This week kicks off the World Economic Forum (WEF). The great and the good will not be flying in from all around the globe, as many did previously on their private jets, to pontificate on the world’s problems as this year the event is virtual. The situation seems apposite given the mess we are in and the prevalence of environmental risks highlighted in the Global Risks report that precedes each meeting, as shown in the list below.
Infectious diseases have made an obvious come-back onto the list after an absence of 10 odd years. To be fair, nobody foresaw the likelihood or impact of the Covid-19 pandemic and identifying global risk are inherently uncertain. One article that caught my attention on the WEF website was on the link between climate change and pandemics. I did see a TV report earlier this year that highlighted how land development in China was encroaching upon the natural habitat of wildlife resulting in more contact between humans and animals that could be an explanation for the initial Chinese outbreak, if indeed that is where Covid-19 first began (just to ensure I do not sound like the orange vainglorious one!). But that report didn’t stick in my mind. Until now.
As the WEF article highlights, the World Health Organization (WHO) has stated there is no evidence of a direct link between climate change and Covid-19. However, they acknowledge that changes in living environments of the animals on Earth caused by climate change may impact infectious diseases. Dr. Anthony Fauci co-authored a paper in September that stated “the COVID-19 pandemic is yet another reminder, added to the rapidly growing archive of historical reminders, that in a human-dominated world, in which our human activities represent aggressive, damaging, and unbalanced interactions with nature, we will increasingly provoke new disease emergences.”
Although not a journal noted for its medical or scientific expertise, this article in December from Rolling Stone on the topic frightened the hell out of me. Just another happy thought to add to expanding list these days! If I had read an article like this a year or older ago, I would likely not have given it as much thought as I do now. And that is a reflection on what the last year has done. Lists of risks such as those in the WEF Global Risks report seem a lot more real today.
My father was not a man of many words, but when he spoke, he generally made a lot of sense. Somebody could not be called anything more derogatory by my father than to be called a clown, a term he generally used often when watching politicians on the TV. He would have had absolutely no time for the current US president, a clown of the highest order in my father’s meaning of the word. Notwithstanding the loss of life from the Capitol Hill rioting, the pantomime that played out on the 6th of January was pure theatre and showed the vacuous inevitable end destination of Trump’s narcissism (and hopefully of Trumpism). Rednecks roaming around capitol building with confederate flags and wearing silly costumes feels like a fitting end. I thought it would be months, if not years, before the doubtless shenanigans that Trump has been up to over the past 4 years (and before that, of course) would be made public in all its glory and before a large proportion of the otherwise sensible 74 million Americans who voted for him would finally see him for the “very flawed human being”, in his ex-Chief of Staff John Kelly’s wonderfully diplomatic words, that he is. My father had another word for him. There are too many issues to be dealt with that are more important than the man child who will, after this week, be a (hopefully!) much-diminished and irrelevant force.
Most people are happy to see the back of 2020 and there is little that I can add to that sentiment. Like others, I have avoided any year end round ups as it all seems too raw. My family and I have been blessed to not been adversely impacted health-wise by Covid-19 during the year. The horrible global death toll from the virus reached the grim milestone of 2 million with some pessimistic projections of the final toll at double that figure, even if mass vaccinations result in the utopian herd immunity (optimistic projections for the developed world to reach such a state by this time next year with the rest of the world taking another 12 months). It seems likely that the public health situation will get worse before it gets better.
Reaching the milestone age of 21 symbolizes the entry into adulthood, an age of maturity, and not just in relation to the legal procurement of alcohol in some countries! Maturity and long-term thinking in addressing the challenges of the coming year, including likely bottlenecks in vaccine rollouts and the rebuilding of multilateral cooperation, should replace the narrow nationalist thinking of the Trump and Brexit eras. God willing, the biblical symbolism of 21 representing the “great wickedness of rebellion and sin” will not be backdrop for the post-Covid era!
