Yesterday, we saw the Dow falling into a bear market – a 20% drop from its high –ending the longest bull run in U.S. equities. This week’s volatility was triggered by the global spread of coronavirus (COVID-19), now officially labeled a pandemic and an oil price war between Saudi Arabia and Russia.
As part of our daily and strategic conversations that we have internally as an investment team, and with our deep network of managers, I wanted to share one such dialog that occurred between John Rowsell (Sendero Partner/Chief Strategist) and Patrick Kenary (Senior Strategist) on the current state of the market.
John:
“None of us should be coming off as epidemiologists. That’s not our specialty. But the reason why this newly discovered virus has garnered so much of our attention is because there’s been a vacuum of knowledge and facts and a fear of the unknown, and that impacts the market. I was looking back in late January, early February where there were people paying closer attention who thought the spread of this virus would be larger than expected. Whatever the mortality rate ends up being, the denominator isn’t known about how many people have this.”
Patrick:
“I spend a lot of time with data. Most people don’t ask questions about data, and I’m not a statistician, but when people tell you a number, you want to think about how they got it. This is unknown. The potential for where this thing could come up is unknown. Nobody’s really faced something like this. Global supply chains, lots of leverage in the system. There was lots of risk out there before there was a virus. People should be prepared for the chance that the market could go down another 20 percent. The only thing you can control is your exposure. So, people have to say: OK, if it’s down 20 percent, am I going to be selling, because I’m scared, or am I OK with that? If you can’t live with that, you have too much equity. That’s how you manage the risk.”
John:
“That’s a commonsense view. It’s like if you can’t stand the heat, get out of the kitchen. That fundamentally is why people need to think about having diversified portfolios in the first place. You can withstand areas of different risk regimes.”
Patrick:
“The other thing people should remember is, it’s not too late to do something. We’re trading where we were trading in August 2019 and briefly in October 2019. It feels like ‘oh no, now it’s too late, it’s already gone down’, but if you were OK with where things were in September, that’s where we are. People should be prudent with the risk they’re taking and adjust accordingly. Nobody should be surprised if we drop another 20 percent.”
John:
“That can happen at any time, in any market. You have to be prepared. The danger is that people get lulled into the expectations that the markets are going to be up 31 percent every year. Last year was the anomaly. We don’t do that very often.”
Patrick:
“The two points to me that are risk things are 1) markets can go down significantly more, so if that would be crippling to you financially then you need to adjust and 2) it’s not too late to adjust. We went up so much it’s like getting anesthetized, you don’t really realize it, but then coming down it’s like electric shock.”
John:
“The other thing I think is a little more interesting, and what people haven’t paid attention to, is how much the fixed income markets have rallied during this turbulent time. The U.S. ten-year bond has rallied to yield levels we have never seen, the yield dropped below 50 basis points. This can be interpreted as a deflationary indicator with how low rates have gotten. Real rates are negative. And we know about 30% of global debit is negative. Our real rates — meaning rates after inflation — are negative at this stage.”
Patrick:
“Another point to talk about is the trade deal and Trump has an overall strategy of trying to disengage from China. To reduce the dependence on China because it’s both bad for national security reasons, it’s bad politically and socially because it’s bad from the manufacturing core of America. I think he was trying to disengage but because we’ve become so entangled that if you did it all at once, the U.S. could suffer a massive economic and market shock. It seemed like Trump was trying to push them to the edge but not off the edge. So, you saw the markets fell off and come back, it was this two-step forward, one-step back that appeared to be Trump trying to get as much as he could without blowing up the markets. That seems like a reasonable strategy to me, because if the markets crashed, he doesn’t get re-elected. He can’t finish the job if he’s trying to disengage from China. However, the coronavirus has accelerated that whole process. It’s kind of now in Trump’s hands, and it seems to be moving at a much more accelerated pace for disengagement. That the US is definitely trying to send a very clear signal to U.S. CEO’s that China is not the place where you should be expanding your business. That is not where the growth is going to be, and corporate CEO’s know this. We’re discovering that something like 70-80% of our antibiotics are made in China, a huge amount of auto parts are made in China. The masks that people need to treat patients who have this disease, they’re all made in China. And that vulnerability is both a bad business decision and a bad national health decision to have everything dependent on China. We fell off in 2018, partially driven by this relatively tight monetary policy by the federal reserve. The federal reserve backed off last year, so it seemed to be that Trump had found this process where we could disengage over 5-10 years.”
John:
“Let’s go back. This is absolutely spot-on. But let’s think about this in context. Whether this is the coronavirus or whether it was trade, what we’re seeing is momentum building for companies to diversify their supply chains. So that we will not be dependent on China. Whether that’s a reaction to trade, or that’s a reaction to this virus. There’s a stream of thought that the Chinese shut down Wuhan and overly aggressively shut down Wuhan [where the coronavirus originated], because they didn’t want to be the subject of another SARS or H1N1, but that may have been an overreaction. But the reality is the corporate CEO’s are going to have to re-evaluate where they source things because they can’t let their businesses be dependent on a weak health care of hygiene system. That’s probably long-term very positive for the U.S. and negative for China. The real risk to the markets is accelerating that problem with China and the decline of GDP and how leveraged their economy may be to the export markets that could be collapsing in on them.”
