Investment outlook second quarter 2020

World economy

Asset managers traditionally publish their outlook for the new year in January. This year, these outlooks proved outdated within a matter of weeks. The global spread of the Covid-19 virus has changed everything.

During the first few weeks after the world learned of the new virus, markets assumed that the problems would be contained in a limited number of countries, much like the SARS, MERS and Ebola outbreaks in previous years. In fact, markets expected the Chinese lockdown to be followed by a period of large Chinese economic stimulus. That in turn was seen as a positive development for China’s main export partners. Markets hit an all-time high on 12 February. At the time, market unrest was limited mainly to companies that rely on Chinese supply chains. Apple and Nintendo for example, both suffered minor disruptions in manufacturing.

As the virus continued to spread, markets everywhere suffered one blow after the other, including a couple of historically negative trading days in March. During the past months, Laaken has increasingly shifted towards more defensive investments in companies with conservative balance sheets. We reduced or sold positions in riskier and more expensive equities such as Easyjet, Mapletree Logistics Trust (logistic centres in Asia), Capitaland Commercial Trust (real estate, including shopping malls in Singapore) and Brookfield Asset Management (private equity, highly leveraged). So far this strategy has only had a limited contribution to the performance of the portfolios. As the Covid-19 virus spread to Europe and the US, market panic hit all investment categories indiscriminately with little distinction between sectors and companies. In a panic driven market crash, equities price on liquidity, not on companies’ financial fundamentals. Much of the 2019 returns were lost year to date and the portfolios are down in line with the benchmark.

Our base scenario is that most of the impact and consequences of the Covid-19 pandemic will ultimately be limited in time. The value of a company is largely determined by the revenues it will be able to generate for its stakeholders in the coming decades, not in the coming months. The reduction in fundamental value of a conservatively financed company that suffers a temporary collapse in demand is limited. Such companies may even emerge from the crisis stronger as they could gain market share from weaker competitors. The situation is profoundly different for companies with too much debt. If they cannot meet their financial obligations, even temporarily, it may lead to permanent capital loss for shareholders.

The current situation is unique because even conservatively financed companies are at risk if they have high fixed expenses. Examples include car manufacturers that are shut down by authorities but facing continuing high labour costs, retail shops and fitness centres with fixed rent expenses, as well as airlines, airports and hotels. Without government aid, we may see a large number of bankruptcies in these sectors, which in turn would lead to higher unemployment, reduced consumer spending and ultimately a prolonged recession.

To avoid this downward spiral, governments have announced support with far reaching fiscal stimulus. Money has been pledged to households, labour costs will be temporarily covered by the state, financing is offered to sectors at risk and states could potentially acquire equity stakes in certain companies. The US has already approved a stimulus package of USD 2.2 trillion, almost 10% of US GDP, and Europe is following suit. A second or third stimulus round may follow. At the same time, the Federal Reserve lowered interest rates to 0% and is providing nearly unlimited liquidity to the markets. The ECB launched an extra EUR 750 billion bond-buying program. These measures will cushion the impact of the current crisis but will ultimately come at an expense; sharp increase in sovereign debt. In the long term, handing out funds and printing money can lead to the depreciation of the value of money. A risky phenomenon, known as inflation.

In every crisis, many companies face difficulties raising new equity or issuing new debt. This is the point where excess risk becomes visible in the wider economy. During the financial crisis, many mortgage backed securities turned out to be much riskier than previously thought. Concerns that banks have once again sought too high risks, in combination with ultra-low interest rates, have resulted in a considerable correction in bank share prices. However, regulation of banks has been tightened since the 2008 financial crisis and banks are now significantly better capitalized. The ECB has called upon banks to hold off on dividend payments and the sector has so far complied.

The ultra-low interest rates of recent years will most likely have contributed to excessive risk taking in search of returns. Where exactly these risks are situated could become clear in the coming months. Private equity funds that invest in private debt or funds with highly leveraged investments come to mind. Under pressure of an unprecedented inflow of money in private equity, funds have had to outbid each other, propelling valuations and deal sizes to new highs. And potentially, to excessive risk. Furthermore, there have been large inflows of money in Venture Capital, mostly towards companies with high growth, but limited prospects of profitability. If new funding disappears, many such companies may face an uncertain future.