In a widely optimistic thought along the lines of rebellion and sin but without the wickedness, the post-Covid era could be characterised by a radical shift in societal norms, akin to the 60’s, where youth culture demands that the challenges of our day, specifically climate change and income equality, are addressed urgently. Combining technology with a passion for action and upsetting lifestyle norms could instigate real change. A new countercultural movement, with its own hedonistic soundtrack, would also be nice after all the introspection of lockdowns! 2020 has taught us that rapid social change can take place and we can adapt to uncertainty if we are pushed.
So back to the realities of 2021! I read recently that those of us lucky enough to be able to continue working relatively unperturbed from home during Covid having been working on average an hour a day extra and that is consistent with my experience (and thus my lack of posts on this blog!). Overcoming the challenges of the current Covid operating environment, such as avoiding the development of splintered or siloed cultures, whilst maintaining a collective corporate spirit will likely be a much-discussed topic in 2021. As the social capital of pre-Covid working networks is eroded by time and Covid fatigue, moving to a new hybrid work/office model in our new distributed working environment, whilst minimising people and talent risk, will create both challenges and opportunities for leaders and managers of differing skillsets.
One of my biggest concerns for 2021 is the financial markets. The macabre sight of stock markets hitting highs as the pandemic worsened is surely one of paradoxes of 2020. The S&P500 is currently trading at a forward PE ratio of over 22 as the graphic below shows.
In November, the oft debated (see this post as an example) cyclically adjusted price-to-earnings (CAPE) ratio for the S&P 500 hit 33, just above the level it was at in September 1929, the month before the crash that preceded the Great Depression! CAPE has only been higher twice in history than it is now, in the late 1920’s and the early 2000’s. Apple (AAPL) is currently valued at a forward PE of over 30 (based upon its 2022 earnings estimates), trading well above the sub $100 level I pitched as fair value earlier this year (in this post). Tesla is often cited as the poster child for crazy valuations. I like to look at the newly public Airbnb (ABNB) for my example, a firm that depends upon cross border travel for its core business, which has lost $1 billion on revenue of $3.6 billion over the last 12 months (revenue down from $4.8 billion in 2019) and is now valued at $100 billion or a multiple of over 27 times sales! The market seems to be solely focussed on the upward leg and ignoring the downward leg of the so-called K shaped (bifurcated) recovery, even though small business in the US generate 44% of US economic activity. The forward PE on the Russell 2000 is above 30. In classic bubble style, speculative assets like bitcoin reached all-time highs. The latest sign is that much shorted stocks are being targeted in short squeeze trades.
This NYT article, aptly named “Why Markets Boomed in a Year of Human Misery” offers one of the clearest explanations for the market euphoria, namely that the “Fed played a big part in engineering the stabilization of the markets in March and April, but the rally since then probably reflects these broader dynamics around savings”. The broader dynamics referred to are the NPIA statistics from March to November. The article highlights that fiscal action taken to support US households through Covid support has resulted in salaries and wages only being marginally down on the prior year, despite widespread lockdowns, whilst spending has fallen. This combination pushed the US savings rate through the roof, over $1.5 trillion higher that the March to November period in 2019.
The arguments about a bubble have been rehashed of late and here are some examples:
In November, Robert Shiller (of CAPE fame) co-authored an article which stated “many have been puzzled that the world’s stock markets haven’t collapsed in the face of the COVID-19 pandemic and the economic downturn it has wrought. But with interest rates low and likely to stay there, equities will continue to look attractive, particularly when compared to bonds.”
The great Martin Wolf of the FT asked (in this article) “Will these structural, decades-long trends towards ultra-low real interest rates reverse? The answer has to be that real interest rates are more likely to rise than fall still further. If so, long-term bonds will be a terrible investment. But it also depends on why real interest rates rise. If they were to do so as a product of higher investment and faster growth, strong corporate earnings might offset the impact of the higher real interest rates on stock prices. If, however, savings rates were to fall, perhaps because of ageing, there would be no such offset, and stock prices might become significantly overvalued.”
The ever-pessimistic John Hussman responded in this market commentary that “when people say that extreme stock market valuations are “justified” by interest rates, what they’re actually saying is that it’s “reasonable” for investors to price the stock market for long-term returns of nearly zero, because bonds are also priced for long-term returns of nearly zero. I know that’s not what you hear, but it’s precisely what’s being said.”
