In our post exploring the top investment themes for 2020, we highlighted the fact that uncertainty would be a theme throughout the year. At that point the Coronavirus was a reason for concern but was not yet a pandemic. Less than a month later the pandemic has thrown the world into a recession and resulted in a stock market crash with equity markets falling by over 30%.
So, is this as bad as things will get, or will it get worse with this global pandemic? In this post we look at the potential impact of the pandemic on economies and markets. We discuss two very different scenarios and explore some of the ways you can protect your portfolio during the unfolding Coronavirus recession.
- Comparing the Coronavirus recession to previous recessions
- Coronavirus recession scenario
- Coronavirus depression scenario
- Why asset allocation is the key to surviving the Coronavirus recession?
- Investments that may prove most defensive during this bear market
Comparing the Coronavirus recession to previous recessions
Every recession and bear market is different. However, the Coronavirus recession that is just beginning stands out in several ways. Firstly, unlike many other global recessions, this one has not been caused by a financial event or crisis. Secondly, it is widespread, with over 150 countries already affected. Technically, what is presently occurring can only be described as a recession after two quarters of negative GDP growth. However, given the very obvious drop in economic activity and the dramatic spike in unemployment claims in several countries, a recession is all but certain.
The Coronavirus recession is a health crisis that is disrupting the real economy. The industries most affected are travel and hospitality, most notably, airlines, hotels, cruise operators and theme parks. As self-isolation measures have been introduced, the retail, manufacturing and construction industries have also been severely affected. Many small businesses like restaurants, hairdressers and other owner-run businesses are also unable to operate. This is important as many of these businesses lack the capital to survive beyond a month or two without operating.
Most of these industries are not typically associated with a financial crisis. They are also not industries associated with high levels of speculation and leverage. The Global Financial Crisis started with the banks and real estate industries, where speculation and the use of leverage are common. This time around it is the real economy that is being affected – but the contagion may spread to the financial sector later.
Governments around the world are providing stimulus and aid to prevent businesses failing. However, the nature of the pandemic means that these measures will have a limited effect until the disease is under control. Businesses will not be able to return to normal for months.
The Coronavirus recession has two other unique features. The first is the dramatic and ongoing oil price crash. Over the past decade the US has increased its oil production from below 6 million barrels to over 13 million barrels per day. The result is that global oil production has been very high and easily able to accommodate supply.
The difference between the US and the world’s other major producer, Saudi Arabia, is that the cost of production is much higher in the US. The Covid-19 pandemic resulted in lower oil demand and the oil price fell throughout January and February. This meant that many US oil producers were already operating at a loss by the beginning of March.
Then, in early March, Saudi Arabia and Russia decided to discount the oil they sold – causing the price to immediate fall to below $30 a barrel. A lot of US oil producers are heavily indebted and now unable to generate a profit. If the oil price stays below $30, this debt will become a problem for the entire financial system in the US. The oil price war is touted as being between Russia and Saudi Arabia – but really the US is just as involved. This may result in new geopolitical tension too.
Corporate debt is the second factor that could compound the effects of the pandemic. Besides the US shale oil producers, there is a lot of other corporate debt in the US and around the world. If this debt becomes unsustainable it will put pressure on the entire financial system. The global economy will, at best, experience a severe recession. However, it could also develop into a prolonged depression if the financial system is overwhelmed.
Coronavirus recession scenario
There are several reasons to believe that the economy and markets could recover quite quickly, if and when, business returns to normal – or at least to close to normal. There will be a recession, but it may be short lived. The length of the recession will obviously depend on the pandemic itself. A vaccine for Covid-19 may be well over a year away. But, a successful treatment regime could be available sooner which would take pressure off healthcare providers. Hospital capacity is being increased rapidly, as is the production of personal protection equipment and ventilators.
China and South Korea have already proven that the infection rate can be managed with enough testing and the enforcement of social distancing guidelines. If home testing kits are developed, the situation can be even more closely managed. The virus may be around for some time, but provided the infection rate is managed, many parts of the world economy may be able to begin operating within months. Travel and hospitality related businesses will still be affected by travel restrictions, but manufacturers, retailers and small businesses may be able to operate.
When it comes to the economy, governments and central banks appear willing to provide aid and liquidity regardless of the long-term consequences. This should be enough to keep most businesses afloat for a few months. If it does appear that the pandemic is under control sooner rather than later – the economy may indeed bounce back quite quickly. Consider the following:
- Valuations are attractive for the first time in years – investors won’t want to miss out on this.
- There will be a sense of urgency on the part of business owners to recover lost revenue.
- The liquidity that has been provided by central banks will have to end up somewhere. If it results in inflation as many predict, that inflation may reflect in asset prices.
The economy may also take time to recover, but if the indicators begin to improve, the market will quickly discount a recovery.
Coronavirus depression scenario
Numerous analysts are predicting a more pessimistic scenario – a global economic depression. There are too many unknowns to be certain of either scenario. Nevertheless, it’s worth considering the more bearish scenario. The most important factor will be the length of time that the pandemic disrupts the economy. This may be prolonged if social distancing measures are relaxed too early. If that happens, a second period of social isolation may be required. The same may occur if travel restrictions are relaxed too soon.
Viral outbreaks often decline during the Northern Hemisphere’s summer and then return the following winter. If this occurs with Covid-19, the world economy may recover briefly in the 3rd quarter, only to fall back into recession in the 4th quarter. So far it appears that the virus has not mutated. But, as the number of infections increases, the chance mutation increases. If that occurs, those who recover from the first virus may not be immune, and a second pandemic could occur.
