Riding the economic wave

Despite the current headlines about second waves ruining holidays, we believe that the economic damage from COVID-19 may not be as severe or long-lasting as many are predicting. We’re not too worried about a second uniform wave of the virus (although local hotspots will certainly keep cropping up). Instead, we’re more interested in the positive impact of the huge wave of official stimulus in the last five months – and how that could lift the global economy if the outlook for the virus is even a little better than feared.

Our viral view is based on evolving theories about the disease itself, and about the prospects for a vaccine. And we’re increasingly optimistic about the positive impact of vast economic support programmes.

We now believe that a V+ type global recovery is more likely than we had previously considered, with an L-shaped scenario less probable (see our scenarios table below). We’ve introduced a basket of positions into our portfolios that should do well if growth recovers strongly – comprised of more cyclical regions and sectors which have lagged the market rally so far.

As a reminder, our four post-coronavirus scenarios are as follows:

From Hammer and Dance to Surge and Burnout

Scientific discovery isn’t just about the facts – it’s more about developing theories to fit the available evidence. If the evidence doesn’t fit, the theory needs to be modified. And as we gather more evidence about COVID-19, the epidemiology is evolving.

The initial body of research, led by Prof. Neil Ferguson at Imperial College, was strongly influenced by what has happened during past influenza pandemics. And at the beginning of a novel pandemic, this is exactly what has to be done – both information and time is limited, so models cannot be built from scratch, they need to be adapted. And as a consequence, it was assumed that COVID-19 infections would occur in waves, exactly the same way as influenza does. These models also assumed that a high share of the population (80%+) would have to contract the virus before it stopped circulating and that the mortality rate was around 1%.

These are all key inputs into any epidemiological model – any change to these can have significant impacts on projections. As the COVID-19 has progressed from a localised influenza-like disease to a global pandemic, the amount of work carried out by the scientific community has been breath-taking.

What does this mean? This means that we now have a much better idea as to what those inputs are. Being armed with this information, people are starting to challenge the model’s initial projections. There is now mounting evidence that far more people than expected contract the disease and show few to no symptoms[1][2]. It could be that the ‘Hammer’ – the aggressive lockdowns – did not need to be as harsh, and won’t be going forward.

Moreover, work from Zurich[3] shows that many individuals may defeat the virus before it even enters the bloodstream – the antibodies in places like the respiratory tract are good enough to do the job. Current tests won’t detect these kinds of antibodies. If that is right, then in areas that experienced a bad first wave, like London and New York, there will be no second wave. In other words the ‘Dance’ – the gradual reopening - may not be as fraught as we previously thought. This surge and burnout of the virus could mean a return to global normality far more quickly than anticipated.

Moreover, much of the world’s pharmaceutical industry is focused on a COVID-19 vaccine. Progress is being made astonishingly quickly as money and brainpower are being concentrated like never before. Our base-case is that by 2021, a vaccine is likely to be widely available – so even if the surge and burnout approach is optimistic, a solution to the problem will be at hand.

Economic Stimulus

Since March, governments and central banks have pumped around $25 trillion dollars into the global economy. The world has never seen such a flood of stimulus. Governments and central banks have learnt the lesson of 2007-08: do not delay.

The UK, although one of the first to act, now looks like something of a laggard, throwing only (!) 20% of GDP at the recession. In the US and Eurozone, the figure is 44% of GDP. In Japan, it’s 60% of GDP.

We believe the authorities did the right thing, given the worst-case scenarios they were presented with. They prevented an economic panic as well as a medical one. However, if it starts to become apparent that the virus is burning out, the stage could well be set for an almost unprecedented economic boom – with governments having abandoned over a decade of austerity-focussed policy. This wave of stimulus is likely to swamp almost everything in its path – in a positive sense!

Portfolio Changes

As we moved through March and April, global markets seemed to be pricing in a U or L shape outcome, whereas we believed that things were more likely to be somewhere between a V and U. We increased our allocation to higher risk assets, but chose investment grade corporate bonds rather than equities.

Now, we believe that there is a higher likelihood of a V+ outcome, with a lower probability of an L scenario. Markets do not currently reflect this view, which gives us the opportunity to put in place a basket of positions that will benefit from a better than expected V+ outcome.

We have taken profit on some of our investment grade corporate bond positions, and moved the allocations into more cyclical equities. If world growth speeds up, then some of the recent winners might fall behind – tech stocks may not look quite so attractive if other sectors of the economy are seeing strong earnings growth.

Industrials and financials have robust balance sheets that aren’t being reflected in their share prices, while consumer discretionary firms are still weighed down by the impact of the lockdown. These all look very interesting if a V+ world materialises.

Our V+ basket has several parts, since recoveries can occur in different places at different times. Portfolios will have some exposure to a blend of Berkshire Hathaway, Global REITs, European and Japanese equities.

• Berkshire Hathaway is a company that we’ve researched extensively over the past few months. Its underlying businesses have pristine balance sheets and look inexpensive, but have lagged due to their cyclical and consumer-facing exposure. In a V+ outcome, we would expect the recovery in real-world demand to boost the Berkshire portfolio.

• Global REITS (real estate investment trusts) have suffered during COVID-19 due to fears over the future of retail and commercial property. We like REITS for two reasons. First, in a V+ world, retail properties may do better than expected for a while. Secondly, much of the sector is actually technological infrastructure (e.g. telecommunication towers) that should be reasonably insulated from COVID-19, but has sold off as if it was fully cyclical.

• European and Japanese equities are highly cyclical due to high allocations to consumer discretionary, industrials and banks, and low allocations to technology. Should a V+ scenario occur, we expect both markets to benefit. Unlike the UK, they have a lower exposure to commodity sectors, and more exposure to the global demand cycle.

[1] https://www.medrxiv.org/content/10.1101/2020.06.26.20140814v2.full.pdf

[2] https://stm.sciencemag.org/content/early/2020/06/22/scitranslmed.abc1126.full

[3] https://www.biorxiv.org/content/10.1101/2020.05.21.108308v1