“Smoke pourin’ out a box car door… in the final end he won the wars, after losing every battle..”
Yesterday evening, I got away from the madness. I sat on the back of my boat in the sun having a chat with my chum Robert Hillman. He’s an uber-quant with Central Bank and Hedge Fund experience who now runs Neuron Capital, the economic modellers. Over a couple of socially distanced beers we discussed the virus, the economy, prices and markets. This morning’s porridge is loosely based upon what I can recall of our “debate” about virus risks and how the economy is likely to develop. (Very nice beers… How many? I have no idea..)
I started by explaining my current thesis:
Over the past few weeks there has been an extraordinary shift in the market’s mindset. We have moved from expectations of a stock market wipe-out and bond Armageddon into a full-blown expectations led rally. This is not about a bear-trap rally anymore – although it might become one again if the virus confounds us! In the next few days, I confidently expect stocks will make new record highs as governments are bounced (rightly or wrongly) into re-opening the global economy.
There is nothing normal about what’s happening. We are stuck in the middle of an economic crisis completely unlike anything that’s ever happened before. It’s not about banks or collapsing financial confidence. It’s a demand/supply shock and more – something wholly outside any previous experience. But, it’s something we are adapting to.
Investors are fully aware of the scale of the Coronovirus economic damage and the unknown consequences its’ triggered. They are now developing investment ideas on where this crisis and prices go next as economies rush to reopen. They are also factoring in how government bailouts and QE infinity have effectively shifted sentiment away from the precipice’s edge towards more positive uplands, and how new virus treatments and vaccines could ameliorate the crisis.
Markets are discounting prices for recovery.
The result is a rally in value stocks – i) those with clear economic upside from the end of lockdown, and ii) those where prices over-reacted and tumbled too far as we bought the worst-case coronavirus scenarios. (As always there are risks associated with guessing what future prices and activity will be. This time its even more dangerous because we still know so little about the virus and the complexity of this crisis on growth and economic activity.)
Let me illustrate the upside moves with one stock:
Ryanair’s stock price tumbled 50% from €16.05 in early February to €8.15 in Mid-March. Sentiment held the future of flying for business and holidays was toast – finished potentially for years. Aviation was the economic sector most shattered by the virus. It was game over for airlines, airports and plane makers. But since May 15th,Ryanair has rallied 45% from €8.45 to €11.74. The stock is still down 26% from its Feb peak, but the perception has shifted from airline stocks being doomed, to how much will they recover.
The market for airline stocks is anticipating how lockdown easing will change the bear scenario completely. Analysts are pointing to Southern European countries’ desperation to kick start tourism – which is an opportunity for Low Cost Carriers to get back into the mass-travel market. They expect initiatives like the UK imposing a 14-day quarantine from early June will be unravelled. The airlines are not going to accept flying planes 33% full because of social distancing. Holidaymakers will not accept the additional costs. I expect planes will be full again by August.
As lockdown restrictions ease, a more pragmatic approach to travel will be fuelled by the airline lobbyists: as virus deaths have been so concentrated in the elderly and infirm, then younger travellers and families should be able to take the miniscule virus risks, while the vulnerable continue to self-isolate. We’ll no doubt see Mick O’Leary make some incendiary remark about how it’s perfectly safe to fly in one of his sardine cans because the chances of anyone under 40 dying of the virus are less than a lightening strike.
We are seeing a similar effect right across the economy: a re-evaluation of how much virus triggered fears over-sold the market. The financial media is full of stories about the global economy emerging from its coronavirus hibernation. Activity is picking up everywhere. Governments are under enormous pressure to facilitate opening their economies. Every single business owner and industrial sector will come up with half-a-dozen reasons why their business is going to benefit from re-opening, and why they should be allowed to do so.
We remain in dangerous times...
First, we still don’t really know as much as we should about the virus. We know it’s not just a flu because of all the other damage to our bodies it can do. We don’t fully understand infection and transmission – although we are getting there. What we do know: if you are one of the 20% who get it bad.. it’s very bad indeed.
