2) During the GFC, fiscal stimulus was late to the game and meagre compared to what is looking at being doled out today. Obama’s “shock and awe” package of 2009 was a trifling $800 billion.  Compare this to the $2 trillion stimulus package signed by President Trump at the end of March, with expectations of more to come.

Despite its aversion to government deficits, Germany is also getting on the fiscal policy bandwagon.  The Canadian government launched a $82 billion plan and then barely a week later expanded it to $200 billion.

It seems likely there will be a price to be paid for all of this stimulus, but as Scarlett O’Hara declared at the end of Gone With The Wind, “I can’t think about that now…  I will worry about that tomorrow.”

3) Everyone is watching the new daily infection rates. If those begin to decline, it may bring some relief to the market and start to restore liquidity, which should help reduce volatility, which will help restore liquidity…  turning the current negative feedback loop into a positive.

At this point, volatility as measured by the volatility index has peaked and rolled over.  That is not to say that it can’t have a second surge higher, but at this point it is a sign that tensions in financial markets may be easing.  However, it may be difficult to ease the liquidity issues completely while society is busy self-isolating.

What does a bottom look like?

During the GFC equity markets dropped roughly 50% from top to bottom.  Will that be repeated in 2020?  We don’t know.  At the time of writing, the top to bottom drop has been 34%.  Given the proactive (rather than reactive) stances taken by governments around the world, we can make a credible case that the final capitulation may be avoided this time, but another leg down is not out of the question.  Particularly as at this point, we don’t have a grasp on the short, medium and long-term economic consequences.

In most bear markets, there is an initial decline, some form of relief rally followed by a re-testing of the low.  We believe the rally in the final week of March is likely more of a relief rally than the first step to recovery and that there is still a high probability of re-testing the lows. 

A recession is undoubtedly going to follow over the coming months.  The length and depth of that recession are likely to be determined by the duration of the “lockdown” period for the global economy.  The shorter the lockdown, the easier it will be for the economy to recover.  The longer it extends, the more job losses will become permanent rather than temporary, lengthening the recovery period. 

But there may also be a disconnect between financial markets and the economy for a period as the abundance of money pushed into the economy creates asset inflation, as happened in 2009.  Financial markets are forward looking and we are already seeing commentators looking past what is expected to be a dismal 2020 for corporate earnings towards 2021 and in some cases 2022.

We believe periods such as these are the greatest opportunities for investors, as the potential future returns on both stocks and corporate bonds increase. 

Let’s take an example, using a firm everyone knows.  Royal Bank’s share prices peaked at approximately $109 late in 2019.  At the time of writing the shares are at $83.  No doubt the bank will struggle with earnings growth for a while due to low interest rates and a rise in bankruptcies, but for arguments sake, let’s assume the share price recovers its previous high in 5 years.  (For comparison, following the GFC, with concerns over the same issues, the share price recovered in 3 years, but we will assume 5 to be conservative).  The share price gains over those 5 years would equal 5.6% per year plus the current dividend of 5.2%, which means approximately 11% annualized returns.  If the recovery time is similar to what happened following the GFC, increase that return to 15% annually – from boring old Royal Bank!

Can we assure you this won’t get worse before it gets better? No. But we firmly believe it will get better and that now is the time to channel your inner Buffett.

Be fearful when others are greedy and greedy when others are fearful.   ̶ Warren Buffett

April 2, 2020 Logan Wealth Management

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