The exponential spread of the coronavirus through Europe, the UK and to North America saw investors take flight, sending the stock markets into their steepest and fastest decline into a bear market in history.
Through March, economies came to a sudden stop as governments implemented varying degrees of lockdowns, ranging from strict lockdowns in Italy and Spain and, initially, social distancing in the UK and US before the full extent of the spread in the virus became evident.
On March 2nd, the second death from the coronavirus was reported in the US. At that time, I underestimated the measures that the government would enact to alleviate the extent of the impact of the virus on the health care system and citizens, and the toll that the virus would have on our everyday lives, and the economy as a whole.
However, I remain steadfast in my belief that investors have engaged in irrational behaviour in response to these events and will revert to making less emotional decisions once confidence returns. In the interim, we can expect to see more volatility, as emotions run high, prompting investors to vacillate between extreme anxiety and euphoria.
The global spread of the pandemic, combined with another ill-timed black swan event, the onset of an oil price war, has resulted in unprecedented challenges for economies and financial markets. These events will ultimately prove temporary, though, as has every other market crisis in the past. Selloffs spurred by panic are often overdone, and it is during these periods that attractive buying opportunities arise.
The economic impact of coronavirus pandemic
There is no doubt the impact on economies of the shutdowns will be severe, with estimates ranging from 24% to 50% declines in US GDP in the second quarter. The OECD has downgraded its global growth forecast to 2.5%, and the IMF has warned that growth this year could end up being even worse. There are mounting concerns that if the global economy doesn’t recover quickly from this, the world could descend into a worldwide depression, the likes of which has not been seen since the last Great Depression in 1929.
The virus has already taken its toll on the labour market, with record job losses recorded. In the US, a total of 16.8 million people claimed unemployment benefits over the three weeks into early April, while in Canada, more than a million jobs (5.3% of all jobs) were lost in March compared with the previous month.
The number one priority for every country around the world is to help its citizens stay healthy until this pandemic has been overcome. Global economies will remain in a sedated state as long as the pandemic is present, and people are immobilized by fear.
Global leaders have already started thinking about how to position their workforce for the day when it’s safe enough to restart economic activity on a larger scale and in a manner that is consistent with longer-term growth goals. However, that won’t be possible as long as the COVID-19 continues to spread.
Ultimately, the growth recovery path of each country will depend on how long economies are shut down, and the economic exit strategy countries pursue once the virus has been brought under control. The toll the virus has taken on GDP could prove short-lived compared to other historical events but, until we know more, it is virtually impossible to predict the likely trajectory of the economy.
Until then, economies will have to rely on the massive monetary and fiscal policy stimulus governments and central banks have extended to provide relief to individuals and companies adversely affected by the economic shutdowns.
Over two emergency meetings, the Federal Reserve cut its official interest rate by 150 basis points to a target range of 0% to 0.25% and in late March announcing unlimited quantitative easing (QE). Other central banks have been similarly aggressive, with Canada slashing its rate by 50 basis points to 0.25% from 0.75% and the European Central Bank maintaining its rate at -0.5% but expanding its stimulus program significantly.
Bloomberg Economics calculates that net asset purchases by the G7 central banks as part of their QE programs were close to $1.4 trillion in March, five times higher than their post-financial crisis peak in April 2009 of $270 billion.
On the fiscal front, the US government announced a $2 trillion rescue package, primarily aimed at getting money directly to individuals affected by the pandemic and small and medium-sized businesses likely to be hard hit by the virus.
Europe put together a fiscal package of close to $900 billion and Canada launched a budgetary package of C$52 billion ($36.62 billion). According to Bloomberg, stimulus packages have ranged from Australia’s 11.3% of GDP and the US’s 7.7% to Canada’s 6% of GDP and Germany’s 4.5%.
Emerging markets have followed their lead, cutting official interest rates and putting in place fiscal packages to prop up their economies during this period. Brazil has reduced interest rates by 50 basis points to 3.75% and eased capital requirements for financial institutions. South Africa has cut its primary lending rate by 100 basis points to 5.25% and announced a QE program for the first time in its history.
