Tuesday 17 March 2020

Coronapocalypse - some thoughts

Over the past few weeks, markets have witnessed a legitimate 'black swan' event with the emergence of the covid-19 pandemic, which has resulted in a catastrophic collapse in global equity markets of a speed and severity that has rivaled - if not exceeded - that seen during the GFC panic.

While initial covid-19 news emerged in late January about a growing Chinese outbreak, which caused an initial 5-10% market sell-off from previously buoyant early-2020 highs, the selling eased and markets recovered during the first half of February, as the spread sharply slowed in China in response to aggressive containment measures. There have been multiple outbreaks in the past, including MERS and SARS, which both proved to ultimately have a far more benign impact than initially feared, and covid-19 appeared to be following a similar trajectory. However, from late February, news of the virus' rapid international spread triggered further sharp declines in markets, and these accelerated after news emerged about the effects in Italy and Iran being much worse than expected, including tales of healthcare facilities being overwhelmed, which were exacerbating death rates.

This was then followed by a slew of accelerating and increasingly aggressive containment measures being announced across the Western world (and some of the non-Western world), which began with the cancellation of large events, before moving on to work-from-home measures; travel restrictions; forced 14-day self-quarantines on arriving international visitors; full regional lockdowns; the cancellation of major sporting events such as the NBA; to finally the complete closures of public areas, including retail venues and restaurants, with accelerating implications for short term economic activity. Famous people have started to get infected, accentuating the sense of powerlessness. Every single day over the past 1-2 weeks has seen the news go from bad to worse, and falling asset prices and escalating economic effects have, in turn, given rise to fears that this may cause cascading liquidity/bad debt/unemployment effects that could morph into an all out financial crisis.

If that wasn't bad enough, markets have also been hit with a "one two punch" (hat tip Buffett) of a breakdown in OPEC+ supply discipline, with the cartel announcing that in an environment of rapidly falling oil demand, that they would not only not cut production further, but actually significantly increase supply, by perhaps 2-3m bbl/d. This is a separate and distinct event/shock from the covid-19 impact, as it was far from inevitable falling oil demand would lead OPEC+ to not only not cut further, but actually significantly increase supply. Oil prices have collapsed 50% to US$30/bbl, which will have significant consequences for the oil production sector (in particular the US shale sector, and its associated sizable high-yield bond sector), as well as the currencies, budgets, external accounts, and economies of the many oil producing countries in the world. Many will be forced to draw down on sovereign wealth funds to support government spending/social programs, exacerbating selling pressure in financial markets as they liquidate assets. In other words, the world has seen not one, but two shocks in sharp succession, which is an extremely rare occurrence.

So what is an investor to do in this sort of environment? Stay calm and behave rationally. It is an easy environment for investors to become emotional/irrational, as not only is uncertainty rife and markets in free fall - something that makes investors emotional at the best of times - but in this case the impact is amplified by the real and visceral fear investors feel for their own health & safety. But what is called for is a calm and dispassionate assessment of the facts. I do my best to provide one below.

There is no question that the impact on economic activity in the short term is going to be very severe, although some of the claims I have seen about the global economy essentially coming to a complete standstill are a vast exaggeration. At the front-end of consumer-facing retail and leisure, that will be the case, but large parts of the back-end global economy will remain relatively unaffected. Agricultural production, for instance, along with food processing, transportation, and retail, will not be affected. Most mining activity, processing and distribution, and construction activity will continue, particularly as China gets back on its feet and stimulates to support economic activity, and fiscal stimulus to counter the effects of the economic fallout through infrastructure spending rises in the West. The healthcare industry will most certainly continue to operate (19% of GDP in the US). Services delivered electronically, along with back-end fulfillment, will continue, as will service industries where employees can telecommute/work remotely (the world has unprecedented ability to do this in the modern era). Government salaries and services will largely continue. In addition, ignored at present is that economic activity is already quickly ramping back up in Asia - particularly in China - and large parts of the developing world with youthful demographics are likely to be relatively less affected, given that the disease disproportionately affects the old.

Nevertheless, there is no doubt that consumer-facing front-end industries such as retail, restaurants and leisure - particularly in the West - as well as the tourism and travel supply chain, are going to be very badly impacted in the short term. The airline industry, in particular, is facing it's worst downturn in history. With more and more countries implementing 14-day mandatory self-quarantine measures for international arrivals, international passenger traffic could fall close to 100% for at least a month or two - a downturn of unprecedented severity. Domestic travel will be less catastrophically affected, but will also likely still significantly decline as people defer non-essential travel.

