Strategy

You don't have to be an optimist to buy equities

Life is full of simplifying analogies. You might look for a needle in a haystack, think about life as being like a box of chocolates or work out how useless it is to rearrange deckchairs on a sinking ship.

The financial industry has its analogies too. The stock market is like a rollercoaster because black swans appear from time to time and derail an economy. Apparently. Good analogies can create easyto-understand images, help compare and contrast different situations – and even inspire people to action.

The COVID recession needed simplifying

If there was ever a time the world needed simplifying analogies, 2020 was it. For starters, the only comparison we had to this situation was the Spanish flu of 1918 – and today’s investors weren’t around then. Events in 2020 were hard to comprehend. China saw fit to shut down and seal off a city of 11 million people. And the virus was so severe that they went on to build a brand new hospital within six days! That scale of response is usually reserved for Matt Damon movies.

The bad health news spread across the world. Hospitals ran out of space, medical equipment was in short supply and mortality rates tragically surged in some places. Economies suffered the consequences. Everywhere you looked the economic news was off the scale. Oil prices went negative (huh?), nearly 20 million Americans lost their jobs in just two months and the global airline industry ground to a halt (not an analogy this time).

In March, we reviewed the possible range of outcomes from the COVID pandemic. How effective would lockdowns be? Would vaccines arrive soon? What would people spend money on? Was the policy response big enough?”

The situation was dizzying. People wanted answers. Across the investments industry four possible economic outcomes were widely discussed, with the labels V, W, U and L. Think of those letters as shapes on a chart describing the trajectory of the global economy. At 7IM, we developed our own versions with slightly different labels: V+, V, U and L. They helped us to simplify the world, filter out the noise and focus on the most important questions. Through the year, we used these scenarios to anchor our portfolio positioning. >>

AHMER TIRMIZI

Senior Investment Strategist

Strategy Continued

The V+ scenario is already playing out

In March, we reviewed the possible range of outcomes from the COVID pandemic. How effective would lockdowns be? Would vaccines arrive soon? What would people spend money on? Was the policy response big enough? We used these questions to model a range of possible scenarios for the US economy in the next two years. As the evidence accumulated we decided that ‘V+’ was the most likely outcome. And that’s exactly what is happening.

Source: 7IM

105

US real GDP index (Dec 2019 = 100) 85 90 95 100

What actually happened

In March, this is where we thought the US economy might go

V+ V U

2008

80

Q4

2019 Q1 Q2

2020 Q3 Q4 Q1 Q2

2021 Q3 Q4

2022 Q3 Q4 Q1

2023

The fiscal response removed ‘L’ – rebalance portfolios

The closest historical comparison to an ‘L’ shaped world – the economy collapsing then flatlining for years – was the Great Depression of the 1930s. That was driven by a combination of bank failures and inadequate policy responses. We concluded that a banking crisis in 2020-21 was unlikely, due to governments and central bankers racing into action. Put together stimulus cheques, furlough schemes, state-backed business loans and open-ended central bank support and you have a huge and breathtakingly quick policy response. It put a floor under the global economy and made ‘L’ highly unlikely. The worst outcome was averted. In response, we had the confidence to rebalance portfolios through March by reducing what had done well (alternatives and healthcare) and buying what had done poorly (equities and real estate investment trusts (REITs).

No repeat of the ’08 financial crisis ‘U’ – selectively add risk

Investors who lived through the 2008 financial crisis remember a slew of ‘end of the world’ predictions and Great Depression comparisons. But that recovery didn’t turn out to be an ‘L’, instead it’s the closest example we have to a ‘U’.

In 2008, the global construction sector had overbuilt, real estate was on its knees and the financial sector was in trouble. These key job-creators lost the ability to create jobs and incomes, leading to drawn out U-shaped recoveries. Was the COVID recession going to be drawn out too?

No. Those sectors that create the most jobs have remained open – technology, real estate and manufacturing. Instead, the COVID recession has impacted sectors that don’t create many jobs, like travel, tourism and recreation. For example, five times as many people work for booming US car dealerships than in the hurting airlines industry. >>

Strategy Continued

The world economy is not firing on all cylinders but its most important cylinders are firing. This means a 2008-style ‘U’ recovery is unlikely. But in March, high yield markets were pricing in defaults three times greater than actually occurred in 2008. So in April we added risk to portfolios by buying cheap credit markets.

The vaccine news was a shot against ‘V’ – buy the laggards

The stimulus packages ended up being highly successful, with companies bailed out, wages being subsidised and widespread mortgage holidays. This led to a surge in global household spending power: in the US the money in people’s bank accounts is close to $2tn, 10% of the economy, but they are struggling to spend it! Moreover, the crucial economic sectors were inadvertently boosted by lockdowns. Companies invested in technology so that people could work from home. They moved houses in search of gardens and studies. And they spent a record amount on goods as they had nothing else to do. And so there is just one thing holding back the global recovery: lockdowns. Remove these and you not only get a ‘V’ but a ‘V+’. Our work on the virus back in the summer suggested we were likely to see lockdowns being eased faster than expected, and positioned portfolios accordingly. We took profits on credit and started by buying US value stocks (Berkshire Hathaway) and trade-sensitive exposures (emerging market equities). We have since added smaller company stocks (global mid-caps) which should benefit from economies reopening everywhere. The vaccine news was an early shot our portfolios were waiting for.

But it’s not 'V+' or nothing

Finding optimistic news in 2020 has been challenging. Instead, our process led us towards buying equities and credit by striking out the most pessimistic forecasts.

Our clients are positioned to do well in a ‘V+’ world – which we think is the most likely. But we still hold a number of defensive positions like alternatives and healthcare for the ‘L’ world. And we continue to see opportunities in some credit markets like US mortgages that should do well in ‘U’ or ‘V’ worlds.

In other words, we don’t put all our eggs in one basket. We prefer to give our passengers a smooth ride. But when opportunities arise, it’s best to board the train before it leaves the station.

The world economy is not firing on all cylinders but its most important cylinders are firing.”