Facing turbulent markets and concern for the health of our clients, colleagues, families, and friends, we’d like to provide you with an update on how we’re managing our asset allocation portfolios through the current environment.
A summary of our key perspectives
- We believe the novel coronavirus (COVID-19) need not materially change the fair value of equity markets, although this belief assumes that governments will take appropriate steps to help economies and companies make it through the current period.
- We continue to follow our long-term, patient, valuation-sensitive process.
- Equities are meaningfully more attractive than they were at the start of the year, given the large fall in their price.
- We stand ready to act as liquidity providers to capitalize on market overreactions and dislocations.
- The opportunity set for dynamic asset allocation today remains one of the best we’ve ever encountered due to the dispersion in valuations globally. The coronavirus does not change that.
Assessing fair value (which has been remarkably stable historically)
We use a long-term, valuation-based perspective to consistently rotate our asset allocation portfolios into what we believe are the most attractively priced areas. As with any valuation exercise, the assessment of long-term, fundamental fair value is critical in determining current attractiveness. While there’s likely to be a severe short-term economic toll resulting from the coronavirus (whether it’s officially a recession will depend on the length of the economic shutdown, which is unclear at the moment), we don’t believe it will have an enduring impact on the fair value of global equity capital.
The fair value of equity markets has been remarkably stable historically. The only events in our experience to truly impair it have been major wars; the Great Depression; and, for global banks, the 2008–2009 Global Financial Crisis (GFC). Most recessions—even deep ones—have not left a lasting mark on the economy or the financial markets, nor have previous global pandemics.
Case study: Spanish flu pandemic of 1918–1919
The most severe pandemic that may be in any way comparable with what would be a very bad scenario for the coronavirus was the Spanish flu pandemic of 1918–1919. Given that it occurred more or less simultaneously to the end of World War I and was followed by a serious depression in 1920–1921, it would be difficult to determine exactly what fair value loss was driven by the pandemic, the war, or the depression. But, at some level, it doesn’t matter which we blame, as the loss of “clairvoyant” fair value for the S&P 500 Index from the peak to the trough was 1% from 1911 to 1918, as seen in Exhibit 1.
This is admittedly an understatement of the impact of the combined war and pandemic, as the trend growth of fair value from 1911–1918 in real terms would have been 8%—making for an aggregate loss of fair value versus expectation of a little over 9%.1 Attributing all of this to the pandemic seems unfair, however, as it implicitly assumes that World War I and the 1921 depression had no impact. For what it’s worth, the U.S. stock market seemed to think the war was a bigger deal than the pandemic: The S&P 500 Index fell 46% in real terms from the end of 1915 to the end of 1917 (when World War I was certainly an issue while the Spanish flu had yet to emerge) against 5% from the end of 1917 to the end of 1919 (the period of the Spanish Flu pandemic).
Simply put, it appears to take an awful lot to change the underlying fair value of the market by more than a few percent. An acute event causing all companies to forgo dividends for a year would reduce fair value by the amount of the expected forgone dividends (roughly 2% to 4% at current valuations). Practically, an event seems to have to either change the path of future return on capital for the world or cause a significant dilution event for shareholders.
Widespread bankruptcies are a simple way to cause that dilution and the primary way a depression reduces fair value. Historically, we haven’t found any events that look to have had a long-term impact on return on capital globally.2 However, we’ve seen an event that caused both dilution and a return on capital fall within a major sector, and it seems instructive to look into that case to see if there are any potential parallels.
Case study: Banks and the GFC
The 2008–2009 GFC constituted a large loss of fair value for the banking sector. First, banks were forced to issue significant numbers of additional shares to recapitalize themselves, and they had to do so at depressed valuations. But even beyond the dilution during the crisis period, increased capital requirements and suppressed net interest margins associated with ultra-low interest rates have impaired their return on capital. We can see the aggregate impact on their returns in Exhibit 2.
Exhibit 2 looks at total returns instead of clairvoyant fair value because not enough time has elapsed since the GFC to be able to calculate clairvoyant fair value. But the combination of substantial dilution and the unique damage to bank business models stemming from regulatory change and monetary policy do give us a template of how fair value can be destroyed. In terms of dilution, global banks had 16% net issuance from 2007–2011 versus net buybacks of 2% for the overall market in the same period. Exhibit 3 shows return on economic book value for the MSCI World Index and banks before and after the GFC.
The dotted lines represent the return on economic book average for the MSCI World Index and MSCI World Banks Index.
For the MSCI World Index, return on capital has been unaffected in the aftermath of the GFC: Return on economic book averaged 9.7% from 2000–2007 and rose to 9.8% from 2011–2019.3 For the MSCI World Banks Index, however, return on economic book over those same two periods fell from an average 12.7% to 7.9%. The pre-2008 figure for the banks probably owes a fair bit to the excessive leverage we saw in the sector leading up to the GFC. But even if we assume that the true profitability of the banking sector was equivalent to that of the MSCI World Index in the years leading up to the GFC, banks’ profitability deteriorated in the period after the GFC by about 20%.
