Monthly Investment Letter: Looking past the peak

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Just a month ago, we didn’t know whether western democracies’ unprecedented lockdowns would be sufficient to slow the spread of the coronavirus. Now, markets have risen sharply as investors have dared to look beyond the peak of the pandemic.

Given that the central scenario laid out in last month’s Monthly Letter (in which new cases of the virus peaked by mid-April) is playing out as expected, in this letter I refresh our scenario analysis, and consider the next three phases of the coronavirus crisis so investors can evaluate the risks and opportunities that lie ahead.

1. In the first phase, normalization, most of the US and Europe allow employees to return to work, but output remains well below pre-crisis levels.
2. In the second phase, recovery, the economy gradually returns to pre-crisis levels. Net new business formation is positive, and workers made redundant during the lockdown find new positions.
3. In the third, post-crisis phase, we are left with the legacy of the crisis: a world more indebted and less global, yet more digital.

Despite the complexity of the three phases, and the wide range of possible outcomes, markets can only process a few key themes at a time, and, over the coming months, we think the market is likely to be driven primarily by: a) how quickly we can move through the normalization phase, and b) estimates of how far through the recovery phase we can get during 2021.

Our central scenario, in which intermittent lockdowns through 2020 mean that some broad recovery phase can only sustainably get underway in 2021, is already priced in by broad equity indexes. But there is no paucity of opportunity in markets today. We continue to believe that credit is cheaply priced relative to its risk, and we overweight US high yield and USD-denominated emerging market sovereign bonds in our US tactical asset allocation. Volatility remains elevated, providing investors the opportunity to gain asymmetric exposure to markets, or harvest yields. And within equities, we don’t think markets have yet fully appreciated the scale of structural change driven by the pandemic – with implications in particular for Digital Transformation, E-commerce, Fintech, Automation and Robotics, Healthtech, Genetic Therapies, and Oncology.

The economic and social uncertainty created by this new virus is extraordinary.

Massive government intervention in the economy means political decisions can now drive a much wider range of market outcomes. And central bank intervention in the bond markets makes diversification less straightforward than in the past. But, with a far-sighted financial plan, flexible enough to take advantage of opportunities, yet disciplined and diversified enough to stay the course, we remain convinced investors can both protect, and grow, capital over the long term.

Central scenario

1) Normalization

Now that we know social distancing policies can prevent healthcare systems from being overwhelmed, governments will begin to make trade-offs between the healthcare system and the economy. In Europe, the majority of restrictions in Spain have been extended to at least 25 April, and France has extended its lockdown to 11 May. But Austria has announced restrictions will start to be lifted from mid-April, while Germany, Switzerland, Norway, Denmark, and Italy are also moving to relax restrictions. This suggests that at least parts of Europe may follow China’s path of resuming economic functioning promptly after imposing distancing measures.

Yet, second-wave restrictions and continued limitations on travel and social proximity in some Asian countries show how western nations face a more complex process than simply flicking a switch. Without a medical solution, the spread of the virus has to be dealt with using a combination of testing and tracing, along with a flexible government intervention policy. This is less disruptive than a full lockdown, but will mean recurring restrictions on businesses and free movement. In our central scenario, suppression starts to be lifted gradually from mid-May in Europe, but renewed outbreaks mean that intermittent suppression measures, including partial lockdowns, are likely. This will only allow for economic functioning to normalize sustainably from December.

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The metrics we are watching

An important challenge for investors is measuring economic functioning normalizing in real time, particularly given that countries, cities, and regions, are likely to remove restrictions both gradually and unevenly. Much of the economic data we usually rely on also is subject to distortions from the lockdown or government policies to save jobs and businesses.

