Shifting through the gears of support

Sydney-based Hamish Douglass of Magellan believes that the extent of government support to businesses will determine the speed of economic recovery from the coronavirus.

The manager of the £7.9 billion St. James’s Place International Equity fund assesses the economic impact of the COVID-19 pandemic and explains how he is positioning his portfolio.

What are your current thoughts on the coronavirus situation?

Modern market history provides no meaningful reference points for the current crisis. The scale of the potential economic damage is bigger than anything else we’ve seen. And, therefore, market behaviour, both during the crisis and in the recovery, could be very different too.

How do you assess the impact of the crisis on the global economy?

We are spending a lot of time trying to understand two fundamental issues:

1) How much economic activity is being lost while economies are in lockdown?

2) How effective will the policy response be in mitigating this output gap?

It is clear that the output gap here is going to be significant and much worse than in a normal cyclical recession. The longer the economic lockdowns last, the bigger the output gap becomes. Governments have responded in different ways to the crisis, ranging from hard suppression (e.g. China) through to softer guidance towards social distancing (e.g. Sweden).

Most nations, including the UK and US, are somewhere in the middle of this spectrum and we expect the total absence of demand here to last between two and six months, followed by a gradual recovery where the desire to normalise is balanced against the risk of further outbreaks.

This period of absent demand could be shortened if we see some form of effective therapeutic to the coronavirus emerging quickly. There is a significant global effort to reduce bureaucracy here and fast-track the process of development, but even in a best-case scenario, a therapeutic is unlikely to emerge in the next six months. This is not early enough to spare us from substantial economic damage.

How effective will the policy stimulus be in offsetting this economic pain?

We have been very impressed by the major central banks, which have moved swiftly and nimbly in this crisis. We have seen massive injections of liquidity into the financial system and an enormous scaling up of quantitative easing. There are some gaps in this support, however, and refinancing of lower quality corporate debt is likely to remain challenging, with huge potential implications for the financial system. The banks are generally in a much stronger position now than they were in the financial crisis, but we still need to be mindful of the risk of debt defaults.

What else are policymakers doing?

The extent of support is likely to determine the ultimate shape of the economic recovery. Most countries are adopting a strategy which directly compensates individuals for their loss of income, but not businesses. This is likely to head off an economic depression, but it will not enable a swift recovery. We are likely to see a deep and prolonged recession, followed by a gradual economic recovery in which unemployment remains elevated for a long time.

The next level of support is one in which businesses are compensated for part of their revenue loss. Here, a larger part of the output gap can be transferred to governments, with the remainder being borne by society. Ultimately, this level of support should enable a U-shaped economic recovery with more rapidity.

The only way to enable a V-shaped recovery is for governments to wholly compensate businesses for their lost revenues. The entire output gap would effectively be transferred from businesses and individuals to governments and, through quantitative easing, to central banks.
The bad news is, nobody is following this strategy, so we should not be hopeful of a V-shaped economic recovery. The good news, however, is that we are not at the end of fiscal support yet – there is more to come.
When can we gain confidence that the worst is behind us?
To a large extent, this will depend on how effective governments are at shifting through the gears of economic support. For now, we simply do not know how deep this contraction will be, nor how long it will last. It is also still too early to understand how and where other stresses in the financial system will emerge.
The market is likely to start recovering before economies do. If there is one learning from the financial crisis that applies here, it is that market confidence started to return when it finally seemed that governments and central banks had done enough.
How have you adjusted the portfolio as the crisis has unfolded?
The portfolio was well-positioned heading into this downturn. We’ve taken a comprehensive look across the portfolio and have been surgical in selling down any positions that look vulnerable in this environment. We have moved from a 6% cash weighting pre-crisis, to a 16-17% cash position today. Approximately 60% of the portfolio is in cash and very defensive businesses that are not exposed to the situation. The rest of the portfolio is exposed to an extent to what is unfolding, but in businesses that are positioned to emerge from this strongly.
We have no exposure to banks, airlines or energy companies.
Will there be an opportunity to make further changes to the portfolio?
Yes, undoubtedly. It is important to be clear here that the world is not coming to an end. The world will change – we are likely to see some fundamental changes in consumer behaviour, for example – but it is not going to stop turning. There will be winners and losers.
We have positioned the portfolio so that it can win even in an environment of a deep recession. The sacrifice we make in that respect is that it might initially lag in a very strong market recovery. But if it does that, I won’t lose any sleep over taking a conservative approach, and nor should investors.
Do you have a final message of reassurance for investors?
The shock to individuals in this health crisis is enormous and we all need a strong amount of empathy and understanding. But I think it is very important that people stay the course and remember that the world is not going to end here.
Magellan is a fund manager for St. James’s Place.
The value of an investment with St. James’s Place will be directly linked to the performance of the funds you select and the value can therefore go down as well as up. You may get back less than you invested.
The information and opinions contained in this blog are for information only. They are not intended to constitute advice and should not be relied upon or considered as a replacement for advice. Before acting on any of the information contained in this blog, please seek specific advice from Gilson Gray Financial Management

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