Q1 2020 Market Outlook: Covid-19 & What It Means for Your Investments

This was written in March 2020.  The analysis that follows reflects the information and market conditions available at that time.  It is reproduced here as a record of the thinking — and as evidence that clear-headed analysis, even in a genuine crisis, produces more useful conclusions than panic.

The Human Reality and the Market Reality

These are two different things.  They interact, but they are not the same.

Inadequate quarantine enforcement, insufficient testing, and overstretched healthcare systems across Europe and North America will produce significant casualties.  This is a human tragedy.  It is also not the primary variable in determining long-term investment value.  Market sentiment and consumer confidence are short-term effects.  Underlying asset values are a longer-term question.  The two should not be confused.  Confusing them produces the wrong decisions at the wrong time.

The Pandemic Trajectory

Since the outbreak began in Wuhan in early December 2019, East Asian economies — Singapore, Hong Kong, Taiwan, South Korea, and Japan — demonstrated early and effective responses.  China has ceased reporting domestic cases.  All new Chinese cases are imported.  The East Asian experience indicates the trajectory: domestic infections peak, flatten, and are replaced by imported cases as the domestic situation stabilises.

Europe and North America are not yet at this stage.  They are the new epicentres.  The race between containment measures and infection spread is ongoing and, at the time of writing, not clearly won by either side.

The Policy Response

Central banks have responded aggressively.  The US Federal Reserve cut policy rates by 50 basis points in an unscheduled meeting.  The European Central Bank launched an emergency bond-buying programme of €750 billion — approximately US$820 billion — to calm sovereign debt markets in Italy and Spain, the most vulnerable Euro-area economies.  Further quantitative easing and rate cuts are expected across major economies.  The US government is proposing a trillion-dollar stimulus package.  Similar measures will follow globally.

These Keynesian interventions are designed to prop up the sectors most affected by quarantine and depressed demand.  They will eventually support equity markets — though the timing is uncertain and the path through the crisis is not linear.

The Recession

Certain major economies will enter recession for at least 18 months.  This is not a catastrophe.  It is an opportunity.  Recessions produce structural changes in government spending priorities, in consumer behaviour, and in the competitive landscape of industries.  Economies facing elections in the next 18 months — the United States and Singapore among them — face additional political pressure to implement social welfare measures that would otherwise be deferred.  Recessions also produce asset prices that do not reflect underlying long-term value.  This is where the investor’s opportunity lies.

The Oil Shock

The timing is unfortunate.  A price war between OPEC — led by Saudi Arabia — and Russia has driven crude prices down 26% to an 18-year low.  Both sides are maximising production to grab market share and force the other to capitulate.  This playbook is from the 1970s and is inadequate for the current environment.  Saudi Arabia’s economy depends on oil for approximately 80% of its revenues.  Russia's economy is more diversified, and its sovereign wealth fund provides reserve capacity to wait out the Saudis.  US shale producers will cut production at current prices and resume it when prices recover, which they will.  The price war will end.  The damage it causes in the interim deepens the recessionary pressure in oil-dependent economies and adds volatility to global markets that already have enough of their own.  The United States has pledged to purchase 30 million barrels for its strategic petroleum reserve — taking advantage of low prices and providing a degree of market certainty that partially offsets the price war’s destabilising effect.

What the Market is Actually Telling You

On 12^th March 2020, the Dow Jones Industrial Average suffered its largest single-day drop since 1987, entering bear market territory.  The flight to safety drove US Treasury yields to historic lows — the 10-year Treasury touched below 0.4%.  This is not primarily a signal about the underlying value of the assets being sold.  It is a signal about fear.  Market selloffs of this magnitude in crisis conditions are driven by sentiment and panic — the forced liquidation of positions, the flight to cash, the suspension of long-term thinking in favour of immediate risk reduction.

The resultant divergence between market price and underlying value creates the opportunity.  Equities have been pushed to relative valuations that are attractive compared to bonds at sub-0.4% yields.  The question for the investor is not whether the underlying businesses have value.  Most of them do.  The question is whether the investor has the discipline and the time horizon to hold through the volatility.

Where the Opportunities Are

Several sectors present specific opportunities at current prices.

Healthcare and pharmaceuticals are the most obvious.  The pandemic has created immediate demand for sanitisers, masks, healthcare products, and pharmaceutical development.  Healthcare stocks are relatively low despite the sector being among the most structurally important in the current environment.  This disconnection between demand fundamentals and stock price is the opportunity.

Technology is a compelling case.  The explosion in remote working, online retail, digital entertainment, and home connectivity driven by quarantine conditions is accelerating structural shifts in consumer behaviour that were already underway.  Technology counters at current prices represent long-term value for investors with an appropriate time horizon.

Asian manufacturing is recovering.  China is reopening production lines.  Major financial centres — Singapore, Hong Kong, Shanghai, Tokyo — are in materially better condition than their European and North American counterparts.  East Asia will drive the early stages of the global recovery.

Hospitality is a contrarian position.  Hotels, airlines, and travel businesses are suffering the most acute short-term pain of any sector.  They will also benefit most dramatically from the recovery — when travel resumes, it will do so with pent-up demand that had been suppressed for months.  The investor who takes positions in quality hospitality names at current distressed prices with an 18-month-plus horizon will be positioned for that recovery.

The Approach

Dollar-cost averaging into positions across these sectors makes sense for investors who cannot time the market bottom — which is everyone, including the people who claim otherwise.  Maintaining a higher-than-average cash balance provides optionality to deploy capital when specific opportunities present themselves at attractive prices.

The market will recover.  East Asian economies are already showing the trajectory.  Policy support from central banks and governments globally will accelerate the process.  The duration of the pandemic and its ultimate severity remain the primary unknown, but neither changes the fundamental case for quality assets acquired at depressed prices with a long investment horizon.  The investor who panics and sells at the bottom locks in the loss permanently.  The investor who buys at the bottom when everyone else is selling is the investor who benefits from the recovery.

These are not new observations.  Every major market dislocation in history has produced the same pattern and the same opportunity.  The discipline to act on it when the noise is loudest is the differentiator between the investor and the speculator.  The noise is currently very loud.  The opportunity is accordingly significant.

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Terence Nunis | Executive Chairman, Equinox Zenith | Author, The 1% Playbook: The Billionaire Cheat Code