Meanwhile, the oil industry is facing challenges. Global demand for oil is usually around 100 million barrels a day. Under normal market conditions, the difference between demand and supply is no more than 1 million barrels. However, demand has plummeted after the Covid-19 outbreak. Airplanes are grounded, trains (often diesel-powered) are parked and people stopped driving their cars. This is causing a supply surplus of between 10 to 30 million barrels a day. Crude prices have fallen to their lowest levels since 2002. Traditional oil producers such as the OPEC cartel and Russia have lost market share to US producers in recent years. Until recently, OPEC and Russia limited their production to support market prices. On 9 March, Saudi Arabia announced that, in spite of the already apparent surplus, they would maximize their production. To further clarify their intentions, they adjusted the pricing mechanism to ’10 dollar under current European prices’. An unprecedented move that could in fact result in negative oil prices, as briefly seen in Canada in 2015.

To support oil prices, president Trump announced the intention to increase the strategic US oil reserves. The proposal would only amount to 77 million barrels of incremental one-off demand, the equivalent of a half a week of current global surplus production. The proposal has not yet been passed by the US Senate. Meanwhile, independent US producers are seeking rapprochement to OPEC through their regulator, the Railroad Commission of Texas, trying to bring the market back to equilibrium. Even if these efforts were to succeed in the coming months, it will take years to fully consume the recent build-up of oil supply. The outlook for the oil industry is bleak.

In closing, it is important to mention the psychology of the current market. In the last 12 years, every major market correction was swiftly followed by an even bigger upswing. All over the world investors have resolved to buying stocks after major corrections. Besides trading days with panic selling, there are also trading days with panic buying. As an active asset manager, Laaken has the opportunity to position its portfolios towards investments in companies with more promising futures that can endure these challenging circumstances.

Fixed income and cash

Our relatively high cash allocation performed well. The portfolio’s underweight duration in fixed income did not hurt performance because interest rates in Europe did not fall and has even increased in some countries. Normally fixed income with a long duration performs well in times of turmoil, but during the last quarter longer interest rates remained steady under the influence of raised inflation expectations. We continue to avoid fixed income with a long duration because of negative yields.  Prices of some corporate bonds in the portfolio have declined as the market demands a higher risk premium. Additionally, the corporate bond market is relatively illiquid and as a result, the quoted prices are not always representative for the bond’s fundamental value at the moment. Contrary to the financial crisis in 2008, the bond market is currently not a good alternative for investors due to the low interest rate environment.

Equities – Most listed companies have published updates on how their business is affected by the Covid-19 crisis. However, it remains difficult to properly quantify the consequences and therefore the outlooks offer little if any real clarity. Earnings season starts next month and results are expected to be poor across the board. The second quarter is likely to be even worse. Some companies haven’t been affected as much as others. Analysts still expect a turnover increase of ‘a mere’ 2% for Visa and American Express in Q1. Companies such as Bayer (agricultural seeds and herbicides) or Nintendo (game computers and games) will only see a minor impact on their business. Nevertheless, their stock prices have plummeted with the rest of the market, offering opportunities for active investors. Other companies will experience a strong increase in demand during the second half of the year. At the moment, many non-essential medical procedures are being postponed to post Covid-19 peaks. This affects companies such as Stryker (producer of artificial knees and hips) or Fresenius (clinics in Germany and Spain). However, these procedures cannot be postponed indefinitely. Contrary to for example a cancelled concert, which will likely not be rescheduled.

Listed Private Equity managers 

Despite looming risks in private equity and despite the blow share prices have taken in this category, many of their funds have billions in committed capital and investor allocation to this segment is unchanged. With lower valuations, this capital can be invested at better prices.

Real Estate

Our underweight allocation to real estate proved prudent, as the real estate index was hit relatively hard. In our previous outlook, we discussed the slight increase of our positions in Unibail Rodamco Westfield and Simon Property Group, due to the relatively strong performance of their malls and attractive valuation. The simultaneous closing of all malls never was a real scenario for Simon Property Group. While its customers (the stores) are obliged to continue paying rent, many will not be able to do so. And although leverage is inherent to real estate, these two companies are financed with long term loans, which should allow them shelter to weather the current storm.

Commodities

Gold prices increased 8% this year. Although gold is usually a good hedge in times of market turmoil, prices dropped during the panic driven trading days in March. As a result of leveraged positions getting margin calls, investors were forced to sell positions. So far, the price developments show similarities with 2008, when gold prices initially increased only 5%, followed by a 90% rally in the years after. Since the Covid-19 outbreak also led to the forced closure of some gold mines, a part of the position in Royal Gold (a financer of gold mining companies that is repaid in gold) was swapped for a position in a physical gold bullion fund.