The following insights from our sub-adviser, Wellington Management, feature the latest from their macro, multi-asset, fixed-income, equity, and commodities teams. Use the links below to jump to your area of interest.
Macro views NEW UPDATE
This page will be updated on an ongoing basis as events warrant, with the most recent insights at the top of each section.
NEW Deflation to Reflation: Sketching the Post-COVID Policy Path
Juhi Dhawan, PhD, Macro Strategist, Boston
June 1, 2020
The debate over the “right policy mix” to combat the pandemic-driven economic disruption in the US will continue to take center stage in the months to come. I believe fiscal policy, in coordination with monetary policy, can put us on a path to reflation, and I would highlight three keys:
1. Near-term fiscal spending: With fiscal spending, the first priority is preventing a deeper recession. Given the nature of this crisis, which resulted in a sudden shutdown of activity, the economic objective is to address cash-flow problems faced by consumers and companies. Thus, the government has spent on expanded unemployment benefits, direct checks to consumers, small-business grants, and paid sick leave. I think the reflation outcome will hinge on successful support for three groups especially impacted by this prolonged shutdown: small- and medium-sized enterprises (SMEs), whose cash position cannot withstand such a pronounced drop in revenues; state and local governments, which are required to balance their budgets; and low-income earners, who depend on their paychecks. These groups account for a large portion of US employment, and successful reflation efforts will mitigate the distress they face.
A few words on small businesses: A pillar of the economy (40% share) and job market (50% share), they have been especially hard hit by the health crisis. This was evident in demand for the first two rounds of the Payroll Protection Program, a lending initiative in the CARES Act that offers the option of changing the loan to a grant if 75% of proceeds are used to support payrolls. In my view, the greater the debt forgiveness for SMEs and the greater the flexibility in the use of such funds, the better the outlook for jobs and the faster the recovery.
2. Longer-term fiscal spending: This is about what comes after the crisis, as the economy opens and the focus shifts to recovery. The key will be sustaining accommodative fiscal policy after the worst has passed—to rebuild the economy and accelerate rehiring of displaced workers. The 2020 election makes the nature and magnitude of any post-crisis fiscal spending unclear, but I see a few areas of agreement. One is a desire to reduce dependence on China, which could mean rerouting supply chains toward the US. This trend is already evident in the United States-Mexico-Canada Agreement (effective starting this July), which requires, for example, a higher level of North American content in the automobile sector. Several health-related supply chains may also be rerouted, as the COVID-19 crisis has underscored the importance of having local products readily available in such a vital area of the economy.
Another point of general agreement across party lines is the need for spending on the aging US infrastructure, though details about size and scope (e.g., physical, green, or broadband infrastructure) will depend on who is in power. Spending that improves the quality of physical or online infrastructure and broadens its reach can encourage R&D, enhance productivity, and boost medium-term growth prospects.
On the flip side, a rush to raise taxes could be damaging. While it’s prudent to address deficits during expansions, tightening fiscal policy too early in a recovery would be counterproductive, since the best antidote for ailing government finances is sustained nominal growth.
3. Extending the Federal Reserve’s (Fed) commitment: In responding to the crisis, the Fed continues to rewrite the rules with aggressive policy action, including establishing special-purpose vehicles to support corporate and asset-backed markets and offering a lending facility to municipalities and states. With the Fed’s immediate and committed response have come signs of healing in credit markets, money supply, lending, and inflation expectations.
More innovation is needed as the Fed steps up in its role of lender of last resort. The Main Street Lending Facility (announced but not yet activated) will be important to ensure funding for large swaths of the economy not directly involved in corporate bond markets. The uptake and impact of the program will depend to a great extent on its design (e.g., few restrictions on the use of funds borrowed).
I also expect the Fed to offer some form of forward guidance and shift the contours of its asset purchases. One way to strengthen guidance would be to use quantitative unemployment and inflation targets. Alternatively, the Fed could temporarily use an asymmetric operational range for inflation, where 2% is near the lower end of the range and the ultimate goal is to deliver a 2% average inflation target over an economic cycle. The Fed could also introduce front-end yield-curve caps for a time (committing to purchase securities at the shorter end of the Treasury curve if yields rise above a certain level), providing a clear signal of its commitment to accommodative policy.
Economy Down but Equities Up: What Are the Assumptions?
Mario Pelata, Macro Strategist, London
May 6, 2020
This year, the global economy is expected to contract at its sharpest rate since 1929. Yet the discussion is already shifting as to how high equities can go. From a macro perspective, I believe equities can rally further only on the following assumptions: the market leads the economy; earnings in 2020 don’t matter; earnings in 2021 and beyond have repriced; and the fiscal and monetary stimulus measures will not only cap the downside but stimulate a strong recovery. I would question those assumptions.
What is the market focusing on today? The market tends to concentrate on just a few issues at a time. Currently, the focus seems to be on three: the flattening and slowing in the COVID-19 infection curve, which means lockdowns in many countries are closer to being relaxed; extreme bearishness in sentiment and positioning, which has so far supported the market rebound amid low trading volumes; and the level of intervention by central banks, which could boost asset inflation through portfolio effects. Investors’ nervousness around this rally is palpable, and positioning remains light. As a result, the market stabilization may continue for some time, but the balance of risks over the long term still suggests caution.
What could be the next market narrative? In January 2010, the market quickly shifted from a strong cyclical recovery after the global financial crisis to a focus on rising government debt. Similarly, in the current environment, plenty of less supportive issues could come to dominate. These might include a resurgence of US-China trade tensions, the first bankruptcies of large-cap companies, a focus on moral hazard, concerns about fiscal austerity in 2021, more attention on the poor market performance in Japan and Europe despite heavy central bank intervention, a strong move in the US dollar (up or down), and an L-shaped recovery.
Does the market lead the economy? From the 1970s to the 1990s, market upturns generally led economic recoveries. Since 2000, however, that relationship has not been so clear. In fact, more often than not, the trough in the ISM Manufacturing Index* has slightly led the turn in the S&P 500 Index.^ True, this recession is likely to be led by the services sector. But it is still a big step to expect a sustained divergence between the economy (persistent weakness) and the broad equity market (stable to up).
Do earnings matter? A significant discount in earnings tends to be necessary for the market to reach a conclusive turning point. Historically, equities have bottomed when the second derivative of earnings revisions has troughed. Given the unusual nature of this recession, many analysts have yet to change their earnings forecasts, and a stabilization is probably months away. Furthermore, although the Price/Earnings ratio (P/E)† recovered faster than the price in 2008, the S&P 500 Index didn’t recover until earnings bottomed out in 2009. So far in this recession, earnings are pricing for a V-shaped recovery, with a material drop in 2020 earnings that is largely recovered in 2021. In my view, that is probably over-optimistic, as it prices with a high probability the most positive scenario, in a highly uncertain environment. But, even at these levels, it suggests a price range of 2000–2750 for the S&P 500 Index, assuming the P/E ratio in 2021 stays in its recent range of 14–19.
Finally, does the degree of stimulus in the system point to a strong and, importantly, sustained recovery? Market leadership so far suggests that it’s more about monetary policy boosting financial assets than about a belief that the various fiscal packages will drive an economic recovery. In 2009, the value/growth ratio troughed on the same day as the S&P 500 Index, and value led the market for almost six months. This time, economically sensitive sectors have underperformed growth-driven stocks, the yield curve is not significantly steeper, the US dollar is not yet on a clear downward trajectory, and high-yield bonds repriced only after intervention by the US Federal Reserve.
Is a fiscal or monetary boost always positive for equities? Not always—at least, not immediately. Since 2010, the market seems to have become quicker to reprice, but only temporarily. That could be either because the long-term effects of these policies haven’t been clear or because central bank intervention impairs market liquidity and adds not only a floor, but a ceiling to market pricing. While the level of stimulus today is unprecedented, the second derivative of earnings revisions in the US is slowing down already. Given these boosts, financial assets should inflate. But, for the rally to be sustained and volatility to drop, we would still need growth in the real economy. And, despite a likely rebound in activity in the third quarter, I expect the level of activity globally to remain below its pre-crisis level well into 2021, though with a wide range of possible outcomes.
* S&P 500 Index is a market capitalization-weighted price index composed of 500 widely held common stocks.
^ ISM Manufacturing Index, which used to be called Purchasing Manager's Index (PMI), measures manufacturing activity based on a monthly survey, conducted by Institute for Supply Management (ISM), of purchasing managers at more than 300 manufacturing firms.
† Price/Earnings is the ratio of a stock's price to its earnings per share.
UK Economy: Elevated Uncertainty
Jens Larsen, Macro Strategist, London
April 28, 2020
A deep recession, a slow recovery, and significant uncertainty in the years ahead call for caution on UK equities.
Bottom Line: Recovery at Risk
The COVID-19 crisis has eliminated the brief window for the UK government to provide macro policy clarity and constructively move the Brexit debate forward. I fear that elevated political and economic uncertainty could delay the recovery from the crisis. These longer-term risks are not a market focus currently, but will come to the fore in the recovery.
