Recovery Investment Strategy

This recovery investment strategy should not be one’s entire investment strategy. A diversified asset allocation driven strategy should remain the core of the whole strategy. However, a dedicated strategy to address the current dislocations and distress can not only be profitable but provide capital where it is needed. This investment strategy seeks to maximize returns relative to risks in the specific context of recession and eventual recovery. 

 

Contagion

The stages of the viral contagion are introduction in the human population, transmission, pandemic, containment, remission and extinction. Society’s response will cycle through ignorance, discovery, panic and understanding. What is highly uncertain is the timing and duration of these various phases. Against this uncertainty, one has to construct a robust investment plan.

 

Social, Political and Economic Phases

Society will cycle through denial, panic, action, normalization towards a new equilibrium.

Government will progress through inaction, panic, containment, normalization and amortization. The economy will evolve from an old equilibrium to panic, recession, recovery and a new equilibrium. Again, the timing and duration of these various stages is highly uncertain.

• Government debt levels are already too high. And are rising fast.
• Real value of stock of debt needs to be eroded by inflation or devaluation.
• Steeper term structures will result.
• More FX volatility. USD initially strong, then to weaken.

Economic policy is already engaged. The lessons of 1929 and 2008 have been well learnt. Monetary policy has been engaged aggressively and may be amplified. That rates are at zero and central bank open market accounts are heavily loaded with securities may mute the efficacy of monetary policy. Nevertheless, no effort will be spared.

Fiscal policy has been engaged to address unemployment and wages. It is likely that fiscal policy will move beyond these initial emergency measures and expand significantly to a higher level. Expect larger deficits across the board. Tax rates will have to eventually rise, and tax codes be more progressive. Sovereign credit risk will be ever present, and accidents could happen, especially in emerging markets. On a relative basis, differential credit strength will likely manifest in exchange rates. Hopefully, countries will coordinate fiscal support with an eye on exchange rates, otherwise FX markets could become volatile. Basically, society has to view countries as roughly equally weak, or equally strong. Any breaking of ranks could result in FX volatility that could require a Bretton Woods redux. Monetary and fiscal policy will be coordinated to encourage inflation which would help to manage the real value of national debts, which will already be surging.

• Corporate debt levels are too high.
• Debt levels need to be reduced. This can only happen through default, repayment or restructuring.
• De-globalization and increasing robustness of supply chains through greater redundancy will increase inflationary pressures.
• Greater credit dispersion and lower credit correlation.
• Good supply of distressed debt. Multi-year opportunity.

The economy is already in recession. The severity is expected to be acute given the sudden and widespread nature of the suspension in activity. A -4% GDP growth number for FY2020 is reasonable to expect. The trajectory of the economy is likely to be U shaped, if this type of characterization is useful. Consensus has postulated L, U, V, W shaped trajectories from recession to recovery. Given human ability, recovery is inevitable, but time frames are uncertain. The duration of recession is one of the most important variables. Investors appear to expect a trough sometime from Q3 2020 to Q1 2021. It is prudent and reasonable to expect the trough to be at the later end of estimates and perhaps even beyond by a quarter or two. The new equilibrium is difficult to picture at this point and will be the subject of another discussion.

• Taxes to rise and be more progressive.
• Household debt levels are relatively conservative.
• Latitude for increasing leverage.
• Consumer debt funding costs must be suppressed. More tranching with senior to outperform.

Households will begin the crisis with balance sheets in better shape than corporates or government, however, the impact of the pandemic on employment and wages will be severe. Direct unemployment benefits, temporary universal basic income and indirect support via wage cost subsidies to employers will be provided by government, further stressing the sovereign balance sheet. This will of course require funding in the form of inflation and higher taxes. The tax code this time can be expected to be more progressive, not by reason of equity but of necessity. Expect also wealth taxes to tax the equity on consumer balance sheets.

 

Markets

Equities tend to lag in the recovery. The first loss nature of equity, the need to discount cash flows further into a more uncertain future, and the highly liquid and high retail participation nature of equity markets will make them volatile and less attractive under such high levels of uncertainty.

Credit tends to lead in a recovery. The seniority of claim, the finite maturities, and the less liquid and less retail driven nature of credit makes it less volatile and more attractive under uncertainty.

Duration is a risky bet. Given higher expected inflation (from more robust but less efficient supply chains, and the incentive for government to encourage inflation when debt to GDP levels inflate acutely,) term structures are at risk of steepening significantly.

