BFI Group Blog

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Sune Sorensen
March 20, 2020

Navigating Uncertain Times...

Many years ago, while wandering the Museum of Modern Art in New York, I came across a small frame in a corner of an otherwise forgettable exhibit. It had a grey image of the globe with a small notation below. Having a lifelong fascination with maps, I went closer and read the quoted text. It read:

“We are living in a storm where a hundred contradictory elements collide; debris from the past, scraps from the present, seeds of the future, swirling, combining, separating under the imperious wind of destiny.”

It was taken from an 1898 article by a little-known writer named Adolphe Rette. I read it a few times and luckily took a photo of it. It stayed with me, and I have had it hanging in my various office spaces ever since. It reminds me first of the importance of focusing on that which you can control, on how you choose to react to the vagaries of “the storm”, and secondly, it reminds me to stay intellectually humble about what is knowable and what is not.

It has been my path to sift through these sometimes-contradictory elements as they collide and work to detect patterns and probabilities, to identify risks and opportunities. It’s a never-ending puzzle that comes with no instructions and it’s one that I enjoy.

During the last month, the swirl of these elements of the storm has sped up once again. Much is in flux and we have moved to a new phase with a distinctly more sober mood intersected with days of outright panic. It is at times like this, when the narrative runs ahead of actual events, that it is prudent to stay vigilant and observe not just what is said, but what is actually taking place.

The COVID-19 virus enters the stage…

Between January 21 and March 12th of this year, COVID-19 has affected multiple continents, with over 3,500 deaths out of over 120,000 confirmed cases according to the World Health Organization (WHO). Confirmed cases have doubled in the last 25 days.

However, much is still unknown, and these numbers are surely not fully representative of reality. The sheer scale of the process of ensuring accurate testing and reporting around the world is beyond the capacity of the WHO or any other organization. When one adds the political elements, differences in healthcare systems and general fog of confusion and misinformation that has been part of this from the outset, it is clear that we are dealing with many unknowable moving parts.

Illustration 1: COVID-19 going exponential, even based on limited data.

Illustration 2: A peek below the headline numbers.

What is becoming clear is that China, the initial epicenter of the outbreak, has moved out of the eye of the storm. Their approach of shutting down significant parts of the country with authoritarian efficiency has led to significant economic damage, but beyond Hubei they are moving back towards full capacity, and cautiously towards normalization of daily life.

Only time will tell if this declaration of “mission accomplished” was a case of celebrating too early to satisfy Central Party objectives, and if so, it will be a major blow to President Xi’s standing. The focus is now on Iran, which is suffering largely behind a veil of secrecy, and Europe, with Italy being hit the hardest.

Europe has a better healthcare system than most places but again we are seeing some confusion, lack of coherent leadership and overarching planning. The US, perhaps unsurprisingly, has been going through a damaging political battle related to dealing with this crisis. The partisanship, along with a much more limited healthcare system, has led to little or no testing and mainly contradictory policy proposals so far.

In his book ‘Epidemics and Society: From the Black Death to the present’, Frank M. Snowden explains: “Epidemic diseases are not random events that afflict societies capriciously and without warning. On the contrary, every society produces its own specific vulnerabilities. To study them is to understand that society’s structure, its standard of living, and its political priorities.” So far, this appears to be an apt observation. It is also telling that what is a global problem, has so far gone completely lacking any kind of cohesive global approach.

Best get to higher ground when the narrative runs ahead of itself…

We can see in the spheres of investment markets and politics that the narrative is running ahead of both the actual spread of the virus and economic developments, and sentiments have swung to the most negative extremes.

While the situation warrants real concern - both in human and financial terms - we are seeing concern turned into hysteria. As there is a vacuum of understanding and facts, the hysteria is being turned into politics and promotions for apocalyptic newsletters. That is a volatile and dangerous mix.

Investors can easily find themselves unsettled and even unmoored from their core beliefs and preset investment framework. In a world long on information but short on insight, the ‘news’ is everywhere all the time. Certainty becomes the domain of the carnival barkers and snake oil salesmen and doubts creep in. As Voltaire put it, “Doubt is not a pleasant condition, but certainty is absurd”. When people with loud voices talk of simple solutions to complex problems, it is generally best to turn up the filter of skepticism.

In the current state of play, most investors are reaching that ‘punch drunk’ stage derived from too many contradictory elements colliding and the swirling ‘noise’ blasting from TV sets and social media everywhere they go. The world is left hanging on, grasping onto thin straws of tweets and soundbites from politicians, central bankers and talking heads. Hope and fear are not much of a strategy, but it seems to be what most participants fall back on in times like these.

In the space of just over two weeks, the US stock markets have dropped from record highs into bear market territory. That is the fastest time between a new high and a bear market in history. The prior record was 42 days and it was set in 1929. Any student of financial history will know that breaking records set in and around 1929 is not optimal. It would be hyperbolic to broadly compare the last couple of weeks to the Great Depression: unemployment in the US and most other places is near record lows and most markets are only down to levels seen a few years ago after a decade of impressive gains. However, it is important to note that the shift in sentiment has been extreme, and that this on its own may lead to real damage in the economy and as such provide further fuel to the market correction.

