The Covid-19 virus changes everything. Our economy is going to morph dramatically thanks to the ineptitude of the Chinese Communist government as well as the slow response by Western leaders. Fortunately, we’ve known for years that our old economy was unsustainable which is why we are far along in planning for how to invest in what is likely the start of a new economic cycle.
The circumstantial evidence suggests that the virus came from the Wuhan Institute of Virology where the SARS coronavirus was being studied. We’ll likely never know if the virus was genetically modified for military purposes because world leaders typically don’t divulge such information. At this point, it doesn’t really matter because the result has been a significant number of deaths and the shutting down of a large part of the global economy.
People in our profession never like to use the “D” word which is economic depression but when 10 million people lose their livelihoods in the span of two weeks and the Congressional Budget Office estimates that second quarter GDP will drop 28% annualized, the “D” word is applicable. It’s a word that denotes pain and suffering but it also marks the beginning of a new cycle and new cycles bring opportunity.
Thanks to intervention by the Federal Reserve Bank and the US Treasury, the drop in the stock market has abated for now. They were wise to move when they did because losses would have compounded as people panicked to get their money out of the markets.
I’ve been watching the development of the Wuhan Virus since the middle of January which has helped minimize losses in client portfolios. Our initial plan was to get out of the companies that relied on China as suppliers of the goods they sell. We sold auto parts stocks, medical supply stocks, and cyclical stocks at first because it was clear that operations at these companies would be negatively impacted.
I thought electric utilities would perform better thanks to falling interest rates and the rising value of their dividends but it’s entirely possible that our economy has been negatively impacted enough such that those dividends are at risk of being cut. It’s something we’ll need to consider going forward.
The good news is that our food investments have performed quite well. Some are still at gains for the year with improving prospects thanks to the likelihood that people continue to eat at home and not visit restaurants. Many of the stocks we own have operations that are perfect for the current environment.
Our government suppliers performed better than the markets with one still at a gain for the year. Given the nature of administering future bailouts, I believe this group will continue to perform well in the future and I’ll look to add names in this space over the next couple of months.
More than ever, successful investing will require avoiding land mines in the market. A good first step will be to avoid the companies that used excessive stock buybacks to hide a lack of organic earnings growth. Think companies like GE, Boeing, and IBM. There will be many new names to add to that list in the near future because US companies have NOT been terribly profitable apart from stock buybacks over the past ten years.
The second step will be to understand how people will live while the economy transitions to a new growth path. For now, the beneficiaries will be companies that sell necessary products and later, it will be in companies that are positioned for the future upturn.
The key will be to use this adjustment period to our advantage to grow client portfolios while we look for the future opportunities to drive our long term investment decisions.
This is where we earned our fees in the last quarter. Not only did we stick with the highest quality bonds possible, we held fairly long maturities for clients and those were winners at a time when low quality bonds did poorly.
The chart below shows the 10 year US Treasury bond. As rates fall, the value of the bond rises and interest rates dropped A LOT!
This is exactly what I expected to happen and it was a gratifying result amidst a difficult quarter. And I believe this is just the beginning. Interest rates on US Treasury debt can potentially fall much further. Given the nature of the economic uncertainty, negative interest rates cannot be ruled out.
Investors who held low quality bonds such as junk bonds fared quite a bit differently than GeoVest clients. Below is a chart of the Junk Bond ETF but this chart denotes the share value of the fund itself so the decline represents lost value. Junk bonds were one of the primary beneficiaries of the recent Federal Reserve intervention but I believe this floor on the value of these bonds will only hold temporarily.
The reason is that a sharp decline in economic activity will surely cut the cash flow necessary to pay interest and principle on this garbage. Thanks to intervention, there is some optimism that junk bonds and lower rated investment grade bonds will somehow make it through this crisis. While possible, I’d suggest the probabilities are quite low unless the Fed is willing to buy those bonds and accept the losses itself.
The US economy had become dependent on service industries and in particular, restaurants and hospitality. That’s where a large number of jobs have been created over the past twenty years.
The pandemic prevents people from congregating so religious services have been cancelled, restaurants have been closed for all but take-out and hotels are closed by government mandate. Airlines are in extreme trouble but so too are automakers. By locking people in place, a wide range of our service economy has been damaged.
That’s not going to change quickly or easily once the quarantine has been lifted. Just consider your own habits. How likely are you to visit a crowded restaurant? How comfortable will you feel on an airplane where the air is re-circulated? Would you take a cruise even if given free tickets? It’s going to take a long time for people to become confident that they won’t catch this dreaded illness.
The bad news is that millions of Americans are going to experience economic dislocation. It’s going to be bad for some time but the US has everything already in place to start reversing this negative situation faster than the rest of the world.
We are now among the world leaders in the production of oil and natural gas. The companies that extract and transport this energy are the most efficient in the world. If you are going to re-industrialize the economy and bring jobs back from China, this energy is the starting point of re-establishing the necessary competitive advantages to recapture the primacy of US industry.
The US is also the world leader in food production. Unlike our geopolitical competitors, we have the ability to supply all of our food needs domestically, as long as we’re willing to forego more tropical and exotic foods.
Best of all, the American workforce has proven itself willing and able to turn on a dime to take advantage of new opportunities. This is a characteristic that many take for granted but it truly sets Americans apart from the rest of the world.
Things are going to be challenging in the US but the rest of the world is in for a much rougher experience. Because the US enjoys the privilege of controlling the world’s reserve currency, we’re able to borrow and spend at the federal level without it hurting the value of the dollar in global markets.
Because we have our own energy and food, the US is far less dependent on trade than countries in the emerging markets and China. Those folks need to accumulate dollars in trade in order to buy food and energy as well as to service the past dollar debt that allowed them to grow in the first place.
Where the dollar has been strong, currencies such as the Chinese yuan, European euro, Canadian dollar and many others have fallen versus the US dollar. This is a huge problem for the world economy because there is somewhere between $13 trillion and $20 trillion in global loans denominated in US dollars that is owed to the global banking system.
If you were a European bank and lent dollars in 2008 to an emerging market economy, your cost of funds has risen by 30% while the borrower in the emerging markets has experienced between a 30% and a 50% decline in the value of their local currency. This is where cross border lending turns into a disaster scenario, particularly when world trade starts to decline.
For the past twenty years, China borrowed dollars and invested in itself and it was this growth that fueled the growth in the Middle East, Africa, South America, and Australia. Growth in China is over and I expect the sharp reversal in Chinese economic activity to continue because consumption is falling across North America, Europe, and especially Asia.
The GeoVest Approach
John D Rockefeller once said: “I always tried to turn every disaster into an opportunity”. Rockefeller created Standard Oil amidst a depression in the oil and gas industry where countless companies went out of business due to low commodity prices. Rockefeller was always there to buy the bankrupt assets “on the cheap” while making his company the most efficient extractor and distributor of motor fuels in the world. That’s the American way.
We’re looking to take a similar approach at GeoVest. In the short term, we’re focused on growing the value of client assets through this transition while we watch for the developing trends that portend a shift in the cycle.
From everyone at GeoVest, we wish you and your families’ health and good fortune through these difficult times. Thank you and it’s our continued privilege to serve you.
Philip M. Byrne, CFA
Chief Investment Officer