However, it is important to remember that the ultimate impact of covid-19 will be a function not just of the severity of the effects, but also their duration. The impact is going to be severe, but there is a decent chance the duration of that severity does not exceed more than a few months. An overlooked reality in that regard is that the worse the short term severity, on account of more and more extreme containment measures (such as NYC's decision to shut all bars and restaurants), the shorter the duration will be, because extreme social distancing measures will inevitably result in a dramatic decline in the virus' average R0 (the average number of new infections each infected individual occasions) compared to the status quo ex ante, which was thought to be about 2.3.

Right now, with the world swept up in panic, there is an intuitive feeling amongst investors that not only is the impact on the global economy cascading from bad to worse, but also that a continuing uncontrolled spread of the virus appears inevitable from here. But that is assuming the worst of both worlds, and it does not seem justified. The spread will rapidly slow from here on account of these measures, and we have already seen in places like China that when extreme social distancing measures are enforced, the case load can rapidly decline, with a lag of perhaps 1-2 weeks.

Aside from government measures, human behavioural responses are also not to be underestimated. As people adapt their behaviour in response to safety concerns, people wearing masks; sanitizing their hands; and being highly sensitive to the presence of sick/coughing individuals nearby, and making efforts to keep a safe distance from strangers, could well (at a guess) halve the R0 by itself - particularly due to the widespread media coverage covid-19 has garnered. In my view, the most likely outcome from here by far is that lockdown efforts result in the volume of new cases starting to rapidly slow 1-2 weeks from now (the approximate lag duration between real case volume and diagnosed case volume).

Furthermore, provided healthcare facilities are not overwhelmed, the death rate appears relatively low. To date, South Korea has engaged in the most extensive testing (under-diagnosis is still a major issue in most markets), and the death rate in South Korea has been 0.6%, and even there, denominator effects are likely still overstating the death rate. Many people say they do not trust Chinese statistics, but South Korean statistics are highly credible. Death rates have been much worse in places like Italy primarily due to a late response and lack of adequate healthcare infrastructure, and it is the (appropriate) fear of the latter that has driven extreme measures in recent weeks in the West to contain the outbreak. That ought to be successful, for the reasons noted, such that death rates should be able to be contained at levels not too dissimilar from South Korean levels, which is about six times as bad as the seasonal flu (0.1%). The flu is also more contagious than covid-19.

In time, if needed, more sensible and less destructive containment measures might be devised and implemented. For instance, covid-19 spreads primarily through droplets emitted by people when they cough and sneeze, that are either inhaled while airborne, or which come into contact with surfaces which are later touched, and transmitted when the toucher rubs their nose or mouth. n95 masks are effective at filtering such airborne droplets. While for the moment, there is vastly inadequate production capacity, a simple and effective containment measure would be to simply require everyone to wear a mask while in public, instead of cancelling all public events/spaces. In most places in developed Asia, the simple combination of masks; temperature screening for all entering public spaces; and aggressive containment of identified cases and people they have associated with, have been largely effective in dramatically slowing the pace of transmission. Given the success we have already seen with containment in Asia, it appears likely to me that investors are being far too pessimistic about the ability of containment efforts to also work in the West at present.

The other important difference to GFC-type downturns from the perspective of the likely duration of the impact vs. its severity, is that a short term exogenous shock has different medium to long term effects than a downturn driven by the collapse of a bubble. When a bubble bursts - such as the US housing bubble during the GFC - demand falls from artificially-high levels to a more sustainable level, and a large measure of that decline is permanent (albeit there may be some short term overshooting effects). After the US housing bubble burst, housing construction and the mortgage financing supply chain, as well as all the consumer spending the prior rapid increase in leverage was supporting, had to revert back to more sustainable levels. The bubble excesses were not coming back (growth eventually resumed, but from a lower sustainable baseline).

A shock-induced hit to demand is different. As soon as the virus is contained and life normalises, demand will rapidly bounce back to prior levels - indeed it may even overshoot to the upside as pent up demand is released (e.g. people that deferred holiday plans take their postponed vacations; postponed conferences/events take place; and people that postponed buying a car or other consumer goods go out and buy them). The recovery will very likely be V-shaped in nature, which is very different to the post-GFC environment. It is being overlooked at present, but a severe and long-duration downturn is much worse than a severe but short-duration downturn.

