6 minute read
Pandemic effects and opportunities
Lessons can be learnt from all crises that affect investment markets. Paul Taylor looks at the changes to society black swan events have caused and the investment opportunities that may arise from the coronavirus pandemic.
As an investor, this is my ninth investment crisis in my 23 years at Fidelity. During my career I have seen markets impacted by the Asian financial crisis, Russian bond default, collapse of Long-Term Capital Management , September 11, tech bust, global financial crisis, sovereign debt crisis, SARS and now COVID-19. Although it if fair to say this crisis is different from each of the previous ones, there are definitely lessons to be learnt from all of them.
One of these lessons is how we approach a crisis such as the one we are facing today. Donald Rumsfeld, United States secretary of defence from 2001 to 2006, during the war on terror, separated risks into known unknowns and unknown unknowns. Rumsfeld was ridiculed at the time, but we can now see the point he was making. He was suggesting there are regular risks we can plan and manage for, and there are some risks that are off the charts and very difficult to prepare for before the event. Some people also call this second group black swan events, aft er the Nassim Taleb book of the same name. The COVID-19 pandemic fits in this second group.
The difficult issue in dealing with black swan events is that you are dealing with little and imperfect data. At the start we have very little data and need to exercise a huge amount of judgment. As time goes by, we get more and more data and analysis and judgment is required less.
In periods when data is scarce and huge amounts of judgment are required, people tend to use heuristics or rules of thumb. These heuristics represent our knowledge of history and what tends to work best in these situations.
A key market heuristic in periods of crisis is to watch the second derivative. The second derivative is simply the rate of change or the acceleration or deceleration of whatever is causing the crisis. I think the market focuses on the point when the second derivative changes from acceleration to flattening or deceleration as it oft en represents the point of maximum pain and destruction.
In the case of COVID-19, that change in the second derivative may represent a heightened point of community concern and also the point of most aggressive government action. It is important to remember that markets are forward looking and typically bottom nine months to a year before the economy bottoms. As the second derivative changes and governments increasingly talk about a six month period, markets can now start to see the light at the end of the tunnel.
The second derivative is now changing in most parts of the world. We are seeing a deceleration of new infections in Australia as well as most of Europe, parts of the US and the majority of Asia. On cue, markets are responding to this change in the second derivative and are now starting to improve. This does not mean market volatility will end, but rather we can see the light at the end of the tunnel and some relief is entering markets.
Governments in recent weeks have used analogies of bridge building and hibernation. They have viewed this crisis as a giant ravine we need to build a bridge over, or a sudden frozen snap where we need to go into hibernation to survive and emerge on the other side. I do agree this crisis is fundamentally one-off in nature and it is all about surviving until we get to the other side. While I believe it is a one-off event, it is important to note life will be different on the other side of the COVID-19 crisis. There have been major disruptions throughout human history and while things get back on track eventually aft er that disruption, there can be many business, educational and community practices that change forever.
For each major disruption we effectively go through a huge social experiment. Under this social experiment we try new things; some work, some don’t. The experiments that work we adopt forever.
Take World War II as an example. As men went off to war, women entered the workforce to perform their jobs. At the end of the war as life resumed and men returned to their jobs, the workforce and its structure had been changed forever. WWII was the catalyst for women to enter the workforce and this increase in the participation rate has been one of the largest contributors to gross domestic product growth globally for the past 80 years. A change occurred during this disruption – women never looked back and our economy and community had been changed forever.
There are other examples, such as the birth and acceleration of the Indian information technology industry post the Y2K bug, which demonstrate changes that occur during major disruptions can alter business, education and community practices forever.
Vijay Govindarajan and Arup Srivastava, writing in the Harvard Business Review, have used these historical examples to show why they think higher education will change forever post the COVID-19 crisis.
Thinking through these sorts of changes following this crisis is where I am spending most of my time at the moment.
Winners
Once we’re over the worst of COVID-19, I expect to see market leadership coming from sectors like technology, resources and travel. We would also see strong momentum in sectors like consumer staples, healthcare and real estate continuing post-COVID-19.
Resources are likely to have one of the quickest rebounds post-COVID-19. Resources is currently the cheapest sector – balance sheets are strong, cash flows are still reasonable and the sector has been significantly negatively impacted leading into COVID-19. Once we see a plateauing of new cases, I think we’ll see money re-enter the sector very quickly, given its value, and especially if China undertakes fiscal stimulus.
Technology, which has also performed poorly over the past month or so, could lead the market following COVID-19, given the sector now has much better valuations, long-term fundamentals and structural growth. While travel should improve post COVID-19, it’s likely to remain more volatile for longer as recovery will be more prolonged.
While these three sectors should rebound strongly given their poor performance, it’s also important to highlight sectors like consumer staples, healthcare and real estate will likely continue their strong momentum post COVID-19. Consumer staples, in particular supermarkets, currently have strong fundamentals and, given Kaufland’s decision not to enter the Australian market and the potential food inflation the move may have prompted, we believe these strong fundamentals will likely continue, even aft er the pandemic.
Similarly, healthcare is very well positioned for the long term, as is real estate, given the likely continuation of very low interest and capitalisation rates. I am looking for those sectors that will recover the quickest, for example, private hospitals, which will benefit from the restart of elective surgeries.
These sorts of crisis periods can present excellent opportunities to upgrade portfolios. Typically, at the start of a crisis, the markets sell off indiscriminately – shooting first and asking questions later, so to speak. So if there is a company you’ve always wanted to own, but it has always looked too expensive, this could be your opportunity to buy a high-quality company with strong long-term fundamentals at much more attractive valuation levels.
As an investor in Australian equities, I am comfortable holding a portfolio of predominately high-quality, blue-chip, large stocks, including a strong cash position. As events unfold over the next few months, we are ready to deploy the cash, upgrade the portfolio and invest in great companies at attractive valuations for the long term.