Lockdown May Last Longer Than in Europe
The UK health crisis is evolving broadly in line with the worst outcomes in Europe but the UK might be a week or two behind. With the Prime Minister recovering from the virus, the government has yet to set out a path to reopening the economy at the time of writing. The UK may follow most other European countries with a very gradual opening, but the risk is of a much longer-lasting shutdown, and I am more negative on the pace of the recovery. I am expecting UK GDP to decline by nearly 8% in 2020, a bigger decline than the International Monetary Fund forecast last week.
My forecast implies earnings shrinking by between one-third and one-half. Although that is (very) broadly in line with the eurozone, large UK-listed companies are more exposed to the sharp decline in commodity prices, suggesting further downside risk. The uncertainty is huge, and the main message is that earnings news is going to be very poor in the next six-to-nine months.
Business Services Sector in Focus
The UK’s relatively large business services sector may be an advantage. This sector will probably benefit from its workforce’s higher rate of ability to work remotely. As the sector is more global in nature, it can potentially benefit from an international recovery.
Policy Response Quality Lagging
The policy response at first looked rapid and large scale, with a joined-up response from Her Majesty’s Treasury and the Bank of England (BOE) providing extensive income and cash-flow support, credit easing, and an aggressive step-up in monetary policy action.
But my initial enthusiasm for the rapid response has been tempered by concerns about implementation. The UK has had to set up an income support scheme in record time, with lots of patches implemented via the benefit system. On credit guarantees, the initial design proved problematic because the government guarantees were limited and got off to a stuttering start. Mid-sized corporates were too big for the government schemes and too small for the Bank of England schemes. The authorities have responded to the many concerns, but it has taken time and gaps remain. The risk is excessive job destruction and more extensive plant and firm closures, which would inhibit the recovery. Thus, I expect the recovery will be relatively slow and incomplete.
Many political and macro uncertainties will return to the agenda longer term.
- Brexit: The government maintains that the Brexit transition period will be over by the end of this year. Given that several negotiators have been off sick and that most of the action is taking place via video conference, this seems optimistic. The risk is an incomplete and costlier deal. Likewise, most of the countries that the government wants to start negotiating trade deals with are also otherwise occupied. The debate about the future status of Scotland and Northern Ireland will not be far behind.
- Increase in fiscal support: In a now almost-forgotten budget, the UK government set out to change fiscal policy for the UK, with a significant step-up in and redistribution of government investment and spending while also effectively abandoning the ambition to lower the debt-to-GDP ratio. The Office for Budget Responsibility estimated that the crisis could add another 15% of GDP to the government debt burden, and the government will need to show how it proposes to deal with that and the many competing fiscal priorities. My guess is that corporates will be expected to contribute to this fiscal reorientation via higher taxes.
- Less migration: The government set out a program that would be likely to lead to lower overall levels of migration. The new regime might eventually allow for inflows of skilled workers, but that would require a complete rewiring of the immigration system.
- Significant increases in minimum wages: The government raised the minimum wage (the National Living Wage) by more than 6% this April, following raises of about 4.5% in each of the previous three years. Looking ahead, the intention is to raise the coverage of the National Living Wage and to raise the level to two-thirds of median earnings by 2024, which would be one of the highest levels in the Organization for Economic Cooperation and Development. In aggregate terms, the effects are probably quite small, but for low-wage sectors, this would be a significant increase.
All May Not Be Lost for China’s Economy
Paul Cavey, Macro Strategist, Hong Kong
April 27, 2020
China recently reported that its gross domestic product (GDP) shrank 6.8% year-over-year in the first quarter of 2020—the first time in modern history that the nation’s economy has contracted. The contraction was sharper than our tracker had suggested, with the implication being that services (for which robust monthly data are not available) likely fared worse than other parts of China’s economy.
Headline: Bad, But Expected
This outcome was largely intuitive and did not come as a surprise to markets in the wake of recent events. Indeed, it’s pretty clear that the COVID-19 outbreak delivered an unprecedented shock to China’s economy—one that hit the services sector harder than it did manufacturing.
On its own, I would have thought that such a poor headline GDP number would have been neutral for Chinese fiscal policy, in the sense that whatever the government did for the remainder of the year, it probably wouldn’t be able to regain the economic ground lost in the first quarter.
Silver Lining in the Details
However, the details behind the headline weren’t as grim as I had anticipated, offering hope that 2020 may not end up being a complete “write-off” for China’s economy after all:
- Chinese industrial production (IP) and retail sales for March came in better than I expected. In fact, the IP data indicate that, by the end of March, output was already back to 95% of pre-COVID-19 levels (which I didn’t think would happen until late April). That makes it conceivable that IP could grow for 2020 as a whole.
- The data suggest that China’s household sector hasn’t suffered as badly as the rest of its economy. The official unemployment rate improved from the relative spike in February, falling to 5.9%. And while first-quarter household income growth slumped to 0.5%, that was a smaller dip than in either consumption or nominal GDP.
- Caveat: I’m not sure how telling these details really are in gauging the general state and direction of the Chinese economy. For example, it appears that small- and medium-sized employers overall have far from recovered yet, which raises the specter of further job losses going forward.
Glass Half-Full View
On the plus side, given that China can still seek to achieve some of its economic aims for this year (for example, growth in household incomes), I see the government’s recent data release as being slightly positive for risk assets.* And the way the data were presented leaves me cautiously optimistic that 2020 may not yet be totally lost in terms of China’s economic development.
* Risk assets (such as equities, commodities, high-yield bonds, real estate, and currencies) have a significant degree of price volatility.
Update on the Eurozone
Jens Larsen, Macro Strategist, London
April 27, 2020
Deep Recession and Slow Recovery, With Political Risks Ahead
Challenges Increase for the Eurozone
Recent data and developments have altered my view of eurozone economies and equities, increasing significant downside risk in my view. Doubts about the path ahead have increased, reflecting fundamental uncertainty about the health crisis, the policy response, and the subsequent economic recovery. A deep recession, a slow recovery, and a steep earnings recession could weigh on eurozone equities. Relative to the recent International Monetary Fund forecasts, the eurozone is likely to experience a bigger dip and a shallower recovery.
Medium Term: Policy Response Will Shape Recovery
In the medium term—six months to two years—the quantity and quality of the policy support will determine both how fast growth can bounce back and how far longer-term damage through job and firm destruction is avoided.
The European Central Banks’s (ECB) intervention is extensive, providing ample liquidity and purchasing assets at a high pace. Asset purchases can be scaled up if necessary and I am confident that the ECB will continue its asset purchases for as long as necessary, and will be willing to hold the acquired assets for a (very) long time.
The fiscal response differs across countries. The fiscal expansion and the credit guarantees are more extensive in Germany and France than in Spain and Italy, where the responses appear inadequate. Countries with weak fiscal positions have more to do, but are reluctant because of the risks associated with much higher debt levels. The absence of a strong, joined-up response at the eurozone/EU level is a constraint.
There are also big questions over the effectiveness of the intervention: Ultimately the key issue is whether firms and households have access to credit or temporary income support, and are willing to use it.
All of this points to slower and incomplete recoveries, particularly in southern Europe.
Will Eurozone Earnings Keep Pace With the US Longer Term?
I currently predict that corporate earnings in the eurozone will recover to pre-crisis levels by the end of 2021, which is a much quicker and fuller recovery than after the global financial crisis. This is a critical difference between the US and the eurozone: US earnings recovered quickly and are now 75% above the pre-crisis peak. In contrast, the weak EU/eurozone policy response could constrain the recovery, and lead to significant growth and earnings underperformance.
Will We Have a Second Government Bond Crisis?
The economic crisis and the increased pressure on public finances has reignited the latent tension between eurozone members about common bond issuance and fiscal support. Countries have engaged in contentious and extensive debates over these issues. I believe the most likely outcome is a gradual process that sees the ECB and stronger European governments providing increasing support to the weaker ones. But the politics may continue to be ugly and the risk of a second European debt crisis is high. Even if government bonds continue to receive support from ECB intervention, the political uncertainty means a continued high-risk premium on European assets.
Are the Risks Reflected in Equity Prices?
I don’t think the risks to recovery in growth and earnings are reflected in eurozone equity prices. Over the next six months, we will have extraordinarily poor earnings and GDP numbers, and I predict the recovery in the 12 months after that will be less than gratifying. In addition, we will have to deal with elevated political risk, which means sustained high-risk premia. This outlook challenges the idea of a continued recovery in equity prices.
What Might “Back to Work” Look Like for the European Economy?
Jens Larsen, Macro Strategist, London
April 13, 2020
- In Europe, lockdowns will likely start to ease gradually over the coming weeks, but will be different country to country.
- Activity in a full lockdown week may be 1/3 lower than “normal.” I estimate that output across the eurozone could decline by 5%-10% in 2020, with much bigger declines in earnings.
- The countries/sectors that experience more extensive lockdown with greater exposure to travel, tourism, and “social GDP” will see bigger declines and slower recoveries (Spain, Italy).
- A large manufacturing sector is an advantage in the immediate recovery (favoring Germany, Switzerland, and to an extent, Italy). Manufacturers/durable goods producers can respond more flexibly to lockdowns and activity should rebound sharply.
