2nd Quarter, 2020
We are focusing our stock selection on sectors where sustainable demand is evident.
THE MARKETS
The last quarter saw a continuation of the COVID-19 risk-on, risk-off scenarios that began in early March. During the quarter, we witnessed an unprecedented fusillade of both fiscal and monetary measures by central banks and governments in their bid to instill a good measure of buoyancy into a global economy that has been ravaged by the pandemic. It is too soon to judge the effectiveness of these stabilization measures as we continue to face new daily challenges in the quest to halt the spread of the virus and develop immunization therapies. Markets are largely influenced by three factors: sentiment, economic expectations and liquidity. At present, sentiment is highly volatile, economic expectations lack near-term visibility and while liquidity has proven adequate thus far, markets continue to face the fast-moving challenges of both known issues and the morphing of unknowns into additional stress.
At the beginning of the quarter, markets were confronting a continued spread of the pandemic complicated by a potpourri of uncoordinated political responses which, in some instances, were in conflict with known scientific findings. The political responses in the USA were for the most part multi-tiered, leading to widespread variances in effects of containment. Overseas political responses were largely of national containment policies that differed country by country; thus, we find ourselves in an environment that resembles the Biblical confusion of tongues known as the Tower of Babel - not a good preamble for investor sentiment. The more positive story lies with global medical competition/cooperation to develop a series of vaccines and treatments to defeat and eradicate the coronavirus. The success of this scientific quest will be a powerful force for improved global sentiment.
In the meantime, markets remain at risk with the uncertainty of a second wave of infections and economic disruption that continues to unfold. Thus, economic expectations will remain elusive until we have a comprehensive damage assessment from which reliable forecasts can be constructed.
As regards the third leg of the market stool, liquidity, the prompt global fiscal and monetary response by governments and central banks has thus far given the markets a reprieve from the abyss of global depression and contained the fallout to one of recession. Although a recovery will eventually commence, it will in a large measure depend on our success in adapting to the new social and economic norms of a post-COVID-19 world. We expect a period where market valuations are likely to be reshuffled, leading to further bouts of volatility as adjustments to sectors begin to reflect these new economic realities. In the meantime, markets should increasingly reward companies with stable balance sheets and solid free cash flows.
The OPEC Black Swan that hatched just as the pandemic was coming into full view has in a large measure been ameliorated as key participants were forced to accept the folly of their disputes in the full dawn of COVID-19. Dire predictions of negative oil prices proved short-lived and markets quickly adjusted to the realities of Newton’s law of action and reaction. As a result, crude prices have now stabilized and most large integrated producers have seen their share prices rise nearly 50% from the lows recorded earlier in the year. Even so, damage has been incurred by the sector and a great deal of marginal shale production will be withdrawn from the market for an extended period of time. Some of it will never return and the USA may once again become a net importer of oil. The impact on the domestic sector will bedevil some banks and the industry for some time to come.
THE ECONOMY
Global economies have fallen into recession of varying degrees due to the COVID-19 and OPEC black swans. The suddenness of the collapse came on the heels of near-full employment economy in the U.S., and in two months, the unemployment rate skyrocketed from under 3% to over 20%. The brunt has been borne in consumer service industries such as restaurants, sports, air transport and in situ retailing. The least impacted have been those in government jobs or in service businesses that are well suited to function remotely. Overall, roughly 30% of the work force is currently without work and receiving unemployment benefits, which, in many cases, will carry on until year-end.
The political pressure to reopen the economy has been met with resistance from both a geographic resurgence of COVID-19 and the disjointed effects at all levels of government. The ability of any credible source to forecast recovery at this time is seriously in doubt. What we do know is that structural damage to the economy is far greater than first reported and the course of repairs or embracing of new norms will stretch out for an extended period of years before we get it right.
There are four post-pandemic factors that will have a significant role in our future economic and societal challenges. They are as follows: the change to remote or off-site working, the redesign of supply chains at all levels, the long-term outlook for globalized commerce and the reconstruction of fiscal and monetary policy to cover the wartime like deficits. We expect these will lead to a major recasting of economic measurement and forecasting. Clearly, the digital age has played its part well in protecting both employees and companies in the pandemic. We do not expect this trend to revert and one can reasonably speculate that skyscrapers may become the next generation of dinosaurs, with significant economic consequences. Redesign of supply chains to fulfill the requirements of the new norms will require a great deal of trial and error and will have to conquer both the dispersion issues of the work force and diminished globalization.
As regards the future of globalization, it is too early to tell what the long-term post pandemic trend will be. It is well known that the rate of globalization has been under threat for most of the last economic cycle as the loss of domestic jobs succumbed to the competitive pressures of cheaper foreign goods. The pandemic may have quashed this due to both unprecedented domestic job losses and the heightened need for secure supply chains. Nowhere is this more evident than in consumers’ growing desire to have drugs produced in the home markets.
The most recent global growth forecasts by the International Monetary Fund (IMF) note further reductions from March, with caveats about uncertainty as the 3rd quarter unfolds.The table below shows these forecasts, which impound the expectation of financial conditions broadly in line with current levels.
The expectations are that forecasts will become more reliable once vaccines are developed and made available on a global scale.
INVESTMENT STRATEGY
Our primary investment strategy is to consistently manage our clients’ portfolios to achieve real returns in excess of inflation, thus maintaining purchasing power through good times and bad. We are now in the midst of an unprecedented and challenging environment, nonetheless our strategy remains in place and our task is to continue to grow your assets beyond inflationary expectations.
In the current pandemic environment, change has been compressed, thus elevating market pressures that generate volatility as short-term factors hold more sway than long-term conviction. Nonetheless, we constantly evaluate both the short-term and long-term expectations. Looking ahead, we foresee a period where portfolio turnover may rise as the economy adjusts to new norms and we make judgement calls on which sectors or companies are likely to stay ahead of the curve or be left behind. In many cases, where we have continued confidence in management’s ability to navigate correctly, we will “stand fast.” In others, we are always on the lookout for the better mousetrap or opportunities that arise from changes in sector fundamentals.
In the present state of the markets, emergency monetary and fiscal measures have marginalized fixed income opportunities, and the uneven rate at which Fed policy has been absorbed has caused liquid asset values to rise, while the benefit for small business is less clear. Thus, there appears to be a disconnect between the markets and economic realities.
Our view is that the full extent of structural damage to the economy is not known and the repair of capital and processes will take longer than the markets’ current view. As such, we are focusing our stock selection on sectors where sustainable demand is evident.
Inflation is the systemic enemy of capital and with politicians, it is always tomorrow’s worry; however, it is our worry today. We believe that the aggregate sum of global stimulus must eventually be monetized as the political establishment lacks the will for major austerity measures. As such, we continue to maintain shorter bond durations, and favor stocks with stable or rising cash flows, sustainable payout ratios, and pricing power. We will look for opportunities to add new holdings of TIPS when/if a positive yield scenario develops. Although initial market reaction to inflation is usually negative, with a focus on the long view, the right stocks will come out ahead.
As always, your comments and questions are welcome. We wish you a happy Independence Day 2020, our 245th.