FX risk will be high. Every country will attempt to inflate and devalue, but not too much. This balance is fine and risky, and a failure of confidence can become an overriding dynamic which could drive rates and FX volatility beyond acceptable bounds. Generally, and on current data (Q1 2020) one expects the USD to strengthen, perhaps for the next 2 to 3 years, and then to subsequently weaken. If sufficient investors hold the same view, take 1 year away from those time frames.

 

Investment Plan:

Credit dislocation: Q2/Q3 2020

These are opportunities arising from de-leveraging in certain asset markets which were initially over-leveraged. The result of excessive leverage and unstable liquidity has led to price falls to such an extent that current pricing excessively discounts even highly draconian commercial assumptions.

• Investment grade CLO bonds.
• Syndicated loans
• MBS, including reperforming loans, agency RMBS, CRT RMBS, CMBS and non-agency MBS.
• TALF 2.0. The US government, specifically the Fed, is providing cheap financing to investors who are willing to bear some risk in financing US ABS. Basically, the Fed is holding itself out as a cheap and cheerful prime broker for the above assets.

 

Distressed Debt: Q3/Q4 2020

The speed of the COVID19 pandemic and the collapse in economic activity has yet to fully percolate through asset markets. Some markets are even rebounding strongly on the news of government support. However, the reality of economic recession will come to bear. It just hasn’t yet. Distressed investing involves identifying the junior-most security that does not face a full write down in a winding up or restructuring scenario. This is rarely in the equity and mostly in the senior or the secured debt. The writing down of the junior most capital provides a degree of safety to new investors.

• Traditional distress debt investing, including performing and non-performing debt where one lends for control.
• CLO equity and mezzanine. While the investment grade tranches are attractive, once defaults actually occur and impact CLO collateral tests, the junior tranches will likely sell off even more than they have.
• Private credit has been in vogue in the last 5 years to the extent that too much money has been channeled into a crowded market. The funds will need to maintain the leveraged financing, and some existing LPs may need liquidity. This presents an opportunity to provide refinancing or to purchase secondary LP units in private credit.
• Real estate opportunities will also present as real estate is naturally leveraged and may require refinancing or rescue financing. Another adjacent strategy is to provide corporate capital relief through sale and leasebacks.

 

Equity Deep Value and Recovery: Q3/Q4 2020, Q1/Q2 2021

Depending on where public equity markets have traded, a case may be made for buying public equities. At current valuations (circa 20X earnings) equities are acutely expensive both in absolute terms and more so in the current context of recession.

• If equity markets sell off more acutely, good value might present.
• Private equity also suffers from over-exuberant pricing and terms. If private equity valuations revert and overshoot, there may be a case for buying. There may be attractive opportunities in PE secondaries.
• In recovery, consolidation, rationalization, and buy outs will be attractive once again as a new expansion cycle begins.

 

New Equilibrium: Q2/Q3 2021

It is unlikely and not entirely desirable that the world should revert to the condition it was in before the COVID19 pandemic. The human race should be, and is prone to, advancing and improving itself. For investors, the difficulty will be predicting not only the pace of the recovery, which is hard enough but its shape. New industries will replace old. There will be new regulations, new structures, new institutions, possibly a whole new way of living lives. Public equity markets will lag in capturing these thematic developments.

• Generally, the New Equilibrium opportunities will be more easily found in Venture Capital and Early Stage growth private equity.
• Technology and biotech will be areas of development. As society prioritize employment, a healthy and educated labour force will become more important. Education and Healthcare will be areas of focus and opportunity.
• Real estate will also be changed by the pandemic. As significant portions of society work remotely, commercial office real estate demand will be changed. The physical structure and scale of offices will be changed. Technology particularly in AI and robotics will change the nature of industrial real estate from manufacturing to storage to distribution. Even residential real estate will change around our response to climate change, to health risks, to evolving distribution chains and to the nature of work.

 

Risks and Contingencies

 

The Pandemic resolves quickly:

One clear risk to a recovery investment strategy spanning multiple quarters if not years is that the COVID19 Pandemic resolves quickly. A cure or vaccine may be invented. The pandemic may burn itself out, organically, or it may meet an unforeseen natural mitigant, the weather, a competing pathogen with more benign mortality, some physical factor. Or a cheap and quick test is found allowing life to return to some normalcy with minimal interruption.

