The Data and the Damage
Stan Miranda, Kamran Moghadam, Arjun Raghavan, Colin Pan
23 May 2020
From an investment perspective, we would all like to have the crystal ball that tells us what the quantum of economic and financial damage from Covid-19 will be.
The answer to this will be most directly determined by when people go back to near-normal levels of work, socialisation and spending. This will in turn be driven primarily by when reported fatalities from the virus drop low enough to give us confidence to resume normality, rather than by governments telling us when and what we are allowed to do. Reported fatalities will drop when centralized resources and processes are in place for isolating the vulnerable, testing and tracing contacts in large quantities, and effectively quarantining infected cases. Medical breakthroughs – whether in treatments or vaccines – could be a gamechanger. We also need the crystal ball to tell us how effective the massive stimulus will be in offsetting the economic damage from the total effects of the above.
Nobody really has the answer but there is a huge amount of intellectual energy being poured into finding the answer ahead of others. Here is our framework in algorithmic form:
We will review all of these inputs but start with our current view of the quantum of economic and financial damage caused by the virus.
Economic forecasts. The experts are saying the global economy will fall by over -4% in 2020 vs. the +3% forecast pre-Covid-19. The global economy is forecast to recover strongly in 2021, rising by over +6%. These estimates incorporate the underpinning of the decline from the $16+ trillion (20% of GDP) in stimulus where GDP would have been nearly 3% lower in 2020 and 1.5% lower in 2021 according to JP Morgan’s interpretation of IMF figures. After two years, economists expect global GDP to still have grown by a cumulative +1.7% from the end of 2019, compared to the +6% cumulative growth as forecasted prior to Covid-19. Put another way, economists expect that we will have lost approximately 1.5 years of global growth.
Corporate earnings forecasts. Analysts are forecasting 20-30% declines in 2020 S&P 500 EPS with an expected recovery of S&P 500 EPS for the full year 2021 to the EPS level of 2019. The expected impact of the virus is therefore to lose two years of EPS growth, not two years of earnings. The crystal ball needs to explain why 23% unemployment in the US, along with less spending from higher savings will translate into a -6% 2020 US GDP decline with a +5% recovery in 2021. The GDP and corporate earnings estimates appear to make heroic assumptions about a return of the economy to near normal levels of activity which appear inconsistent with the trajectory of Covid-19 cases and deaths.
We have already seen that, unlike Asia where they are ~90% back to normal, the first lockdown will carry on for longer in Europe and the US, but with greater freedom than we had at the outset of the lockdown. Looking across the data shown in Exhibit 3, we estimate that social and economic activity is at 30% and 70% of 2019 levels for London and the United States, respectively.
The data that bring us to this conclusion is provided from answers to six questions below.
Q1. Have lockdowns in the US, UK and other major economies dropped the cases and mortality rates enough for people to return to work and engage in less social distancing soon?
Europe and the US are opening up before case rates have dropped anything like what happened in Asia. Other parts of the world are seeing exponential case rate growth despite lockdowns.
Exhibit 1: Path of Covid-19 cases by geographic area (earliest regions to latest to experience)
Q2. What is the likelihood of a second wave and second set of lockdowns in the US, UK and rest of Europe?
We continue to believe that there will be second waves once people narrow their social distancing, but we are not yet seeing many examples of it. To date we have seen no real evidence of large scale second wave outbreaks at a country level. This can be seen in the countries that were earliest to have eased restrictions including South Korea, Germany, Denmark and Austria below. While restrictions have only been eased at the margin (red line indicates lifting date) it is none the less a promising sign so far. All countries have continued to see a decline in active cases.
There have been minor outbreaks at a regional level which seem to have been contained. In Seoul restrictions were imposed on bars/nightclubs after a man reportedly spread the virus to several others. There have been six new cases reported in Wuhan which has led authorities to test the entire 11M population. In Chinese cities along the Russian border there have been reports of cases with the virus still yet to reach its peak in Russia, this has led Chinese authorities to impose tighter restrictions at key land border points. In Germany the Robert Koch Institute warned that the infection rate was rising but R0 remained close to 1.0 and the virus was under control.
