In the famous fairy tale “Goldilocks and the Three Bears”, Goldilocks only eats the bowl of porridge that is not too hot and not too warm, but just right. Similarly, investors have undoubtedly enjoyed the last decade, as economic growth has been steady and positive, but not too high as to put upwards pressure on inflation. Like real GDP growth, earnings per share (EPS) growth was low, but positive.
Share buybacks, often funded by adding corporate debt, improved the earnings per share ratio, which made stocks look attractive in terms of valuation. The low rate environment further enhanced the sentiment that there were no alternatives to risk assets. Large private equity players, some of which are now begging for bailouts, helped push up valuation multiples by extrapolating low rates and steady cash flows into the future. Any hiccups along the way were swept under the rug by the elites that gather in Davos every year. It certainly kept the ‘buy the dip crowd’ active.
Unfortunately, this goldilocks scenario also gave rise to what is called the most unloved rally. The marginal buyers were mainly the companies themselves buying back shares. Did they do so because they thought the future was very bright, or because they did not want to invest in an uncertain world of low growth? Private investors and institutional investors were no marginal buyers, as the macro environment didn’t feel genuinely strong. Would we have seen 1.3% real Eurozone GDP growth or 2.3% real US GDP growth without the monetary stimuli, budget deficits, US tax cuts, currency interventions? In fact, the level of intervention has often been underestimated, which has kept us somewhat more defensive over a number of years. This has not been detrimental to portfolios, as less risky international government bonds performed exceptionally well over this period.
In the meantime, global debt had grown to USD 250 trillion by the end of 2019. And therein lies part of the problem. How can we solve a debt crisis with more debt?
At some point the pile of debt becomes unstable and fragile. When a snowpack is close to its breaking point, a small trigger can cause a large avalanche.
The Trigger
The economic system was vulnerable due to a lack of cash flows (USD and other) to repay coupons and principal. The trigger of this avalanche turned out to be the abrupt halt to the economy brought about by the global lockdown as a result of the COVID-19 outbreak.
At the start of the year, market participants thought the virus outbreak would stay confined to China. As the virus spread, markets started pricing in the closure of large parts of the global economy. The volatility of most asset classes and currencies spiked and levered players faced margin calls, which led to forced-sell orders where ever liquidity could be found. The amount of leverage in the system led to one of the largest and fastest declines ever in some asset classes. Unprepared investors had very little time to act due to the aggressiveness of the selloff. On some days, price action seemed strange as ‘low risk’ assets became part of the sell-off as well. This is what happens in a panic: correlations shoot up and diversification is of little help. The liquidity event was quickly countered by central banks (especially the Federal Reserve) which supplied the necessary flows, as companies drew on existing credit lines in what felt like quantitative tightening. Still, one should necessarily refer to it as a “stimulus”. Central banks and governments merely tried to stop the economy from completely going under.
The Avalanche
As we indicated in the former paragraph, the corona virus is not the real problem, but just a trigger. In due time, we will overcome this health crisis, either by building up an immunity, or by coming up with a cure. But in economic terms, the real problem remains.
On the one hand, there is a lot of debt. On the other hand, there seem to be issues with the plumbing of the financial system. Remember that the Federal Reserve (Fed) already faced the repo issue in September 2019, some weeks before the outbreak of the virus. First, they reassured us that it was a one-off. Soon after, they said it would only be temporary. Half a year later, the Fed is still facing this issue and is battling on different fronts, trying to plug the holes in the financial system (US repo, international repo, US dollar swap lines).
Luckily, with enough effort and coordination, these issues can be addressed. However, the current debt pile and potential solvency issues are less likely to be taken care off in the short run.
The size of the debt outstanding, and more specifically, US dollar debt, is simply astonishing and weighs on economic growth. Moreover, countries that contribute most to global GDP growth are feeling the negative effects of an aging population. Liabilities linked to social security and Medicare seem unsustainable. As a result, economic growth will likely remain low, as the debt situation keeps hanging over its head like the sword of Damocles.
