This article was originally written and published by Openly Investing.
“Panic plays no part in the training of a nurse” – Elizabeth Kenny
I start with the quote above as a benchmark to how we should all try to behave when the going gets tough. Doctors and nurses deal with stressful events all the time, often when people’s lives are at risk and I can only imagine the pressure that they are currently undergoing. These unsung heroes are dutifully helping people that have contracted COVID-19 and just getting on with it, with minimal fuss, but knowing that their actions can make all the difference. We should applaud them all.
The last few days have been anything but calm and in some instances, it was out and out panic with circuit breakers being triggered in the US and steep declines in Europe. The yo-yo in asset prices should be expected given the uncertainty created by COVID-19 and now the price war in oil. Italy is now in total lockdown and instances on COVID-19 are on the rise, but the global recovery rate is also increasing and instances in China appear to be plateauing.
In update #1, I expressed that the world as we know it has changed in some regards. People are scared, there is panic in the supermarkets and as a race, we are in various states of lockdown – whether that be self-imposed or by government intervention. These measures are intended to slow the spread of contagion and I hope we prevail and stamp COVID-19 out, but only time will tell.
What we are currently experiencing is a double crisis. The first is well known if not understood; The rapid spread of COVID-19 outside ‘ground zero’ coupled by some sensationalism, social media and other mechanisms has proven to be a heady cocktail, changing people’s behaviours. Whether this is short or long-term in nature remains to be seen but from an economic standpoint, the impact will be significant. How the situation resolves itself will unfold in due course, but make no mistake, it will be resolved. This may mean that COVID- 19 becomes endemic – an illness that is constantly present e.g. influenza – but we will find a vaccine and immune systems will adapt or, it disappears as quickly as it emerged.
I also suggested that many countries will have negative growth for the first three months of the year, that supply chains will need to be rethought, that policymakers (both Government and Central Banks) will provide economic stimulus and that interest rates and inflation will remain low. I have not changed my thoughts here; COVID-19 has indeed changed things.
The weekend saw a significant breakdown in relations between the 13 nations that comprise OPEC and Russia. Oil prices plummeted in response to the ‘demand shock’ created by the spread of the virus, followed quickly by a ‘supply shock’ at the behest of Saudi Arabia and the breakdown of talks with Russia.
Whilst at first, we may view the fall in the oil price as welcome, it is the financial impact that has heads turning. The oil industry and exploration, in general, is supported by an enormous pool of debt. Often this debt is issued on projects that are high risk and the success or failure to find and produce oil will see those bonds rise or fall in price. Given the nature of the enterprise, the debt is largely low quality with high yields to compensate investors for the higher risk. The banks too are lenders to this industry and also reliant on good exploration results to recoup their money.
The issue here is that traditionally, Saudi Arabia and more broadly OPEC have massaged the price of oil through either increasing or decreasing supply depending on demand. The success of such practices has always depended on compliance between members of OPEC and Russia. This relationship has now broken down, the stability of the price of crude oil may be questionable. Once profitable wells may now be producing at a loss and ultimately have to shut down. Shale oil in the US is almost certainly uneconomic at current prices and the recent action will drive many to the wall and bankruptcy. This is also important because this sector of oil production allowed the US to become less dependent on the Middle East for oil.
The last time we saw this type of event in the oil sector was in 2015/16, where well over 150 oil companies went bankrupt with a debt burden of over US$85bn. That is a significant loss for investors. Whilst that was clearly bad, if the current situation remains it may be worse this time around with estimates of US$110bn of debt at risk. Whether this will be a long-term phenomenon remains to be seen. Russia could capitulate (although this would be unpalatable) and demand may return reasonably quickly – although I would note that storage use will currently be high and may be used to satisfy the increasing demand.
Outside of the Federal Reserve interest rate cut, the US has been relatively quiet on measures to address the certain malaise in economic activity caused by COVID-19. With the Democratic Primaries in full swing, my concern is that any actions will be political in nature as opposed to taking firm action to address the issues at hand. For example, the Administration has moved a proposal to Congress to cut income taxes until after the election, a move opposed by the Democrats. While this may be welcome to some, it will only be beneficial to the economy if people actually spend the windfall. At the time of writing, the number of confirmed COVID-19 cases in the US continues to rise and even senators are self-isolating. In my opinion, the administration needs to move to stop the spread of the illness through better testing and other measures rather than tax cuts – New York has deployed the National Guard to do just that. For example, fiscal stimulus in the form of increased government spending ought to be a priority, but has yet to be announced.
Overnight, the United Kingdom has done just that. The Bank of England announced a 0.5% reduction in interest rates to 0.25%, a fiscal stimulus package of GBP 30bn, and pledged a further GBP 600bn package (approximately NZD 1.23 trillion by 2025). This money will be aimed at infrastructure and is the biggest fiscal package in decades.
China appears to be recovering, and a visit to Wuhan by Xi Jinping a symbol of the recovery underway, but we are not out of the woods yet. Italy has taken additional measures to slow the spread, and airlines are cutting capacity across the board. It is clear that some airlines will not survive, and some will need to be bailed out by governments or file for bankruptcy protection. This will pressure some debt as with the energy industry.
In conclusion, the recovery in prices on Tuesday (our Wednesday) was pleasing, but we must remember that investment prices are a slave to news headlines at the moment, and that euphoria was reversed in international markets overnight. Good news will continue to see some bounce in asset prices and ‘risk-on’ currencies such as the NZD, but it should be remembered that we are in a period of extreme volatility and movements in prices can quickly reverse.
Without a doubt, in the short-term, some assets are clearly over-sold and some, such as fixed income, appear to be overbought. But they can remain this way for longer than one can stay solvent and wholesale switching has proved problematic to investors throughout history. At this juncture, the disposal of quality investments that have already been indiscriminately thrown out may not prove to be a good strategy, but it is highly likely that bounces in lower quality investments will be met with selling to de-risk portfolios.
It is important to keep in mind that capital destruction only occurs when a company goes bankrupt or an investor realises a loss on a position. If you are a long-term investor there will always be periods of pain but ultimately, the patient investor will be rewarded.
Remember the hunt for yield and dividends? That is the practice of chasing lower quality, higher paying dividends or coupons. That is fine whilst the ‘party’ lasts but when the tide goes out, one can see who has been wearing the emperor’s clothes. This is why we believe in quality and sound investment credits and have avoided chasing yield for yield’s sake.
Stay tuned for update #3
Tim Chesterfield
Chief Investment Officer
12 March 2020
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