The scenarios outlined above refer to the pandemic itself. But there are also economic factors that will compound over time. Bankruptcies are already a certainty. The longer the economic disruption lasts, the more bankruptcies will occur, and they are likely to compound. When a company files for bankruptcy, its creditors are all at risk. This will also affect companies that have been relatively unaffected too date.
Rising unemployment will put pressure on governments and businesses. Besides a global humanitarian disaster, people will default on mortgages and other payments. Government revenues will fall, credit markets will tighten up, and there will be no appetite for risk. The wealth affect will work in reverse, and consumer spending may remain low, even after lockdowns are ended.
Marginal and unprofitable companies will struggle to access capital as investors and banks become risk averse. Corporate debt that has been ignored for years will suddenly become all important. If the oil price remains low, US producers will cease production. This will add to already tense international relations.
After the GFC from 2007 to 2009, many analysts predicted high levels of inflation would result from the quantitative easing policies. This inflation didn’t really materialise as economies grew and Chinese exports kept export prices low. This time around, inflation may occur if economic growth doesn’t return and asset prices don’t rise.
The US election may also complicate matters later in the year. Difficult decisions may be delayed until next year to avoid them affecting the election – thereby creating another recession in 2021. If this more bearish scenario plays out, it will be a result of the Coronavirus recession creating a vicious cycle of events within the financial system. This scenario could last for several years and cause extensive damage to the global economy. But, we are still a long way from the second scenario.
Why asset allocation is the key to surviving the Coronavirus recession?
The above scenarios paint two very different pictures of what the world might experience over the next one, two or three years. There are still a lot of unknowns. Even if we had an exact timeline for the pandemic, the global economy is too complex to make forecasts with any precision. Moreover, asset prices and the economy do not always move together. Reality may also turn out to be somewhere between these scenarios.
For this reason, there is little point in positioning a portfolio for a specific outcome. An investment portfolio needs to be positioned for ALL outcomes. The past six weeks has proven that picking one asset class can be very risky. Some safe haven assets have not behaved as one would expect them too – while others have. Silver for example fell 37% in less than a month. Bitcoin, which is often described as a safe haven asset, has fallen more than equity markets over the last six weeks.
The gold price also fell sharply, though it has on balance performed better than other asset classes. US treasuries have proven the most resilient and are up over 6% year to date. Hedge funds have also for the most part performed well. Catana Capital’s Data Intelligence Fund has outperformed equity markets by a significant margin so far this year. The sharp rebound in equity markets in the last week of March is also a reminder of what will happen if a recovery does occur sooner than expected. If the news begins to improve, investors are likely to move back into equities, and defensive assets will underperform.
The only reliable way to protect capital in such an environment is by diversifying risk across several asset classes. Effective asset allocation ensures that losses in one asset class can be partially offset by gains elsewhere. Capital must always find a home somewhere, so there will always be one or two assets that do outperform. On the other hand, now that equities are cheaper, there is also risk to not having any equity exposure.
Investments that may prove most defensive during this bear market
As with any recession, certain asset classes are likely to outperform during the Coronavirus recession. During previous recessions, hedge funds, bonds and gold almost always outperformed risky assets. If the bear market persists, this is likely to continue. Of course holding cash is another way to hedge a portfolio, providing liquidity, and ensure you have buying power if equities decline further.
Given the potential for a corporate debt crisis, only investment grade government bonds should be considered now. If you are looking for income, dividend stocks with low debt levels and high margins may be safer than corporate bonds. During any stock market crash, investors usually look to defensive companies. These include consumer staples, healthcare companies, utilities, and defence contractors. Many of these may outperform, but again it’s important to be selective and consider margins and debt levels.
Typically, tech stocks are seen as risky, not defensive. In this case some tech companies are proving to be defensive because they are less affected by what is happening in the real economy. As mentioned, we don’t know how long the recession will last, and whether it may become a depression. But there are companies that are well positioned right now, and are also well positioned for the next decade.
Most notable for stock pickers are companies that support remote working and education. These are trends that were gathering momentum before the pandemic and are now seeing growing user numbers because of the pandemic. Zoom Video Communications (US: ZM) and Slack Technologies (US: Work) are the standout companies here – though their share prices are already reflecting this. Microsoft (US: MSFT) is already a leader in the cloud space, but the pandemic is accelerating adoption of its Teams platform. Other industries seeing an increase in user number are those involved in telemedicine, online education, gaming and esports. These are the types of stocks one can accumulate into market weakness and should not be chased.
There are lots of other software companies to consider too. For the most part, these companies have low fixed overheads and their employees can easily work remotely. Their revenues will fall this year, but if they have wide margins, they will be able to survive. However, tech companies that are not actually profitable must be treated with caution. The market has been obsessed with revenue growth for the last few years – but that may change now.
There is a lot of potential upside for these types of stocks – but risk does need to be managed carefully. If the indices continue declining, few stocks will be spared.
Conclusion: Surviving the Coronavirus recession
Some experts have predicted a pandemic like this for years, while to most it is another Black Swan event. Regardless, it will be with us for some time, and market volatility is likely to last at least a few months, and possibly a lot longer.
The Coronavirus recession is creating the best opportunities we have seen in years, but there is also potential for a lot more downside. Investors should use market weakness to buy quality stocks – but should also make sure their portfolio will be able to survive a prolonged bear market.