The big questions about the virus remain: how many people are susceptible who could cause another crisis in the health services? Robert from Neuron Capital expects the next few weeks will provide answers – if lockdown easing results in increasing cases its likely to be on a regional basis. We know infections in places heavily hit, like London, are now minimal, but if contacts start to rise again, we could see the need for local lockdowns in cities in regions that went into lockdown before the virus took off. (That’s what seems to be happening in Korea’s new infections this morning – new regional outbreaks.)
Second, the economy has taken a massive shock in terms of supply and demand. Although this crisis is totally unlikely any previous financial crisis – money is running out at many firms. Despite all government support and the trillions raised by large corporates on the bond markets, its clear many mid-sized and smaller companies are struggling to qualify for rescue packages or loans. The Bank of England said 30% of UK coporates have liquidity buffers for 3 months or more. Neuron dug deeper and reckon less than 20% of firms in sectors like Transport Equipment and Machinery have such a buffer.
There are going to be breakdowns. After we discussed the US Volvo factory that had to shut soon after reopening because of supply issues, Robert said: “the low cash buffers in some manufacturing firms could be particularly concerning for further supply chain disruption, especially where customers have little or no ability to substitute other products.”
And, we are going to get a massive shift from growth investment strategies towards cost containment – which is why companies will cut costs and jobs. (Some firms may increase investments to build market share as the smart contrarian move! Expect to see lots of distressed asset plays in coming months in commercial property, housing, logistics and oil!)
Third, lest we forget equity and bond markets looked overpriced before we’d ever heard of COVID-19. We were already talking about the numbers of “Zombie” companies that couldn’t survive a full blown financial or economic crisis, and how a rates rise would result in massive number of defaults. The virus crisis was a trigger, but swift action by the authorities has kept the Zombies on life-support (???) (Zombies on Life Support? That must be about the most confused metaphor I’ve ever employed..!)
It’s difficult to argue that record stock prices, record bond market issuance and record low yields and bond spreads are justified when the global economy has just undergone such a fundamental shock with massive unemployment and rising debt nailed on?
I put a significant slice of my own investment portfolio into cash, anticipating a major correction in prices, and was prepared to pile back in once it happened. But I missed the bottom. It came too early. I was unconvinced by the price recovery that began in March. I am certainly not tempted to put my cash back to work when stocks are now a gnat’s crotchet of where they were pre-crisis.
Fourth – and this is the big problem... Consensus is breaking down. For a few weeks the globe was united against the virus. We saw cooperation on the grand scale. Then it started to breakdown. The virus has become another front in the developing China/US cold war.
Here in the UK, we’re witnessing a second Civil War break out. Its broadly aligned the same way as the Brexit civil war, but trust in the government is evaporating even faster. Polite discussion about the safest and most effective way to reopen the economy has been buried in bitter polemic and hyper-emotional fury over what the government has done and hasn’t. Boris has squandered his popularity and allowed his detractors to seize the moral high-ground. There has been enormous wasted energy focused on the pointless Dominic Cummings saga. April’s “wartime” unity has turned to bitter recrimination.
The sad fact is the Government hasn’t really done anything wrong (except for not doing the politically astute thing of shooting Cummings (twice) when it had the chance.) Economically Sunak has made all the right noises. The debates about Lockdown timing are pointless – the government acted on advice (which was based on limited information) and while mistakes were clearly made, the reasons the UK has the highest numbers in Europe probably make sense – for instance, London is unlike any other city in terms of connections and density.
The economy will recover.. but I suspect there is still a lot of noise to come..
Meanwhile.. in a galaxy far far away…
I will comment on the European Union’s €1.5 trillion power grab and the mutualisation of European debt in depth tomorrow (I hope).
TO BE CLEAR:
I don’t have any problem with the plans for the EU to increase its budget to finance crisis recovery. It’s a wonderful, generous and brave initiative. If workers in Germany, and the rest of prosperous Europe value increased European unity so highly let them make it happen! If they are willing to pay the pensions of Southern European workers, for their taxes to fund these economies and everything else that goes with them, while sacrificing yet more of their democratic sovereignty to the unelected Brussels nomenklatura, then good luck with this laudable European initiative. (US readers…. historically based sarcasm alert.)