Coordinated fiscal stimulus could turn things around
As we think about the economic effects of the coronavirus, it seems unlikely that the world could see something approaching the kind of dilution we saw from the banks in the GFC. It’s even harder to see what kind of long-term effects might be the equivalent of banks’ return-on-capital challenges since the GFC.
With that said, it seems highly likely that efforts to contain the virus will have a severe economic impact. The acute impact in terms of loss of economic activity may be larger than in a standard recession, although we can hope it might not be for as long as a normal recession. The saving grace is that since this is a truly exogenous shock, there’s likely little harm in governments stepping in with massive fiscal stimulus to ensure that people can afford food, shelter, and medical care and that business bankruptcies can be held to a minimum.4
We believe the moral hazard problem associated with saving companies in a downturn simply does not apply and the calculus on deficit spending should also be suspended in almost all cases. Right now, the focus in our view should be on getting to the other side of this event with as little permanent harm to the population and the economy as can be managed. If that requires trade-offs in future policy flexibility, so be it. Once we get through this period, long-term expected returns on capital seem unlikely to change in a meaningful way. Therefore, it’s hard for us to imagine why this should be a material long-term negative for future growth.
We’ve believed for a number of years that a plausibly effective way to cure the world of its addiction to low interest rates would be a meaningful, globally synchronized fiscal stimulus. Suddenly, that looks like a much more likely scenario than it previously seemed, although it’s far too soon to see what effect the stimulus might have across the economy.
It may well be that in the short run the financial markets will continue to decline meaningfully before they go up. But without having better information than other investors on the likely path of the coronavirus, it’s hard for us to want to reduce the forecasted return on our portfolios or to speculate on what reactions investors will have to uncertain news flow.
Sticking to our time-tested process
For that reason, we’re holding firm in portfolios and continuing to follow our investment process. That process has not led to any drastic changes in overall portfolio positioning. We have, though, begun buying equities in multi-asset portfolios as our process dictates.
Our highest-conviction asset classes currently are emerging market value stocks and liquid alternative strategies. In neither case do we believe the coronavirus should have a material impact on medium-term expected returns.5 While U.S. equities are certainly cheaper than they were a couple of months ago, we don’t believe they’re at fair value yet (as of March 16). Of course, market conditions have the potential to change rapidly. We’re constantly evaluating the markets and stand ready to act as a liquidity provider and take advantage of opportunities if handsomely rewarded. Likewise, we’re prepared to manage risks as necessary.
The opportunity set for dynamic asset allocation today is one of the best we’ve ever encountered due to the dispersion in valuations globally. The coronavirus doesn’t change that. We believe the portfolio has been well compensated for the risks we’ve taken in several areas. And, we’ve positioned the portfolios in assets that we believe are priced to deliver potentially strong returns going forward.
Our approach relies on our 32 years of experience assessing valuations and market conditions and our willingness to bear risk when we believe the portfolio will be adequately compensated for doing so.
Ben Inker is head of GMO’s Asset Allocation team.
- There’s some cheating in this calculation, as I’m using the whole-period average growth of fair value as my expectation, and in 1911 we wouldn’t have known that. There’s no effective way to avoid look-ahead bias with a technique that necessarily involves knowing the future, however, so that can’t reasonably be avoided. But given that payout ratios were higher in the earlier part of the 20th century and growth rates were lower, the 9% estimate is a generous estimate of the loss of fair value relative to “expectation,” and if I had a way to fairly adjust the estimate, I’d cut it by a couple of points to 6% or 7%.
- On the face of it, periods of high inflation do seem to coincide with low return on capital in the developed world. However, if you adjust for the effects of inflation on interest costs and depreciation, the effect seems to be minor.
- Return on economic book is a proprietary measure built by GMO’s Global Equity team that adjusts book value and earnings for intellectual property, the effects of buybacks, and other distortions that we believe affect accounting figures.
- The ordinary harm in bailing out companies (and to an extent, individuals) in a downturn is that it incentivizes irresponsible behavior. In this case, that’s not really an issue. Almost no restaurant will survive a period of six months in which dining out is banned—at least, if they still have to pay rent and wages. Stepping in to save the business is in both the short-term and long-term interest of society.
- Liquid alternatives have been less affected by recent market events than equities have been. The activities remain attractive, and we’ve seen indicators, like merger spreads, widen out in recent weeks. But as prices drop through fair value for equities, equities’ longer durations will likely start to be a material argument in their favor.
Originally Posted on March 23, 2020 – GMO Update: Managing Our Asset Allocation through COVID-19 Turbulence
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