Posted 20.03.2020 in Industry Updates
What is becoming clearer is that governments around the world are implementing huge stimulus packages targeted at small businesses and at-risk households with the twin goals of assisting the vulnerable, and assisting small businesses weather the storm of Covid.
In this Covid-19 update I want to go a little deeper to discuss why we are seeing the wild swings in the share market.
At a high level, markets are huge information processing machines which moment-by-moment factor in new information to set prices for bonds and shares.
The fundamentals of share investing are that shares are valued based on their expected future earnings – this valuation methodology applies to all asset classes including commercial property. Investors assess the future earnings they expect to receive from an asset and use this information to decide how much they are willing to pay.
Because the future earnings are less certain, investors discount the future earnings to compensate for the risks they reasonably expect, and therefore discount the value they are prepared to pay.
During normal markets, earnings expectations and discount rates are quite stable and that’s why markets are for the most part, uneventful. Every now and then, uncertainty creeps in and shorter-term investors will place a deeper discount on future earnings based on the higher perceived risk. This ‘risk discount’ on future earnings is what causes share prices to fall as investors sell the shares, unwilling to risk their future earnings based on the new ‘risk’ information.
Investors are helped to assess earnings expectations because all publicly listed companies are, by law, required to release guidance on expected earnings based on the company’s ongoing trading performance.
We only need to look at the frenzied buying of groceries to recognise that these are not normal times.
I could never have conceived writing this, but this week I am likening the markets to the toilet paper frenzy. Is it rational? Not exactly. Is there reason to be concerned about the Covid-19 and its impacts? Sure. (We will discuss some of the implications later.)
Occasionally, an event occurs where markets react violently because price discovery (value determination) is almost impossible as information about future earnings is so uncertain. This was the case in September 2009 when Lehman Brothers collapsed, and is certainly the case today, where each new day is another page in the Covid-19 story.
Right now, companies are so uncertain about their future earnings they are suspending their earnings guidance altogether. This creates a level of uncertainty markets rarely deal with, so markets seek to price in the worst-case scenario.
In the absence of information to price shares accurately, some investors can apply massive discounts to expectations of future earnings which results in selling and sharp falls in prices. If fear sets in – as it sometimes does – the falls on markets can be dramatic as we have seen since February 20 this year.
Last week we also had the double-whammy of the oil price shock, which I wrote about in our last update. The failure of the OPEC producers and Russia to reach a production agreement meant that oil prices dropped 30%, further uncertainty and selling in the oil and gas sector.
There are several issues that make the Covid-19 event unusual. To begin with, most recessions are demand driven. This means that in the absence of consumer confidence, demand for goods and services dries up causing job losses and reduced spending. In a normal economic slow-down there is plenty of capacity to produce goods and services, it is the lack of demand that has the economy contract.
Covid-19 is changing the economics in that we also have supply-side risks. In China we have seen the closure of factories, towns and cities interrupting supply lines. As other countries ‘lock-down’, closing their borders as Italy did earlier this week, we will see further disruption to travel, disruption in supply chains, and this will in turn create further economic concern. Now with airlines suspending all but core operations we begin to see the depth of impact of this crisis.
This is where we do need a reality check, as there is no precedent for widespread lockdown of entire countries. It is news like this that markets are trying to price in.
There are many commentators suggesting markets are over sold and that a rebound is due, with some fund managers even saying stocks look attractive. We believe it is far too early to be so optimistic. It will take time for the full impact to be known and for risks to be appropriately priced.
The Covid-19 crisis is only just making its mark on the developed world and while much of this risk may already be factored into stock prices, we need to be prepared for further developments. We also need to consider the additional fear as people consider the impact on loved ones.
As I said in an earlier communication, coordinated government intervention is critical and the focus needs to be on ensuring businesses are still here when the recovery comes. As the Australian government rolls out stimulus measures the major banks have announced a ‘soft-glove’ approach to business borrowers. This is very good news and a stark contrast to their aggressive approach to credit assessment in the GFC. Australian banks have a very cosy operating environment and it is now time for them to fulfil their side of the social bargain.
If there is any good news it appears that the rate of transmission in China has flattened considerably. That’s not to say the Covid-19 virus has been eliminated in China, far from it, but containment measures appear to be working. Getting the second largest economy back to full production will take time but it is a critical factor in rebounding the global recovery from this remarkable event.
Many clients have asked us about portfolio rebalancing, some even suggesting that this is an excellent buying opportunity! Our investment committee has been monitoring events, and every investment we hold closely, and while markets continue to be volatile, we will not be making significant rebalancing action.
That said, rebalancing in falling markets is important and we plan to undertake incremental rebalancing for most portfolios soon. We are in the process of reviewing every portfolio and will continue to do so on an ongoing basis.
Our first consideration is for income stream liquidity for our retired and retirement transition clients. Ideally, we will maintain six years of defensive asset positioning for future income and rebalance around this core requirement.
For accumulation clients the rebalancing equation is simpler, however rather than a hard rebalance to benchmark we will be taking an incremental approach.
In truth it is hard for many of our clients to process just how they should think about these events.
“Expect volatility but don’t panic, would be my view, because before 12 months, I think we’ll be looking back, and this event will have passed.”
This is the view of one major fund manager presenting to investors last week. I hope he is right.
Over the years I have had many, many conversations with clients about risk. In times like this I am reminded that risk is what is left when you have planned for everything else.
For our clients we strongly encourage calm. Looking at one’s portfolio value today may cause discomfort; however, we do not have a single client that has a need to sell a single share in this climate. Indeed, all clients living off their portfolio will have multiple years of cash and bonds to fund to fund lifestyle during the inevitable recovery.
I have said to many investors over the years – “during the course of our relationship there will be severe market events and you will be very uncomfortable – when they happen, it’s our job to keep you safe.”
Ultimately, investment risk is like turbulence in a plane. The Captain announces, “Ladies and Gentlemen, we are experiencing severe turbulence. Please return to your seat, stow your tray table and fasten your seat-belts.”
Like air turbulence, market volatility is acutely uncomfortable while it lasts, but it subsides, and we get to land safely.
As highly respected economist Don Stammer wrote in the Australian recently; “No stock market panic ever lasted…nor will this one.”
If you need to get in touch with Capital Partners, please call through first on 6163 6100, and we can advise you of the best process. Our team is working hard to meet the needs of everyone in our community and will continue to do so in the coming weeks.
Thanks for reading this update. We are thinking of you during these challenging times and we encourage you to call us with any concerns you may have. Please stay safe.
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