Second-order cascading liquidity effects are also already being discussed and discounted, but people are exaggerating the risks here in my view. Prior to the GFC, many corporates and financial institutions were relying on short term paper, and money markets seized up. Due to the GFC experience, very few financial institutions and large corporates now rely on short term money markets to fund their operations, and most operate with large liquidity buffers and long dated debt maturities. This means there is much more time before pressures/debt market disruptions will impact funding. Short term debt markets might close, but that won't impact most companies for quite a while due to the presence of the said liquidity buffers, which included not just cash, but committed bank revolvers, which many companies are now in the process of drawing down.

Funding pressures in the banking system also seem unlikely, as not only are banks now much more liquid than pre-GFC, due to a combination of much higher regulatory liquidity requirements and management prudence (reflecting cultural change in the post-GFC era), but central banks are also implementing substantial liquidity support. After an initial spike, interbank rates have recently sharply fallen in the US for this reason. Furthermore, very significant fiscal stimulus is coming. There is a very good chance, for instance, governments provide financial support to airlines - the US has already suggested this, and I would expect the EU to follow in the not too distant future as well.

With respect to the banking system, while bad debts will increase, the magnitude of the hit to the credit-worthiness of their borrowers will depend on the duration as well as the severity of the downturn. Banks in the US and Europe have lent conservatively over the past decade, and interest rates and hence debt serviceability burdens are low. Most of their borrowers will therefore be able to manage through a 1-2 month hit to their incomes, and banks can and likely will provide short term forbearance measures on repayments. One of the risks is IFRS-9, which requires banks to front-load provisions on the basis of an expected credit loss model. This could force banks to take large upfront provisions, discouraging lending and pressure capital. However, European regulators have already said they are considering granting temporary capital relief to banks (relaxing capital ratios), and importantly, we are not coming out of a period of rapid credit growth. When credit growth goes from 20% to 0%, the economic effects are substantial, but when they go from 2% to 0%, much less so.

While there is much talk of debt levels being extremely elevated, this is a vast oversimplification. What has really happened is that government debt has significantly increased in the post-GFC era, but government bond yields have collapsed to zero, and while high government debt could be a problem long term, it is most certainly not a problem at present. Meanwhile, private sector debt intermediated by the banking system has been falling for 13 years in both the US and Europe relative to GDP. Household debt in the US, for e.g., has fallen from more than 100% to only about 75% at present. Banks, individuals, and to a lesser extent, corporates, have been deleveraging for 13 years. Furthermore, not only has debt to GDP fallen, but interest rates are also at record lows, such that the debt servicing burden is now actually at very low levels by historical standards.

There are pockets of excess, to be sure. Debt levels in the private equity space, for instance, have mushroomed. However, this debt is well structured, being covenant light, long term, and low cost, while the private equity industry has US$1tr of committed 'dry powder' (funding commitments clients have either provided or are obligated to provide when called, which is not yet invested). While private equity is arguably in a bubble, it is not a bubble that will quickly unravel.

The outlook for oil appears more challenged in the short term, as the combination of falling demand and rising supply ought to continue to pressure oil prices, and in the worst case they could easily fall to US$20/bbl or less. However, even here, it is not impossible OPEC+ comes back to the negotiating table. The demand outlook has rapidly worsened over the past week or so, and Saudi Arabia's response appears highly emotional. Russia's stance was more justified - they merely wanted to maintain existing cuts (rather than cut further), noting accurately that cuts to date had merely resulted in increased shale supply, and that it was too soon to assess the magnitude and duration of the covid-19 impact on demand. They did not want to suspend existing agreed cuts. Saudi Arabia, by contrast, were initially pushing for aggressive additional cuts, but angered by Russia's lack of co-operation, appear to have reacted emotionally, throwing their toys out of their cot and responded by saying they will instead begin to pump as much crude as possible starting from 1 April (likely about 2m bbl/d above their current production of about 10m bbl/d, at maximum capacity).

Sheiks don't like not getting their own way, but once their arrogant temper simmers down a bit, it is possible they could come back to the table - particularly because in Russia's case, one of the reasons they did not want to cut was that they felt it was premature to assess the demand impact, but the week or so since that stance was maintained has seen the demand outlook rapidly worsen.