Exploring the path(s) ahead…

Let’s take a look at some knowable aspects of the spread of COVID-19 and the economic impact and outline some different potential paths ahead. Then we will take a look at some general key lessons for investors.

McKinsey has been producing an ongoing series on the crisis titled ‘COVID-19 Facts and Insights’, which is the most balanced and pragmatic commentary I have come across. In the latest version, they provide the following ‘Executive Summary’:

“COVID-19 continues to spread rapidly around the world. Four transmission complexes (i.e. China, East Asia, Middle East, Europe) are active, with a fifth emerging in the US. Governments globally are preparing for the virus to hit their countries.

“Epidemiologist consensus suggests that the virus is highly transmissible and disproportionately impacts older segments of the population with underlying conditions. The average patient infects 1.6 to 2.4 other people, and based on recent research, the fatality rate for patients in their 70s was three to four times the average. Other reports describe fatality rates for patients under 40 to be 0.2 percent.

There are, however, three swing factors that remain unclear but could play a large role in how the virus evolves:

,“The extent of undetected, milder cases., Those that are infected often display only mild or no symptoms, so it is easy for cases to be missed. Some studies suggest that there may be more instances of mild cases than are being detected, which means the fatality ratio could be lower.

,“Whether the virus is subject to seasonality,. There is no evidence so far on whether COVID-19 will show seasonality (i.e. naturally reduce in the northern hemisphere as spring progresses). Coronaviruses in animals are not always seasonal but have historically been so in humans for reasons that are not fully understood. The behavior of this COVID-19 strain is, at this point, not entirely predictable.

,“Asymptomatic transmission,. Evidence is mixed about whether asymptomatic people can transmit the virus, and about the length of the incubation period.”

Given these considerations, there are three possible scenarios for COVID-19 and its economic impact. See illustration 3 for an overview of these three potential paths as outlined in the Mckinsey study. As with most affairs of mankind it will likely be more nuanced than this, but it serves as a foundation for further thought.

Illustration 3: The three-pronged fork ahead...

For investors, it is key to mark out signposts for these different paths so you can begin to allocate probabilities, monitor developments - and where necessary, course-correct as we move forward down our future path.

From an allocation standpoint, as the broad selloff continues, it is key to understand how different sectors are affected beyond the broader sentiment of panic and margin-call driven selling pressures.

McKinsey provides the guide below (see link at the end of the report) with a look at the key affected sectors: Tourism & hospitality, Aviation/Airlines, Oil & Gas, Automotive, Consumer products, Consumer electronics, semi-conductors. I would add the Pharmaceutical and broader Healthcare industries, as well as Insurance and the Banking and Finance industry, as they are always going to be affected by major dislocations in the broader economy.

Some of these effects will stem from the impact on supply chains, others from demand factors and some from a combination of both. Some will be positively affected, but most will be negatively affected, at least in the short- to medium-term. It is important to note that many of these sectors were already struggling due to changing long-term global trends, and the recent trade & technology competition between mainly the US & China.

Considering all these aspects, even in a ‘Quick Recovery’ scenario, it is difficult to see how the global economy can avoid tipping into recession in 2020.

China, where we have the most actual data on the effects of the virus, was already struggling and the disruption to their internal economy alone should put them at sub-5% GDP growth and if Europe and the US end up being significantly impacted economically it would take away their key export markets. As China has been the main driver of GDP growth for the last two decades, that bodes ill for the rest – Japan and South Korea were already struggling and have been directly affected by the virus, Europe had shown some relative strength, but Germany was struggling as its important auto sector was hit from multiple fronts.

The current virus-related effects, hitting mainly the already challenged Southern nations – namely Italy, that appears to have been teetering on the edge of the abyss for a long time – could be a catalyst for trouble in the banking sector to reemerge. The US, in terms of confirmed cases, appears to be following the less than stellar path of Italy, with sub-optimal preparations and implementations of plans to deal effectively with the issues at hand. Italy went from no real hint of trouble to national lockdown in three weeks.

The US has a large part of the population with insufficient or no healthcare plans, a lack of physicians – Sweden has 5.4 physicians per 1000 people, Switzerland 4.2 and the US 2.6- which, beyond the politics, has resulted in much lower levels of testing. In terms of the number of COVID-19 tests performed per million of the population (as of March 11th) the US has tested 26, Italy 1,005 and South Korea 4,099, according to Statista. It should also be noted that there is much less of a safety net, in terms of sick pay and other benefits. This has only been expanded as the ‘Gig economy’ has led to more so-called ‘Zero-hour contracts’, with part time work and self-employment leaving people unable to self-quarantine and to seek medical help or even basic testing, without significant financial repercussions. This again could lead to a more broad and exponential spread of the virus, with both humanitarian and economic implications.

Illustration 5. Different approaches lead to different outcomes.