Exhibit 2: No significant second waves from regions which have already come out of lockdown
Governments are opening up and “essential workers” are back to work, but a combination of remaining controls and self-imposed behavior is still constraining economic activity as you can see in the table below. There would appear to be a low likelihood of second waves given people are continuing to social distance, but the two-month lockdowns have not reduced deaths enough to make people comfortable to move about freely. We are therefore not yet focused on a possible second lockdown, but rather are quite concerned that the first lockdown will be protracted well into the summer months. You can see from the table below that the UK, France and Italy are still the most locked down from measures of the percentage of normal activity (note that the heat mapping shows red for the highest negative %’s under normal).
Exhibit 3: Percent of normal activity in various parts of the economy (countries and cities)
Over 40 US states have now begun the process of reopening. New York and New Jersey have followed the pattern of Italy with exponential growth, containment and an encouraging pattern of case and death declines. The majority of other states have avoided major outbreaks but are seeing a continuing low level of case growth. In the four other largest states, Texas, California, Illinois and Florida, we are seeing 800 to 2000 new cases a day with no pattern of decline. The charts below show a mixture of states that have re-opened (green frame), have regional re-openings (orange frame) and that are still in lockdown (red frame). It appears that most of these states that re-opened did not meet the Federal guidance of 14 days declining cases prior to re-opening.
Exhibit 4: US Daily cases pre and post re-opening (through 22 May)
One of the richest data sources we have found is the Covid-19 Infections Tracker which forecasts the number of new cases and deaths out to August for all countries and individual US States. It is a depressing picture for the UK and states like California, Illinois and Texas where projections indicate continued moderate levels of 60 (Texas) to 200 (UK) new deaths per day in each region through the summer. This is not an outcome conducive to people returning to normal activity levels.
Q3. Are we doing enough testing, tracing and isolation to get R0 down below 1.0? When can we reduce social distancing?
As our Covid-19 update #11, we wrote a 3-page note intended just for government audiences which provides the answer to this question which we summarise here. It is mostly informed by my interview with Professor Danielle Allen, Director in charge of the Harvard Safra Centre, who has been responsible for several research papers which President Trump and his health advisors have only recently benefitted from. Please email me if you would like to see a copy of what we wrote.
To answer the question above, Germany executed well with tracing contacts, while the tough lockdowns in Italy and France contained cases enough for their relatively modest amount of testing to work. But the US and UK are the most worrying as the case levels are still high relative to PCR testing capacity and most US States and the UK are only just now recruiting tracing teams.
With new case levels at 2,500/day in the UK and 25,000/day in the US, current testing levels of 100,000/day in the UK and 500,000/day in the US are not enough. Our view is that even after case levels drop further, we need mass PCR testing for certifying that people can feel safe again with less social distancing. Many businesses will never recover with the current 2-metre / 6 feet distancing requirements. Getting to high levels of testing and tracing is a massive logistical challenge involving adequate supplies of PPE, swabs, reagents, PCR lab processing machines, tracing staff recruitment and training, sample shipment and IT support throughout. This requires strong leadership placed at the right regional level. On 7 May, Baroness Harding was assigned this role in the UK. To date no US state has hired any meaningful number of trackers. In early May, NPR surveyed all 50 states and with responses from 44, they reported that there are plans to hire a total of 66,197 workers. California announced a partnership with UCSF to put 3,000 people a week through its 20-hour contact tracing training, with a goal of ultimately having 20,000 contact tracers. New York state also announced a plan to hire as many as 17,000 workers. Estimates of how many are needed range from 100,000 (CDC) to 300,000 (15 person days x 20,000 cases per day) in the US.
PCR tests have high levels of accuracy if administered correctly. We continue to see this as the key to opening economies as demonstrated by Korea, Taiwan, Hong Kong and China.
