Investment and Economic Strategy Beyond COVID Suppression
Posted 05 May 20
A term for our ages
The term Suppression is evolving in its meaning as government’s themselves shift their health and political objectives. It is also an economic strategy with increasing economic and financial market reach and implications. We think their medium-term economic consequences are yet to be fully appreciated by the community, let alone hit the economy.
In the near term, the economy will bounce back from its decimated base, but it is the lag effects from 6 to 24 months that we think are under-appreciated and under-estimated, in particular bank bad debts and constrained credit growth occasioned by higher unemployment settling at higher rates, and higher underemployment at 20 year highs. Perhaps most crucially, the expectations of the last 30 years will need to adjust, particularly in terms of bond yields which have declined over this period to near zero.
The Danger is in the assumptions.
Should the strategy reliance on a vaccine?
We can see the suppression has been presented to Australians as a process to keep us in a holding pattern pending a vaccination. This assumption concerns us.
From a risk management perspective, our mantra is always – the danger lies in the assumptions. In this instance, the assumption that a vaccination can be developed over the next 18 months should at best be a 25% likelihood and is not our base case. We think this needs to be seriously challenged.
We are somewhat encouraged that the Federal Government narrative is turning to COVID management through testing, tracking and healthcare preparedness. This is more realistic and acknowledges that is potentially a much longer health issue to be managed.
Where we sit.
Macro support has been strong.
Australia and US direct government support has been exceptional. This is immediately supportive to income for business and wage earners.
Australia is well-positioned at this juncture with the national cabinet having the crisis coordinated well. The level of direct stimulus both here and the US has been exceptional which we can see before us. This is buttressed household income and to a lesser extent business income. Combined with supportive central bank action here, in the US and the UK, the economy has been provided immediate liquidity. The economic and financial crisis has been averted.
Australia is well-positioned.
Australia finds itself now well-positioned to lift its suppression stages to Stage 1. Australia is positioned in the top right-hand side of the quadrant in Figure 2 below. Our level of testing, tracking and health system preparedness appears to support easing and lifting certain suppression strategies.
The balance of risk now and post COVID
Balance of risks assessment is at the core of Cameron Harrison’s analysis and processes.
Since the COVID-19 crisis began, we had an opportunity to speak with several investors.
The common themes across each of those discussions were the three key questions:
- What is different this time?
- How do we see the current financial and economic risks?
- What do we do with our portfolio, positioned them in the new term and also the long term?
Is it different this time?
If we compare COVID crisis to previous recessions that we have been through before in Australia, such as the GFC, Dot Com and the recession we had to have in 1990s, it has been different this time. The primary difference is the speed of which market been corrected, from the high in late February 2020 and the low in March 2020 (as presented in Figure 3 below).
Typically, this crisis period will take several month or years. At least 6 months before policymakers acknowledge the issue, with policy responses not occurring until much later. In the case of COVID-19, the health impact has proceeded the economic impacts. This is allowing the policy support to be deployed in a timely fashion. The measures have been successful in flattening the curve and most likely eliminate the risk of economic depression.
As the attention now has turned to lifting isolation protocols, with infection rate near zero and the load on emergency departments not significantly above normal, we are going to see a phase that looks like an economic recovery. This opinion has been reflected in the markets which has shown since late of March. However, this opinion appears to be overly optimistic. We can see a number of economic and financial risks in the market.
How Cameron Harrison sees the current financial and economic risks?
Investment risks tend to be like an iceberg. On the surface, everything may appear to be fine, but danger often lies beneath. The policy response has made the true economic impact hidden. Normally at this point of crisis, we would have a strong understanding of unemployment, consumption, credit growth and trade. As it currently stands, the impact remains unquantifiable. As an example, the most recent unemployment data still hovers at a low 5% range, yet we know three million Australians currently are on Job Keeper payments. This represents over a quarter of Australia’s workforce.
Many of these workers will return to work with their current employers, however, from our discussions with business owners, many of these Job Keeper workers will not be returning. This is particularly true for the hospitality industry.
It is worth remembering that the Australian economy was in poor shape leading into this crisis, with high underemployment, very low wage growth, and very high household debt. These factors led us to reduce our allocation to Australian equities in January 2020. It is the build-up of this economic sludge will inhibit a ‘V’ shaped recovery in Australia. If the recovery is not ‘V’ shaped due to either a second wave of infection or other cause, then the forbearance shown by banks will dissipate and they will have little choice but to exercise their right to bring in security lending which will lead to foreclosures.
Under this scenario, the risk across different sectors is uneven. Finance providers and banks would be significantly impacted along with discretionary consumption and travel industries. These risks are shaping the actions that we have taken in our portfolio in recent weeks, such as reducing our already low allocation to banks from 8% down to 4% and exiting out of our more discretionary consumer investments.
How Cameron Harrison positioned our portfolios in the new term and the long term?
How have the portfolios performed?
Figure 5 below illustrates the performance of Cameron Harrison’s core economically responsible Asset Allocation Strategy against the ASX200.
What we noted early in this financial year, is equity markets around the world are running quite strongly. Through our two-monthly Rebalance Program, we sort to take the gains from equity markets and reinvest across lower-risk asset classes, principally interest-bearing securities and cash.
We are entering 2020 in a lower-risk position. Cameron Harrison took a further decision to reduce exposure to Australian equities which has positioned the portfolio quite well. Throughout the second half of 2019, we were able to move up with the market and bank a lot of the gains. Through the downturn in February 2020 and March 2020, the ASX200 declined close to 20% since the start of the financial year, while we are closer to 8% and at the end of April, the number is closer to 4.5 %.