If that does not happen, it seems probable oil prices will fall further and a rapid supply response from the shale patch will be forced. OPEC+ can ramp production up by perhaps 3m bbl/d, but shale produces something in the order of 6m bbl/d, and most of it is uneconomic below US$30/bbl. Importantly, shale wells have rapid decline rates, so you have to continue drilling in order for production to not rapidly decline by >20%/pa. If prices fall to US$20/bbl, you'll probably see US shale production halve in the next 24 months, absorbing all of OPEC+'s excess capacity, while it is probable global demand has recovered from the covid-19 hit and reached new highs comfortably within this timeframe, as trendline global growth in demand continues to exceed 1m bbl/d pa. In the meantime, an increase in inventories, tanker storage by oil speculators/arbitragers, and increases in government strategic stockpiles, might help absorb some of the excess supply. Bankruptcies in the shale patch nevertheless seem likely, and there will be some hits to the high-yield debt space here. However, the losses do not seem likely to be large enough to be systemically destabilising.

What does all of the above mean for markets? It is important to remember that the outlook for markets is not the same as the outlook for the economy. The US had one of it's worst recessions in history in 2009, and yet stocks had one of their best years in history in that very same year. Market prices are not driven by the economy per se, but instead a combination of liquidity and emotion, because these are the factors that drive the demand and supply for stocks, and that is what set prices (the economy can effect liquidity and emotions, but ultimately it is the latter factors which determine prices).

At present, we have record levels of global liquidity, as central banks slash rates to zero or less, and revert to rapid QE money-printing. However, that liquidity is not yet finding its way into stock markets as there is a sharp divide between risk/volatility tolerant capital, and risk-averse capital. The world is drowning in risk-averse capital, and central banks are creating more of it by the day, while the availability of risk-seeking capital is collapsing as people flee risk and hold more cash/bonds.

But how sustainable is this situation? It is likely that the magnitude of the sell-off has been amplified by two factors. Firstly, in an era of very low interest rates, people have 'reached for yield', and one manner in which they have done so is by increasing their stock allocations - particularly to yield stocks perceived as being relatively low risk (i.e. REITs, utilities, consumer staples, and other 'low volatility' stocks/sectors/ETFs). Money that would typically hold bonds rather than stocks is risk averse capital that is not cut out for the volatility that befalls equities from time to time, and a lot of this money has likely been panic-exiting.

Secondly, the widespread media coverage and the fear felt by the 'man on the street' has likely resulted in a larger than average amount of redemptions from end investors as well. This has created a major liquidity squeeze, forcing managers to dump shares to meet redemptions. On top of that, we have likely been witnessing rapid deleveraging of market players with leveraged books (along with margin calls), as well as fund managers increasing their cash allocations as their fears about the outlook grows, and as buffers against further upcoming redemptions.

That's a lot of selling and a lot of liquidity stress in a short space of time, but it can't last forever. The most skittish money will leave first, and during turbulent times, stock moves into 'strong hands', as they say. Deleveraging will end, redemptions will slow as anyone that is going to panic and pull all their funds is likely already doing it, and fund managers can only increase their cash allocations so much (often they are restricted by mandate as to how much cash they can hold). Furthermore, the more markets fall, the larger investors' cash and bond allocations become relative to their equities allocation simply because equities have fallen in value so much. This will eventually cause some investors to increase their exposure to equities - particularly as interest rates fall lower still.

Even if you're a fund manager who is bearish on the outlook, if you're maximum allowable cash allocation is 10% and you've already gone to 10%, and redemptions stop, you will stop selling. And investors often forget that market prices can rise not only due to an increase in demand/buying, but also due to a decrease in supply/selling. The latter is usually the primary means by which markets rebound from the depths of a panic/downturn - selling lets up and prices start to rise. In time, rising prices leads to an increase in demand, as confidence builds and buyers start to return.

In other words, at some point the amount of liquidity in the volatile equity space will stabilise, and the volume of selling will then abate, and at that point, markets will stabilise/start to recover even if the economy continues to weaken, because for stocks to go down, there has to be a new source of fear that triggers a new wave of selling. That requires either increased liquidity stress, or the news to get much worse, triggering even more people to sell in fear. If the news doesn't get much worse - it just remains bad - the impetus to sell more declines.