We therefore monitor the passage through phase 1 using a combination of big data and employment data. More specifically, we think we can be confident we are leaving phase 1 and entering phase 2 when Google data of retail and recreation footfall reaches >80% of pre-crisis levels, when mobility trends such as public transport as well as city and air traffic reach >75%, and when employment indicators show significant signs of improvement as well. Although employment data is normally a lagging indicator, in this cycle it is more likely to be a coincident indicator. So we will also be watching the US unemployment rate and the number of European furloughed workers who have returned to full-time work.

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2) Recovery

In our central scenario, intermittent lockdowns through 2020 mean that the recovery phase only sustainably gets underway from the beginning of 2021. How quickly the economy and corporate profits return to pre-crisis levels thereafter will depend on the success governments have in reducing bankruptcies and job losses. We estimate that unemployment by the end of 2020 will be 100–150% higher than precrisis levels in the US, and will be 25–50% higher in Europe, and S&P 500 profits will be down 26% in 2020.

The nature of government support may be the key to the recovery in 2021. Policies that pay furloughed workers a high proportion of their wages should have the effect of boosting consumer spending once the lockdown is over, since many furloughed workers will have saved some money during the lockdown. If workers are sufficiently secure in their jobs, they will spend their savings and the furlough policy transforms into a stimulus. The USD 1,200 payouts to most adult Americans should also act as a stimulus to spending for those people who have kept their jobs during the lockdown.

Although we expect a recovery in 2021, we don’t think corporate profits will recover levels reached in 2019 until 2022. We estimate that S&P 500 profits in 2021 will be around 5% lower than in 2019. Assuming we are on course for this scenario, we would expect the S&P 500 to be trading at around 2,750 by the end of 2020.

Upside scenario

1) Normalization

In our upside scenario, most countries in Europe and the US decide to start lifting suppression measures from early May, allowing many types of economic functioning to sustainably normalize by the end of June. Achieving this could involve strategies like implementing widespread testing while using mobile phones to trace infections, thus keeping the virus well within the capacity of healthcare systems to cope with new cases. An alternative path could be the discovery of an effective medical treatment that significantly reduces the strain on hospitals, allowing societies to begin to see COVID-19 risks more like seasonal flu risks. It could also involve measures that limit movement for more at-risk groups but allow the majority of the working-age population to resume normal activity.

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Medical breakthroughs

As of today, no treatments are known to be effective against COVID-19. Developing an effective treatment could help to reduce the pressure on hospitals and intensive care units, by reducing patients’ length of stay or keeping less severe cases from progressing. This would help to manage second and subsequent waves of infections. One type of drug that looks promising is nucleoside analogs, a class of drugs that can block the virus’s replication process and slow its spread in the body.

Results from the first clinical trials of one such drug, remdesivir, are likely to be available in the coming weeks. Based on the very limited data to date, it could well show signs of efficacy. Should the data be positive, remdesivir’s manufacturer can produce enough of the drug to treat around 1 million patients in the coming year. There are at least two other nucleoside analogs being trialed for COVID-19.

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2) Recovery

In this scenario, the lockdown phase is short enough and government policy effective enough that we enter the recovery phase in a relatively strong position. We estimate that if economic functioning can normalize by the end of June, unemployment in the US is likely to end the year at 75–100% higher than pre-crisis levels and 0–25% higher in Europe. The effect of the massive monetary and fiscal stimulus in recent months would help to restore economic activity to pre-crisis levels by 2021. For 2021 as a whole, we would expect S&P 500 profits to exceed levels reached in 2019 by around 6%. In this scenario, we would estimate the S&P500 trading at 3,150 by the end of 2020.

Downside scenario

1) Normalization

In our downside scenario, suppression is lifted in the coming months, but a major second wave of the virus overwhelms healthcare systems and leads to a renewed lockdown, setting back the recovery phase by up to a year, and contributing to a high degree of political caution about lifting lockdown measures again. As well as being a humanitarian disaster, this could lead to significantly more business failures and permanent redundancies if more successful government intervention also fails to materialize.