What Is In the Price?
The evolution of the epidemic, the authorities’ response, and individual/firm behavior remain uncertain. Moreover, when the contraction is this large and the policy extensive, we cannot expect the usual relationship between growth and earnings to hold.
I believe valuations reflect a “normal” recession, rather than an extraordinary near-term output contraction with an incomplete recovery. Risks are to the downside until the full extent of the GDP and earnings reduction has become clear and macro uncertainty subsides.
Returning to (New) Normal
Several countries have started talking about how to ease restrictions. Many have set up expert committees to define strategies, and there may be some European coordination.
- Austria and Denmark, which responded early and aggressively, may be first to start easing. The Austrian plan starts with opening small shops, then extending to large ones, followed by hotels and restaurants by mid-May.
- Spain has extended the shutdown to April 26 but has promised to review some production restrictions.
- Italy seems to be taking a more conservative approach and may not loosen restrictions for some time.
In addition to warm words about better collaboration, I expect EU leaders to map out areas where there can be more future financial support. If they are willing, this could be presented as a relative success and a stepping-stone for doing better. But the politicians and the political incentives are hard to judge.
Implications for GDP
Despite the uncertainty, I have drawn some broad conclusions.
- My analysis suggests that activity is about 1/3 lower than “normal”, translating to roughly 0.7% of annual GDP lost for each week of shutdown.
- Global and European activity started to decline well before intense restrictions commenced, due to behavioral responses from firms and individuals.
- The recovery will be slow and incomplete because governments will be cautious in lifting restrictions and both consumers and companies will also respond cautiously.
- Manufacturing and construction restrictions will be eased before retail, with restaurants, travel, and tourism last.
The broad picture is one of extensive restrictions for at least 6-8 weeks, followed possibly by months of reduced activity. These are only educated guesses, and the employment and activity indicators need to be watched closely, and interpreted cautiously.
GDP will decline significantly in the first half of 2020, then a sharp but incomplete rebound in Q3 will likely contract again by 7%. The range of GDP losses may be between 5%-10%, with those countries with less restrictive lockdowns at the lower end and those with longer-lasting and more extensive restrictions at the upper end. A slightly longer lockdown and a modestly slower return to a slightly lower level of GDP would shift the numbers significantly.
What About Earnings?
Eurozone earnings in 2020 could be cut between 1/3 and 1/2 compared to last year. Earnings are always hard to forecast, but it is particularly tricky in this environment where we have a mix of unusually large swings in GDP and aggressive government intervention.
Dire Consequences for the Travel Industry
The European travel and holiday sectors have already been hit hard by the shutdown and the effect is likely to extend well beyond the government-imposed restrictions. Consumers and firms will be looking to make up for lost income and may reduce their normal holiday, restrict travel activity, and be wary of going abroad. It is hard to argue for any resemblance of normality in these sectors this side of the summer holidays. The Mediterranean countries are likely to bear the brunt of the loss of this season.
Durables Goods Producers More Resilient
Producers of durables can shift production over time, can produce to and sell from inventories, and can make effective use of their labor forces. These features usually make them very volatile, but they are helpful in the context of a sudden stop. These companies can make good use of furlough schemes. Moreover, demand for durables is less likely to be affected by behavioral change than some of the social activities in the service sector. To stimulate activity in goods production, governments might decide to provide further incentives, such as scrappage schemes.
For companies with strong balance sheets and cash balances, the rebound will likely be very strong. Germany and Switzerland stand out in Western Europe, while many Eastern European countries, which are tightly integrated into the manufacturing supply chains, will also benefit.
Can the Eurozone Crisis Response Prevent a Longer-Lasting Crisis?
Jens Larsen, Macro Strategist, London
April 9, 2020
- The eurozone crisis response is likely enough to prevent the COVID-19 crisis from morphing into a government-bond crisis, but the resources and facilities of the European Stability Mechanism (ESM) require further strengthening.
- The crisis has created lasting political scars, and higher debt levels may constrain the recovery.
- To gain conviction on a eurozone recovery and eurozone risk assets, I need more clarity on the health crisis and more confidence in the adequacy of the fiscal response.
What Does the Policy Response Look Like?
COVID-19 may be a symmetric shock in the sense that it hits all countries, but it is asymmetric in its intensity and in individual countries’ capacity to respond. In the eurozone, Italy and Spain currently look particularly hard hit. Their limited fiscal capacity may mean a more tepid policy response that prolongs the crisis.
Apart from the European Central Bank (ECB), the joint response of the eurozone/EU has, so far, been poor, lacking in coordination, size, and urgency. Although the response is improving, there is significant political damage to be dealt with over the coming years.
There will be further attempts to strengthen the EU’s response in the near term and chart a more productive future course. There is a high chance of an agreement that entails:
- Allowing countries to access the ESM with few conditions
- A joint financing scheme for temporary unemployment
- Several smaller fiscal/financial initiatives
In addition to warm words about better collaboration, I expect EU leaders to map out areas where there can be more future financial support. If they are willing, this could be presented as a relative success and a stepping-stone for doing better. But the politicians and the political incentives are hard to judge.
Why Does This Matter For Investors Now?
The ability to respond jointly to this crisis is critical to sustain the eurozone and to avoid a repeat of the sovereign bond crisis.
- Can the ECB’s aggressive purchase program keep government bond spreads in check and avoid a financial and government bond crisis? I think the answer is yes.
- Medium term, the fiscally weakest governments—most obviously Italy—may need to rely on the ESM for additional funding. For that to work, Italy needs to be willing to ask for support, and the other eurozone governments need to be willing to grant it on a large scale and with few conditions. This will be politically contentious, but I believe it is financially and politically feasible. This week, they should take the first step.
- Long term, will there be continued support for the EU/euro project? The crisis has likely eroded popular support, and weak recovery will strengthen that trend. But there are no good alternatives. It would be a brave leader who decides to compound a fiscal crisis with a sovereign debt and financial crisis.
What Does This Mean For Eurozone Risk Assets?
At this point, I remain cautious. Valuations may seem “attractive”, but I still lack a clear sense of when the lockdowns will end and how we will return to “normal”. This makes it hard to judge how large and prolonged the hits to activity and earnings will be.
Our analysis suggests that the immediate downturn is very deep and that the jump in unemployment—even if temporary—is large. If the recovery is slow, the risks to government and private-sector balance sheets will intensify and the political fallout will be harder to handle.
Even with my relatively constructive take, there are some big hurdles to navigate in the next few weeks. I think caution is justified until this fundamental uncertainty recedes.
Has the World Changed Permanently?
John Butler, Macro Strategist, London
April 9, 2020
To be clear, no one can answer that question with any degree of certainty right now. There are still too many unknowns. But for my part, I have a hard time envisioning a scenario where the COVID-19 crisis does not leave an enduring imprint on the global landscape.
The Global Economy Is Reeling
By way of context, global growth is currently contracting at its fastest pace since the Great Depression hit in 1929. The range of potential outcomes is broad at this point, but I estimate that the economic fallout from the crisis has already shaved around 7% off global GDP, with more damage to come. Unemployment rates in most countries will likely rise by double digits as tens of millions of jobs are lost worldwide.
When Might it Turn for the Better?
The timing of an upward turn in the economy will depend largely on the healthcare sector, particularly the race to find a COVID-19 vaccine, and the speed at which governments begin to soften and lift containment measures. At that point, of course, there will be a bounce in growth as the economy restarts, but it may be short-lived and probably won’t be sufficient to replace the lost economic output.
I Expect a Slow, Weak Recovery
Beyond the bounce, I think a V-shaped economic recovery is unlikely to materialize. Instead, I believe it will take years for the global economy to fully recover from this massive blow. The fiscal and monetary policy response has been swift, but the likely surge in unemployment suggests weaker trend growth going forward. Widespread job losses and income insecurity may require a protracted period in which companies and households rebuild their balance sheets and savings.
Fiscal Policy Is Merely Filling a Hole
The fiscal policy measures announced by global governments to date amount to a little under 4% of global GDP. In my view, the measures taken thus far should be seen not so much as providing economic stimulus, but rather as necessary first steps towards helping fragile households and absorbing private-sector losses. In that sense, they are merely “filling a hole”, so to speak, and only partially at that.
The Euro Area Is Especially Vulnerable
The European nations have delivered an uneven fiscal response to a common and tragic shock, from totally inadequate in Italy and Spain to closer to what is needed in Germany and Switzerland. Some countries will be able to cope with the burden of additional public-sector debt; others will not. How the euro area manages this crisis will determine the viability of the euro going forward.
This Is More Than a Temporary Shock
This crisis may well have lasting implications for economic, social, and political preferences in the future. Structurally, I believe the world is likely to look different in many ways on the other side of it, including:
- Income inequality may widen, while income insecurity will likely have increased. Historically, both forces have tended to boost support for more populist politics. I expect that trend to gain traction.
- I foresee a shift toward bigger government and more centralized control. The social value of certain sectors may be recognized more explicitly—for example, through permanently higher government spending on healthcare.
