In today’s Macro Briefing we take a look at the longer-term impacts of the coronavirus pandemic on the global economy and potential investment decisions. Ensemble Capital explains that identifying the “next normal” for investors is a nuanced process, in which the short-term impact of the pandemic may be quite clear, but the longer-term trends it accelerates, creates or destroys are far less obvious (read full piece below). The Pennock Idea Hub, meanwhile, explains why the pandemic is likely to add to the longer-term headwinds for equities, and why gold will represent a hedge against falling investment confidence over the next decade. In the shorter-term Goldman Sachs and Top Down Charts both report optimistic signs over the reopening of the global economy, while Moody’s warns that the market may be underestimating US corporate default risk.
Substantive's Top Themes - Best of the Broker Notes
1. Default Outlook: Why the implied default rate may not be all it seems
It’s an especially busy time for ratings agencies as they rush to downgrade credit ratings across the board. It’s almost too hard to keep track of newly-minted fallen angels and the many high-yield issuers falling to the floor. Investors don’t seem bothered though. The Fed asset purchase backstop has been well covered already. That's led to a much lower implied default rate than what played out back in 2008/09. As Moody’s write in a recent report, the high-yield bond market implicitly believes that the losses arising from the impending climb in the default rate will be considerably less compared to what followed from 2008-2009’s Great Recession. This pricing suggests the market is looking for the U.S. default rate to top out closer to 10% compared with November 2009’s post-1930s high of 14.7%. Moody’s corroborated this with their own measure - the average expected default frequency metric (EDF) – which suggests a similar same trend. However, as Moody's highlight, there are alternative ways to assess the probability of defaults, which provide a different result. They highlight the ratio of high-yield downgrades to high yield issuers. Typically a rise in this ratio leads the high-yield default rate by two quarters, and it has a strong correlation. Currently that ratio is headed towards, and will likely surpass, 2009's 32.8%, which then resulted in default rates almost doubling between 1Q to 4Q 2009 to 14.5%. So from the perspective of the second-quarter 2020’s extraordinarily large number of high-yield downgrades, a rise in the default rate from April 2020’s 5.4% to 13% by 2021’s first quarter seems likely, Moody's conclude.
2. Early recovery and relative value opportunities
Callum Thomas from Top Down Charts provides another perspective on the diverging paths of those countries making an early recovery from the coronavirus pandemic versus those countries that are still in free fall. Thomas has compiled this chart that measures the average consumer sentiment reading for countries like China, Korea and Germany, whose May reading was higher than the low point of the last few months for “early recovery” and the average reading for countries, such as India, Brazil and Russia, whose May reading was a new low for “still falling”. Thomas says this is an interesting graphic for a few reasons. First, it shows there is life after Covid-19, and that there are early rewards for those countries who took more decisive moves to contain it. Secondly, and most importantly for investors, it shows quite plainly the idea that there are going to be differences not just across industries and sectors, but also across countries as this rolling global crisis progresses.
3. Encouraging, early lessons from the “early openers”
A continued rally in markets depends on whether the world can continue to reopen without triggering renewed virus incidence and renewed lockdowns, according to Ian Tomb at Goldman Sachs, who has learned three encouraging early lessons by comparing countries that have reopened more quickly, such as New Zealand, versus less quickly, like the UK, since early April. First, he says, “early openers” have not – yet – seen higher confirmed virus incidence; second, most financial markets have now begun to reward reopening with modestly higher asset returns and easier financial conditions; and third, not all re-openings are the same, with the risks of reopening appearing lower for countries with low versus high rates of new confirmed cases. While these lessons are encouraging, they are likely to shift as reopening progresses, says Tomb. Accordingly, he sets out high-frequency tools that can help investors track the shifting risks of reopening – both globally, and on a country-by-country basis.
4. What gold is telling us about confidence
The decline in the stock/gold ratio is a worrying sign for long-term equity investors, says Pennock Idea Hub’s Cam Hui. Many see the ratio as a barometer of optimism and pessimism, but he goes further. It is, says Hui, a barometer of investment confidence in human ingenuity – after all when you bet on stocks you’re betting on humans endeavouring to do productive things, and when you bet on a shiny inert metal, you’re betting on a shiny inert metal. The stock/gold ratio peaked in the summer of 2018 and has been falling ever since, notes Hui. That trend is likely to continue, he says, accelerated by the effects of the coronavirus pandemic, as the outlook for equities faces a number of long-term headwinds in the form of de-globalisation, rising protectionism and a difficult growth outlook. Gold represents an insurance policy against falling investment confidence, not rising inflation, says Hui, and investors should re-evaluate their portfolio allocation policy in light of these factors affecting asset returns over the next decade.
5. Intrinsic Investing: Coronavirus – the next normal
While it’s a huge mistake to expect a quick return to pre-Covid norms and trends, the widespread belief that coronavirus “changes everything” is similarly a misreading of how humans operate, says Sean Stannard-Stockton, chief investment officer at Ensemble Capital in the latest post from Intrinsic Investing. That is why in looking to identify the “next normal” for investors, and analysing the companies his firm owns in client portfolios - and those it might like to invest in - he has been carefully trying to think through the major coronavirus-driven changes in trends that may impact them. It is not, says Stannard-Stockton, particularly difficult to understand the short-term impacts, but most of the value of a company is made up of the cash flow it will produce over the coming decades. Accordingly, he explains some of the more nuanced, longer-term effects of shifts, such as rising levels of remote working, ecommerce and digital payments or the re-shaping of global supply chains, he thinks may play out and that investors need to be acutely aware of tracking in the future. It is important, says Stannard-Stockton, to note that these are trends he believes are likely, but that is very different from knowing what the future holds for sure. He says that is why, so far, his firm has only added two new companies to its strategy since the crisis began and exited only one due to losing conviction in the business. The fact is, says Stannard-Stockton, we are all still grappling with how the reality of human society and global business will change, but as we gain conviction in what trends will persist and which will prove to be short lived, we will continuously adopt these views into our portfolio management decisions.