1st Quarter, 2020
Although growth will return, do not expect a return to “status quo ante bellum.”
THE MARKETS
As we started 2020, global markets continued upward, buoyed by the momentum of 2019’s strong returns. However, the momentum peaked in the U.S. in mid-February, and record levels were quickly erased by a sudden and precipitous decline that was punctuated by heightened volatility. The dramatic change was triggered by the “unknown unknowns” of the global COVID-19 pandemic and the known knowns of a self- inflicted global energy price war by the world’s largest and lowest cost producer, Saudi Arabia. The simultaneous arrival of these two Black Swans has been disruptive in different ways, but with a compounding and deleterious effect on global economic growth that has yet to be fathomed.
In the first instance, COVID-19 created an unprecedented climate of fear and very quickly disrupted accepted behavioral norms across the globe. In general, the majority of population groups dislike change; thus, the rapidity of the COVID-19 pandemic has compressed behavioral change and in turn supercharged fears of the unknown. In a world that has been drifting away from economic globalization, the all-out mobilization of governments, business, and the health and scientific communities in a common defense to quell the virus appears to be gaining traction in calming fear and creating a growing understanding that this pandemic can be overcome, even though it will force new adaptations faster than we would like. We will carry on, but need to embrace significant changes to our economic and social well-being.
Regarding the oil Black Swan, over the last hundred years there have been a number of events - wars, depressions, embargoes, and acute geopolitical upheavals - all related to an imbalance of the supply and demand of oil. Each event was largely spontaneous and disruptive, and the rebalancing of supply and demand was not without hiccups and economic consequences. In the present, Saudi action has further limited near-term investor sentiment and seriously upended the economics of alternative energy, which for the most part have been based on the long-term price of fossil fuels. All this will result in a serious geopolitical struggle over the cost of subsidizing alternative sources of energy in an environment where governments’ stimuli to quell the pandemic has left them heavily indebted. The markets will likely have an easier time addressing the present state of the traditional energy markets as there are ample historic records regarding the rebalancing of supply and demand. Markets are likely to have more of a struggle in valuing the global economy beyond the demise of COVID-19. Although growth will return, do not expect a return to “status quo ante bellum.”
Keeping the forgoing in mind, we can expect more volatility, particularly related to specific industry groups such as airlines, cruise operators, and already distressed retailers as the effects of pandemic disruption become more discernible. This seems probable even if liquidity stress levels in financial markets abate and a financially created Black Swan is avoided.
Before the two Black Swans hatched, we were looking at an environment in which the U.S. dollar had started to roll over, profit margins were receding, and many earnings gains were due to share buybacks. We are now in a recession, and stocks can be valued on that phase of a business cycle. The challenge this time is for us to understand the realignment of sectors within the next business cycle and make our estimates according to expected new norms.
THE ECONOMY
One of the basic rules of economics is that all forecasts are subject to change without notice. We now live in this environment of unprecedented pandemic fallout that has engulfed the entire world. The overwhelming global response has focused first on containing and defeating the pandemic and secondly on massive fiscal and monetary action to keep the global economic machinery functioning through the course of the health emergency.
As a given, all economies will face disruption, but not necessarily the destruction as witnessed in Zimbabwe where the government has abandoned its currency. The concerted stimulus actions taken by governments through their legislative and monetary authorities are designed to bridge the economic chasm created by the pandemic. Personal and social disruption caused by the pandemic is unavoidable, but all will benefit from the economic buffers put in place to limit capital destruction and maintain the supply chains supporting the necessities of life. Presently it is just shy of impossible to predict where the economy will be a year from now. However, by bridging the chasm in supporting business and employment initially with nearly two years of existing budget expenditure, business and consumer confidence should be sufficient to recover sooner rather than later. To maintain this course to recovery, governments will have to make it clear that they will continue to fund as necessary should the initial calculus fall short.
