March 16, 2020

Covid-19 and Investment Path – March 2020

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Firstly, the health issues

Much has been written on the medical and health issues of COVID-19 in recent weeks by people far more knowledgeable than I am, and much more will follow in the weeks to come. Nonetheless, there is no doubt we are going to see a huge increase in the number of cases of the virus in the coming days and weeks. This is not due to any new pattern in the spread of the disease but most likely to a major change in the requirements to be tested. Until recently, if you had a flu-like illness but had not recently travelled to affected areas of high contagion such as China or Italy, you would not be tested. The Covid-19 and Investment industry outlook is being tested also, and with equal uncertainty.

The spread of Covid-19

With the spread into communities from individuals who had travelled to those countries, anybody who might be suspected to have contracted the virus will now get tested. This is due to the way in which the global health care systems work; you get tested if you meet the case definition, and the case definition included travel only up to the last few days. So, expect to see hundreds if not thousands of new cases being announced on a daily basis especially in the US as testing increases and with it a raised level of panic. The amount of panic buying internationally of sanitising and basic food stuffs in supermarkets over the last few days is testament to the current irrationality of the moment.

Despite the growing hysteria this is not the Zombie apocalypse, albeit if you are in the elderly age group  or a new born child (both groups having lower immunity rates), have a pre-existing medical condition affecting your respiratory or circulatory system or other conditions such as Diabetes, you really do need  to take care.

Health Services worldwide are focusing on slowing  down  the  spread  of  this  disease not because they don’t want to eradicate it entirely (there is no vaccine yet available), but because health care staff are over-stretched tending to those that present to hospitals or phone services with possible symptoms.

Despite promises from governments in recent days to throw money at this global emergency, the fact remains that all national health services have been constrained by the lack of sufficient physical staffing which existed almost globally before the outbreak started.

Realistically speaking, it is one thing to expound on financial injections now being made available to health services and another to actually put experienced and qualified staff in sufficient numbers on round the clock shifts to deal with the problems on the ground.

Why is slowing the spread important?

Put simply, the more that cases are stretched out over a longer period, the more that health care systems have time to prepare with less chance of being overwhelmed. Spreading out the infection rate means a more measured response, less chaos and less fearmongering as well as providing better care to those who have contracted the virus.

Most people might be surprised to hear that this type of “Black Swan” virus was actually anticipated by virologists and epidemiologists – minus the very useful information on what, when, where and how big. After the last COVID-19 case is gone, there will be pandemics in the future, they have always been in our past.

Also expected by these medical specialists was the degree of initial apathy and inertia due to mental framing in how little respect was given to the effects of the virus. There is often an inability to correctly appreciate risks that you have no experience of or where one over-relies on historical data. In a nutshell, humans (politicians, investment analysts and doctors alike) have initially behaved as expected but are  now learning quickly. We expect this of humans.

So what are the global economic issues?

It is uncertain when economic activity will resume to a consistent level worldwide as monetary policy support is needed to mitigate the credit crunch risk, while a fiscal push is required to support the shock   on the supply side. In the short term there will most likely be business failures, especially those in local communities such as coffee shops, pubs and restaurants as well as larger national operations such as hotels, airlines and tour operators. Most of the bigger economies have learned the lessons of the Great Recession from 11 years ago and have started to take appropriate action in this regard.

More central bank interventions, after the recent Federal Reserve’s interest rate cut, and more fiscal policy, on top on what has already been announced in various countries, will gradually kick-start economies from the lethargy that will result from mass self isolation and social distancing. These measures will most likely cause economies to stabilise and avoid a global recession. Indeed, encouraging signals are already coming from China, where activity is gradually resuming.

What does the Economic data tell us?

Of the Developed Economies, Italy with its high level of elderly citizens is most at risk due to its extremely large Government Debt, which is almost 135 per cent of GDP before the slowdown in economic activity due to the virus. This may well have a major long term impact on the overall Eurozone project. In the US, the declaration of a National Emergency by Trump last Friday as well as the Food and Drug Administration’s acquiesce to fast track COVID-19 test approval might be more telling than one might suspect. Despite last Friday’s 8% rebound, the US public reaction to the likely large number of infections that will evolve in the coming weeks will lead to a continuation of the stockmarket roller coaster.

Financial Support from Governments

The provision by many governments of financial support to those, hopefully, temporarily laid off work as well as the likely postponement of tax collection will have serious impacts on those countries’ current accounts as well as the likely deferral of many capital based projects which would also have brought future cashflow benefits to economies. The best laid plans of governmental budgets of recent years have now been blown wide open and will most likely result in future sovereign bond issuance and or further quantitative easing. In addition, the current and possible future cancellation of many cultural and sporting events will have direct impact on regional economies.

Speaking of regional economies, let us not forget that the BREXIT issue has not disappeared and with the interruption of face to face negotiation by way of social distancing and clampdowns on travel this will make an already difficult situation even more challenging. It could force the hands of all negotiating parties to be either more considerate or more belligerent. Time will tell. It will also delay the other international trade negotiations of Britain with the US, Canada and Australia to name a few.

