It’s a global pandemic, and as of this writing we have only glimmers of medical advancements. Business and social restrictions ease, but that does not imply a return to previous habits. Extreme unemployment levels will necessarily be reflected both in consumption and production. Governments are responding with unprecedented fiscal and monetary responses, and debt is rising. It’s an election year, and the political climate could charitably be described as contentious. We live in the Chinese curse of interesting times.
Investing requires that there will be future cash flows, and that there will be some value in the cash itself at the time of that income. As always, many future scenarios are possible, even likely, both short term and long term. What is an investor to do? Take a deep breath, and go back to the basics:
- Review current status and goals.
- What is the planning time horizon? If it’s long enough, no adjustment may even be needed now, let alone panic.
- What does the balance sheet look like today? Consider not only asset values, but values by asset class.
- What is the outlook for income and expenses, if it is able to be assessed?
- How have these items changed over the last few months?
- Check your assumptions.
- What does the current investment policy suggest about your view of the world going forward?
- Has the pandemic or political reactions to it changed your world view in any way? Whether it has or not, investing is based on this assumption. If you believe that economies will grow, and that companies will make money and return it to bond holders and shareholders, then investing in financial assets makes sense.
- Have tactical adjustments been undertaken? If so, a set of decision rules is implied. Be sure these are documented, along with the outcomes.
- Assess the possibilities.
- Inflation: The Fed has indicated that they will keep interest rates near zero for an indefinite period of time. This will be accomplished by purchasing treasuries and corporate bond ETFs. The money exchanged for these instruments will leave all capital markets awash in liquidity. Inflation will be determined by where that money goes – without an increase in velocity, prices for goods, services, and assets can remain low or even deflate. The Fed has attempted to hit target inflation for 12 years without much success. In recession, inflation seems less likely.
- Growth: How bad will this be, and for how long? We can look to China and Europe, whose journey in the crisis started prior to ours, for clues to a path forward (https://us.matthewsasia.com/resources/docs/pdf/Sinology/041620-Sinology.pdf). However, our economies differ in structure and makeup – our experience won’t match theirs exactly.
- Asset classes: This is where things get interesting.
- Will the Fed’s liquidity flow directly into risk-on assets, regardless of economic conditions, and renew the bull market of the last decade? This would suggest that growth would continue to beat value, see recent article from Ben Carlson (https://awealthofcommonsense.com/2020/04/why-value-died/). Other analyses show that conditions are ripe for the value and size factors to outperform once again (https://www.osam.com/Commentary/a-historic-opportunity-in-small-cap, https://www.gmo.com/globalassets/articles/white-paper/2020/aa_darkest-before-the-dawn_4-20.pdf).
- Will fundamental economic conditions be reflected in further equity declines? John Hussman’s analysis continues to point in this direction (https://www.hussmanfunds.com/content/comment/), also reference the GMO article above. This would suggest more of a wait-and-see attitude, possibly with technical decision points (https://www.advisorperspectives.com/articles/2020/02/10/market-timing-with-the-s-p-500-golden-cross-and-a-recession-indicator).
- Fixed Income:
- In previous newsletters, characteristics of bond ETFs were discussed. The behavior of the funds during March was exactly as expected – ETFs reflected actual bond trading conditions more quickly and accurately than open end funds (https://www.barrons.com/articles/muni-bond-and-other-etfs-are-trading-at-big-discounts-heres-why-and-what-to-do-51584549677).
- Also in previous newsletters, advantages of active fixed income funds were detailed (yes, at this point these two ideas are somewhat conflicting). GMO has published a white paper with additional research (https://www.gmo.com/globalassets/articles/white-paper/2020/pc_passive-aggresive-agg-part-ii_2-20.pdf).
- Going forward, we know that long rates will be held at zero. Although this limits return potential, bonds are still an important diversifier.
- Options can be used to hedge other financial positions. Research has shown that options are an inefficient way to hedge equity risk both over time (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3383173) and more recently (https://www.msci.com/www/blog-posts/did-hedging-tail-risk-pay-off-/01784814215).
- Real assets: Real estate, commodities, and natural resources. In the medium term, it’s possible (likely?) that Fed liquidity will not be withdrawn quickly enough in the event of inflation, and real assets are a way to hedge. However, in the short term, they will suffer any deflation along with financial assets, and in the long term, those real assets that are not income-producing should not be expected to grow beyond inflation.
As an investment manager and investor, I have to be an optimist. Josh Brown’s classic column sums it up the best (https://thereformedbroker.com/2013/04/28/optimism-as-a-default-setting/), and Jared Dillian recently updated the idea through the lens of the pandemic (https://www.mauldineconomics.com/the-10th-man/human-ingenuity). Asset allocations may change, but investing in financial assets will remain.