What does all this mean for our strategies?
First, markets have already reacted – a lot. To put things in perspective, the VIX (implied volatility indicator) has spiked to levels associated with the global financial crisis (GFC). Global interest rates have dropped even further and synchronised to the lowest levels in history, particularly now even in the US. Implied default rates have spiked, and rapid negative revisions to GDP imply that, at a minimum, we have entered a short-term recession.
Equities have fallen by circa 20% year-to-date and by substantially more since recent peaks in February – all in a just a few weeks. Many cyclically exposed equities have already fallen by twice as much. Firms with leverage or negative cash flow have, predictably, performed the worst. By any reasonable measure, the market has quickly become somewhat ‘cheap’, certainly compared to bonds, but also on long-term P/Es, expected growth rates, etc.
The ability of governments to get the infection rates under control and turn them over, as accomplished in Asia, will be a key metric to watch. It is difficult to envision that markets can really stabilise until there is some evidence of such an event.
We are confident that governments will underwrite much of the disruptive financial impacts for individuals and companies, such that we will see limited insolvencies or defaults. Already measures have been announced by the Bank of England and central banks, implying policymakers understand they must stop contagion in populations from becoming contagion in financial markets. This will require more coordination amongst legislators underwriting rescue and stimulus measures. It is worth noting that governments know that the crisis becomes exponentially more expensive to underwrite (in terms of disruptive economic effects and real financial costs) if it continues to grow. This provides a strong incentive for a “whatever it takes” strategy, much like the GFC.
From an investment perspective, we believe this is one of those periods where the priority is to not over-react. Our portfolios are significantly overweight asset-backed businesses in clean electricity and waste. The events unfolding are unlikely to have a material impact on utilities’ underlying businesses, either in a short-term or structural way. We could argue that, as long duration assets, there should even be some upside pressure on valuations, perhaps offset by market risk premia impacts.
As regards the impacts of lower oil prices, we would note two things. First, oil is an almost non-existent part of the global electricity supply mix, save for within the Gulf States/Africa and a few island nations. The only bearing oil has is via pricing for LNG, which is derived by a mixture of long-term contracts and oil-linked price formulas. As such we do see some downward pressure on imported natural gas prices ahead (on those formulas) which, paradoxically, may create some headroom for additional renewable development, as a complementary resource. The second point is that US natural gas prices are extremely depressed, in large part due to the growth in shale oil production and ‘associated’ gas. If we believe US oil production will need to reverse in volume, it is likely that associated gas production will also fall, perhaps rapidly. This could put some upside pressure on gas prices in the intermediate term, which generally would be supportive of slightly higher power prices, particularly in the US. For now, the demand shock of lower energy needs would counter any of those impacts. We don’t believe that a sharp decline in electricity demand in the West is likely through this crisis, but we will see some impact.
As for the remainder of our portfolios, some of which have exposure to various forms of industrial verticals, we see varying degrees of the same impact. This is an exogenous and transitory shock and, as such, is not the kind of event that we seek to exploit or use to reposition strategy. Factors associated with the energy transition and sustainability may be slightly disrupted in the short-term, but we can’t see many risks emerging derailing any of our core investment themes or overall positioning over the medium term.
We continually examine the portfolios for robustness, in terms of how well the portfolio investments can weather events like these, and if we see anything that presents as a real structural change, we can act accordingly. We are looking for opportunities to either increase weightings in existing holdings or establish new positions in great companies if relative valuations and performance accommodate. And, while we may not be at the end of this large market correction, we are certainly now some way from its beginning, and stocks in our portfolios are demonstrably cheaper and thus more, not less attractive.