- I think public-sector debt ratios will be 15%-25% higher coming out of this crisis, yet the populace may have a greater tolerance for government spending projects, more generous social safety nets and larger fiscal deficits.
- My long-term “deglobalization” theme will likely accelerate from here, aided by continued deterioration in the already fractured relationship between the US and China.
- For now, the focus should be on avoiding global deflation. Over the medium term, however, I believe deflationary fears will give way to a growing acceptance of inflation.
Bottom line: The world is not ending, but it may indeed be a changed place in the wake of COVID-19.
Update on ECB Actions
Jens Larsen, Macro Strategist
March 30, 2020
- The European Central Bank (ECB) has shed most of the remaining constraints on purchases. It will be able to support an aggressive expansion of sovereign issuance this year.
- The eurozone’s fiscal response lags behind, but will catch up over the coming weeks as growth deteriorates.
- Eurozone political leaders will likely eventually endorse using the European Stability Mechanism (ESM), but will need to go further.
ECB’s Pandemic Emergency Measures
The ECB has published details of its €750 billion Pandemic Emergency Purchase Program (PEPP).
When the decision was made last week, the ECB stressed the flexibility of its implementation. This decision is the practical implementation of that:
- Greece is included in the program.
- The 33% limit on the share of eurozone members’ bonds that the ECB will hold under its existing programs does not apply to the PEPP.
- The ECB can buy across the yield curve, from very short maturities (down to 70 days) to very long ones.
- The ECB has accepted pari-passu* treatment in the event of a sovereign-debt restructuring.
Few Constraints Remain
The last three points were news, I believe, and demonstrate that the ECB will disregard past constraints in order to respond to the pandemic. The remaining constraint is that the purchase amounts are guided by the ECB’s capital key, which, in turn, reflects the size of the economies, rather than the size of the debt market or the current needs. That said, the ECB can temporarily deviate from that key and lean into specific markets if necessary.
Program Can Scale up if Necessary
With purchases of more than €1 trillion (>8.5% of GDP) before year end, the ECB has given assurance to the market that the sharp rise in debt issuance that we will see in the coming months will be absorbed. I think that is an important assurance that will keep sovereign spreads in check.
Challenging Debt Position of Many European Governments Remains
Many European sovereigns will see sharp rises in issuance and in debt-to-GDP as a result of this crisis. Italy has particularly challenging dynamics, but it is not alone. The ECB will end up holding much of that increase on its balance sheet, in all likelihood for a long time. By the end of the year, the ECB will likely hold more than 30% of GDP in its asset purchase programs. There is no reason why it should stop there.
ECB More Aggressive Than Political Leaders
Heads of government have so far failed to reach an agreement on how to approach the challenges facing the fiscally most vulnerable countries (as of March 27, 2020). I expect that they will eventually agree to use the ESM to support EU governments, whereby individual governments can draw up to 2% of GDP on credit lines with light conditionality. Any country can apply, but it is done on an individual basis, so it will still be debt. I don’t think EU leaders are ready to contemplate a ‘joint debt instrument’ that goes beyond the use of the ESM. Although such a solution would provide a helpful backstop, it would be politically challenging for many countries.
Support Required Beyond Italy
If a broad range of countries draw on the ESM for funding at low rates, which it effectively establish a practice of near-joint issuance of debt. All eurozone countries would be on the hook for much of this increase in debt, either via the ESM or, ultimately, via the ECB. That, I think, is the practical reality. The politics need to catch up.
Does This Go Far Enough?
Speaking only for myself, I think it does, for now. The ECB can act aggressively in the interest of the eurozone as a whole—that is what its mandate says. It is not surprising that the eurozone’s political leaders are focused on their own national crisises, and that they struggle with decisions that have deep political and fiscal implications.
The German and Dutch (and other) governments are not willing to give grants on a large scale. Imagine the politics of handing over hundreds of billions of euros to another rich country at a point of economic crisis. I think they will ultimately be willing to lend their credit and accept that the ECB acts as a backstop, but they are not there yet.
This Supports Eurozone Fiscal Response
In comparison to the US, the discretionary increase in fiscal spending may look less impressive so far. But in the eurozone, the automatic stabilizers—the rise in spending that comes about when revenues fall and unemployment rises—are much bigger, particularly when the GDP decline is big. The ECB’s decisions and the ESM measures will ultimately buy some room for this fiscal response.
* Pari-passu is a Latin phrase meaning "equal footing." In finance, "equal footing" means that two or more parties to a financial contract or claim are all treated the same. Pari-passu is common in bankruptcy proceedings as well as debts such as parity bonds.
Let’s Examine Those Buybacks
Mark Whitaker, CFA, Equity Portfolio Manager, Boston
April 23, 2020
Amid the impending government stimulus, the issue of stock repurchases has once again hit the headlines. Buybacks are often framed as the poster child of corporate greed or lapses in governance, designed to line executive pockets and enrich existing shareholders at the expense of broader long-term value creation. But the first critical point to remember is that buybacks should be a distribution of profits that remain after all constituents have been taken care of, and they should not be done at the expense of any stakeholder, including employees.
Let’s assume that the buybacks we have seen have been made with good intentions and examine what influenced the decision making. Stock repurchases are one of five capital allocation tools available to public companies, along with business reinvestment, acquisitions, dividends, and debt reduction. Like any other capital allocation decision, there are times when buybacks make sense, and times when they don’t. How, why, and when management teams take these actions matters greatly. Skilled capital allocation separates well-run companies from their peers, and this period will be no different.
The second point is that suboptimal capital allocation decisions are nothing new. Profits increase during good economic periods, and the resulting cash rarely sits long with the company; it is usually invested or distributed soon after profits are realized. Historically—and still today in some industries—cash has tended to flow toward expanding company assets: building new mills or mines, laying more fiber-optic cable, acquiring land, and many other examples. These have sometimes been poor decisions, sowing the seeds of oversupply, creating painful periods during cyclical downturns, and leaving companies short of cash when they need it most.
Over the past decade, corporations seemed less willing to build ever-greater capacity, possibly because of the scars from the global financial crisis. Cash piled up, and buybacks became a popular outlet for spending it. Some prices paid look poor in retrospect, making owners question those decisions. But I think investors should look in the mirror.
Collectively, we have pushed corporations to optimize everything, from cost structure to capital structure, leaving no spare dollar lying around. If a management team deviated from that norm in recent years, the board or CEO could expect a call from an activist. Large distributions in the form of buybacks naturally followed, seen as easier to flex and more tax efficient than dividends. Might business owners (that is, shareholders) be better off if companies had a chance to be opportunistic—which could mean sitting idle for an extended period and letting cash balances increase? Unfortunately, I believe many investors would contest such a practice.
My overall point is this: Capital allocation is a critical and differentiating skill for management teams. This period will once again demonstrate that. Companies that make good capital allocation decisions—including stock repurchases—while still considering all constituents are the rare gems that I prefer to invest in. I invest with an owner mentality and decades-long time horizon. To me, it’s common sense that a business that helps all its stakeholders succeed can thrive long term. I believe that, as investors, we should support and hold companies accountable for doing right by their stakeholders, and we should do so in a thoughtful, case-by-case manner. We could, for example, back compensation plans with long horizons that give management time to be patient with capital. In my view, creating an environment supportive of successful capital allocation helps all market participants and society at large.
Does the Recent Rally Mean the Bear Market Is Over?
David Lundgren, CMT, CFA, Director of Technical Analysis, Boston
April 21, 2020
The S&P 500 Index’s* substantial market rally from recent lows has led many investors to question whether a new bull market has begun. In my view, bear market history should give pause to anyone who thinks we are off to the races again. In the US, prior to the recent crash, there have been nine bear markets of at least 20% since 1987. Figure 1 offers several lessons from these bear markets (each gray and white section), showing the meaningful lows and gauging the magnitude and quality of any rallies that were recorded as each bear market unfolded. For instance, in 1987 there were two major lows. Between the crash and the next low, the market rallied 15% (retracing 38% of losses). But this rally did not end the bear market.
- In my view, the “Break swing high?" column is the key part of this table (highlighted in blue below). It shows whether each rally after a new low was strong enough to close above the high from the previous rally.
- Each bear market ends with a “Valid" breakout to new highs. Most bear market rallies, ranging here from 6% to 28%, did not recover above a prior high and were followed by a retest of lows. In three rallies (marked “false"), the S&P 500 Index closed above prior highs only to later hit new lows.
- Regardless of the magnitude of the rally, or the size of the retracement, until the market breaks above a prior high, the risk of lower lows cannot be ignored. Even then, they are still possible.
- I believe there are two key takeaways for the current bear market. First, although the recent 28% rally is high compared to history (15% average), its 50% retracement of the decline is still below the average (64%). Second, thus far, we have not had a breakout (valid or not) above the prior high.
Bear Markets Since 1987
|Date of Bounce Low||% Rally||Retrace (%)||Break swing high?||Was the low later
|Was the retest a new low?|
Source: S&P 500 Index | As of 4/14/20
According to recent history, this bear market is likely not over until the S&P 500 Index closes above the last high of this downtrend (roughly 3,200). Therefore, I believe we are capped to a 2,900 to 3,000 best-case upside potential (which would match the bear market rally historical average of a 64% retracement).