A contingency plan would involve having pre-arranged credit lines against the illiquid assets in the portfolio allowing one to quickly reposition into a long equity beta posture. A ready shopping list is of course useful, populated by risk-on assets such as equity index or high yield ETFs.

 

Monetary policy exhaustion:

Given the scale of monetary stimulus, even before central banks have had the opportunity to roll back the policy responses to the 2008 crisis, the risk of monetary policy exhaustion is significant. Hyperinflation, rising interest rates, steepening yield curves could result. Inflation linked bonds, floating rate debt, interest rates swaps and swaptions, are tools needed in the kit before the event.

 

Fiscal policy exhaustion:

The debt mountain in the economy was clear before the pandemic. The massive amounts being spent on emergency support for the economy are substantial, by Q1 2020, the US has budgeted 11% of GDP in stimulus, Japan some 20%. These initial fiscal support programs will not be the end of it. Further deficit spending should be expected. The funding of these deficits once the pandemic is contained and once the economy has stabilized will be questioned. Hyperinflation and FX volatility are real risks. One should consider FX hedging options and where one can avoid such currency and country risks altogether.

 

Inflation:

Heavily indebted governments will seek to inflate their way out of debt. Deglobalized supply chains, more robust supply chains with more built-in redundancy will encourage cost push inflation. Hedges such as inflation linked bonds, gold, interest rate swaps and floating rate debt instruments should be included in the toolkit.

 

Taxes:

As national debt levels surge so too will taxes. Investors need to do periodic and continuous tax planning, reviewing their investment holding structures so that they pay fair levels of tax but are not paying more than they expect or should.

 

Expropriations, Prohibitions and other Weird and Wonderful Beasts:

These are extraordinary conditions and extraordinary things can happen. It was in 1933 that President Roosevelt passed executive order 6102 prohibiting the hoarding of gold. The Bretton Woods currency system (1944-1971) was enacted in wartime. The recession triggered by COVID19 is still in its early stages and its evolution is highly unpredictable. One can only guess at the strange innovations that could beset us; fixed maturity currencies, a new system of fixed exchange rates anchored by the RMB, the mutualization of Eurozone sovereign debt via covered bonds, the establishment of a Federal Corporate Finance Agency to guarantee loans, tax receivables securitizations, the abolition of freehold property, and other seemingly outlandish ideas.

 

Growth is much worse than expected:

The central scenario behind this recovery investment plan is already gloomy. Even so, the risk remains that reality is worse. The economy could take 3 to 4 years to bottom. The recovery, when it happens, could be very slow with global growth below 2% per annum. The stressed conditions could exacerbate the US China rivalry, perhaps precipitate proxy wars, or war could arise elsewhere where we don’t expect it. The EU could fragment as adversity tests the integrity of the union. China could be widely blamed for the COVID19 pandemic leading to economic sanctions with global consequences. The economic stress could amplify feelings of inequality and injustice fueling localized civil unrest. Nationalism, trade war and protectionism could rise.

Many of the assets in the recovery strategy are illiquid and of long gestation. These will need to be hedged. Liquid investments can be sold, at a cost. Where investments are maintained they should be senior in claim, higher in credit quality and lower in equity beta. Gold will be a sought-after asset.

 

Long Term Possibilities:

Human response to adversity is to either cooperate or compete. The actual response will be difficult to predict and will be different in each context. The COVID19 pandemic presents us with acute adversity which will test the direction we take. Already, in the last 10 years, globalization had been in decline as nations sought to be less interdependent and more self-sufficient.

The supremacy of the US dollar may face a challenge from the Renminbi. China faces the trade-off between internationalizing CNY but relinquishing some control or maintaining control but sustaining the dominance of the USD. The challenge may not come from CNY but from some hitherto non-existent digital currency, sponsored by America’s rivals, or disenchanted friends.

Supply Chains: Efficiency X Robustness = a Constant. Supply chains to be restructured for more robustness. This implies diversification of supply chains, and to some extent, self-sufficiency. The robustness of supply chains need not imply self-sufficiency but can be achieved by diversification, not just geographically but between labour intensive and automated. Costs likely to rise but there will be increased capex as well.