Q4. What is the update on vaccines?
Over 120 vaccines are currently under development, but with only 6 in clinical trials, the rest are pre-clinical. The most advanced vaccines at present are those from CanSino (phase 2) and Oxford University (phase 2) and Moderna (phase 2). These companies have aspirations of producing enough dosages of a working vaccine to assist frontline workers by the fall of 2020. Oxford have established relationships with AstraZeneca and the Serum Institute of India allowing for production of 100 million doses by year end (assuming approval). Moderna released promising phase 1 trial results on 18 May, although this is only the first of many steps in the drug approval process.
Exhibit 5: While there are over 100 vaccines in development, most are still in pre-clinical trials.
Under the White House programme entitled “Operation Warp Speed,” the United States plans a massive testing effort involving more than 100,000 volunteers and a half dozen or so of the most promising vaccine candidates in an effort to deliver a safe and effective one by the end of 2020. The project will compress what is typically 10 years of vaccine development and testing into a matter of months. To get there, leading vaccine makers have agreed to share data and lend the use of their clinical trial networks to competitors should their own candidate fail. Candidates that demonstrate safety in small early studies will be tested in huge trials of 20,000 to 30,000 subjects for each vaccine, slated to start in July. The Moderna vaccine, developed in partnership with the NIH, will be the first to the enter large-scale testing in July, and may be joined by the vaccine from Oxford University and AstraZeneca.
Q5. Are there any changes to what we expect to happen in our economic scenarios?
In summary, we still believe our three scenarios below reflect the range of possible outcomes as shown below.
Exhibit 6: Range of likely scenarios with base case of continued social distancing through summer
But we now have seen more clearly through the clouds about what is happening at street level. The severity of the current contraction guarantees that economies initially will see one or two quarters of very strong growth when businesses resume operations. It is not clear what will happen beyond this bounce as many businesses, especially small ones, may decide against reopening given the uncertainty about future revenue growth and the restrictions imposed by new physical distancing procedures. BCA, in their 22 May report, emphasises that many of them are financially fragile with the median company holding less than one month’s cash on hand. BCA quote OpenTable estimate that 25% of US restaurants will close permanently. Fiscal stimulus cannot force these businesses back into business.
Despite the increasing clarity on the negative economic effects of the virus, markets have remained resilient. Investor sentiment remains at extremely low levels with huge amounts of market shorts in place. These factors have historically underpinned equity market floors. The S&P 500 at 2950, 13% off its pre-Covid-19 peak, may still make sense in light of the economic damage being mostly limited to 2020 and 2021 and the scale of the stimulus.
These factors imply that there is now a lower probability of there being a near-term 10-15% equity market correction which decreases the potential value of tail hedges like gold, inflation-linked bonds and tail-hedging funds that we have in many client portfolios. However, the downside remains a non-trivial risk and we are retaining our “safety net” exposures to protect in such a scenario.
Turning to the longer-term, the extent of stimulus being pumped into the economy will have repercussions over the next decade. The growth it saves today will likely cost us in the future and we are unclear on how much of this is priced into markets today as this also depends on how future discount rates evolve. To help inform this thinking, we next turn our attention to review some key longer-term structural changes to the economy.
Q6. What will be the longer-term structural changes to the global economy?
Here is a preview on what people we respect are saying today about tomorrow. As you read through it, think about whether markets have discounted these headwinds (or tailwinds, in the case of areas such as technology) into risk asset prices today.
- Structurally higher unemployment will remain due to small company failures, while large companies will continue to gain market share without the need to hire given operating leverage. In the US, after spiking to the current 15% rate, unemployment is expected to end 2020 at c. 8%, but end 2021 probably c. 5-6% (vs. the 2019 low of 3.4%). A University of Chicago study forecast that 42% of recent job layoffs will end up being permanent which would point to 8% unemployment in 2021. Europe had high unemployment going in and will suffer more from export market shrinkage (China turning inward).