This technical pressure is countered by the Federal Reserve’s wall of liquidity hitting the market, which is likely to keep a floor under prices as we work through the economic hangover of the virus. In my view, this suggests a base-case range of between 2,900/3,000 and 2,600/2,700 in the months ahead.
* S&P 500 Index is a market capitalization-weighted price index composed of 500 widely held common stocks. Past performance does not guarantee future results.
^ A low is retested when the market returns to the S&P 500 Index level that was reached on the date listed in column 1.
Forget About the Market; Focus on Stocks
David Lundgren, CMT, CFA, Director of Technical Analysis, Boston
April 14, 2020
After its recent bounce, the S&P 500 Index* is now wrestling with our near-term upside target in the 2,700 range. In my view, we are starting to see evidence that the market is normalizing, setting the stage for a bottoming process to begin. And even if the market sees new lows in that process, I believe it will hold above 2,000-2,100. From this point forward, however, I think whether or not we retest the bottom before moving higher is irrelevant. I believe it is time to ignore the market and instead focus on the factors, regions, industries, and stocks that will lead in the next bull cycle.
Will the Market See New Lows?
The dominant consensus view seems to be that the market will see lower lows. Investors then appear to be split between the bulls and the bears, but both camps seem to confidently expect this near-term outcome. My best-case scenario is more bullish, with the S&P 500 Index continuing higher without a retest of the bottom. Though this would break with longer-term historical precedent, it would mirror what happened in 2019 after the lows of Q4 2018. Until recently, my outlook assigned a 35% probability to this scenario, whereas the combination of the consensus new lows followed by a recovery to a bull market had a 65% probability. However, a strong close above 2,700 could indicate that the best-case scenario is playing out. In fact, at this point, I am actually leaning toward no new lows, particularly since so many investors (bull and bear alike) expect them. Importantly, however, I believe it really doesn’t matter.
Either Way, the Waterfall Decline Should Be Over
Regardless of whether or not we get new lows, the market should now begin to differentiate between the winners and losers of the next cycle. This impending differentiation is what drives the “divergences” that characterize a bottoming process. Specifically, divergences develop as the index moves to new lows, but most stocks do not follow. At the same time, sentiment does not get as bearish, and correlations and volatility do not get as high (i.e., the macro-driven waterfall is over).
This list of inputs is generally referred to as market internals. If we are indeed in the beginning phases of a bear-market bottom, as I believe we are, we should not see market internals go to new lows, even if the index itself does. This would mean we need to shift our emphasis away from macro-technical conditions (the market) toward micro-technical conditions (stocks). In other words, as the waterfall decline ends, the market is no longer all that matters.
It's Time to Focus on Tomorrow’s Leaders
We should therefore focus on recognizing the factors, regions, industries, and stocks that the market is selecting for future leadership. Of course, the market constantly differentiates between winners and losers, even during waterfall declines. Importantly, divergences would make this differentiation more pronounced. Until recently, winners have been safety, growth, momentum, the US, China, and stocks that benefit from COVID-19. Losers have been cyclicals, value, Europe, and stocks that are in harm’s way of COVID-19. From here, as we transition regimes from waterfall back to bull cycle, some mixture of new leadership should begin to emerge, whether we retest the bottom or not.
Though the market could fall to new lows with no divergences to speak of, this scenario is not in the cards for me. In my view, even if it does move lower, the S&P 500 Index will hold near our previous bottom and there will be clear differentiation between winners and losers. If that is the case, I believe investors should start looking for leaders now.
* S&P 500 Index is a market capitalization-weighted price index composed of 500 widely held common stocks.
The World Is Watching
Wendy Cromwell, CFA, Vice Chair, Director of Sustainable Investing, and Portfolio Manager, Boston
March 31, 2020
During this period of unprecedented upheaval and disruption, some companies will rise to the challenge of the moment, while others will not. In many cases, their most enduring actions—and the ones that help them survive—will include environmental, social, and governance (ESG) decisions as well as financial ones. How are companies ensuring employees’ safety? What benefits are they providing? How are they treating customers and communities? Are they evaluating the resilience of their supply chains?
During our engagement calls with executives and boards, we are asking questions like these to understand how each company is responding to the COVID-19 crisis and considering all its stakeholders. I’ve included a few of our investors’ insights here:
Carolina San Martin, CFA, Director of ESG Research
On a recent energy-company call, it was clear that the board and management have increased their focus on employees in light of the COVID-19 crisis. While they didn’t rule out layoffs down the road, their first capital expenditure (capex) cuts this week did not include any reduction in force. They plan no change in their commitment to their energy-transition strategy. In fact, management believes this crisis may accelerate action on climate change, because it has given the world a stark picture of what massive economic and societal disruption looks like. They cited a strong culture of collaboration among the board and management teams, who say functioning as a team is paying off during this crisis.
Michael Shavel, CFA, ESG Research Analyst
I think times of crisis help investors get a better sense of whether companies do what they say they do. It’s easy to publish a shiny sustainability report that highlights how employees are key assets, suppliers are partners, and customers are the lifeblood of the business. But during tough times, we get to see how boards and management view and prioritize various stakeholders. There’s no one right way to go about it, but we should at least be looking for consistency between the message we’ve been hearing and the actions being taken. A lack of consistency might suggest that we apply more skepticism to other elements of the business narrative.
Mark Whitaker, CFA, Equity Portfolio Manager
Will companies pay employees during the shutdown? How are companies prioritizing the safety of their workforce? My recollection is that after September 11, 2001, and during the global financial crisis, layoffs were broad and cold. While the subject of layoffs is always painful, I am heartened that thus far—this time, and in a small way—it feels different. When this period is over, will we be able to point to real differences? Will the view of certain corporate cultures be enhanced? I’ll be interested to see.
Prachi Shah, CFA, Global Industry Analyst
The key difference between my flow-through assumptions last week and what the company provided today, is that they will be paying some inactive labor. I think we can apply this assumption to other similar businesses. It is the right thing to do for society, and it will probably set a precedent.
Jessica Fry, Business Associate
We should keep thinking about how all companies in the portfolio interact with customers. This could be a differentiator, depending on consumers’ reaction. Many airlines and hotels are offering refunds for customers not wanting to travel. Grocery store chains are making it easier on shoppers with “elderly hours.” I think the effects on corporate culture and customer relationships are going to last a lot longer than the market impact.
Mark Mandel, CFA, Equity Portfolio Manager
One of the world's largest home-improvement retailers announced it is temporarily adjusting store hours to better serve customers and communities in response to COVID-19. The company understands that this action is essential to the communities it serves, and says it is committed to keeping stores open during times of crisis and natural disaster.
Eunhak Bae, Global Industry Analyst
On a call last night, the CEO highlighted various employee and community actions the company was undertaking. I thought it was a strong statement of its commitment to be a good corporate citizen and of confidence in its financial health. The actions included bonuses for lower-level employees, emergency-fund relief for employees facing financial hardship, supply-chain support for protective equipment, and help for small business vendors with liquidity issues. I plan to give management positive feedback when we speak to them next week.
The World is Watching
Wendy Cromwell, CFA, Vice Chair, Director of Sustainable Investing, and Portfolio Manager, Boston
Saints and Sinners
Mark Mandel, CFA, Equity Portfolio Manager, Boston
March 26, 2020
This crisis represents a seminal moment for responsible investing. To this juncture, many portfolio managers have understandably struggled to incorporate environmental, social, and governance (ESG) into their investing frameworks. ESG can feel steps removed from buy/sell decisions and seem arbitrary, as though conclusions are reached by applying personal values.
I see this changing right now. Starting with Wellington’s recent virtual Consumer Conference, and continuing over the past couple of weeks, we have had hundreds of touch points with company management teams. Those conversations have broached topics affecting a wide range of stakeholders:
- Is management working from home?
- Who is coming into your offices/stores/warehouses/factories?
- How are you dealing with employees?
- How are you accommodating customers?
- Are you building supply-chain resilience?
- What’s happening in your local communities?
These discussions have felt natural, because they are very relevant to long-term shareholder value. Stakeholders will remember companies’ actions during this crisis for a long time. The ability to hire, rehire, and retain talent will be shaped by reputations developed now. Brand loyalty may be gained, strengthened, or lost based on how customers are treated. If an investor is asking questions like these today and considering the inputs when making investment decisions, then ESG is part of their framework.
For better and for worse, the media is becoming more focused on corporate behavior. The Financial Times has added a “Saints and Sinners” section to its Moral Money newsletter, this week lauding a few producers of emergency healthcare supplies and criticizing a few online retailers, pharmaceuticals, and even professional sports teams.
Our colleague John Averill asked in Wellington’s Morning Meeting yesterday about best practices for treating employees during this crisis. I have learned that the answers are very case-specific. Some companies that have financial flexibility and benefit from strong current business trends can go a long way to help. Technology companies and grocery chains are two that come to mind. Some companies may want to do the right thing but are less flexible, hamstrung by the size of their workforce and the realities of the current environment. Hotel chains or food service companies are recent examples. Even companies that seem best-positioned to weather this storm may have to grapple with important employee welfare issues, including childcare, heightened stress levels, and, of course, illness.