Automation and Labour: Automation has already been increasing and the pandemic and lockdowns will only accelerate the adoption. There will be immediate adverse impact on labour potentially to the extent that the right to own automata is questioned. Artificial intelligence can both extend or replace human ability. General AI’s ability to do both will be extended with consequences on how we live and work.

Centralized versus Decentralized Planning. Conventional economics contends that decentralized decision-making results in the best outcomes. With higher quality and quantity of data and the tools available to big data, the constraints upon central planning are significantly mitigated. As information tends asymptotically towards perfection, central planning may yield superior outcomes to the second-best solutions of decentralized planning.

Everything we do, our consumption, or work, our investments, our private, social and professional behavior, has an impact on everything else, whether we are aware of it or not. Every investor is already an impact investor, the question is whether they are consciously doing so in a responsible way or not.

The microscopic impact investment goals are well known. How much can we reduce poverty by, how many more mouths can we feed, how many people can we keep healthy, how many minds can we educate, how can we promote racial and gender equality, how can we power the world without destroying it, how can we get more people to work and consume, how do we build an equitable society, maintain and preserve our habitat, and promote collaboration amongst all peoples.

There are macroscopic impact goals as well. To see what they are we need a clearer view of what existence is and means, and the place of sentient beings within this ecosystem. The primal essence of existence is information. The whole of existence is not only information but the processing of it to achieve progress, learning, wisdom.

Each sentient being represents consciousness which can be thought of as collections of information that are self-aware, to varying degrees. Humans occupy a high position in the ordering of consciousnesses. We can store and process more information than most other living things. Yet even human beings are subject to severe limitations in intelligence and wisdom. We are the zoological analog of neurons, or transistors. We have limited knowledge of general conditions around us, limited access to information, and limited information processing power. We are not even sure as to our greater purpose in life. We have been endowed with certain abilities, limitations and impulses. We seek fulfilment and purpose to flourish yet know not our precise purpose. We resemble transistors in a microchip. If the purpose of the microchip or computer is to solve some macro problem, it is the purpose of the transistor to solve a part of the problem and transmit the result on to other transistors.

Humans therefore have a duty to receive information, in all its forms direct and indirect, process it, and transmit it, by our thoughts and actions. The collective action of humans in this endeavor serves the greater purpose, even if that purpose eludes the individual. We are therefore duty bound to behave rationally and collaboratively. This is hard because rationality is not well defined or unique.

If we accept that our role is the processing of information, certain macroscopic impact goals present themselves. To obtain information, we must both actively seek it as well as be open to its receipt. To process information, we must have learning. To transmit the information post processing, we must be responsible. To be efficient and effective, we must collaborate. To collaborate requires humility and a recognition that we are one of a multitude of transistors.

Obtaining information involves learning, obtaining and retaining facts and data. It requires curiosity. The quality of output is highly dependent on the quality of input so obtaining high quality information, ensuring it has sufficient content, is not contaminated, is relevant and unbiased, is important.

Processing information requires that we develop and constantly upgrade an efficient program. This involves a lifetime of continual learning. The output of this program is how we react to all external stimuli, the general conditions that surround us. Our actions form part of the input for others, perpetuating a chain of information processing that permeates all consciousnesses.

All this sounds theoretical and impractical, yet these concepts can inform a set of principles by which to invest.

Investors need to invest in knowledge and fact. One must always know what one is investing in. One needs sufficient and high-quality information to make sound decisions. Information which is highly concentrated and multi-collinear is less informative than diverse and independent data. Information needs to be taken in context; some information exhibits different behavior under different regimes and such artefacts need to be considered in the processing of the information. Basically, this just means that one must have as much of the facts that one can get, that the facts are not simply repetitions of the same, and that the facts are taken in context. The obtaining of information has to be circumspect. Too little data and the conclusion will be unstable. Too much information risks a false sense of security surrounding conclusions. Taking information out of context also impairs the reliability of conclusions.

The best investment is in rigorous understanding. Investors need to understand how the economy functions and how businesses and assets are priced. This has its bases in economic theory, finance, and behavioral science. In addition, common sense is an oft-overlooked ingredient in the recipe. Armed with the ability to make sense of the information before them, the investor is better able to make rational decisions on what to buy or sell.

Some industries appear contrary to the well-being of humanity; should the responsible investor fund them? Tobacco, gambling, munitions, alcohol are potentially detrimental to well-being. What about high fashion which feeds vanity, or travel which has a high carbon footprint and can hurt certain habitats and communities, or pharmaceuticals which charge exorbitantly for their drugs? Is technology a bane or boon? Will robots replace or augment?