And the equally sunny veteran market player Jeremy Grantham opened his latest investor letter (the wonderfully titled “Waiting for the last dance”) thus: “The long, long bull market since 2009 has finally matured into a fully-fledged epic bubble. Featuring extreme overvaluation, explosive price increases, frenzied issuance, and hysterically speculative investor behavior, I believe this event will be recorded as one of the great bubbles of financial history, right along with the South Sea bubble, 1929, and 2000.”
Grantham points out that the necessary monetary and fiscal reaction to the pandemic has created heighten moral hazard – “The longer the moral hazard runs, and you have this implied guarantee, the more the market feels it can take more risk. So it takes more risk and builds yet more debt. We’ve counted too much on the permanence and the stability of low rates and low inflation. At the end of this great cycle of stability, all the market has to do is cough. If bond yields mean-revert even partially, they will be caught high and dry.”
I particularly liked Graham’s summary of the past 20 odd years of monetary policy – “All bubbles end with near universal acceptance that the current one will not end yet…because. Because in 1929 the economy had clicked into “a permanently high plateau”; because Greenspan’s Fed in 2000 was predicting an enduring improvement in productivity and was pledging its loyalty (or moral hazard) to the stock market; because Bernanke believed in 2006 that “U.S. house prices merely reflect a strong U.S. economy” as he perpetuated the moral hazard: if you win you’re on your own, but if you lose you can count on our support. Yellen, and now Powell, maintained this approach. All three of Powell’s predecessors claimed that the asset prices they helped inflate in turn aided the economy through the wealth effect.”
There is no doubt in my mind that we are in an asset price bubble currently, notwithstanding the fact that it is likely to continue for some time yet. Although not quite at the level of Joe Kennedy hearing the shoeshine boy talk about his equity positions, I have been struck by the attitude of late of my more junior workmates when they optimistically talk about their equity and bitcoin investment gains. It’s more akin to a level of the mobsters’ spouses trading internet stock ideas in the Sopranos! The TINA trade on steroids or the TINA USP as in “there is no alternative, Uncle Sam’s paying!”.
There is little doubt that extraordinary action, both monetary and fiscal, was needed to counteract the impact of the pandemic. In the words of Andy Haldane, chief economist of the Bank of England, “now is not the time for the economics of Chicken Licken”. It is the sheer scale and reliance on government intervention into markets that surely is unhealthy in the medium to longer term. Central banks now act as market makers, distorting market dynamics such that continued newly created money chases an ever-shrinking pool of investable assets. William White, formerly of the BIS, recently commented that monetary policy has been asymmetric whereby Central banks have put a floor under markets in crises but failed to put a cap on prices in bubbles.
Fiscal stimulus has exploded the world’s government debt stocks. Fitch estimate that global government debt increased by about $10 trillion in 2020 to $78 trillion, equivalent to 94% of world GDP. The previous $10 trillion tranche took seven years to build, from 2012 to 2019. The most immediate impact has been on emerging market debt with sovereign downgrades prevalent. Kenneth Rogoff, former chief economist at the IMF, warned that “this is going to be a rocky road”. High debt levels can only be contained in the future by austerity or inflation, neither of which are pleasant and both of which would further compound high levels of inequality across the world. Covid has laid bare the destructive impact of inequality and anything that will increase inequality will inevitably impact social stability (eh, more populism anyone?). We have, of course been here before, living through it over the past 13 years, but this time the volume is up to 11.
Two other issues that will keep us occupied in 2021 are climate change and cyber risks. 2020 has recently been declared one of the hottest on record. Despite the estimated 7% fall in CO2 emissions in 2020 due to Covid lockdowns, we are still, as UN Secretary-General António Guterres highlighted this week, “headed for a catastrophic temperature rise of 3 to 5 degrees Celsius this century”. David Attenborough’s new TV programme “A Perfect Planet” illustrates the impact that the current temperature rises just above 1 degree are having right now on the delicate balance of nature. The COP26 summit in November this year must be an event where real leadership is shown if this fragile planet of ours has any hope for the long term. The other issue which will likely get more attention in 2021 is the successful cyber intrusions using Solarwinds that the Russians pulled off in 2020. An anonymous senior US official recently stated that “the current way we are doing cybersecurity is broken and for anyone to say otherwise is mistaken”.