In his recent book, Skin in the Game, author Nassim Taleb talks about via negativa; essentially, we know what is wrong with more clarity than we know what is right. I find this to be especially true about company actions today, and about ESG in general.
In sum, there is no one “right” approach for companies to take. Each must consider a matrix of options and stakeholders, including employees, customers, and shareholders. And their choices are constrained by their specific financial reality. Investors need to apply judgment, just as with traditional fundamental analysis: Is a company doing a good job reaching balanced decisions, given the multidimensional issues it faces? Are management’s choices consistent with its culture and strategy? Are these behaviors consistent with the reasons why you own the stock, and with your time horizon for investing?
We’re All in This Together
Michael Carmen, CFA, Co-head, Private Investments, Boston
March 24, 2020
I thought I would put a few thoughts out there, as we once again navigate a difficult market environment.
- During periods of extreme volatility, mistakes are inevitable. Right now, it may seem like every transaction we made before the market declined looks bad and every upgrade we’ve made since hasn’t worked out. Don’t look in the rearview mirror; the information is changing fast. Just focus on trying to make the right decision for your clients every single day.
- Maybe another way to say this is, don’t let a bear market (or a recession) go to waste. An old mentor of mine once said, “You might need to underperform in the near term in order to outperform in the long term.” Remember, while some of these prices will probably look amazing two years from now, they could still look horrible next week.
- Stay true to your investment philosophy because it will ultimately serve you well. The worst mistake I made during the global financial crisis was getting more conservative at the beginning of 2009. It was a bad decision and led to a period of disappointing performance.
- Stick to your guns, but always be flexible as new data arrives. A flexible mind is a sign of strength, not weakness. Don’t be afraid to adjust your “philosophy and process” if you believe there are ways to make it stronger. After that period of poor performance in 2009, we added our Up/Down valuation framework and we have never looked back. Time and again, it has been super helpful in giving us a much better quantitative view of the downside if a thesis didn’t play out.
- As our colleague Mark Whitaker likes to say, “Stocks can always go lower.” In 2009, the poster child was Las Vegas Sands, which dropped 99% from its high. Don’t anchor yourself into a specific price. The old adage that the market can remain irrational longer than you can remain liquid is true.
- Sleep! I know it is very stressful and I’m sure everyone has lain awake in bed at 2:30 a.m., wondering what could possibly be coming at us next. I know I have. But none of us can make good decisions for our clients if we are sleep deprived. And we don’t have to commute to work right now, so we have all that time back. In our tenet “client, firm, self,” self might be last, but it’s still a priority. Take care of yourself.
In my 21 years at Wellington, even in the depths of these bear markets, I have always wanted to come to work because I knew I was sharing the experience with my colleagues. We are all in this together. I’ve now experienced three horrible, stressful, life-changing periods in the markets. It is awful. No one likes to lose money. No one wants to underperform their benchmark. But as another veteran investor, retired portfolio manager Ed Owens, once said, “Betting against the survival of the universe has been a bad gamble for millions of years.”
Preparing for Even More Volatility
David Lundgren, CMT, CFA, Director, Technical Analysis, Boston
March 17, 2020
Other than direction, what distinguishes uptrends from downtrends is their different return and volatility profiles. Uptrends are the result of investors’ steady confidence in their market outlook, which is constantly reinforced as the market marches higher. This momentum feeds on itself, emboldening investors to buy every dip. As a result, uptrends provide strong returns and low volatility, producing a very attractive Sharpe ratio.*
Downtrends are quite the opposite. Uncertainty about the market outlook materially undermines investor confidence, flipping the behavior from buying dips to selling rallies. From time to time during downtrends, we get multi-standard-deviation rallies. These are often headline-induced gyrations that ultimately fail, repeatedly dashing the hopes of investors. Eventually, a new sort of confidence returns to the market, where investors are “confident” that the world is going to end so they proceed to sell everything, regardless of price. Then we bottom. This combination of progressively lower prices and extreme intermittent volatility results in a very unattractive Sharpe ratio.
The current downtrend is no different, and investors need to prepare for an even more volatile period. In the autumn/winter of 2008/2009, after September’s 20% decline from all-time market highs was already on the books, multi-standard-deviation rallies of 5%–10% became “normal.” Each one was driven by hope, triggered by some unprecedented government intervention or exciting headline. In all cases, my personal bottom-identifying checklist of trend change never indicated an actual change. In other words, the trend remained down despite these voracious rallies. Worse, the ensuing percentage decline to ultimate crisis lows was still at least another full bear market, or -20%, away.
This is not a forecast, and I’m not suggesting we doubt every rally, but until the trend shifts from down to up, there is little reason to chase hope-fueled upticks that run the risk of failing.
In 2008, we referred to the investor fear that spread through markets as “contagion.” Today, in addition to the actual contagion of the coronavirus itself, we are dealing with investor contagion that is responding to policy contagion. As leaders try to stem the spread of this virus by canceling events, closing attractions, and declaring states of emergency, the pressure increases on private-sector leaders to respond similarly or risk indictment, in hindsight, for doing nothing. We are hearing questions like, “Is it too soon to buy?” and “Is it too late to sell?” Both queries share a tinge of hope that the lows are in. Both are essentially asking “Are we going lower?,” implying that the panic button has yet to be hit. If consensus was that the market had farther to fall, these questions would be different. People would be asking, “How much cash should I withdraw?,” “How safe is my money market?,” or “Which should I stock up on, soup or beans?”
I do not have the answers, but that is mostly because, as a trend follower, I don’t ask many questions. Trend following is about identifying what is happening and doing that until it is no longer happening—without making forecasts as to when conditions might change. It’s not perfect. One criticism we often get is that trend-following strategies only do well over the long term because of “crisis alpha,”^ meaning they protect capital when things really go bad. Guilty as charged. If compounding is about digging small holes during downtrends and fully participating during uptrends, then I believe trend-following potentially offers a solid, repeatable approach. In the current environment, digging small holes is paramount until better market conditions return.
* Sharpe Ratio is a measure of the excess fund returns per unit of risk, as measured by standard deviation.
^ Alpha is the measure of the performance of a portfolio after adjusting for risk. Alpha is calculated by comparing the volatility of the portfolio and comparing it to some benchmark. The alpha is the excess return of the portfolio over the benchmark.
Factor Insights: A Drawdown Comparison to the GFC
Gregg Thomas, CFA, Director of Investment Strategy
March 17, 2020
I have heard many comparisons between the current crisis and the global financial crisis (GFC). To me, this shock feels similar in terms of uncertainty, but somewhat different from a factor perspective. We compared the first two months of the GFC and the four weeks ended March 13; these two periods equated to about a -25% market decline. Several high-level observations stood out:
- Key takeaway: The worst-performing factor was clearly solvency risk, followed by value. We think the market has been engaging most on companies that might not pass the “going concern” test in the face of the first real growth shock we’ve seen since the GFC, and that these companies are seeing a massive increase to their discount rates. Our definition of solvency looks at the relative distance to a default (similar to the model used by credit-rating agencies), identifying distress at the individual company level by considering the interaction between capital structure and stock-price volatility. For capital structure, we look at leverage on the balance sheet and add back fixed-cost structures such as lease obligations, pensions, etc.
- This isn’t just a reaction to leverage. Looking across our factor returns, there is a direct correlation between a factor’s exposure to solvency risk and excess return. Leverage is much less explanatory. Overall, the market is pricing high solvency risk nearly three times more than high leverage.
- Unlike the first hit of the GFC (September and October of 2008), this time around there is not as much on the other side from a style perspective to cushion the blow (e.g., low volatility and profit stability factors are ahead, but not by much).
- Up to now, the weakness in value factors has far outstripped the gains in defensive and quality factors. During the GFC, this was more balanced.
- Dividend yield has not protected like it did in 2008, largely because the highest yielders are in energy and financials, which have higher exposure to solvency risk.
Given continued high uncertainty, we are being thoughtful about factor exposures, solvency risk, and stock-specific risk, and when in doubt, we are taking the defensive side.
Thoughts on a Complicated Crisis
Vera Trojan, CFA, Equity Portfolio Manager, Boston
March 13, 2020
As a longtime emerging-markets investor, I have faced more than one major crisis. The current environment, however, strikes me as more complex than any I have seen.
It is developing as an interplay between a health crisis, a further unraveling of the post-World War II geopolitical order, uncertainty caused by climate change, a potential financial crisis, and a fundamental rethinking of the role of business and the investment industry in society.
As I think about all these factors, crisis investing 101 is an obvious place to start:
- Be wary of illiquidity and debt.
- Take advantage of opportunities to upgrade your portfolio.
- Avoid banks and other leveraged financials.
- Be prepared for extreme volatility.
- Take shelter in stable businesses with solid balance sheets in economically and politically stable countries.