"Cameron Harrison had conservatively positioned our main Core Asset Allocation Strategy over the last 15 months, and again in January 2020. Broadly our position for the next 30 years that will look and behave differently from the previous 30 years."
Managing Partner at Cameron Harrison
Long Term Performance
Worth remembering that although the global pandemic and economic isolation are new, market downturns are not. This is the fourth occurrence that our portfolio managers have faced, first being the recession that we had to have, followed by the Dot Com and then the GFC. These crises (unfortunately) tend to happen every 10 years, while they are all different there are some common approaches that we have employed previously and we using again.
Cameron Harrison has successfully navigated choppy waters before and utilised the same four key principles:
- Dynamic Asset Allocation
- Industry Selection
- Quality Bias
Combination of these factors has lead our performance for the last 20 years since early 2000, shown in Figure 6.
It is the end of ‘Easy Street’
COVID has brought forward this pivot as a 100-year exogenous shock. What does this New World look like? It is not necessarily bad, but it will require business to employ deft management strategy, governments to employ brave policy and most importantly, investors will need to question and probably alter the economic and financial assumptions that we have operated by for the last 30 years.
The economy post COVID would be like:
1. The end of the 30-year Bond Bull Market
Which has delivered correlated returns for bond, equity and property investments. With sovereign bond yields at or near zero, this path is at an end. It doesn’t necessarily presage that yields will go up, but it does mean the rate of change downwards in yields is finished.
2. Extent of leverage
In past shocks, wars and recessions, households have exited these situations with relatively low debt and leverage and activity through consumption demand was able to re-engage. What is different this time to post WW2 and the early 1990’s is that both governments and households do not have this capacity given the extent they have leverage themselves since the GFC.
3. Household balance sheets.
Household balance sheet and consumption demand were ‘shot’ going into COVID. They are going to come out of it worse, with prospects for wages and salary growth poor.
These factors cause us to be more pessimistic on the banking sector than consensus views, and this is largely because we think the level of unemployment will settle above 6.5% and be accompanied by a further downshift in average hours worked and hence increased underemployment.
5. All hail fiscal policy
With long term interest rates and short-term rates through monetary policy having declined to 30-year lows, near-zero, the potency of monetary policy has been neutered. This now leaves us with fiscal policy and increased government spending and implicitly, involvement in the economy. We can see here the US Government debt is approaching and likely to exceed, the levels of WW2 peak debt. In Australia, government debt will approach $1 trillion – sobering given that pre-GFC Australia had near-zero net debt. The scale of COVID fiscal stimulus is unprecedented, standing to date at US$10.6 trillion.
Something less immediate and tangible to see, is a potential of trade liberalisation being reduced. In particular, China has been at the heart of industry supply chains for the last 15-20 years. Business risk management and geo-political pressures will likely alter - if not back to local economy.
7. Spare capacity (underemployment)
We have longer-term concerns for inflation, but for the next 2 to 3 years we think spare capacity and underemployment will resoundingly mute wages and price pressure.
So, what does this mean for industry & business?
A brave new world for industry and business
There will be some tough and brutal adjustments. Some have already been happening whilst others you could argue, were overdue. We would highlight a few key items that we think industry and business will need to address, and that investors should be looking for.
The retail format was already under substantial change, and this will accelerate with further pain for physical retail format such as malls.
Businesses will need to incorporate further resilience, both from the supply chain to financial buffers. The implications go to levels of working capital, leverage, the structure of further long-term debt, and development of even more advanced financial risk management tools.
3. Local vs Imported
Demand and risk management preference to source inputs locally.
4. A renewed drive for efficiency
Necessity is the mother of all invention, and nothing brings out necessity more than a crisis, this is a key element of business and industry evolution and probably a net benefit.
5. Survival of the fittest
Related to efficiency, capital will become scarcer and capital will flow the brightest and most promising. Low interest rates have permitted the weaker and marginal businesses to just exist. We would expect that these businesses will fail, and whilst brutal, is again probably a net benefit for the medium to long term.
In summary, the three key elements that we invite you to draw out from today’s discussion are:
- Our Asset Allocation and asset strategies entered the COVID crisis in a very conservative posture, concerned with key elements of household balance sheet and monetary policy settings. Whilst we were clearly not anticipating a COVID like shock, we were nonetheless prepared for an economic and financial shock. This sees: A quite muted impact of client wealth positions when compared to the large, broader declines in markets, and places our strategies and client wealth positions to carefully navigate the balance of risks ahead.
- Cameron Harrison balance of risks analysis and its incorporation into all our strategy settings continues our partners successful 40 years navigation of economic & financial market crises.
- There will be profound changes to the economic, industry and businesses beyond the COVID crisis and the lifting of suppression policies. Many of these changes are already on-foot, others imminent, and due to this crisis other changes which will spur new innovations and better ways of operating. Most of all however, the easy street gains and the expectations of the last 30 years will need to substantially alter and change.
Peace of mind investing
Cameron Harrison have been advising business owners and their families on asset allocation and intergenerational wealth management for over 50 years. We have demonstrated over a long period our ability to manage investments through both the good times and bad by keeping the client at the centre of our business.
For more information on our approach to investment strategy or any other inquiries, please contact us on +613 9655 5000.
Photo by Zach Vessels, on Unsplash