So, 2021 promises to be another significant year, one of more change but, at least it will be without the clown (hopefully). I, for one, will eagerly wait for any signs of that new countercultural movement to take hold, whilst listening out for that hedonistic soundtrack!
As we face the peak weeks of the COVID19 virus in the major developed economies, one thing the current COVID19 outbreak should teach us is humility. As humans, we have become far too arrogant about our ability to shape the future. A new book by the economists John Kay and Mervyn King (a former Bank of England governor during the financial crisis) called “ Radical Uncertainty” argues that economists have forgotten the distinction between risk and uncertainty with an over-reliance on using numerical probabilities attached to possible outcomes as a substitute for admitting there are uncertainties we cannot know. How many one in a century events seem to be happening on a regular basis now? Their solution is to build more resilient systems and strategies to confront unpredictable events. Such an approach would have a profound impact on how we organise our societies and economies.
Currently, planning for events with a large impact multiplied by a small probability allows us to effectively continue as we have been after assigning the minimal amount of contingency. Imagine if sectors and industries were run based on been prepared for tail events. That would be a radical change. Very different from our just in time supply chains which minimise capital allocation and maximise return on investment. Our approach to climate change is an obvious case in point and how we have heretofore ignored the environmental externalities of our societies and economies. Given the financial costs this crisis is going to place on future generations, I would suspect that the needs of this cohort of our society will become ever more urgent in the aftermath of the COVID19 pandemic.
As many people grapple with the current uncertainties presented by this pandemic, we are currently at peak uncertainty in Europe and the US. We are only now getting a sense of how the outbreak is peaking in Europe given the lock down measures in place. How the virus reactions to the relaxation of current measures, how the outbreak will peak across the US and other continents, the economic impact of the outbreak, or the societal impact amongst many other issues are as yet unknown. We do know however that with time over the coming weeks some of these answers will become clearer. For example, as the graph below from the FT shows, we known the approximate path of the outbreak given the policies being pursued today.
A positive narrative could be that existing medications pass rushed COVID19 trials and prove they can blunt the impact of the virus thereby altering the shape of the curve. We can also speculate that once the first wave is contained, we will develop strategies on a combination of mitigation measures (e.g. reduced isolation methods, antibody and other testing to return sections of the population to work, immunity passports, etc) to slowly transition to the new normal. The logistics of such a phased return to normal will be complex and a nightmare to enforce, particularly if self-isolation measures are in force for lengthy periods and people believe any second wave can be well contained by battle hardened health systems. We can be confident that a vaccine will be developed, hopefully by early 2021, but it will take time to get the vaccine distributed and administered in bulk. Mid 2021 is likely the best we can realistically hope for.
At this stage, my rough guess at a base case scenario on the timing for European and US lockdown is 3 to 5 weeks with another 6 to 10 weeks to transition to a semi-new normal. That’s somewhere between mid-June and early August with Europe leading the way followed by the US. A more pessimistic case could be that discipline amongst the population gets more lax as the weeks drag on and a second wave gathers momentum with a second lockdown required over the summer followed by a more timid and gradual transition afterwards lasting until the end of the year. Obviously, these timings are pure guesses at this time and may, and hopefully will, prove way off base.
The economic impacts are highly uncertain but will become clearer as the weeks pass. For example, with just the first fiscal stimulus package passed in the US, the politicians are already listing their priorities for the second (and likely not to be the last either), Morgan Stanley expect the cyclically adjusted primary fiscal deficit to rise to 14% of GDP and the headline fiscal deficit at 18% of GDP in 2020, as per their graphic below. Given the unknown impact of the crisis on GDP numbers, these percentages could approach 15% to 20% with total debt of 110% to 120%. It’s depressing to note that prior to this crisis the IMF said the U.S. debt-to-GDP was already on an unsustainable path.