The other framework I am using is time horizon: What will be the shortest- and longest-lived aspects of the challenges currently upon us? Arguably, the coronavirus itself will be the first to pass, with consumer fear abating. Quality names in the most impacted sectors, such as travel and entertainment, may be the first to recover. Longer term, a financial crisis is a real risk, given the leverage, volatility, and illiquidity already in the system. Banks, which will be at the center of any storm, are already suffering due to record-low interest rates and slower growth. In my view, even the highest-quality banks will not be spared if a real crisis unfolds.
Geopolitical discord will also be with us until a new order emerges. The challenges of a multipolar world are myriad, and in my mind, the seeming unraveling of OPEC is a symptom. As it is difficult to imagine the players coming together again, it may be prudent to underweight oil. While most of Asia benefits from structurally lower oil prices, the stresses in the Middle East will become more acute and destabilizing.
As China and the US are the two pillars of a multipolar world, they also are likely to be key components of long-term investment strategies. China has been the first country to bring the coronavirus under control and its stock market has performed relatively well in a global context. Attractive ideas potentially include top internet players, consumer cyclicals, and service providers. Outside of China, we are looking for idiosyncratic structural growth businesses, such as certain research-driven pharmaceutical companies and various technology names.
US Dollar—Transient Headache
Henri Fouda, Portfolio Manager, Investment Boutiques, Boston
March 26, 2020
Why Has the US Dollar Spiked?
I have long believed that the carry advantage of the US dollar was unsustainable. The coronavirus crisis has precipitated the collapse of that carry advantage. The world, especially the developed world, is flat, with no real carry-trade advantage in evidence anywhere.
If monetary and fiscal policies were the only variables affecting the exchange rate, the effective dollar exchange rate would be lower as a result of the relative actions of jurisdictions across the globe. Instead of dropping, however, the dollar’s effective exchange rate has spiked sharply. Market commentators have advanced several theories as to why: liquidity, uncertainty-driven dollar hoarding, risk aversion, the US having the strongest army in the world, the dollar as a reserve currency, margin calls, and so on, all of which may be contributing.
The common underlying theme seems to be the anticipated contraction of the world economy subject to a dual supply and demand shock, with economic activity coming to a standstill in some sectors. Such discontinuities are not usually incorporated into standard economic models. Harvard University Economist Dr. Kenneth Rogoff recently likened the current situation to a war in economic terms.
Will Currency Markets “Self-Heal”?
Daily exchange rate fluctuations represent not only investment and speculative demand, but also the day-to-day demand that supports commerce, tourism, and all other economic activities. Disruption, or the anticipation of disruption, of those activities could lead to sharp movements in exchange rates. Those disruptions, in my opinion, should be transitory rather than permanent, because exchange rate excesses are “self-healing.”
An example in recent memory is the Swiss franc. It was brutally “unpegged” from the euro during the European financial crisis. This sparked a sharp revaluation. But given the reality that Switzerland was competing directly with its EU neighbors, the exchange rates had to adjust quickly the other way to reflect Switzerland’s less competitive situation.
Look For a Correction
Likewise, when normal economic activity resumes—or economic agents anticipate its resumption—it will become apparent that the dollar’s effective exchange rate at the current level is crippling the US and world economies. The dollar will correct and potentially overshoot in the opposite direction. In fact, a sustainable correction of the dollar’s effective exchange rate might be an early sign that activity is “normalizing.”
Bank Loans at an Attractive Discount
David Marshak, Fixed Income Portfolio Manager
Jeff Heuer, CFA, Fixed Income Portfolio Manager
March 24, 2020
Over the past few weeks, growing concerns around the coronavirus and its potential impact on the global economy have caused steep declines in financial markets. The bank-loan market has not been immune from this weakness: The average dollar price of the S&P/LSTA Leveraged Loan Index* was 78.4 as of March 19.
Current index price levels imply that roughly 45% of the bank-loan market is going to default.^ To put that in historical context, the highest trailing 12-month default rate actually experienced by the bank-loan market was just above 12% in November 2009.†
Using a medium-term outlook, it is our view that the bank-loan market is oversold at these levels. While we do expect the default rate to increase, primarily in the commodity-sensitive sectors, we don’t believe it will come anywhere near 45%. As a result, we believe the current bank-loan market offers attractive price appreciation and total-return potential for bank-loan investors with a longer time horizon.
And history is on our side: If investors had bought bank-loans at similar prices to today’s in the past, including at the height of the global financial crisis, they would have enjoyed double-digit returns in the following 12 months. In fact, investors who were contrarian during the oversold conditions of 2008 were rewarded handsomely when the market snapped back and returned over 51% in 2009!
* The S&P/LSTA Leveraged Loan Index is a widely used measure of the bank loan market.
^ Estimated default rate calculation based on current market pricing. Assumptions: Any defaulting loan will have a recovery of 60 and performing loans will return to a price of 95.
† Source: Moody’s US loan default rate, November 2009.
Where to Buy the Future
Brian Barbetta, Global Industry Analyst, Boston
April 23, 2020
As I argued in my March 18 post, “Technology: The Future Is On Sale,” now may be an opportune time to “buy the future” at potentially bargain-basement prices, particularly in the technology sector. By way of follow-up, here is my latest thinking on trends and industries that look poised to emerge as winners (and, conversely, losers) on the other side of the COVID-19 crisis:
- Digital advertising
- Digital goods consumption (e.g., video games)
- Cloud collaboration tools
- Online education
- Direct-to-consumer business
- Linear TV, cinema
- Traditional advertising
- High-end retail
- Physical branch banking
- Physical goods
- Business travel
- In-class education
- Supply chain/middlemen
A number of quality companies in the “potential winners” column have recently been trading at attractive relative and absolute valuations. I believe equity investors should consider using this opportunity to add (or increase) exposure to some of these stocks.
Technology: The Future Is on Sale
Brian Barbetta, Global Industry Analyst
March 18, 2020
In recent comments, my colleague David Lundgren, director of technical analysis, challenges the notion—proliferated of late by TV talking heads and social media feeds—that the stock market swoons over the past couple weeks have created a “can’t-miss” buying opportunity that equity investors should seize upon now (or soon), before it’s too late.
To be clear, David believes (and I agree) that the recent market selloff has created an attractive buying opportunity for long-term investors as markets recover when the coronavirus crisis subsides, although we are clearly not there yet.
However, he also astutely calls out the technology sector as a notable outperformer—a bright spot amidst all the market gloom—that looks likely to sustain its recent outperformance as consumers and businesses continue to leverage technology in all its forms:
“I would be remiss to not highlight how well the tech sector has been performing since this crisis began. This is impressive and warrants a continued overweight, in my judgment, unlike all other cyclical areas.”
As a technology analyst, I'd like to build on that last point. I, too, expect the sector’s recent outperformance to continue, driven largely by some key trends that all appear to be accelerating along curves that were already pointing upward, including:
- Streaming consumption replacing linear TV
- Digital advertising replacing linear models
- E-commerce replacing brick-and-mortar retail
- Digital goods consumption replacing physical (e.g., video games)
- Cloud collaboration tools replacing face-to-face interaction
- Online education replacing the traditional classroom
- Direct-to-consumer replacing legacy supply chain/middlemen
A number of stocks with exposure to these and other trends have sold off indiscriminately with the broader market and are now trading at what I consider attractive relative and absolute valuations. Accordingly, I believe this is an opportune time to initiate longer-term investments in select tech names (or to add to existing holdings).
Like David, I don’t expect to be able to perfectly call the market bottom, but look at it this way: Hypothetically speaking, if the markets were to close tomorrow and then reopen once the worst of the crisis was over, what would you want to own? I believe the future is on sale, and I think investors should consider buying.
Oil: From Short-Term Demand Concerns to Structural Supply Disaster
David Chang, CFA, Commodities Portfolio Manager, Boston
March 9, 2020
There’s no two ways about it: the OPEC meeting on March 6 was a disaster that could end the Vienna Agreement, reverse the market-balancing efforts of OPEC+ since 2017, and lead to an all-out price war. Amid the shock caused by the coronavirus, oil demand is currently contracting at its fastest pace since 2008. Demand was originally expected to grow by one million barrels per day (bpd) in 2020. Now, we think demand growth could be negative for the year.
Prior to the meeting, the Saudis suggested further cutting production to shore up the price of oil in response to the recent coronavirus shock. Russia refused to cut, as this would cede market share to US shale. The Saudis, as in 1986 and 2014, decided they would not go it alone, so no cut was announced. Over the weekend, Saudi Arabia sought to demonstrate its resolve, lowering its official selling price (OSP) by US$8/barrel, the largest reduction in over 20 years. This decision will affect approximately 14 million bpd of exports that compete with exports from Asia, Europe, and the US. As a result, while the market had widely anticipated production cuts of one to 1.5 million bpd by OPEC+, we now could see additional surpluses, driven by a protracted price war.
Potential market fallout
Amid potential production increases from OPEC and Russia, it is important to remember that this is the most oversupplied market of the last two decades, given long-planned production increases from offshore fields in Guyana, Brazil, and Norway, coupled with the recent virus-related demand collapse. While Saudi Arabia is likely to boost production from 9.7 to 10 or 11 million bpd, most other OPEC members are already effectively producing at capacity. The market is in no condition to absorb another million-plus bpd. This move is effectively the Saudis saying that they are unwilling to support the market on their own.