2) Recovery

In this scenario, economic functioning would not sustainably normalize until June 2021, and the damage inflicted to jobs and businesses in the interim means that the economy would enter the recovery phase in a very weakened state, with high levels of unemployment, and with some workers permanently leaving the labor force due to skill loss.

In this scenario, S&P 500 profits in 2021 would be around 20% lower than levels achieved in 2019, and we would likely only see profits reach prior highs in 2022 or even 2023. We would expect the S&P 500 to be trading at around 2,100 by the end of 2020.

Our scenario analysis for markets

Taken together we arrive at the following matrix of three scenarios, defined by: a) how quickly economic activity normalizes, and b) how economic activity and corporate profits stand in 2021.

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Finding the right multiple

Valuations are a function of a discount rate and a growth outlook. The very large increase in government debt to support the economy creates uncertainty about the long-term growth outlook. But equally, the very low level of interest rates should boost valuations, and investors might also be willing to pay a higher-than-average multiple if they expect a continued earnings recovery through 2021 and into 2022. On balance we think a slightly higher-than-average multiple is justified to anchor our central scenario. The S&P 500 has traded on an average forward price-to-earnings multiple of 16.7x over the past five years. In our central scenario we apply a P/E ratio of 17.6x to our 2021 EPS estimate of USD 156.

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Phase 3: Post-crisis

Even after corporate profitability and economic activity return to pre-crisis levels, we foresee structural changes: a world more indebted, less global, yet more digital.

Financing elevated government debt levels will likely require a combination of financial repression, taxation, and moderately higher inflation. The combination of financial repression and moderately higher inflation will amount to an effective tax on conservative savers, and so will therefore require investors to reconsider the place of bonds and cash in their portfolios. Alternative diversifiers including option strategies, dynamic allocation strategies, and private markets will need to play a bigger role, as well as assets like gold and Treasury Inflation-Protected Securities (TIPS), which may additionally provide protection against the risk of higher inflation. Potentially higher tax rates, combined with elevated financial market volatility, will also increase the importance of financial planning and strategies like tax loss harvesting.

We foresee structural changes: a world more indebted, less global, yet more digital.

The world will also be less global. Pandemics have a habit of driving xenophobia, and we should expect more populism and protectionism. For investors, a less interconnected world will create different outcomes in individual countries and increase the importance of global diversification. But we also expect this trend to create opportunities. The fourth industrial revolution has enabled local manufacturing, but uptake has been slow due to the cost of investing in local infrastructure. But with the virus highlighting the need for robust supply chains, and coming shortly after a period of heightened US-China trade tensions, we think that, for many companies, this crisis could tip the balance in favor of local, rather than global, production. We expect companies exposed to Automation and Robotics to experience higher demand.

Finally, the world will also be more digital. Lockdown measures have forced many consumers and businesses to change fundamentally the way they buy and sell goods and services, accelerating digital adoption rates. Once the crisis is over, consumers may not fully revert back to use of brick-and-mortar shops, a boost for companies exposed to E-commerce and Fintech.

Policymakers under pressure to improve the quality and efficiency of healthcare delivery are also likely to turn to Healthtech, boosting demand for areas from healthcare IT, to cutting-edge innovations like telemedicine and population health software. Other key related themes in which we see significant investment opportunity are Genetic Therapies and Oncology. Genetic therapies have the potential to significantly improve the efficiency of healthcare delivery, and, with the rate of growth in new cancer cases likely to be double the rate of population growth until 2040, we expect the market for oncology drugs to grow by low-double-digit percentages each year.

Investment recommendations

Considering our scenario analysis, we currently see a better risk-reward trade-off in credit than in the global equity indexes. Further upside for equity markets as a whole would likely require additional fiscal or monetary stimulus, greater clarity about exit strategies, or a medical breakthrough.

Credit

We see credit as attractively priced at present. Monetary and fiscal policy is deliberately targeted at ensuring that companies that were viable prior to the coronavirus crisis remain viable. Corporate behavior has become much more bondholder friendly, including cuts to share buyback programs, dividends, and capital expenditures. Historically, when credit spreads are as wide as they are today, credit investors have enjoyed attractive subsequent returns.