Forecasts aside, we must now accept the fact that the U.S. is in a recession and both internal and external demand will be curtailed but are unlikely to collapse as is currently the situation in China. Loss of external demand can in a good measure be offset by public works spending on infrastructure, a sector that has gone beyond its physical utility. Internal demand will face the challenge of refocusing largely due to the forces of change wrought by the pandemic; thus, when fog of the pandemic war lifts we will be awash in new forecasts as alterations to our economy become apparent
In the case of energy, forecasts have always been based on the economics of fossil fuels. The Saudi-instigated price war is with us and the potential damage to energy self-sufficiency is real given our recent sufficiency has been dependent on the production of higher cost shale oil and gas. The consumer and non-energy users of gas and oil will partake of a near-term price windfall that is unlikely to be of a longstanding nature. The serious economic fallout from the current price disruption will be to the economics of alternative energy sources and the global warming agenda, which for the most part rely on subsidies. There is a traumatic difference in the amount of subsidies with oil at $20 per barrel vs. $60. The future cost of alternatives is likely to become contentious as long as the current situation persists.
Looking ahead to clearer horizons, we can expect a return to forecasts coming early and often. In the meantime, we need to accept the recession scenario and watch the data unfold as to how a U-shaped recovery will take hold. Will we have an extended bottom of the U and how long will it take to exit the trough? We think markets are in the range of recession pricing but subject to sector volatility, driven largely by pandemic influences on economic and societal change.
INVESTMENT STRATEGY
Earlier in 2020, IIM began an asset allocation review as the spread between rising equity valuations and declining profit margins began to widen. As a result, equity allocations that had grown beyond client specific targets were modified by reducing outsized positions. We also continued our strategy of reducing risk using low beta stocks. Fixed income opportunities declined in line with the Fed’s policy of accommodation. Accordingly, we maintained high quality, short duration portfolios, with tight credit spreads causing a preference for U.S. Treasury securities. Emphasis was placed on holding higher cash or near-cash balances and using well-covered dividend stocks to offset the decline in fixed income yields.
With the near simultaneous arrival of the two Black Swans, a sudden and all penetrating fear of the unknown gripped the population, creating an unprecedented surge of market volatility across all sectors, leaving a wide gap between market prices and asset values in many cases. In a period where entire markets become disorderly, our strategy is to STAND FAST with the high quality stocks that we hold for long-term returns. Our equity selection puts great weight on management’s ability to ride out market disruptions; in the present case, a number of our holdings have rebounded meaningfully year-to-date.
While there is no certainty that extreme market disruption has passed, we believe that in the absence of a third Black Swan of financial origin, asset values will be more reflective of recession scenarios and we will manage these risks accordingly.
One fact that has now come into focus is that our way of life will change. Our primary task then is to discern the direction and magnitude of change and the likely impact sector by sector and company by company of your holdings. The rate of economic recovery will weigh importantly on our decisions and recommendations.
MAINTAINING OUR CONTINUITY
Beginning Friday, March 13, IIM has operated in a new format based on our existing disaster recovery plan, which lays out remote management and execution of our normal daily in-house routines. Our South Main Street Ipswich office remains open and is manned by two partners from 7:30 AM until 5:00 PM Monday through Friday. Each principal is located on separate floors, with any direct interface conducted at appropriate distances. Our administrative team functions remotely from their homes via secured data and internet connections, and everyone is accessible by telephone or internet. The team has secure access to all our functions. The only drawback is that we cannot have morning tea and coffee together or shared conversations at the water cooler.
The investment team meets on Tuesdays and Thursdays via teleconference, and we easily exchange investment materials electronically. In the daily routines, internal telephone conversations substitute for impromptu meetings. Client communication by phone or email continues normally. Clearly, client meetings cannot be conducted in the current environment other than by telephone, and we look forward to the day we can once again meet in person. We are in regular communication with our third party providers and can report that trading continues to be handled in an efficient manner but remotely.
Above all, we value the personal and professional relationships with all IIM family clients. We believe our team structure provides depth of coverage and resiliency.
Finally, we want to assure you that we continue to place great emphasis on cybersecurity and are constantly monitoring our internet traffic to guard against any nefarious intrusions. In the present pandemic, there is a meaningful surge in nefarious activity that requires all of us to be on alert. We will never ask any client for sensitive personal information over the internet nor will we ask anyone not on the IIM team to contact you. If such an instance occurs, please contact us immediately.
As always, we are available to address your needs and concerns.