What about US shale?
While US shale production could materially decelerate under US$40 West Texas Intermediate (WTI) crude prices, it would take six to 12 months for the lower rig-account activity to flow through to lower production. In this environment, for prices to stabilize, lower production is required immediately, meaning the oil price will have to fall to cash costs before producers are encouraged to shut in their wells.
Additional concerns and risks
- The global economy. Does this raise the probability of a recession? Low oil prices clearly benefit the consumer. However, below a certain threshold (I’ve generally assumed around US$40), low oil prices can disproportionately negatively affect the global economy in a much broader sense. Low oil prices stress export and fiscal revenues among several emerging markets and further pressure fragile US industrial activity.
- US energy (production, equities, and credit). In contrast to 2014 to 2016, US producers have less latitude to reduce costs and enjoy more limited access to capital markets. Meanwhile, this disruption is happening when financial markets are already roiling.
- Currencies. With a floating ruble, Russia is in a much better position than Saudi Arabia to absorb a price shock. Will Saudi Arabia address this situation through a devaluation or floating of the riyal?
- Inflation expectations and quantitative easing. As this development potentially extends the duration of low oil prices, might we see even lower inflation breakevens, allowing for additional central bank action?
- High oil inventories and negative carry. Overproduction will translate into rising oil inventories and a steep contango* in the futures curve. This will likely generate a negative roll yield that can invite further systematic selling of oil and extend the price slide.
If there is a tiny silver lining, in the longer term, this decision has the potential to rebalance the oil market by accelerating a slowdown in non-OPEC production, from the US and the rest of the world. OPEC’s restraint since 2017 has allowed non-OPEC production to grow and capture incremental gains in global demand. While we may see this trend reverse, it could be a long process. The focus for now will be on the more immediate consequences of Friday’s debacle in Vienna.
*Contango is a situation where the futures price of a commodity is higher than the spot price (the current price in the marketplace at which a given asset can be bought or sold for immediate delivery). Contango usually occurs when an asset price is expected to rise over time.
US Consumer “Recession” Ahead?
Evan Hornbuckle, Global Industry Analyst, Boston
March 9, 2020
While the US consumer entered 2020 on firm footing, based on what I know today, I think it’s probable that confidence gets hit hard enough to drive at least a few months (and maybe 6+ months) of discretionary spending declines. In such a fast-changing environment, this is clearly impossible to prove today, though we have seen deceleration in the most recent week of our consumer credit card panel data.
Importantly, a large minority of US consumer spending stems from the wealthiest 10% of households. Consumer confidence and household net worth (which correlates highly to equity markets) are big drivers of spending for this cohort, and both are taking heavy enough punches now to suggest overall consumer-spending declines. Depending on how broadly the virus spreads (my base case is a broad outbreak), US jobs could also eventually take a hit, which would disproportionately hurt the lower-income cohort, whose savings rate is perpetually at ~0%. It’s possible the Fed pulls more rabbits out of its hats to counter these pressures, but I’m skeptical; conversely, we could see fiscal measures like payroll tax cuts, which could be a bigger spark to spending.
Sectors that could be hit hardest include cruise lines, airlines, hotels & casinos, restaurants, and malls, among others. Sectors that could be most immune include home & personal care (HPC), food & beverages, beauty, housing, and e-commerce, among others. Some stocks in the “hit hardest” category have already gotten hammered 20%–40% so I’m not suggesting there are no good stocks in that bucket, even if fundamentals are about to roll over. In fact, I don’t find the above delineation (“hit hard” vs. “most immune”) overly helpful for forward-looking stock picking because I’m focused as much on assessing what’s already embedded in the stocks as who has the highest/lowest earnings-per-share risk. I’m also cognizant that the market will eventually look through the virus-related disruption (likely well before the virus disappears), and I think the consumer rebound could be sharp if a cure is found quickly. So overall I have adopted a conservative mentality, but I am still looking for opportunities to play offense where the market is over-/under-shooting.
A Tailwind for US Housing
Nate Kieffer, CFA, Global Industry Analyst, Boston
March 9, 2020
Despite the knee-jerk reaction of many investors (economy bad = housing bad), I think US housing can potentially be a safe haven if the coronavirus pushes the US economy toward a recession. It is hard to overstate the impact of the sharp decline in rates. Historically, when trailing six-month mortgage rates are up or down >50 bps, that has tended to trump all other factors in housing.
Of course, it will take some time for mortgage rates to catch up with the 10-year Treasury yield. As it stands today, the spread is already at a level we haven’t seen in over 30 years excluding the global financial crisis. But I think it is fair to say that the powerful mortgage-rate tailwind that we have seen over the last seven months has at least 13 months to go, which could potentially lead to fundamental outperformance versus other cyclicals.
Asia Tech as the “Canary in the Coal Mine”
Anita Killian, CFA, Global Industry Analyst, Tokyo
March 9, 2020
The coronavirus turmoil is just another in a long string of challenges faced by the Asia tech sector over the past two decades. First up was the Asian financial crisis, followed by the bursting of the tech bubble, the SARS scare, the global financial crisis, the Thailand floods, the Japanese earthquake, the US-China trade war, and now COVID-19. I think it’s fair to say that Asia tech companies have grown quite resilient in the face of hardship. I call them the “Navy Seals” of the global economy.
I see no reason why the current crisis should be much different from past episodes. Asia tech stocks may have led the way into the storm, but if history is any guide, they (especially the hardware stocks) may also lead the way out of it. This is because technology is so pervasive in the global economy that it has become nearly 100% coincident with what is happening in real time. Asia tech can be thought of as the “canary in the coal mine,” so to speak, meaning it may be a good place to be positioned for an eventual recovery.
I would not necessarily rule out a second-half rebound in sector fundamentals. I believe the situation on the ground is much better than might be expected:
- Demand actually appears to be pretty strong or at least “delayed strong,” meaning the intentions are there, even if not fully acted upon yet.
- Many factories are nearly fully back in operation as of this writing, while utilization rates are high and inventories low.
- Prices for many products have been going up and should rise again in April when new second-quarter contracts are signed.
I believe this relative strength and optimism is being driven by trends and forces I highlighted earlier in the year: 5G equipment and handset demand, inventory restocking, memory market recovery, China localization, Chinese semiconductor development, and migrating supply chains. The only area that looks dubious to me is the auto market, but that could change dramatically if China stimulus comes through. My bottom line: I think COVID-19 is having a sharp, but likely a fairly short-lived, impact on business in Asia “tech land.”
Update on Currencies – Euro and US Dollar Uncertainties
John Parsons, Currency Portfolio Manager
March 31, 2020
What Would Winston Churchill Say Today?
It would be interesting to hear Churchill’s thoughts on the current crisis. Sadly, we will never know, but we do know he didn’t think much of currency traders:
“There is no sphere of human thought in which it is easier for a man to show superficial cleverness and the appearance of superior wisdom than in discussing questions of currency and exchange.”
With those stinging words ringing in my ears, here are my thoughts on currencies in the current environment.
The Euro Faces Existential Threat
I think the euro will face an existential moment in the coming weeks. That can be avoided if the eurozone countries move to risk-sharing and towards a full fiscal transfer mechanism. Since adopting the single currency, Italy has hugely underperformed (30% below the average level of GDP of other member states, as we enter this crisis) and has suffered high social costs as a result.
Today, Italy does not just need a credit line or a central bank buying its debt, nor does it need conditionality—it needs a cash transfer. At the end of this year, real GDP growth in Italy going back to 1995 will be close to zero and unemployment could be above 15%. No loans will change that. The eurozone will very soon need to make a decision on this.
US Dollar Uncertainty
The dollar has rallied strongly recently, benefitting from its reserve-currency status and a scramble for dollar liquidity. With the help of the US Federal Reserve, that has begun to fade. The dollar will now be judged on public health policy and fiscal policy over the next few months. Both fronts entail uncertainty and risk.
Given there is so much we do not know, the future for the dollar is unclear, with many unanswered questions.
- What will the US-China relationship look like in five years?
- What does the end of independent central banking and the potential introduction of ‘Modern Monetary Theory’* do to the world’s reserve currency?
- Will the euro survive?
- Will China emerge from the crisis stronger relative to the US?
New Crisis, New Rules
We do know that the world has changed this quarter, in ways no one could have imagined. Applying old rules now can be very dangerous. Two of the great promises made by policymakers after the 2008 crisis were “we will improve income inequality and reduce the levels of debt in the system as a proportion of GDP”. They failed on both counts and many societies will not now accept the same solutions to this crisis.
In most jurisdictions, the worker, shareholder, and governance relationships will change dramatically. Societies will demand a different set of priorities, starting with public health, against a backdrop of deglobalization and more volatile geopolitics.
A different Churchill line would now seem to apply to investment decision making: “Thought arising from a factual experience may be a bridle or a spur”.
* Modern Monetary Theory is a heterodox macroeconomic framework that says monetarily sovereign countries like the US, UK, Japan, and Canada are not operationally constrained by revenues when it comes to federal government spending.
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