To my clients:
If you have not already, please read my special update from yesterday: Special Update: Summary of Defensive Measures Taken and Road Ahead
It will be a terrible week for North American stock markets with indices likely to finish down in the 15 to 20% range.
I have a meeting at 1pm today and will then be offsite shortly thereafter, so I am sending/posting this update early – hence my inability to cite the exact magnitude of declines above. But, obviously, things were indeed “terrible”.
I wasn’t sure if I would write an update today, but feedback from clients has inspired a further thought or two I’d like to share. I’d also like to look ahead to the likelihood of further portfolio action next week. Let’s get to it.
First, let’s talk about the policy response to coronavirus, and what the goals are. Simply put, the main objective is to slow the rate of spread. Coronavirus spread is likely to exhibit normal bell-curve distribution. Without unnecessarily flashing readers back to high school/university level math classes, a bell curve simply means that there is a normal distribution pattern to most things in life, including catching a virus such as COVID-19. The length of time it takes for that distribution to play out as well as reducing the maximum peak of the curve is what’s at stake here. To these ends, you will begin to see more regular mention of the phrase “flattening the curve” in the mainstream press. Graphically, the goal is as follows:
The healthcare system has a finite capacity. There are only so many doctors, nurses, rooms, and ventilators available to treat people. If too many people contract the virus too soon (the red bell curve), the capacity of the healthcare system is exceeded and more people would die than would be the case if transmission instead follows the distribution of the blue curve. It’s important to point out that the red curve would not just impact people with coronavirus, but accident victims, heart attack victims, stroke victims etc. In other words, the death rate from all manner of life-threatening conditions would increase because of limited capacity..
Absent a vaccine, natural immunity in the population (such as the modest level of natural immunity that exists for the flu), or the development of an effective treatment, the only way to achieve the blue curve is via the actions now rapidly expanding throughout North American society – social distancing. No large gatherings at sporting events, concerts, movies, theatres, parades, restaurants etc. Limited travel. Vastly expanded work from home initiatives. And, unfortunately, school closures. On this last front, I strongly suspect that my young children (ages 7 and 9) may be going to their last day of school today. Spring Break begins after today, and I’m not sure they will necessarily go back before summer. Were this to happen, a lot of parents would be forced to stay home and/or limit their work activity. Needless to say, all of these social distancing initiatives will dramatically slow economic activity.
And the reduced economic activity just described can, and I think will, lead to recession. In normal times, provided the stocks chosen are quality, blue chip, mostly dividend payers, I fully believe in the RBC mantra of “give equities the benefit of the doubt”. But given the disproportionate market declines that accompany economic contraction, recessions are the exception. As clients and readers of these updates will well know, recession has been the economic state that I have been laser focused on identifying so that I could proactively scale back equity (stock) exposure on behalf of clients ahead of such an eventuality. Assuming of course that the coronavirus pandemic does indeed result in recession, then with current client equity weightings sitting at 20 to 30%, I believe I have achieved this objective.
So what now?
Well, first I should note that I added a small 1% weighting to a gold bullion ETF this morning. Not a gold mining ETF, but rather, actual bullion. I don’t intend to go too far down this path (mostly because I do not understand the economic basis of gold other than a significant chunk of the world population believes in it as a monetary alternative), but it seemed like the traditional hedging characteristics of gold might argue in favour of a small allocation at the edges of portfolios. Again, I do not intend for this position to become disproportionate in client portfolios.
Second, there is rampant speculation that the Fed will announce yet another rate cut next week. There is widespread speculation that the cut may be all the way to zero. If so, this implies a 1.25% rate cut! I don’t have time to check right now, but I’m pretty sure that has never happened. Regardless, if the Fed cuts in any size approaching that magnitude, there likely will be an uptick – perhaps a significant uptick – in the markets as a result. While I don’t intend to reduce client equity any lower than current levels, what I may well do is purchase a negatively correlated equity ETF that drops in price when markets go up, and rises in price when markets go down. In other words, if the Fed delivers on the forecast rate cut as well as potentially other quantitative easing programs, this described ETF will drop in price and provide an opportunity to added to portfolios to insulate any potential further decline in markets (which I strongly suspect will happen as the economic impact of social distancing measures becomes better understood and modeled into economic forecasts).
Lastly, if/when further market declines materialize as a result of a sober realization of the economic consequences of social distancing initiatives, I intend to begin opportunistically adding quality names that will be well positioned for the recovery from this current crisis. Because yes, it is a crisis, AND we WILL come out the other side.
I apologize, I went longer than I intended… that’s it for this week. All the best and stay safe,
Nick Scholte, CIM, FCSI
Vice-President & Portfolio Manager
Scholte Wealth Management
RBC Dominion Securities Inc. │ Tel: 604.257.7569 │ Fax: 604.235.9950
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