We are overweight hard-currency (USD) emerging market sovereign bonds (EMBIGD), and see current spread levels of more than 600bps as attractive. Since 2000 there have been 52 months with EMBIGD spreads in excess of 500bps. Subsequent 12-month total returns were positive in all cases, with a median return of 13%.

Emerging market sovereigns have lower external vulnerabilities in aggregate because hey have better current account balances today than they did during previous crises. Multilateral policy has also been deployed through the IMF and the Federal Reserve’s dollar swap lines to lend support. At current levels of 600bps, spreads are close to pricing in our downside scenario (700–800bps). In our central scenario, we expect spreads to tighten to around 450bps.

We are overweight US high yield (HY) credit. At current levels of 764bps, high yield bond spreads still offer attractive return potential, particularly given the Fed’s decision to expand corporate credit facilities to allow for purchases of bonds recently downgraded below investment grade. Since 1987, there have been 89 months with spre ads in excess of 700bps, and subsequent 12-month total returns were positivein 87% of cases, with a median return of 17.5%. In our central scenario, we expect US HY spreads to tighten to around 550bps, and 350bps in the upside case.

We overweight TIPS against US government bonds. TIPS will outperform if realized inflation comes in above the current very low US 5-year breakeven rate of 0.65%. In our central scenario of the recovery phase sustainably getting underway in 2021, we think it's likely that realized inflation will gradually rise back to 2%. Then in the post-crisis world, policymakers will tolerate moderately higher inflation to address elevated government debt levels.

Equities

Overall equity market indexes are close to pricing our central scenario. At this point, the key opportunities are in a) taking advantage of elevated volatility to earn coupons (e.g. through put writing), b) using elevated skew to gain asymmetric exposure to markets (e.g. through risk reversal strategies), and c) looking for selective exposure in oversold opportunities, resilient stocks and sectors, and in companies that could see an enduring boost in demand as a result of the crisis, including those exposed to Automation and Robotics, Digital Transformation, E-commerce, Fintech, Oncology, and Genetic Therapies.

FX strategy

We overweight the British pound versus the US dollar. The Fed’s measures to ease USD funding stress, and the coordinated action from the UK government and the Bank of England to support the British economy, have already triggered a rebound in GBPUSD in recent weeks, and we expect that rebound to continue. We forecast that GBPUSD will reach 1.40 by the end of 2020. Economic conditions in the UK are similar to those in Europe and the US, but the UK has a deeply undervalued currency – our estimate of fair value on a purchasing power parity basis is 1.57.

We close our basket of high-yielding emerging market currencies. We close our overweight position in the Indonesian rupiah (IDR), the Indian rupee (INR), and the Brazilian real (BRL), funded by short positions in the Australian dollar (AUD), the Taiwan dollar (TWD), and the Swedish krona (SEK). The position received some protection due to the pro-cyclical short positions, but we now see little upside as the coronavirus crisis spreads to emerging markets.

Commodities

Oil

OPEC+ reached a deal to cut oil production by 9.7mbpd on 12 April, but we think the cuts will do little offset the near-term destruction in demand. Lower prices are needed to trigger further production shut-ins in North and South America and prevent inventories reaching capacity limits. In the medium term, however, output cuts may help rebalance the market and support prices if demand recovers in 2H20. We see Brent falling to USD 20/bbl or lower this quarter, but rising to USD 30/bbl by the end of September and to USD 43/bbl by the end of December.

Gold

The two most important determinants of the gold price are real US interest rates and expectations for the purchasing power of the US dollar. Led by Fed easing, we now expect real US interest rates to dip deeper into negative territory and perhaps even test the post-GFC lows. Also, the forces behind a potential debasement of the US dollar have intensified. We have raised our gold price forecast to USD 1,800/oz.

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