It is for this reason that markets will bottom not when coronavirus economic impact is at its worst, but when the crescendo of worsening news is at its peak. Over the past week, the news has continued to go from bad to worse at an accelerating pace, as the situation has worsened in Italy; the speed of new cases has accelerated around the world; famous people have been infected; and then more and more extreme containment measures have been announced, from restrictions on large events, to travel restrictions, to complete lock-downs; to now forced closures of retail and entertainment venues. That escalation in bad news has given people a new reason to panic more every day.

However, it is going to be hard for this acceleration in bad news to continue, because we have already basically reached the practical limit to which social distancing measures can be implemented (closing bars, restaurants, and retail establishments, such as in NYC), so the pace of shocking new headlines about such measures will have to slow. Meanwhile, the large temporary rallies we have seen during this downturn highlight how upside sensitive markets are to even a whiff of good news - a situation that likely exists because there is a record amount of cash sitting on the sidelines at present, which is a latent source of demand. As noted, it is hard to see how such aggressive containment measures will not result in a slowing in new case rates becoming evident in 1-2 weeks time, and any headlines that suggest the rate of spread may be slowing will likely cause markets to very violently rally.

The reason for the violent rallies we have already seen on a few occasions on the way down is easy to understand technically, because at present we have a 'multiple equilibria' situation: we have record amounts of liquidity on the sidelines which is looking to enter the market, but a wholesale reluctance to buy while prices are in free fall. What this means is the second investors feel prices might be set to rise, they will rush to buy, while when prices rise, the impetus to sell relents. In other words, demand is a function of price (demand increases as prices increase), and supply is also a function of price (supply increases as prices decrease). We should therefore expect extreme volatility for this reason.

Although it is impossible to know, my intuition is that we are very close to - if not at - the bottom. Indeed, there is already some good news starting to emerge in Asia that is being ignored by Western-centric investors. China, South Korea, Taiwan & Singapore for instance have all had success in containing the virus, and economic activity is rapidly recovering in China - one of the world's largest and most important economies, which drives significant demand for commodities and construction materials - which is very important to the economic outlook for commodity-exporting countries. There is more to the world economy than merely the US and Western Europe these days. It is surprising that no one currently seems to think that the rapid recovery the Chinese economy is experiencing is of any importance.

New anti-virals are also being worked on around the clock which could significantly mitigate the worst symptoms, and hence meaningfully reduce death rates, with some people optimistic antivirals could start to become available as soon as April. Vaccines will eventually follow but will take much longer. Right now, investors have assumed no such mitigations/treatments will become available, so this is a major upside risk.

It is often said that the four most dangerous words in the investing world are "this time is different", but perhaps the most important are "this too shall pass". In times of crisis and uncertainty, it is easy for investors' time horizons to shrink to mere months. However, taking the long view, human societies are resilient and adaptable - history proves that, and while humanity and the global economy are in for a very difficult few months, we will find ways to manage the impact, adapt, and get through this.

Good investing is a lot like sailing. When you set out to sea, you should not assume perpetually calm conditions even if all you can see is blue sky and calm in every direction. You should anticipate the occasional storm, and when you find yourself in a storm, while it is tough and uncomfortable, you should reassure yourself that the storm will eventually pass. We have currently entered a storm. One should have prepared themselves in advance by paying prices with a suitable margin of safety that reflect the fact that storms will happen from time to time; if you have done so, there is no need to panic when a storm arrives. The storm - while violent - will eventually pass.

If there is any good to come out of covid-19, it is that it has exposed a radical lack of government preparedness in the West for necessary pandemic response. For instance, if we had stockpiled n95 masks in large numbers, containing the virus would be easy - simply hand them out to all and insist that everyone wears one in public. The cost of doing that would pale in comparison to the economic costs now being incurred on account of that lack of foresight. In the long term, exposing this lack of preparedness might result in a change of behaviour, and better preparedness for future pandemics that could be much more catastrophic - for instance a highly contagious disease with death rates of 20%.

We should prepare for public health emergencies like this is in the same way the military prepares for war. You don't start building aircraft carriers only after war is declared - you need to be in a state of perpetual readiness that recognises that anything can happen at any time. The Western world has been caught completely unprepared, which is a failure of leadership - yet another that can be added to a very long list. With a bit of luck, this covid-19 episode will result in a change in behaviour and much better preparedness in the future.

In the meantime, stay safe.