The impact of our actions may be unpredictable, their net effects indeterminate for years to come. Many impact investors demand measurable impact in short time frames. We can only guess at some of the impact our actions will have, a year or decade or a century into the future. Decision making under such uncertainty, amplified by the long time frames is difficult and humbling. Intractability may discourage action, which is itself a negative impact. Often, life presents us with tradeoffs and asks that we balance the costs and benefits as best we can. The optimal solutions are known only far in the future. The best we can do, it to be mindful of our actions, to collect information assiduously, process it thoughtfully, and to act responsibly. If we do so, we will have as good an impact as can reasonably be expected.

Micro-goals can be pursued more specifically but even these can sometimes suffer from unintended consequences and adverse selection. Some of the UN’s 17 Sustainable Development Goals are mutually incompatible in specific contexts. The cost of carbon emission reduction may be a price too high for certain less developed countries and would result in negative social and economic outcomes. Hydroelectric renewable energy displacing communities, responsible labour practices impair household income and employment, price controls in pharmaceuticals depriving R&D budgets, are examples of the complex relationships in societies.

Another issue is that measurement has its limitations. Campbell’s Law states: “The more any quantitative social indicator is used for social decision-making, the more subject it will be to corruption pressures and the more apt it will be to distort and corrupt the social processes it is intended to monitor.” Goodhart’s Law states: “Any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.” These and the Lucas Critique are warnings that goal setting in impact investing is not easy and that sharply defined impact metrics can have unintended consequences.

These limitations and difficulties should not discourage us from investing responsibly or consciously. It means that we have to do the best we can, a vague principle but one that can guide our methods.

To invest responsibly, we should do so in an informed way, which means data collection. To collect data, we first have to know what is important to us. Investors seek to make money, so the financial rationale is the central objective. However, the investor should also determine all those other factors that are important to them. Environment, Social and Governance factors are one classification which has made responsible investing more systematic. Conceptually, the investor should consider all the impacts that their actions can have, from the environmental, social, political, physical and economic. A mental or systematic appraisal of a course of action should consider if that action has positive or negative consequences to these factors. Sometimes it will be possible to clearly define and measure this impact, and other times, it will be difficult, and a qualitative and subjective determination will have to be made. Once all these objectives are defined, the nature of the data required to make these determinations will be better understood and the investor can proceed. Understanding the priority and tractability of the objectives also puts the data in context and improves data collection advising when precision is required and when a rough sense will do. Inappropriate prioritization of data can confound analysis as much as insufficient data.

Analysis and decision making requires understanding the underlying relationships and interactions represented by the information. The analysis should always begin with an exploratory approach rather than seeking to justify preconceptions. Even so, biases are inevitable and should be recognized so that results can be understood in context. An exploratory approach can either be structured where a theory is being tested, or it can be strongly exploratory where a theory is sought. It can be parsimonious (start narrow and widen) or it can be comprehensive (start wide and focus.)

For the responsible investor, those non-financial objectives will need to be considered. The consequences of the profit optimizing solution on the environment, society, economy and on the investor themselves, needs to be considered. It will not always be possible to have a positive impact on all factors, or indeed on the majority of them. Prioritization and judgment are important. Most important of all is that the investor is behaving conscionably, diligently and honestly. That honesty is very important and regards an awareness of one’s own limitations and the limitations of the operating conditions.

 

Some principles (including some general, non-impact specific comments):

• Recognize that balance is central in decision making. Processing information under uncertainty invariably requires balance.
• Make as much money as possible, but sustainably over long horizons. Successful investors are efficient processors of information. Financial success increases capital and thus the strength of signal from such investors. If you are also a philanthropist, you can always give it away.
• Realize the trade-off between efficiency and stability.
• Have a net positive impact across environmental, social and economic goals, minimizing damage and maximizing benefit.
• Have all the relevant facts and recognize which ones are more important than others. Spurious and over-analysis reduces the informational efficiency of the system.
• Recognize that one’s actions are a source of information for all agents in the system (oneself included) and avoid actions which might reduce or impair the informational efficiency of the economy.
• It is possible to bootstrap this informational process by taking actions to send information to oneself.
• Avoid over paying for assets simply because other agents are doing so.
• Avoid hoarding liquidity when the economy may require it.
• Arbitrage reduces arbitrage opportunity and thus improves information efficiency.
• Diversity of information is a good. Introducing diversity is the basis of contrarian investing. When informational diversity already exists, the benefit of adding to it is reduced.
• Crowded trades reduce informational efficiency.
• Analysis without action impairs the informational efficiency of the system.
• Emotions are a source of information, but should be processed rationally. The emotions of others can be mined if one is not similarly emotional. One’s own emotions are more difficult to process given their self-referential nature.