The Winter-Flu and Covid-19

Ironically, there may be some benefits to be got from the COVID-19 situation. A key aspect of preventing the spread has been to highlight (if it was ever needed) the importance of handwashing which has been taken seriously onboard and may actually stop or reduce the more “normal” Winter Flu season in its tracks. In addition, the use of video conferencing by offsite doctors to review more common ailments has not only worked towards containing contamination by COVID-19 but also may become a formalised working practice going forward.

On the climate based issues the short term fall in travel is reducing global footprints and substantially impacting on global pollution, especially in China. Economically, the widescale use of video conferencing and home working will change the dynamic on the need for large office spaces most likely resulting in a negative impact on commercial property rentals and valuations.

How do investors keep a financial perspective?

Maintaining composure in stressful times is not easy, whether it’s dealing with the knee jerk reaction to stocking up on home goods or dealing with turbulent stock markets. Such events usually take us into unchartered territory and test us all a little more. However, “unforeseeable” events happen more often than we anticipate, but the principles for navigating them remain familiar.

A financial Black Swan

The coronavirus outbreak has been described as a “Black Swan” event. Coined by scholar and former Options trader Nassim Nicholas Taleb, a “Black Swan” is an event that comes as a surprise, has a major effect, and is often inappropriately rationalised after the fact with the benefit of hindsight. The term is  based on an ancient saying that presumed black swans did not exist – a saying that became reinterpreted to teach a different lesson after black swans were discovered in the wild.

The simplest way to start to understand the financial issues is to think about the price of a share quoted on a stock market. Put simply, it is an amount of money that seems fair for the earnings of a company, paid out in dividends (or which experiences a price appreciation), in perpetuity. If the same share traded on a price earnings ratio of say, 20, what this means is that you are paying twenty times the current year’s earnings to buy the share.

If so, what’s the problem with one bad year? Unfortunately, it is not as simple as that, otherwise markets would not have reacted as negatively as they have. The other key ingredient in assessing shares is uncertainty, which drives prices downwards. In the current environment investors simply don’t know which specific companies will survive or how accurate their financial projections are likely to be. But overwhelmingly, companies will survive, but not without pain. It does not take a massive return to profitability to get stock markets to rebound, just a little less uncertainty and a bit more clarity.

Forward-looking markets

The key thing for investors to remember is that markets are forward looking. There is no obvious correct response to the news – it has already been incorporated into market prices by people with access to the same news information. Responding “after the fact” to falling or soaring markets is the whole reason why investors tend to do worse than they should. Perfect hindsight is great, and some people get lucky with timing, but studies consistently show that composure and resisting the impulse to react or overreact is the key ingredient to successful long-term investing.

The challenge with being tempted to get out of markets when they have sold off is that it imposes  another very awkward decision – when do you get back in? If you got out in the first place because of real concerns, you are unlikely to get back in when things are at their most dire (i.e. the bottom of the market). More likely, composure returns only after a sustained rebound, and risking missing a large part of the recovery carries consequences. Sitting it out by staying invested is tough, and the next few months will be particularly hard emotionally for some people depending on their own aversion to risk. Nonetheless, it’s exactly what existing investors need to do.

What history teaches us – Part 1

At the time of writing and as someone who has been in the investment advisory business for 33 years, I can firmly say that markets have gone from being overly complacent to being overly pessimistic, discounting a prolonged period of stagnant growth. This is nothing new. Any examination of past stock markets over any rolling 15 year period will actually show short sharp shocks followed by longer term gradual recoveries which very much compensate for the interim falls.

The most recent example before the COVID-19 related fall was President Trump’s berating of China in the trade negotiations in the last quarter of 2018 which resulted in a gradual 15% fall over a two week period. This was then followed by a full reversal in the first 6 weeks of 2019. What we are currently experiencing is a temporary setback, albeit more likely to be prolonged compared to what was expected a month ago, but it will be followed by a recovery.

For many months, perhaps many years, markets have been itching for a big sell-off. This is now the end of the largest bull market in history. Widespread stock market corrections are inevitable and it’s a matter of when not if, so investors are always on the lookout for a reason to sell. Many have been ready with their fingers on the button, waiting for a reason to push it. The virus outbreak gave them that reason. Stock market falls and crashes are, whilst very uncomfortable, normal. They are the rule, not the exception,   and are part of the journey.

Investment Cycles in mind

Stock market history shows us time and again that this happens. Just like the weather changes throughout the seasons, markets  go  through  cycles  of  good  and  bad  periods. Any investor with a long-term time horizon should expect to see this happen. To fully appreciate these cycles it is worth reviewing some of the more notable and momentous falls in living memory and how investors would have fared over the long-term had they remained composed. The chart above shows a euro investor with 100% of their money in global equities just before the market crash in September 2008 to the weekend just gone.