Although the euro zone comes into the crisis with less debt, last year it was 86% of GDP, Jefferies said in a ‘worse case’ outcome where nominal GDP falls 15% this year, the bloc’s budget gap would balloon to 17% of GDP from just 0.8% last year. They estimate in this scenario that the euro zone debt-GDP ratio could rise above 100% in 2021. As a percentage of GDP, Morgan Stanley estimated the G4+China cyclically adjusted primary deficit could rise to 8.5% of GDP in 2020, significantly higher than the 6.5% in 2009 immediately after the global financial crisis. Unemployment rates in the short term are projected to be mind boggling horrible at 20%+ in some countries. It seems to me that the austerity policies pursued after the financial crisis will not be as obvious an answer to repayment of this debt, not if we want western societies to survive. Addressing generational and structural income inequalities will have to be part of the solution. Hopefully, an acceleration of nationalism wouldn’t.
On the monetary side, the Fed’s balance sheet is now estimated to be an unprecedented $6 trillion, an increase of $1.6 trillion since the start of the Fed’s unprecedented bailout on the 13th of March. Bank of America estimates it could reach $9 trillion or 40% of GDP, as per the graphs below.
As to corporates and the stock market, dividends will undoubtably be under pressure as corporate delevering takes hold and without the crack cocaine of the bull market, share buybacks as the graph below shows, I fear there will be more pressure on valuations. The Q1 results season and forward guidance (or lack thereof), although it may have some surprises from certain firms in the communication, technology and consumer staples space, will likely only compound the negativity and uncertainty.
Using unscientific guesses on my part, I have estimated base and pessimistic operating EPS figures for the S&P500 as below. Based upon a forward PE (on a GAAP EPS) of 15 (approx. 12.75 on operating EPS basis), which is the level reached after the dot com bubble and the financial crisis, the resulting level for the S&P500 is 2,000 and 1,600 in the base and pessimistic scenarios respectively. That’s a further 20% and 35% drop from today’s levels respectively.
The coming weeks will likely be horrible in terms of human suffering and death across the developed world (one cannot even comprehend the potential suffering in the developing world if this insidious virus takes hold there). There is always hope and uncertainty will reduce over time. Major decisions will need to be made in the months and years ahead on the future of our societies. Learning from this pandemic to build more resilient societies and economies will be a task that lasts many years, possibility even generations. Major changes are coming after this health crisis subsides, hopefully they will be for the better.
There can be little doubt that March 2020 will go down in history. I fear that April 2020 will bring more pain and suffering across this little planet of ours. I have, like I am sure you have also, looked on in horror as events unfolded over the past weeks and felt emotions I never thought possible as I fear for family, friends and communities. We have to hope that medical science will come to assist us with treatments to take some of edge off this insidious pandemic until we can mass produce and distribute a vaccine for COVID19.
Until recent days, I have not had the stomach to sit down and try to read up on how this nightmare may end. The data, both medical and economical, that will come out in April will likely shock but will hopefully at least help us to figure a route out of this. Right now, I doubt we will ever go back to the world we lived in just a short few weeks ago. The price that will have to be paid for this human tragedy once the virus is conquered will, I fear, include destroyed businesses, unemployment, financial hardship for many and a debt crisis (both corporate & sovereign). If things get really bad, I would fear for social cohesion in the months and years ahead in many communities and countries. So, in trying to start to figure out where we go to now, the exhibits below are those I have taken from some recent reports (as credited) that I thought worth sharing.
Notwithstanding these fears, I do think it’s important to have hope and there are many things happening during this crisis that point to hope. Families getting stronger through adversity and a focus on what is important for us all are just two positives. We’ll see what the coming weeks bring….
This blog represents my personal views and is not reflective of the views or opinions held by any company or employer I work for currently or have worked for in the past. The views expressed herein are based solely upon publicly available data. No views expressed herein should be taken as an endorsement to take any particular course of action in the markets. The basis of this blog is that different views should be expressed and readers make up their own minds on the what they believe and act accordingly.
This blog represents my personal views and is not reflective of the views or opinions held by any company or employer I work for currently or have worked for in the past. The views expressed herein are based solely upon publicly available data. No views expressed herein should be taken as an endorsement to take any particular course of action in the markets. The basis of this blog is that different views should be expressed and readers make up their own minds on the what they believe and act accordingly.
deconstructingrisk 