Navigating the storm…

Whatever the actual developments in individual economic sectors, national economies and the overall global economy turn out to be, investor sentiments have already taken a sledgehammer to most global markets. This can be deeply unsettling to the unprepared, especially after a prolonged period of apparent stability and bullishness. There is a reason why financial history tends to be a ‘flat circle’ – the human mind tends to overshoot both optimism and pessimism. Extended periods of prosperity tend to make people complacent, which in turn leads to rising valuations, skewed incentives that promote a ‘bad process, positive outcomes’ mentality (akin to “winning” in Russian Roulette), poor business and investor practices and increased fragility across the system. Eventually, the ‘Minsky Moment’ arrives and it all unravels. Faced with the change of paradigm and the shock of the unknown, sentiments quickly jump to the other extreme. This is why it’s called; “stairs up, elevators down.” Risk appears to spike fast, mainly because we don’t look for the warning signs in time. Change is a process, not an event. As such, you can identify signs of changing dynamics and map out different scenarios and prepare for them to some degree.

As we headed into 2020, nobody had factored in a worldwide epidemic as a potential trigger for the unraveling of the global economy and financial markets, but some discerning investors had been monitoring the signs that indicated that we were due a change in sentiments and the underlying economic paradigms. This led to some taking actual measures and gradually “leaving the party early” – taking profits where valuations were at the most extreme, dropping the use of leverage, cutting out exposure to heavily leveraged industries and those facing fundamental headwinds, increasing cash levels, taking a long-term view and searching for areas of permanent value, creating a thesis on enduring global trends and identifying industries and individual companies that are well positioned to harness these trends, hedging exposures where possible and generally tightening the risk management framework by asking challenging questions about current procedures, and stress testing them and the people who oversee them by exposing them to adverse scenarios.

The key to successful investing lies not in riding every move to the absolute peek, but in having a strategy that endures in the bad times. Morgan Housel recently wrote: “Compounding is not about earning the highest returns. It’s about earning pretty good returns for the longest period possible. Earning 20% a year and getting washed once a decade will leave you worse off than earning 8% a year and being able to hold your ground when times get rough. Survival means different things. It means having a strategy whose downsides you’re preemptively familiar with, so you’re prepared both psychologically and financially when they occur. It means being able to make decisions without being handcuffed by the timeline of debt repayment. It means having a huge gap between what could happen and what you need to have happen to do OK.” There is an edge in having a ‘Margin of Error’.

These are the kind of conversations I have been part of with the investment team at BFI for the last 12 months. The general BFI approach of no allocations to highly leveraged companies (financials and oil in this cycle), clear communications with investors and no use of leverage - which means you will never be a forced seller- as well as hedging strategies and physical precious metals as a key component should prove optimal compared to most other strategies.

Daring to hold significant cash as an active manager is rewarding in times like these. Cash has the power of optionality. You have choices when others have few. You can decide to stay on the sidelines, you can make allocations when you are ready. There is a saying; “A ship at harbor is safe, but that’s not what ships are for.” Having the choice of when to leave the harbor and what course to chart is key. To navigate these waters, you will need Cash, Courage and Coherence of thought. Few have all three when it matters.

Some thoughts before we set sail…

Overextended markets have had some investors on ‘hot coals’ for some time now, while fear of missing out (FOMO) and ‘career risk’ for some kept them in, although increasingly paranoid and looking for the exit. Others have embraced the warmth of the herd, drunk the cool-aid and become intoxicated, chasing returns into the thin branches. It would appear that the trigger that finally sends this herd over the cliff in pursuit of a quick exit has been the COVID-19 situation. Some have sought this excuse to exit, some just panicked, and others have rightfully identified sectors and companies that will be affected and exited. Beyond the very real human costs, there has been some long-term and some more transient economic effects from these events, but mainly it has been a change in sentiment. The virus has so far proven more ‘viral’ on social media and in the mainstream news than in the real world.

Fear has the upper hand currently, but people’s longing for the status quo when faced with a peek into the abyss should not be underestimated. The protectors of the status quo – namely governments and their central banks - will no doubt find willing audiences for their proposed solutions as they did back in ‘08. Markets are already hankering for the quick fix of central bank stimulus and so far, the New York Fed – as always closest to the action – has obliged with a ramp up in their REPO activities from the low hundreds of billions drip to the low trillions flow. More is certain to follow, and fiscal spending plans are currently being set in motion in China, Japan and Europe.

Time will tell if these factors can slow the stampede and eventually reverse the trend, or perhaps even carry us back to the balmy waters of only a few weeks ago. As always, it pays to be prepared for all outcomes. Taking a long-term view is always key in my opinion, but especially important in times like these.

Jeff Bezos once said, “People always ask me: What will change in 10 years-time? I tell them that it is what is NOT going to change that is the most interesting. Because that you can invest in or build a business around.”

Beyond identifying risks, that line of thought is at the center of my work and the work I do with the BFI investment team. The wind and the waves are always on the side of the ablest navigators. Such a navigator requires the foresight that experience brings, good maps and a steady hand in times of turbulence.

In times of change it is good to talk. Feel free to reach out to me and the BFI team with any concerns or questions you may have. No one has all the right answers, but together we stand a better chance of finding them.


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