- Disinflation followed by inflation. We are already seeing deflation in major economies given the severity of the lockdowns. There is no chance that developed economies will be able to grow out of their rising debt-to-GDP levels. No voters will favour the degree of austerity that would be required to bring deficits and debt-to-GDP back to reasonable levels. That implies easier monetary policy than would be warranted by economic conditions, leading to higher inflation. However, governments and central banks will also need to limit inflation such that rising healthcare and social security costs, as well as debt service, remain sustainable over the longer term.
- Ongoing massive fiscal and monetary stimulus will favour some sectors more than others. This points to a bigger role of government which is generally not helpful to economic productivity.
- Companies will invest in resilience, not growth suggesting lower foreign direct investment and business investment typically driving growth out of recession. Investors will want to identify those companies “leaning in.” Corporate investment levels will be constrained in any case by already high levels of debt and shareholder propensity to push for deleveraging for resilience.
- Deglobalisation through “on-shoring” and supply chain diversification will exacerbate nationalist trends which were in place prior to Covid-19. Reductions in immigration means slower labour force growth and higher average wages. Deglobalisation will be more evident from the decoupling of US & China than any other change as we discussed in Partners Capital Insights 2020. With the virus’s Chinese origins, we will see many current customers and suppliers diversifying away from China.
- Savings rates will continue to rise as those living more on the economic edge prepare for the next pandemic or other unexpected economic shock. The 60+ demographic will continue to cut discretionary spending such as travel in order to save for rising healthcare costs.
- Property market excess capacity - the office sector will suffer as more companies adopt work-from-home and hot-desking policies, although lower density may raise effective costs. We expect retail to continue to suffer given continued social distancing measures and the acceleration of eCommerce adoption.
- Higher individual and corporate taxes to fund fiscal deficits will stunt both consumer spending and business investment. This will be both related to cutting government deficits and funding higher healthcare costs, although the costs of redundant pandemic readiness resources is not a big enough number to spur a boom in the sector despite what many analysts are saying.
- Borders effectively closed for much of 2020 and possibly part of 2021 – quarantines, selective travel bans, etc, with some trading and tourist hubs using technology and testing to bring flows back. Travel restrictions are only likely to be fully lifted once a vaccine becomes available.
- Boost to growth in the digital economy – accelerating trends in place prior to Covid-19 as businesses and individuals turbocharged their use and understanding of technology to get through the crisis. There is also an added incentive to accelerate the adoption of labour-saving and productivity enhancing technologies.
The combination of the above structural changes would seem to point to slower global economic growth and slower corporate profit growth given the pressure on margins from rising wages from onshoring, supply chain diversification, and resiliency investment. Balancing this is the probable fall in discount rates we are likely to see over an extended period.
The next few months will give us further clarity on what the future will look like, which will feed into revised long-term return assumptions by asset class. With a further drop in expected interest rates and the risk of inflation and rising rates, portfolios should continue to favour equities over bonds. And with lower expected traditional asset class returns generally, active management and private assets should continue to warrant high portfolio allocations.
Q7. What implications does this update have for our investment strategy and manager selection?
Despite the huge amount of uncertainty in the outlook for economic growth and financial markets, we are focused on staying disciplined and true to our core investment principles as we navigate our client portfolios through this market environment. While we do not time overall portfolio risk, we continue to look across asset classes to determine how we can optimally allocate overall risk and rebalance your portfolios. Although we are informed by both fundamental and technical factors, some judgment is inevitably involved in the exact timing, size and asset class choices for rebalancing and tactical asset allocation.
Our economic scenarios argue for a shift in favour of more credit exposure at the expense of equities and absolute return (adjusted to maintain equivalent risk levels), with a focus on pockets within structured credit where we see compelling risk-adjusted returns. The distressed cycle, for which we have been patiently waiting, also seems to be picking up steam given accelerating downgrades and rising defaults, and we will be continuing to allocate to a series of distressed managers in the coming quarters. Finally, we continue to favour certain sectors within equities that will be most resilient in the post-pandemic world such as technology and life sciences, as expressed actively through our managers or through our newly-launched New World Equity Portfolio.