 

Thus the investor may invest with positive impact, always acting with mindfulness, cognizant of known unknowns and unknown unknowns, and never acting carelessly or neglecting the greater purpose. These principles may appear to be general and lack specific impact objectives, but they encourage the efficient processing and transmission of information, which is an important macroscopic impact objective. 

 

 

 

The Outlook Under The Shadow of COVID 19

7 Apr 2020

 

How is 2020 different from 2008?

2008 was a US housing crisis distributed globally by the banking system.

US housing was overvalued and over leveraged. The mortgages they supported had weak underwriting and credit standards. Banks from Europe and Asia had entered the US market and were thus exposed. The resultant housing market crash led to a banking crisis which led to a credit squeeze causing an acute recession.

2020 is a massively distributed, spontaneous economic shutdown caused by a virus pandemic.

Most assets are overvalued. Corporate assets from equities to bonds to commercial and industrial real estate are over leveraged. The exception this time is the banking system which has spent the last 12 years in rehab and are thus stronger than the non-financial corporate sector.

In 2008, the prescription was to save the banks and to restore the credit transmission system. The alternative credit conduits were the bond, loan and ABS markets. It was important, therefore, not only that interest rates were low at the short end but across the curve as well. Also, investors had to be encouraged to increase their risk appetite and move down in credit quality. Enter QE and financial repression. Once credit transmission was restored, the economy would heal itself. It did, to a point.

The 2020 recession will require different medicine. Failure to withdraw QE once the economy had recovered from 2008 has meant less capacity and efficacy of additional monetary stimulus. The nature of the problem also presents challenges to even conventionally unconventional monetary policy. Such policy was designed to address a failure in the credit distribution system. But either a) the non-bank credit infrastructure is breaking, and the old policies are useful for restoring it but no more, or b) it is not breaking and policy is in a sense wasted. The complacency of people and markets have resulted in a shockingly fast sell off that has threatened the functioning of the credit markets from treasuries to commercial paper, from corporate bonds to mortgage bonds, from loans to structured credit, and from high yield to investment grade. The Fed has stepped in to do what it can, and it has had to prioritize to minimize moral hazard. Avoiding it altogether is impractical. The result is that by early April, a month from the steepest market corrections, and albeit rather shakily, the non-bank credit system is functioning.

The 2020 COVID 19 pandemic prevents people from working and spending. Restoring some normalcy will require the invention of a cure, a vaccine or an organizational change to how we live our lives. We do not have much visibility into any of these 3 avenues. The current approach appears to be to limit the spread of the virus by reducing the opportunity for contagion. This severely limits the ability for people to work or spend. People who are unable to leave their homes and socialize cannot consume as before. This represents a large-scale reduction in demand which puts strains on business and threatens large-scale unemployment. This has already begun with jobless claims in the US reaching almost 7 million at last count. The same physical constraints on mobility limits the ability of people to go to work resulting in a significant supply shock. Absent exogenous shocks, demand and supply deficiency means recession and an uncertain inflation outlook.

Many countries have begun massive fiscal stimulus programs. These include some form of universal basic income paid directly or indirectly via businesses. On balance, this is inflationary and can lead to FX volatility.

 

Is there hope?

Human ingenuity is a powerful thing and it is likely that a solution to the COVID 19 virus will be found as well.

Even before the virus is tamed, people will find new ways to live their lives. Humans have been reminded that pandemics recur and that there will always be a new disease and challenge. People will have to find new ways to work, to consume and to interact with one another.

In 2019, there were many instances of social discord: Gilet Jaunes in France, anti-extradition protests in Hong Kong, pro-independence in Catalonia, tax protests in Lebanon and Brexit. The world was clearly divided, to a great extent due to inequality. Adversity has been known to unite people, and COVID 19 is a global blight afflicting everyone. There is an opportunity here.

