And Now We Wait...

Mar 15, 2020 | Dann Cushing


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What a moment to be alive. A generation from now, the mass distancing and isolation period upon which we are embarking seems likely to be remembered as a time when the entire developed world made a collective sacrifice...

...for the greater good. The catalyst is obviously unwanted, but the response seems heroic.

From an investment perspective, the question is just how much of a sacrifice will need to be made. More specifically: 1) will this be limited to a 30-60 day pause for the global economy; and, 2) can our financial system withstand the shock in the meantime?

The first question is the more unnerving one for investors since can only be answered probabilistically. Medical research from John Hopkins University indicates 14-days of distancing or isolation should have a major impact in slowing the spread of the virus. Also, spring is arriving and evidence exists that viruses by their very nature have a more difficult time spreading when humidity and temperatures rise. However, until the market sees hard data by way of the “curve flattening” for daily new infections – perhaps as early as this week – the odds of normal spending patterns resuming quickly are further away from 100% than most investors would like.

That said, there are a few helpful factors to keep in mind: 

• A substantial amount of consumption is being deferred rather than outright cancelled, which creates helpful cash implications in industries where customers pre-pay for goods or services (ex. airline tickets);

• The US consumer has been driving the global economy, and US household balance sheets remain strong relative to before the Financial Crisis;

• Debt problems are most frequently triggered when payments are missed, yet interest rate are low and rapidly falling; and perhaps most importantly,

• There is an important social difference for banks and lenders between the current situation and 2008 – it is one thing to impose a day-of-reckoning on irresponsible housing speculators, but who wants to be in the news for forcing business or families into bankruptcy when the world is working together to stop a health crisis?

A separate event with a more predictable implication for spending was the power-play by Russia earlier in the month to increase oil production. Implemented at the most damaging possible moment for many economies, the move presumably will be a lasting one since Russia faces a long-term win-win from the pain inflicted: either they gain important political concessions such as the removal of US sanctions; or they cripple the North American oil industry allowing themselves and OPEC to eventually regain pricing power. 

An estimated $200B of capital is spent annually in the US on oil and gas production, which equates to 1% of GDP before including the multiplier effect from employment and wealth effects. That number is now virtually certain to contract meaningfully. However, it also comes with a major offset: the drop in oil prices for consumers and business around the globe equates to a massive fiscal stimulus package. After a period of rebalancing, the stimulus should outweigh the pain. For example, JP Morgan now predicts a net 0.3% increase for US GDP in 2020 resulting from lower oil prices. The impact in Canada is somewhat more negative, although the benefit from a weaker currency is an added offset.

As for the second investment question mentioned above – “Can our financial system withstand the shock in the meantime?” – the past week provided a hopeful outlook. Thursday and Friday were two of the most severe trading days in history. As always, in the midst of it there some odd anomalies: many ETFs traded at a wide discounts to their net asset value; investment grade bonds declined more sharply than during the financial crisis; and even the price of US government debt started to decline, which is the exact opposite of what typically happens during a flight to safety. But when the Fed offered up a $1.5 trillion liquidity facility for banks, barely 5% of it was used – hardly a sign of a systemic need for cash.

All of this implies that while the price of risk was hit hard last week, access to cash was not. This is exactly the trade-off that regulators have tried to create over the past 12 years by limiting the amount of inventory that dealers can hold for their own accounts. Finding a buyer in moments of stress is harder now, but at least you don’t have to worry about the solvency of the whole system.

So – with all of that as context, a couple of thoughts for the days and weeks ahead:

• Following the 20 worst trading days in history for the S&P 500, 90% of the time equities dropped even lower at some point over the following three months before rebounding. That says something about human nature. It isn’t unreasonable to think that we may hit another pocket of fear before we start to see infection data turn, or even if the data do turn but don’t do so relatively quickly or uniformly. At a minimum, Friday’s effervescent 9% recovery seems premature.

• At the same time though, using Thursday’s closing price the S&P was trading at a price-to-earnings ratio of ~15x on trailing earnings. That is the lowest level since markets emerged from the aftershocks of the European debt crisis, and in-line with the prior crises-of-confidence that have occurred over the past 10 years. We might not be out of the woods yet, but equities are now certainly pricing in a decent amount of risk.

What that appears to leave us with is a highly uncertain environment, but one where there remains factors tilted in favour of a relatively positive outcome and where valuations seem more reasonable (using Thursday’s close, at least). Given that, patiently starting to pick away at buying equities with fresh cash seems to be in order. As we eventually emerge from the current environment, corporate characteristics that are likely to fetch strong equity valuations remain those who are cash rich (offering security plus the ability to invest while competitors are recovering), dividend growers with an adequate yield (which will be attractive in a low interest rates environment), and as always companies with growth stories that are fairly independent of the overall economy.