These, and other emerging market countries, are facing even more significant challenges than their developed-world counterparts. A large share of their populations is underbanked, which means monetary policy stimulus packages may not be as effective as in developed countries. Also, given the crowded living conditions of large parts of their populations, people can’t engage in social distancing. Thus there’s a far greater threat of the virus spreading rapidly and already weak health systems coming under severe pressure.
If the major economies can get the pandemic under control by May and the US, the world’s largest economy, is restarted, then the global economy may very well avert a depression scenario.
Company earnings taking strain
A broad scope of companies has felt the devastating impact of the COVID-19 crisis, and the extent of the effect on their earnings is only likely to become evident in the coming quarters. But I don’t expect these depressed conditions to continue in the long-term, and thus our view on the intrinsic value of most our holdings remains unchanged. While this is a challenging period, it has opened up the opportunity to acquire quality companies at more reasonable valuations.
Another concern we have, particularly at this stage of the business cycle, is what will happen to earnings-per-share (EPS) growth and we have been troubled for some time about what was really underpinning this ratio. EPS ratios are important to stockholders because they ultimately measure the extent of the value their equity investments are offering by quantifying the proportionate share of the company earnings investors receive for each share they hold. If the EPS is increasing, it typically means that the business as a whole is becoming more profitable, which is great for shareholders.
However, another scenario was already playing out before the crisis. While aggregate earnings had stalled, EPSs were still rising simply because share buybacks resulted in fewer outstanding shares for a company. Many companies had been repurchasing their shares on the open market, and this widespread practice could very well distort EPS growth such that it is not reflective of the overall change in profitability of the company. In these instances, an improving EPS is a result of a decreasing share count. At some point, share repurchases will reach a limit and, unless supported by a viable business model that generates the profits to underpin EPS, the growth in EPSs will come to a halt.
It was even more troubling that a plethora of companies had tapped the high yield market to fund share repurchases. The worrying question is, what impact will this have on company balance sheets when rates start to rise? While right now, it looks like that scenario is still far down the road, monetary policy conditions can change quickly. Remember it was just over a year ago that the Fed policy was hawkish and in a rising rate cycle, and before we knew it, central banks had shifted into a dovish rate-cutting cycle.
Economic growth has been precariously balanced on a fulcrum of low-interest rates – the lowest we’ve experienced in modern history. Policymakers and central bankers are debating the possible impact negative interest rates could have on the global economy in the longer term. For now, however, they have become the status quo in many developed markets and are likely to stay at these levels until economic conditions get onto an even keel.
Only time will tell what the consequences of such low rates will be, but I don’t believe they will be positive because they send all the wrong signals and create artificial incentives for borrowers. Within this context, we have been and will continue to be careful to avoid entities that are over-reliant on these super-low interest rates.
Ultimately, for companies to grow in a meaningful way, we need higher levels of productivity to kick in.
Diversifying to take advantage of global exposure
In the wake of the crisis, it is still possible for mature economies to produce meaningful growth. But the rate at which they do grow will depend on the level of innovation and ability to find new ways of doing things. I still believe that significant growth will come from the emerging markets over the long-term, given their favourable demographics, namely young and growing populations, and their ability to leapfrog more mature economies in the application of new technologies.
Canadian investors should be particularly concerned about the lack of diversification offered by the Canadian stock market, with the S&P/TSX Index giving investors outsized exposure to the resources and financial services, at the expense of other sectors in the economy. Investors should give serious consideration as to how they can ensure their portfolios are sufficiently diversified to take advantage of other opportunities available elsewhere.
Oil crisis hits hard
The other major market challenge that the world had to deal with during March was the fallout from the oil price crisis that resulted from failed OPEC negotiations in late February to cut back production further in the face of collapsing demand. Since then, oil prices have shed more than 60%, and oil-producing countries have been hit by a double whammy of slumping oil revenues and the effects of the coronavirus on their economies.