China may extend aid, financial and technical, to the rest of the world given its relative success at containing the pandemic. It may take advantage of America’s isolationism and nationalism to advance an agenda of engagement with the rest of the world.

Europe. A monetary union without fiscal union was unusual. The massive fiscal stimulus programs launched at the national level will place countries balance sheets under differential stress which will manifest in sovereign spreads. This may encourage Europe to consider a fiscal union.

Environmental and social factors may be prioritized in development and investment. Unrestricted development can be risky with unforeseen consequences. The destruction of natural habitats leads to closer interaction with new species often allowing a pathogen to migrate to human hosts. This is the likely path of COVID 19. Perhaps the pandemic may encourage more thoughtful development strategy.

President Trump’s clumsy management of the COVID 19 pandemic in America may see him replaced by a more thoughtful and moderate President who can turn the considerable resources of the US to more constructive engagement of the rest of the world.

 

What are the risks and challenges?

Adversity presents humans with two choices, unite to overcome that adversity, or pursue a selfish, isolationist policy.

In all major upheavals there are winners and losers. Millions of jobs have been lost around the world and many of these will not come back. Millions will have to adapt, and not all successfully. The cost of welfare will rise substantially straining public finances. The social implications could be serious and could lead to political turmoil.

America faces a Presidential election in November. There is a chance that the incumbent Trump may try to delay or disrupt the election on account of the COVID 19 pandemic.

Europe’s fiscal stimulus may encourage some member states to seek a fiscal union which other members may be reluctant to fund.

The existing competitive tensions between China and the US are a risky backdrop to geopolitics. America may use COVID 19 as an excuse for confrontation by seeking to pin the blame on China. This scenario may spawn other difficult scenarios.

Many developing nations are ill-equipped to deal with the economic fallout from the COVID 19 pandemic. Sovereign defaults and devaluations could destabilize economies and regimes.

Economic support programs are dealing with a problem which is hard to measure. The initial programs dealt with liquidity and cash flow needs. They are also reacting to the human cost of the pandemic and extrapolating to the economic cost. Subsequent stimulus will need to be calibrated to deal with the recession. Macro data is too low frequency to be an effective guide.

Massive monetary and fiscal stimuli to support demand while supply constraints persist could lead to high inflation while having limited impact on demand.

Crises that involve massive fiscal and monetary stimuli often precipitate rethinking of currency systems, such as the Bretton Woods system in the aftermath of WWII.

 

What are the opportunities and threats?

The scale of the economic crisis could encourage a rethink about how people live, how production is organized and the nature of constructs such as money, or companies, or economic systems.

We might already live in a post scarcity world. Here we define post scarcity to mean that we have the means to satisfy all human needs, not wants. Nothing can satisfy all human wants except a radical change in mindsets. The problem could lie in that we do not yet live in a post monetary world. We have all we need but the claims on these things have been poorly distributed leading to poverty and surfeit. How do we get from current conditions to those post scarcity conditions?

The massive printing of money may render the stuff worthless. Yet we do not know how to organize an economy without money. When major currencies begin to lose value alternatives may be sought. A currency that discourages hoarding might be useful. This might be effected by issuing a digital currency with a maturity limit on legal tender, for example.

Humans are adaptable and will find workarounds to live through the COVID 19 pandemic. Some of these workarounds will become a normal part of life as we emerge from the pandemic. Humans require food, shelter, interaction, entertainment and work. Essential supply chains will need to be made more robust through redundancy and compartmentalization.

Technology and automation can help. On the demand side, online shopping has already made serious inroads in replacing brick and mortar retail. Some goods and services do not lend themselves to online transactions. Travel, F&B and other experiential services are examples. Technological solutions such as augmented and virtual reality may present alternatives. Delivery will evolve as well from manned to unmanned drones. Manned delivery might well become a luxury.

Manufacturing will be increasingly automated with the displacement of labour. Smarter AI and more generally applicable automata will make factories even more automated with less and less human intervention.

There will be significant changes in real estate. Already, people are discovering that they can be effective working at home. The demand for commercial real estate will likely not recovery pre pandemic levels. Residential real estate will be priced not as much for proximity to cities and work, but to recreation and natural features like rivers, parks and hills. Population density will become a factor. Industrial and logistics real estate will also see change as manufacturing and distribution dynamics change.

 

What are the practical implications for investing?

