It was autumn, and a First Nation tribe on a remote reservation asked their new Chief if the winter was going to be cold or mild. Since he was a Chief in a modern society, he had never been taught the old secrets. When he looked at the sky, he couldn't tell what the weather was going to be. Nevertheless, to be on the safe side, he replied to his tribe that the winter was indeed going to be cold and that the members of the village should collect firewood to be prepared.

Also, being a practical leader, after several days he got an idea. He went to the phone booth, called the National Weather Service and asked, "Is the coming winter going to be cold?" "It looks like this winter is going to be quite cold indeed," the meteorologist at the weather service responded. So the Chief went back to his people and told them to collect even more wood in order to be prepared.

A week later, he called the National Weather Service again. "Is it going to be a very cold winter?" “Yes," the man at National Weather Service again replied, "it's definitely going to be a very cold winter." The Chief again went back to his people and ordered them to collect every scrap of wood they could find.

Two weeks later, he called the National Weather Service again. "Are you absolutely sure that the winter is going to be very cold?" "Absolutely," the man replied. "It's going to be one of the coldest winters ever." “How can you be so sure?" the Chief asked. The weatherman replied, "You should see this First Nation tribe I follow - they are collecting wood like crazy!"

Similar to the Weatherman, financial market participants are constantly on the look for clues about where markets are heading, which in many cases end up being poor signals that give a false sense of security.

As we enter these unchartered economic times as a result of the enormous disruption of COVID19, having the ability to focus on what’s important and taking an independent approach to portfolio management is crucial to avoid additional permanent losses of your capital.

Since the outbreak of this pandemic in February, I have laid out the growing risks to financial markets and the urgency of mitigating risk.

In this note, I explain why we are preparing our clients for a deep global recession that will likely outlast the COVID19 pandemic and the basic outline of our investment strategy during this period.

“The pessimist complains about the wind; the optimist expects it to change; the realist adjusts the sails.” - William Arthur Ward

 

The COVID19 pandemic continues to take a tragic human toll while wreaking havoc on health care systems and economies across the globe. As we warned in our last note in March, different forms of population lockdowns would be necessary to contain the spread of the virus until a vaccine is found, which would likely have a significant impact on financial markets and the economy. As of the 9th of April, confirmed cases worldwide is nearing 1.5 million and is still growing at a double digit rate. Around one third of the global population is now under some form of lockdown and entire industries have been shuttered or drastically curtailed.

Since the outbreak of the pandemic, there has been a debate between those that believe that the economic fallout from population lockdowns will lead to worse long term health and financial outcomes to society and those who believe that allowing a novel virus to ravage through a population is immoral and will likely lead to a collapse of the country’s health system. I do not intend to chime into this debate, largely because both sides have very strong arguments which are hard to counter given the uncertainty around the virus.

Our focus in this note is on what we would like our clients to know about what is guiding our investment and financial planning recommendations from here on.

The most important factor we would like our clients to know - The global economy was already fragile before the COVID19 Pandemic.

One of the factors that makes comparing the economic effects of COVID19 to past pandemics difficult, in our opinion, is the enormous amount of global debt going into this crisis.

According to a World Bank Group report “Global Waves of Debt” (released December 2019 – before the Covid19 outbreak): “The latest wave of debt accumulation began in 2010 and has already seen the largest, fastest, and most broad-based increase in debt globally in the past 50 years. […] All previous debt waves ended with widespread financial crises and coincided with global recessions (1982, 1991, and 2009) or downturns (1998, 2001). These crises were typically triggered by shocks that resulted in sharp increases in investor risk aversion, risk premiums, or borrowing costs, followed by sudden stops of capital inflows and deep recessions.”

Ray Dalio, Founder of Bridgewater Advisors, one of the largest hedge funds in the world, in a July ’19 Bloomberg interview, explained how he envisioned the current wave of unsustainable rates of debt growth ending: “I think that the paradigm that we are in will most likely end when a) real interest rate returns are pushed so low that investors holding the debt won’t want to hold it and will start to move to something they think is better and b) simultaneously, the large need for money to fund liabilities will contribute to the “big squeeze.” At that point, there won’t be enough money to meet the needs for it, so there will have to be some combination of large government deficits that are monetized (central banks printing money to cover government expenditures), currency depreciations, and large tax increases”.

The series of events described in the World Bank report and by Ray Dalio (the external “shock” that caused past crises and how governments are likely to respond) look eerily similar to what we are currently witnessing, even when ignoring the continued increase in costs associated with government pension and health programs that will somehow need to be financed in the future.

As Josh Nye, an RBC Senior Economist laid out in his latest financial report (see attached): “In both Canada and the US we [RBC Economics] think GDP declines in Q2 will exceed 30% on an annualized basis. For reference, neither country has seen a quarterly decline or more than 10% in over half a century of record keeping… The response [to the Covid19 crisis] from fiscal and monetary authorities has also been unprecedented in its size and speed. Central banks have cooked up an alphabet soup of liquidity and lending programs to alleviate stress and improve the flow of credit to businesses. Ultra-low policy rates are back (for those that got away from them) and QE is being ramped up, including by central banks new to large scale asset purchases. Governments have pledged billions in direct support for businesses and households and even more in loan guarantees…”

Although we hope that a medical breakthrough will allow a quick return to normalcy and pent-up demand sparking a quick and robust V-shaped economic recovery, we do not believe it would be responsible to assume it as a base case scenario. On the contrary, our clients should be prepared for a debt crisis of global nature that leads to a deep recession that outlasts the COVID19 pandemic.

For investment and financial planning implications, please reach out to my team.

 

You can find the articles I referenced in this note here:

RBC Financial Markets Monthly – April 2020 – Off the Charts 

Financial Times: The Seeds of the Next Debt Crisis - With debt levels already at a record high, coronavirus raises the risk of a credit crunch in a world of low interest rates - https://www.ft.com/content/27cf0690-5c9d-11ea-b0ab-339c2307bcd4

Interview with Ray Dalio on Paradigm Shifts - https://www.bloomberg.com/news/articles/2019-07-17/ray-dalio-says-gold-may-be-the-answer-to-coming-paradigm-shift

The World Bank - Global Waves of Debt: Causes and Consequences - Dec. 2019: https://www.worldbank.org/en/research/publication/waves-of-debt

Macleans: Coronavirus plunges Canada’s economy into the abyss – April 6, 2020 - https://www.macleans.ca/economy/economicanalysis/coronavirus-plunges-canadas-economy-into-the-abyss/

China's factories reopen, only to fire workers as virus shreds global trade – https://www.reuters.com/article/us-health-coronavirus-china-manufacturin/chinas-factories-reopen-only-to-fire-workers-as-virus-shreds-global-trade-idUSKBN21D0IG