In order to get out of the current situation relatively unscathed, a number of things must be taken care of:
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If possible, a debt deflation should be avoided. It leads to a continuing negative spiral from which it is hard to escape. One can compare it to a black hole. If we continue on the path of the last decade, it is highly likely that we end up in this scenario at some point. The alternative, namely a scenario of higher inflation, will have its own challenges. But, at least in this scenario, capitalism works. It is a scenario that gives people hope and prospects.
There are obviously more challenges in this difficult financial environment.
As Ray Dalio, Stan Druckenmiller and others have mentioned, the tools of monetary policy are becoming less effective, which is not the same as saying that there are no more tools. It can even be questioned whether negative rates are productive at all due to the potential subsequent unintended consequences. Still, what to do if we end up in a scenario of serious deflation? Rates would have to be negative to avoid real rates from shooting up. The latter scenario would slow down global growth once again.
Although we clearly have a lot of challenges to deal with this decade, we remain optimistic and believe that these challenges can be overcome.
The way forward
There are different possible outcomes. The investment teams are working hard to learn more about said outcomes, but it is too soon to come up with an all clear picture. Over the coming weeks and months, pieces of the puzzle will become apparent in the markets, and policymakers will give us a glimpses of where we are headed.
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Policymakers can try the muddle-through approach of the last decade. However, debts have increased, monetary policy is becoming less effective, there are talks of de-globalization and we are not even out of the current recession yet. It is doubtful that the same recipe will bring us back to normal. In fact, this “normal”, as mentioned in the introduction, was already subpar when placed in a historical context.
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The most likely scenario is one where a joint effort between governments and central banks tries to accelerate inflation. This might be through a combination of a form of Modern Monetary Theory (MMT) , that is gaining a lot of traction, and Yield Curve Control (YCC) , whereby yield curves are kept just steep enough to keep the financial sector alive. It might be accompanied by a rise in gold against most currencies (including digital currencies). Will it work? It is still uncertain, but it looks like the path of least resistance.
And then there is this silent (perhaps idle) hope. Ideally, at some future point in time, we might go back to true capitalism where intervention of policymakers is kept at a minimum. A system where the government promotes sound capitalism with a better balance between the reward for labor and capital. If employers were to install this, inequality would taper off and social unrest, a byproduct of inequality, would gradually move to the background.
How to position?
As of late February, we have positioned our portfolios defensively. We have an underweight position in most volatile asset classes such as equities, listed real estate and high yield. With regards to high yield and listed real estate we specifically mentioned in the past that these assets are less liquid. As a result, they are difficult to sell in falling markets. This was not foresight, but just common sense of portfolio managers who have already witnessed multiple storms. We were also highly underweight in investment grade corporate bonds, where yields failed to reflect the changed quality of the indices (higher weight of BBB paper). The investment case had become asymmetric. Heads, you do not win, tails you lose. Instead, we mainly invested in international government bonds, where yield curves were still interesting. In addition, we added gold (where possible) to hedge against the above-mentioned scenario. Little did we know that this scenario would play out so quickly.
In terms of equity selection, we prefer quality growth. A style often perceived as more expensive. In our view this is not always the case, as long as you focus on companies with solid balance sheets.
At the end of March, we decided to buy some US (our preferred region) and European equities, which suffered the most. We are currently still underweight because markets often correct in a W-shape. As a result, there might be another leg down in the near future. We have a relatively high conviction in inflation-linked bonds and gold. Inflation-linked bonds obviously suffered during this disinflationary correction but at some point, one hardly priced in ay inflation for the next 10 years. Moreover, the majority of these bonds have an inflation floor embedded into them. The asymmetry of potential outcomes has become really interesting. We also like gold. Gold will often diversify the equity risk well. The same can be said for government bonds, at current prices, there is no cap on gold while the upward potential for government bonds is limited. The biggest advantage that gold has is the fact that it does not have any counterparty risk (Exter’s inverse pyramid), which might prove to be of high value in the future. Both investments fit well in the scenario where economic growth will return to higher levels, accompanied by relatively higher inflation levels than those of the previous decade.
In terms of equity selection, we remain positioned in the same styles. The next couple of weeks could be a little difficult since the so called ‘crap’ rallies can temporarily push these styles downwards. We also have to be careful with the consumer discretionary sector, because it is possible that the consumer will need time to adjust to the new environment.