We now know how quickly the virus can spread and how dangerous it is. In that knowledge we have reacted by shutting down swathes of the economy on a global scale. This suppression is working at slowing the spread of the virus and case numbers are already beginning to slow. Some countries are even considering relaxing physical distancing measures. However, we do not know at what level we can operate the economy without allowing the virus to resume its spread. We do not know how quickly we can restart the economy.

Financial markets reacted to the initial shock by selling off acutely, at a pace comparable to 1929 and 1987. Fortunately, governments responded with massive stimulus and relief programs worth trillions of dollars. This has restored some order to the markets and even prompted a sharp recovery in certain more liquid, retail accessible and sentiment sensitive markets like public equities and bonds.

Less liquid and more leveraged structured credit markets such as CLOs and ABS have seen prices fall more acutely to levels which suggest they might offer value.

It has only been less than 2 months since markets began to take the COVID 19 pandemic seriously. The future of the global economy remains very clouded and there is much we do not know. It is likely that emergency financial aid continues for the foreseeable future, until either the economy stabilizes, or a sovereign balance sheet breaks. It is likely that unemployment will be persistently higher as some industries fail to fully recover. It is likely that the economy is already in recession and that such recession will persist for another 2 to 3 quarters. It is possible that such recession lasts longer than that. It is likely that growth will not regain pre pandemic levels for some length of time.

The outlook for earnings growth is therefore negative and uncertain. The ability to forecast cash flows for any length into the future is poor. Therefore, for long duration assets or equities, valuations need to be significantly discounted. Shorter maturity assets less reliant on long horizon forecasting are preferred.

 

Summary:

Equities are probably cheap, except that visibility of earnings is very poor, and its hard to discount cash flows that are unpredictable into the distant future. That said, equities have the most volatility when it comes to recovery. Then its probably prudent to await clearer signs of recovery and miss the first days of recovery, which are more of speculative than investment.

IG bonds are probably cheap, and visibility or cash flows is average to poor. The duration that comes with IG bonds may not be an effective hedge if inflation flares up.

HY bonds are fair on a default and recovery adjusted basis. Cash flow visibility is very poor and the defaults have yet to even begin.

Mortgage Backed Securities. This is not a single market but a spectrum of them from agency to non-agency, from IG to HY. The price declines generally across all submarkets of ABS suggests that there is some real value here. Automatic, systematic selling due to deleveraging or ratings limitations have led to indiscriminate selling and assets trading below fairly draconian economic assumptions. Investors need to calibrate their allocations to their convictions.

Syndicated loans. Loans are probably cheap with fairly good visibility to cash flows. There will be downgrades and defaults but market pricing is assuming very severe default and recovery assumptions relative to historical experience and underlying economic prognoses.

CLOs are an interesting structure over syndicated loans. These have also been the subject of automatic, systematic, rules based selling which has led to dislocated prices. Current pricing also implies very draconian default and recovery assumptions. IG CLOs have fairly predictable cash flows and are attractively priced. HY CLOs and CLO equity are also very attractively priced but are subject to very uncertain cash flows and are likely an opportunity for later in the cycle of this crisis.

Distressed opportunities such as traditional corporate distressed investing, chapter 7 and 11 solutions, are probably an opportunity for later. The proliferation of covenant lite debt will delay actual default until non-payment which is likely to come 2 to 3 quarters later. This has the potential to be a multi-year opportunity to rescue some fine, viable operating business which had over leveraged themselves in the decade of cheap debt.

Private market opportunities will be dealt with separately in another post.

 

Even assuming one had lots of cash to invest, its not easy. Liquid markets like equities and bonds are volatile and sentiment driven. There may be a quick recovery or another leg to the crisis. A more tractable approach is to seek structural instabilities. We seek opportunities in the shadow banking system, especially those parts which may be over-levered. Private credit is one area of opportunity where more recent vintages were levered and vulnerable to unwinding. Weak structures can provide a supply of cheap assets and weak LPs a source of cheap secondaries. Structured credit (CLOs, MBS, BDCs and mREITs) is another area where lack of liquidity, over-optimistic pricing, and ratings driven investors conspire to cheapen these asset classes well beyond their fair value even under draconian economic assumptions. It is tempting to trade the more liquid and volatile equities markets for recovery but the speed and uncertainty of price discovery makes this very risky. A longer term investment strategy should look for a more sustainable supply of cheap assets which can be tapped for months and years and this would target the private markets.