Patrick:
“There’s been this ‘squeeze and release’ Trump has been doing on trade.”
John:
“There’s a void of trustworthy information regarding China’s economic health. That void of information creates uncertainty for markets, and that’s why you’ve got markets reacting the way they did.”
Patrick:
“Within the U.S., it appears that we could have a downshift in activity. I have to imagine there’s a bloodbath in the airlines, the hotels, and cruise ships, obviously. An economy is a lot of real live fixed assets that are in the world and people should go to those buildings and see those factories and fly on those planes. Those things are financed largely with debt coming out of a banking system. It all hums along as long as people show up and fly on that plane and that money goes to the bank and some of it stays in the airline and everyone’s happy. When the activity stops, it’s like a heart attack. Because what ends up happening — the banks need money. They have debt. So if you don’t pay the bank, the bank’s got a liquidity problem. And so the more levered you are, the more prone you are to these heart attacks. The U.S. is a way less levered economy and has way more cushion but that doesn’t mean it’s painless. China on the other hand, has incredible means of controlling this. It’s kind of an experiment. When you have an economy that’s the second biggest economy in the world and is going through something that’s probably worse than ’08 in the U.S., but they have the ability to say, ‘stop, we’re gonna unplug it, and everybody you’re not allowed to do this, and you’re not allowed to do that, and if you don’t do what you’re told you’re going to jail.’ ”
John:
“You mentioned banks and you made the allusion to banks not being able to lend, think about this. With the ten-year bond yield down in the 60 basis point range — overnight money is still at what, 110 basis points?” Banks cannot make money under these conditions.
Patrick:
“It’s a losing proposition.”
John:
“Banks are in the business of borrowing money and lending it over a long period of time. They’re losing money today. That’s not going to persist. That’s how this stuff infects — how financial markets get infected by this.”
John:
“As for energy. The thing about energy — energy is reacting to real demand destruction for the first time, and that’s a little different. The Saudi’s and Russian’s have now exacerbated the problems in the energy sector. Going back to the banking system, when the banking system starts consistently losing money on lending money, they’re going to stop lending money. And you withdraw a credit from the system, you do have challenges.”
Patrick:
“The first step they’re trying to do is trying to stop people from converting out, that’s another word for selling. They’re trying to stop everyone from converting it to cash. G7 ministers are going to meet on Tuesday because that’s the thing they’re trying to stop. The second order effect of — people scramble for liquidity and they start selling everything. If you fire people and there’s less liquidity, then people can’t pay their bills. They have to get their arms around liquidity and there’s this big hiccup to cash flows. It may be that we’re all overreacting. What it sounds like to me is that what makes it a little difficult to manage is not necessarily that the symptoms aren’t that bad, the death toll isn’t that high, but it’s highly contagious and if 20% of your work force gets the flu, it’s hard to run your company.”
John:
“One of the points you have to be careful with — people may have perceived last week as a dip-buying opportunity. There’s more uncertainty in the world that this just being a dip-buying opportunity. But the chances of there being continued downsides is not insignificant.”
John:
“We came into the year for very low expectations for what the overall performance of the equity market would be. The one thing we felt confident about was that we would see more volatility, and we could easily see the market down 10% over the course of the year. Once again, we were proven correct a lot faster than we expected. Not because we saw this coming but because rationally, looking at it, we thought that was possible. Which goes to the point Patrick made earlier. If you’ve got more equities than you’re comfortable with, then you’ve got a problem. If you are comfortable with your investments — you’ll be fine.”
Patrick:
“Yes. you might have more than your comfortable with but it’s not too late. You can do something about it. The reason to adjust is not because we’re going to go down, it’s because you have too much risk.”
Patrick:
“As for final thoughts, I’ll go first. This is something I’ve been emphasizing. The US has a lot of underlying strengths, geopolitically, geographically, financially. It kind of runs the global financial system. If the world is going to be de-globalizing, the U.S. is the one big long-term beneficiary. Maybe it’s slightly more efficient to have a globalized economy, but it hasn’t been that great for large swaths of the country. This sounds like a political speech but it’s not. To have a big project, like a New Deal, for putting America back to work in a lot of things we weren’t doing over the last thirty years, I think that’s a big positive for America. Theory is that America is the place in the world to invest, right now.”
John:
“I would reiterate that in the short run this is disruptive and for a lot of individuals it may be painful but from a macro standpoint, this just reinforces the trends we see taking place in the strengthening of the U.S. economy and the positioning of the U.S. economically around the globe. Secondly, I would reemphasize because of events like this bring into sharp contrast, the need for people to understand they need to have well-balanced or well-diversified portfolios. A balance in their portfolios is needed so they can live through these times of volatility.”
Sendero has always taken pride in being intellectually independent and having access to smart investors. As this market volatility continues and we look forward to the next bull market, we will continue to share our insights and recommendations to help you with your long-term goals.
If you have any questions or want to have a conversation about the market, please contact Liz, Ed, Fred, Scott, Tyler or myself. Your Sendero team is ready to help.
Best regards,
Amaury de Barros Conti
Vice President, Research & Strategy
210-930-9409
aconti@sendero.com
