Our last written communication at the end of February closed with “…during periods of high uncertainty as we are in today, the saga will have plenty of chapters ahead of it.” Little did we know or even suspect that the ensuing month would contain record-setting price volatility in the stock and bond markets. In fact, the Dow Jones Industrial Average had its worst quarter since 1987 while interest rates hit new lows for that same period.
What type of economic recovery might we expect to see over the coming months? Visual descriptions have suggested ‘V’, ‘U’, ‘L’ shaped recoveries. While most are not anticipating a ‘V’ shaped snap back the focus of investors seems to be on how far down the economy dips and how long the rebuilding phase lasts.
It appears to be a foregone conclusion that the COVID-19 is putting the world into a recession but what seems less clear is the shape of the recovery. To answer this question requires economists to make decisions about the trajectory of the virus – generally beyond their skillsets.
We would anticipate health authorities to issue a gradual return to regular working activities and for ‘social distancing’ to be part of the social fabric for a while. This gradual return will slow spending on travel, shopping, restaurants, hotels, etc – at least in the establishments that survive the downturn. As the chief economist at Citigroup Inc. suggested, ‘it takes more time to get back to play than to get back to work.’ This may well cause the second half of 2020 to recover more slowly – a concern for our consumer and service lead economy. China may be providing some insight to our economy as they are seeing consumer caution even though authorities have indicated it is now safe to return to those discretionary activities
Key to much of this recovery, regardless of its shape, will be how quickly businesses bring back jobs. In the U.S., expectations for unemployment could spike to 15% (Goldman Sachs) although the current consensus for 2020 as a whole is 3.7%. For perspective, keep in mind that approximately 40% of Americans are unable to fund unexpected expenses of $400 without borrowing and 25% of households live paycheck to paycheck (McKinsey & Co.).
Further tempering a rebound will be the levels of borrowing (corporate & individuals). Both have taken advantage of low interest rates to raise their borrowings which slows their abilities to bounce back after a crisis. Individuals may need to sell their second homes to fund diminishing incomes and corporations may need to cut capital expenditures and sell shares (at lower prices) to reduce debt or repay government assistance.
Recognizing that we are in a re-election year we are not surprised that policy makers have pulled out all the stops to avoid an extended recession – perhaps to a level that exceeds that of the 2008 financial crisis. Households will receive credit extensions and help covering wage bills to avoid firing workers. The Fed and U.S. Treasury and other central banks have reduced interest rates and commenced ‘facilities’ which help lower the stress on worldwide markets by maintaining liquidity in various markets.
What could produce a more rapid or snap-back recovery? The common answer to this question is: ‘pent up demand’. It seems logical under the current circumstances to anticipate this – after all, it was as if someone cut the cord amidst a strong economy. Why wouldn’t demand resume where it left off before the virus gripped our economy – particularly with the injections of cash from various governments around the world? Some segments of our economy may. But there is a good chance that the influence of the quarantine experience lingers in peoples’ spending habits and many small/medium sized businesses simply decide they don’t want to rebuild. The ‘X’ factor in all of this seems to be the lingering anxiety; it may weigh on the markets well after the growth in virus cases begin to flatten and turn downward (consumer sentiment for March dropped to 89.1 – the largest monthly drop since October ’08). What happens in Asia may well enlighten us about our own recovery – so their economic data bear watching (China’s manufacturing activity rebounded strongly in March).
“The more things change, the more they stay the same.” (Jean-Baptiste Alphonse Karr ) Well…things certainly have changed in the last several weeks but what is the ‘same’ about these circumstances? In a word ‘fear’. We have experienced recessionary fears and their impact on investment markets in previous economic cycles. Perhaps what seems new to us this time is the influence our fine regional medical facilities and personnel have on the importance of data. Good policy response relies on collecting good data…much like what we do in managing investment portfolios. By paying attention to the data and controlling the input of fear we look forward to improving the prospects of our clients’ portfolios over the coming quarters.
Against this backdrop we will be reinvesting bond maturities in very short maturing positions as we anticipate being able to reinvest at higher levels in the ensuing quarters while we monitor credit conditions for corporations and municipal entities. Our high-quality holdings will continue to provide insulation against deteriorating credit environments and reduced ratings.
In our Core Equity strategy, we have continued to behave like a long-term investor, using the current stock market weakness as an opportunity to move our portfolio even further up in quality. This means an increased focus on balance sheets and cash flows. Right now the outlook for earnings is highly uncertain but cash flow is really a more telling number to be used in looking at valuations and judging stability. We have continued to focus on cash flow and free cash flow yields. In this latter measure, technology and health care companies have stood out so it is no surprise that we have been overweighted in both sectors for quite a while and remain so today.
Looking forward, a couple of trends have risen to the top of our list when thinking about how things will look “on the other end” of this. First, distribution capabilities have become even more valuable. While the trend toward online shopping has been in place for years, the Coronavirus will, we believe, hasten that transition as more shoppers opt to use the convenience of at-home delivery and brick and mortar retail options diminish as the declining footprint of this industry has been accelerated. We would point out that many traditional brick and mortar retailers have been successfully transitioning a large part of their business to on-line including Target and Best Buy, two names currently in the portfolio. Second, we believe that the current (or upcoming) recession will result in a pick-up in merger and acquisition activity as companies are either forced to pare down operations or seek to do so for strategic purposes. As a result, those companies that have cash will be in a position to make acquisitions at more attractive prices and put their money to work profitably. Berkshire Hathaway has been sitting on a cash hoard of over $200 billion for a handful of years now and private equity firms like KKR and Blackstone have a lot of dry powder available for investment. Third, and perhaps we are stating the obvious here, but health care will become an even greater focus around the world. The aging of the population, both domestically and throughout many parts of the world, has been a factor in the increasing importance of health care. Now, as preventative measures become more prominent, the amount of money spent on health care is poised to rise.
In our growth strategy, we continue to lean on some of the technology leaders with net cash on balance sheets and strong market positions. Two local giants AMZN and MSFT are currently our two largest positions in the portfolio and continue to benefit from surging online delivery orders and, practically overnight, everyone’s switching to working remotely, driving demand for cloud services. At the same time, we continue to retain exposure to some smaller companies with cloud-based software-as-a-service (SaaS) models (ServiceNow, Avalara, Docusign, and several others), which held up well in this environment. Two of the largest media names GOOGL and FB, which rely heavily on advertising to drive their revenue fared less well, but with net cash at these companies equal to GDP of some smaller nations ($100bln+ for GOOGLE and $45bln for FB), there is not a large concern about them making it to the other side.
We also continue to have a large exposure to Healthcare, which we increased deliberately to make the portfolio slightly more defensive in the current environment. While some of the healthcare names held up well, others have suffered as hospitals urged people to delay non-essential/non-urgent procedures to prepare for the spike in Covid19 cases. We think that forgoing some of these procedures in the next couple of quarters means pent-up demand in the quarters that follow and expect these businesses that supply leading surgical tools and devices to recover quickly.
Overall, we increased defensive characteristics of the growth portfolio, while at the same time maintaining exposure to important growth areas like cloud services and AI, digital infrastructure, and innovative healthcare products and delivery systems. We expect to maintain this more defensive positioning in our growth strategy through this period of economic uncertainty.
We know these are stressful times and as always we are here to assist you and handle any needs and questions that you may have. We have faced difficult markets in the past and we will get through this too.