The OPEC+ countries went back to the negotiating table, with the US taking the lead on efforts to secure extensive production cuts. We anticipated that a deal would be reached between Saudi Arabia and Russia. What actually emerged was an agreement to cut 9.7 million barrels per day (mb/d) from 1 May 2020 for an initial period of two months to end-June. For the next six months to end-December, the reduction will be 7.7 mb/d, followed by a 5.8 mb/d cut for the next 16 months through to end-April 2022.
During the initial period, US, Brazil and Canada will contribute 3.7 mb/d to the global cuts, Russia and Saudi Arabia each agreed to cut 2.5 mb/d barrels a day and the remainder will be spread across other countries in the grouping.
In the wake of the announcement, Brent crude oil price rose more than 4% to about $32 a barrel.
In Canada, the announcement that TC Energy Corp. will go ahead with the construction of the Keystone XL pipeline between the US and Canada in April after Alberta committed to investing in the equity and providing a loan guarantee was certainly positive news for the Canadian energy sector.
Though there are challenges for the sector in the near-term, namely a supply-demand balance that is out of sync due to COVID-19 and the impact of the recent oil price war between Saudi Arabia and Russia, the industry will recover from this pessimistic state over the medium to long-term. Admittedly, the energy sector may look a lot different by then because of the increasing role of renewables in the energy mix. It’s a global game, and Canada needs to participate by moving to more environmentally friendly means of production.
Although the world is currently awash in crude, the reality is that the world will need more energy produced through various sources, including renewables. For the time being, however, renewables cannot entirely meet global demand and countries such as China and the US will be using a lot more energy after the COVID-19 pandemic has subsided and their economies are rebooted.
China and the US announced their intentions to take advantage of current low prices by building up their strategic oil reserves. The US Department of Energy planned to by 30 million barrels by the end of June but then reversed the decision towards the end of the month. China, however, is still going ahead with its plan to buy enough oil to cover 90 days of oil imports, which amounts to about 900 million barrels.
Assessing the risks
Among the market dislocations that have been brought on by the confluence of two black swan events has been a global liquidity squeeze prompted by the massive demand for dollar-based short term funding globally.
As banks struggled to meet the extremely high levels of demand for dollars from corporates running into short-term funding issues and investors were forced to fund margin calls, the Federal Reserve was called on to act as the “central bank for the world,” and it did so. In mid-March, it announced it would offer $175 billion in overnight repos and $45 billion in two-week repos to add liquidity to the markets. At the end of March, it went a step further and introduced the FIMA Repo Facility, which is a repo facility aimed at central banks and international institutions.
The substantial fiscal packages have meant that the already high government debt-to-GDP ratio has gone up further making it is necessary to keep rates low or risk stalling major economies around the globe. However, at some stage, these will have to be brought down through higher taxes or lower government spending. But at such high levels, it could be a long time before countries reach sustainable debt ratios.
The recently negotiated trade deal with China will also have to be revisited once the US gets past the coronavirus crisis. The deal will likely be renegotiated because China will not have the capacity to purchase as many US products as was expected under the trade deal, and the US will need parts and supplies from China.
What can we expect post the pandemic? We are likely to see less globalization, more nationalistic corporate and economic policies and more national control of supply chains, at least for a time. Nonetheless, there could also be alliances formed between countries that seem friendly, but these will all be done while looking over the shoulder. This may very well be the state of the world until we once again become comfortable with each other and again embrace the potential offered by globalization.
I’d like to close this month’s update by thanking the numerous people working in healthcare, grocery stores, warehouses, and sanitization services who are doing their best to keep us safe and well-fed. I’d also like to thank our wonderful clients for their belief in our team and investment process during this tumultuous time. Together we will get through this.
Garnet O. Powell, MBA, CFA is the President & CEO of Allvista Investment Management Inc., a firm with a dedicated team of investment professionals that manage investment portfolios on behalf of individuals, corporations, and trusts to help them reach their investment goals. He has more than 20 years of experience in the financial markets and investing. He is also the Editor-in-Chief of the Canadian Wealth Advisors Network (CWAN) magazine. He can be reached at gpowell@allvista.ca