Exhibit 7: Partners Capital Pandemic Investment Playbook
|Global Equities||1.Take advantage of re-openings of exceptional hard closed managers to upgrade manager lineups|
|2.Maintain allocations to longstanding investment themes at attractive entry points via specialist managers. This include long innovation (tech & biotech) and Chinese internet/technology stocks targeting China's growing consumer spending.|
|3.Allocate to heavily dislocated small calls via our active US and European small cap managers|
|4.New World Direct Equity Portfolio. On 12 March we launched a basket of direct equities that accesses 8 current investment themes through single-name equities we classify as "virus agnostic" (80% of portfolio) or "overcorrected" (20%)|
|Absolute Return||5.Arbitrage strategies: Merger spreads are trading at historically wide levels and there is increased dispersion in fixed-income arbitrage.|
|Credit / Distressed||6.Liquid credit market dislocation plays – focus on CLOs and RMBS|
|7.Private Debt stressed/distressed opportunities in secondary markets, rescue financing and distressed for control.|
|Private Equity||8.Private Equity – Lean into distressed environment and access top closed managers|
|Safety Net Assets||9.Diversification of Safety Net Assets in a volatile and "zero rates" environment, including allocation to gold, inflation-linked bonds, tail-hedging hedge fund strategies and put spreads.|
|10.Municipal Bonds: significant recent dislocations suggest moderate alpha opportunity with dynamic allocation models. VRDNs attractive at present (2 standard deviations after tax yield).|
With the extreme market volatility in March now firmly in the rear-view mirror, we have also been able to step back and assess whether our managers are the right ones for the current and post-pandemic environment.
The events of the past few months have only accelerated themes and trends which were meant to play out over much longer timeframes. This greater rate of change points to greater opportunities for active longshort equities managers especially in areas such as consumer, technology and healthcare, consistent with our thematic positioning pre-Covid-19. While China will be negatively impacted by the restructuring of global supply chains and continued geopolitical tensions, our focus on the domestic consumer market and continued digitalization of the economy remains intact and ripe for alpha generation. In addition, we continue to underweight sectors and geographies which may continue to face structural headwinds such as energy, financials and emerging markets (excluding China).
Markets increasingly driven by Covid-19 news flow and increased geopolitical tensions also points to a greater need for nimble and opportunistic managers at the expense of dogmatic managers which cannot adapt to the new world order, or managers who are too large to be nimble. For example, several of our generalist equities managers were quick to recognise the dramatic and lasting impact of Covid-19 and quickly rotated as much as half of their portfolios from sectors/companies with headwinds to those with tailwinds. Conversely, value-oriented managers who are unable or unwilling to recognise the acceleration of long-term structural changes may continue to struggle. Quantitative managers, which generally struggled in Q1, may also be less well-positioned to navigate the Covid-19-driven news flow and geopolitical risks that lie ahead.
Upon examination and reflection, our managers generally passed the test of March 2020 with very few exceptions. While market movements blew through most downside stress tests, our managers successfully navigated through and have emerged stronger as a result with tighter risk management. The quarter has reinforced our conviction in most of our managers who have demonstrated calm, discipline and opportunism, with our best managers seeing this as an opportunity to further enhance long-term outperformance.
Finally, another reflection of our manager quality has been the fact that many of our closed managers opened to new capital to take advantage of the opportunities presented by the market dislocation. This is part of our standard playbook for periods of even small corrections. We reached out to several dozen managers including those who we have never successfully accessed. We had extraordinary success in March and April on this front, allocating to over a dozen managers. Many of our clients will have benefited from these new allocations within our Master Portfolio, other pooled vehicles and our latest Condor vintage.