“This is the time for high-quality portfolios, broadly diversified and spread, that have staying power, so that we can sleep well, waiting for the cycle to recover eventually.” Watch our latest update with Group CIO Yves Bonzon.
Events and decisions taken by the American and European governments follow one another at a frantic pace. On the one hand, containment measures to curb the spread of virus COVID-19 are plunging developed economies into an inevitable recession. And for now it doesn’t stop, with some countries going so far as to close all public places including bars and restaurants.
Someone told me the other day: ‘even during WWII in 1939-45, factories did not stop working and shops remained at least partially open’. I would add to this that during the war, the world economy was not as globalised as it is today and, above all, the financial system was much more rudimentary and therefore easier to stabilise. In addition, the financial system at the time was not as leveraged as it is today. We live in a world where there are far too many nominal claims after three decades of relentless ‘financialisation’.
This makes us vulnerable whenever a deflationary shock threatens to trigger a domino effect leading to chain reaction of failures in the economy and disorderly debt liquidation. Deep deflation would ensue threatening democracies. Recently, we have had a misleading sense of investment security due to the lack of endogenous imbalances in the United States and in Europe. The exogenous shock of the COVID-19 pandemic is proving much more infectious to the global economy mainly because of the administrative measures that governments have to take to prevent their healthcare systems from being completely overwhelmed.
MMT is the required response
MMT (Modern Monetary Theory) advocates making fiscal policy work in concert with monetary policy. Last August, the BlackRock Institute published a white paper co-authored by Stanley Fischer and Philipp Hildebrand on the subject. It suggests giving central banks a fiscal leeway to inject liquidity directly to the private sector whereby the amount would be up to a few percentage points of the respective countries’ GDP.
In the last few days, central banks have reacted quickly and as comprehensively as possible over such a short period of time. The Federal Reserve has cut interest rates to virtually zero and, above all, boosted QE (quantitative easing). Critically, USD swap lines between the major central banks were re-established to provide ample USD funding to central banks outside the US. I also consider it wise for the European Central Bank and the Bank of Japan to not lower policy rates even further into negative territory. Negative rates are known to damage the banking system. We must not add a problem of credit supply when credit demand is contracting rapidly.
For investors, this means focusing on the urgently needed fiscal policy response. The private sector, households and companies are hurt by a major natural disaster, COVID-19. Losses must be offset by monetisation, otherwise a severe recession followed by several years of chronic deflation will ensue.
Survival guide and recommendations
The current situation is so complex and evolving at such a speed that our recommendations must be divided into several sub-chapters:
#1: The recession is already priced in
At this stage, the recession is already priced into asset valuation. You can tell from those asset classes which still present decent liquidity conditions for trading purposes that the market is clearly pointing to a contraction of the economy. So what was initially perceived as a temporary shock in the economy that would eventually go away sooner rather than later, has turned into recession, simply because governments had to take unprecedented measures – essentially shutting down large chunks of the economy.
#2: A fast fiscal response is needed
From these recession levels in financial assets, where are we going? Given the shock is broadly impacting the real economy, and small businesses are losing their cash flow entirely overnight for an unknown period of time, until the contagion starts to recede, it requires a very fast fiscal response, but critically a fiscal response that is monetised. You cannot achieve this by transfer. Those who own wealth have already been hit by a substantial shock that will restrict consumption. Every dollar spent is someone else’s income. So we need fiscal policy, including monetisation of the checks.
#3: Watch out for efficient countries
The ability of countries to take forceful decisions fast enough is a critical function of their ability to print the money that they borrow and to take fast political decisions. For instance, in the fight against the virus a country like Singapore has been extremely effective. So investors should primarily look at assets that are exposed to countries which have this ability to take fast decisions and print the money they borrow.
#4: Don’t catch a falling knife
This is not a time for extreme bets. This is a time for diversification. One should not be tempted by catching a falling knife; buying the assets that have suffered the most. It’s a time for survival, getting over the crisis. This requires maintaining a good quality of sleep, and it means having a good quality of assets in one’s portfolio. Price and value can substantially diverge in the short-run, but if we know that our assets ultimately have value, we will resist the temptation of selling at the wrong time.
#5: Crypto has failed the stress test
Crypto assets have been one of the new things in the last decade. The initial narrative of crypto promoters was that they would eventually protect [investors] in case of a big crisis. Crypto assets have fundamental merits, which will deploy their effect over time in the coming years. But as a diversification tool in portfolios they have failed that test at this point, falling almost twice as much as leading equity indices.
#6: Gold is on hold
Gold is perceived by most as the ultimate safe haven asset in times of crisis. Strangely enough, gold initially responded positively, then subsequently corrected quite substantially as well. So gold has really not played out as effectively as one could have hoped. The reason being that gold is essentially a protection against hyperinflation or systemic risk. We are not yet at the stage at which gold has merits as a systemic hedge, but this might become the case, and the recent pullback in gold can be taken advantage of by investors to further diversify their asset exposure.
#7: Don’t trust absolute valuations
Very critically, absolute valuation metrics are unfortunately of limited help at this stage, simply because there’s uncertainty about the cash flow. So yes, DCFs [Discounted Cash Flow] eventually work most of the time, but when no one knows what the policy response will be, who exactly and in what proportion will be affected, unfortunately we cannot rely on those [metrics]. We should really take the medium to long term view in terms of the substance of the assets in which we invest.
#8: Don’t take big bets
As a function of what the policy response by leading governments will ultimately be, the outcome for the main assets – safe-haven bonds, credit, equities and gold – might diverge dramatically. This is no time for taking a big bet one way or the other – into cash, into equities, into credit, into bonds. This is the time for high-quality portfolios, broadly diversified and spread, that have staying power, so that we can sleep well, waiting for the cycle to eventually recover.