The message here is that investors who stayed the course were rewarded. Similarly, if you invested the day before the Dot Com crash in 2000 (the NASDAQ peaked on March 10th 2000):

Source: FE Analytics

And finally, if you had invested before Black Monday in October 1987.

Source: FE Analytics

The key thing is to expect market corrections – and many of them over the long term. There has been at least 13 corrections (a correction is defined as a decline of 10% or more) and eight bear markets (a decline of 20% of more) since 1980 (using the dollar performance of the MSCI World All Country Index as a proxy for the stock market). Equity markets give a positive expected return above less risky assets such as cash deposits because of this volatility. It is the long-term price that investors must pay in order to reap the rewards of positive expected growth over time. Stepping back from short-term thinking, and instead considering the recent turbulence in the context of any person’s long-term financial plan, the correct question shifts from ‘Should one sell?’ to “Is now a good time to buy given that equity markets are cheaper now than they were?’

What history teaches us – Part 2

No amount of watching the news will provide you with the clarity you are seeking with regard to stock market movements in the short term. Steve Forbes, the founder of “Forbes” magazine, once famously said “You make more money selling advice than following it. It’s one of the things we count on in the magazine business – along with the short memory of our readers.”

As humans, we are hard-wired to seek out information that may represent a threat to us and then act quickly to preserve ourselves and live to fight another day. Is it any wonder therefore that many of us remain glued to the media at times like this? Regardless of what any latest crisis is about (this time it         is COVID-19), we have experienced market falls and then market recoveries as economies themselves recovered. Here are a few headlines over the last 40 years or so from some of the biggest and most well- respected global publications like Time magazine, The Economist and others:

Aug 1979 – “The Death of Equities is… a near-permanent condition”

Aug 1997 – “Don’t just sit there…. sell stock now!”

Sep 1998 – “A World Meltdown?”

Sep 2008: “Wild Day Caps Worst week ever for stocks”

2010: “Fear Returns”

Oct 2011: “Nowhere to hide – Investing during a time of crisis”

July 2014: “Americas lost oomph”

December 2018: “Ugliest Christmas Eve plunge – ever”

Listening to sound Financial Advice?

Who would have ever invested having listened to or read all of this? Yet the press hardly ever reports stories of gradual and solid growth, perhaps because such growth is the norm whilst  falls are the exception. Markets have always delivered over the long term. Yes, some investors have been luckier than others depending on when they invested, but that is just luck – and luck permeates every aspect of our lives, not just investing.

Turn off the radio, go for a walk and remind yourself about what is important – tune out the noise. As humans we use a mental heuristic or shortcut of over weighting recent information – look beyond the recent headlines. Focus on what you can control – your own investment risk level versus your need and willingness to take risk, diversification, controlling costs, managing taxes, rebalancing appropriately and keeping a long-term view.

Never mind all that, how does all of this impact on my pension and investment funds?

This depends on how your funds are invested. If you are invested 100% in equity funds then most likely your funds will experience a parallel downward movement in line with the falls of  the major stock market indices such as the FT100, Eurostoxx 600, the Dow Jones and S&P 500. On the other hand, if you are in a mixed fund, normally referred to as a Managed Fund, the percentage reduction will broadly depend on your holding of equities. If your equity position      is circa 60% of your portfolio then you will most likely have seen a fall of circa 60% of whatever these global equity indices have experienced. It is really important to understand that these are falls in value and not outright losses.

A good analogy to understand these falls is to look at them in the same context as to how you might value a family home. If the price of a nearby house is sold for less than what it was originally quoted then that fall in value only impacts the house that was sold. Your own house has not lost any value as you have not sold it. So when, over time, local property prices increase, so will the relative financial value of your own home. Losses or gains on homes are of no consequence unless the house itself is sold. This is the same with stock market investments.

Irrespective of the issues surrounding COVID-19 and the economic and investment impact, our advice has not changed. This can be summarised as follows:

1. If your targeted retirement age is more than 10 years away (and many of our clients retirement dates are at least 20 years away) then the recent volatility is no real concern as these falls in value are broadly regular occurrences, albeit that most such falls don’t have the dramatic background of the current health problem!

2. If you are continuing to make, say, monthly contributions to your pension fund then thenext few months will be an opportunity to invest at cheaper fund prices than in the past.

3. Similarly, if you are not likely to need access to investments in the next 7 or 8 years then hold tight and the market will recover – see our explainer notes above.

4. For our clients who are looking to retire in the next few years we have always advocated that you have sufficient cash either in your pension account or on hand in a personal account to smooth over downturns such as those experienced in the last few weeks.

5. Similarly, if you have retired, we have always made it a priority that our clients hold at least three years’ expenditure in cash so as to provide personal liquidity for emergencies and not need to cash out from their post retirement funds.

6. Finally, if you have cash deposits that are not needed for liquidity or emergency funds then the next few months will be an opportunity to consider making long term investments, all for the historical reasons set out.

In producing this document I would like to acknowledge the permission of our discretionary fund manager partner, PortfolioMetrix, to use some of their own commentary as part of this document.  

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