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Keep calm and carry on
Rainbow, Tunnel or Black Hole ?
In 1939, just before WWII, the British government produced the following motivational poster, now widely used in countless bits of merchandise, especially in the UK. Its purpose was to prepare the public for what was inevitably going to be a very difficult period for the UK.
In a similar fashion, but with far less typographic style and visual impact, politicians everywhere are trying to convince the quarantined public that the unprecedented times we are all going through are temporary and a return to the good old days of the last ten years are just around the corner.
On the virus front they are probably right. The social distancing measures are effective when the public respects them (however outright impossible to implement in some poorer emerging markets). Once again I will refrain from making any statements better left to virologists and statistical epidemiologists but rather just say this will be contained eventually and any second wave of transmission will be dealt with aggressively until there is a vaccine.
Most of the forecasts assume this contagion will be controlled within the next 2-3 months. This optimistic view is the only one compatible with a V-shaped recovery and the possibility of return to the previous economic path. Our way of life is disrupted but reverts to what we see as “normal”. Bull market resumes, fuelled by low rates and the global central bank backstop. I would call this the Rainbow scenario. It is still raining but you can already see the lovely colours before the sunshine.
A middle of the road scenario is that the contagion will be controlled by the end of the year as we tackle secondary waves of infection that create random new lockdowns like the one we just saw out of the blue in Singapore during the last few days. In this scenario the recession is much deeper globally, however the fallout can be contained again by central banks and fiscal policies and a return to economic normality in two years or so. A new “normal” is set for the next few years while everyone adjusts to lower consumption patterns in what may be described as a U-shaped slow recovery. Markets remain volatile and in bear mode for 1-2 years as they digest data and new economic equilibria. I would call this the Tunnel scenario. It is dark and scary but in the distance there is some faint light; unclear exactly how far but clearly there.
A bad scenario is if there is a delay in finding an effective treatment and the virus is still circulating around the globe well into the 2021 winter flu season. Or the virus mutates into something even nastier. In this case the world goes into a longer term depression or as some economists call it an L-shaped “never happening” recovery where the previous normal is never recovered. The pandemic then permanently destroys a part of the economic activity in a period that could last anywhere from a few years to decades. This is the Black Hole scenario. Pretty descriptive.
A recent paper by the San Francisco Fed on the “Longer-Run Economic Consequences of Pandemics” has looked at a dataset stretching back to the 14th century looking at 15 pandemics and large scale conflicts. This tends to support the Black Hole scenario but for reasons I will briefly touch upon it may not be fully applicable in the 21st century.
“Significant macroeconomic after-effects of the pandemics persist for about 40 years, with real rates of return substantially depressed. In contrast, we find that wars have no such effect, indeed the opposite. This is consistent with the destruction of capital that happens in wars, but not in pandemics.”
- Jordà, Òscar, Sanjay R. Singh, Alan M. Taylor.
For choice, I would go with the Tunnel scenario. And it is not because I have any view about the virus spread or the science of vaccine development. It is because the Tunnel scenario view is the best way to risk-manage and navigate this market while at the same time taking into account what is happening in the real world and not just in central bank balance sheets.
The public markets are trading currently on the Rainbow scenario. I would also call this the FOMO trade. Participants conditioned over a decade to buy the dips are not going to change overnight. They have anchored their reality to the highs of January 2020 and can only visualise closing that gap. Pension funds allocations with 30 year horizons will not change strategy over a quarter. They need multiple quarters of bad returns. In this scenario there is not much to do, just wait for the gap to close while stuck at home. Most wealth managers I know have instructed their clients to do just that - nothing. Upside : hopefully up to flat or so for the year. Downside : another 30% or more of painful losses. Not a great payoff asymmetry for inaction.
On the other extreme in a Black Hole scenario, however unlikely , there is little to suggest. Capital markets will be illiquid and provide sub par returns for any risk an investor assumes. Capital is going to flock to low yield safe government backed investments while investors save a large percentage of any income and consumption collapses long term. I see this as unlikely for two reasons : the massive balance sheet expansion that puts a floor on assets and gives breathing room for recovery and also the state of technology; in all prior episodes of pandemics people did not have access to the healthcare innovations we have today and could not work productively remotely. Automation was minimal to non existent. That made the effects and the outlook of pandemics much worse in the past.
That leaves the Tunnel scenario as the most likely in my mind but also the best risk management mind-frame. It is more defensive and allows readiness for further negative developments plus optionality for new deep value investments.
In this letter I wanted to focus on the qualitative & risk management implications of various views on the future path of the global economy. A portfolio allocation that is defensive and keeps optionality open could be :
Bonds & Short Term paper : 50%. In terms of bonds, names in telecoms and utilities plus good quality oversold names in non consumer focused sectors. Credit to outperform equity for some time. Developed markets to fare better as funding becomes a struggle for emerging markets.
Equities : 20%. Low debt/leverage names taking into account dividends wont be the same in the next few years and in a lot of cases will go to zero and recover very slowly. Healthcare, Logistics, some tech names, some Gold streaming & miners, some infrastructure. Banks to be avoided - they look cheap but for good reason. The L2/L3 asset skeletons in the closet are quite scary.
Cash : 20%. Short term trades and capital ready for deep value investments any time in the next 2 years.
Hard Assets : 5% in physical gold
Digital Assets : 5% - actively managed portfolio with long bias
FX : USD bias
Revisiting the vol trade mentioned in previous letters :
Volatility is still a sell, however the short suggested in the 80’s is now deeply in the money. Expect a new normal for volatility in the mid to low 20’s.
Again I cannot say too many times that this is the time to rebalance rather than try to pick the bottom and hope for a miraculous recovery to the previous market regime.
Happy to answer your questions and hear suggestions for subjects to explore. I sometimes post quick markets commentary on Twitter and some ideas on TradingView. Feel free to connect with me on LinkedIn.
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We will get through this - keep safe and sane !