We often hear from policymakers the desire to get to the “other side” of the COVID-19 crisis, but what exactly does that look like? Will we spring back to the pre-coronavirus goldilocks economy, or will it be a hard slog to recovery?
The answer depends mainly on which country you live in, the effectiveness of the health response and how much the government and central bank is willing to stump up, according to Hamish Douglass, Chief Investment Officer of Magellan.
At an investor webinar yesterday, Hamish framed his response by outlining three fundamental issues.
Caption: Hamish Douglass, Chairman, CIO and Lead Portfolio Manager at Magellan
Issue 1 - Duration of the economic shutdowns
As a first off, he observed that most governments are moving to shut down their economies and thus would face an output gap, the duration of which hinges on the health response chosen:
- The ‘hard suppression’ strategy – Where the government locks down the economy and closes its borders for 6 to 8 weeks. This is likely the “most effective” way to minimise the overall hit to gross domestic product. Following this, the economy can be reopened provided there is strong infrastructure for testing, contact tracing and monitoring of any new cases. This is what China has done.
- The ‘controlled-mitigation' strategy – Where strict social distancing is implemented so that parts of the economy can remain open for as long as possible but at the cost of lengthening the output gap to between 8 weeks and 6 months, depending on the effectiveness of various health responses.
Most countries outside China are operating between these two playbooks, and it’s possible that if an effective drug is found and scaled globally, quickly, then the output gap could reduce further.
Issue 2 - Policy responses to mitigate the economic damage
The second issue is policy responses being undertaken to limit the economic fallout and here he sees four possibilities:
- V-shaped recovery – Where the government and central bank would effectively subsume the cost of compensating businesses for 100% of lost revenue so they can continue to pay their workers, rents and mortgages. This would limit a rise in unemployment despite a GDP hit, and activity would restart when lockdowns are lifted. Hamish says only Singapore and Denmark appear to be favouring something like this.
- U-shaped recovery – As above except not 100%, so society would share some of the pain with government. Germany so far favours this model.
- Deep and prolonged recession – The government adopts a limited-compensation approach and pays workers 70-100% of salaries capped at the median wage. As a result, personal balance sheets are preserved but businesses, landlords, utilities and banks are left to shoulder the burden, which may cause some pain when they come out the other side.
“Even if many businesses survive, they will emerge with additional debt or balance sheets that are materially impacted. This would impact their ability to invest and employ staff as many would need to cut costs to survive even when the economy restarts. This strategy would head off the most dire economic outcome but is unlikely to head off a deep and prolonged recession with materially elevated unemployment.”
Hamish says this is the path most western governments are taking. But the next scenario is scarier.
4. Downright depression – The government provides little to no stimulus, resulting in a whopping 17-50% collapse in annual GDP depending on the duration of the output gap. Most businesses go bust, property prices crash and banks face severe losses.
“This is the depression scenario. Fortunately, almost no developed world country is following this strategy. We fear many emerging markets will not have effective mitigation strategies and are not able to step in to fill a meaningful part of their output gaps.”
Unfortunately, this looks like the likely road for some countries in Africa, Latin and South America, Southeast Asia and also India.
Meanwhile, for most major economies, scenarios 2 and 3 are the most probable outcomes, but Hamish notes that governments and central banks are continuing to calibrate their responses, adding that he’s been impressed with the “scale and speed” of how central banks, in particular, have responded to the crisis so far.
Issue 3 - Fundamental and permanent changes in consumer behaviour
The third key issue in this mix is when the recovery comes, will consumers simply spend like they did before the crisis? This is critical to the nature of the recovery and who will benefit or lose on the other side.
Hamish says significant events like wars have lasting effects on consumer behaviour including their propensity to save and desire to spend big on big-ticket items.
“There are areas where it’s likely this is going to have a very lasting impact on consumer behaviour. The cruise line industry would be an obvious example. It’s possible that the travel industry will undergo fundamental and lasting demand changes as retirees will probably not want to travel overseas for an extended period of time. Businesses may determine that much business travel is inefficient and discretionary, and meetings can be undertaken via video conferences.”
The quantum of these changes will depend on the duration of the output gap, responses by policymakers and the shape of the recovery.
For now, Hamish says the situation remains fluid and it’s difficult to see how the next 12 months will play out given the health crisis and financial responses are evolving on a daily basis.
How Magellan is positioned
At the event, Hamish reiterated the defensive positioning of Magellan’s global strategy, summarised as follows.
- Cash at approximately 15% (held in US dollars).
- Meaningful investments in businesses that are likely to prove resilient in this environment such as the three US utilities (Eversource Energy, Xcel Energy and WEC Energy), the US-based telecom-infrastructure company Crown Castle International, three consumer staples (Nestlé, RB and PepsiCo) and the Swiss-based pharmaceutical company Novartis International.
- Most major technology investments are likely to be resilient in this environment (including Microsoft, SAP of Germany, and China’s Alibaba and Tencent).
- Technology investments with more cyclical exposure (Alphabet, Apple and Facebook) are very well positioned to weather any downturn due to their financial strength and are likely to participate strongly in any recovery. Visa and Mastercard are similarly positioned.
- Luxury holdings (LVMH of France and Estée Lauder of the US) own some of the world’s strongest brands, have solid balance sheets and benefit from sourcing about one third of sales from Chinese consumers. China is one of the best-placed economies to recover from this situation, which will also benefit Alibaba and Tencent.
- Magellan’s three restaurant companies (McDonald's, Starbucks and Yum! Brands) face a challenging demand situation over the next two to six months as the world shuts down. Post this slump in demand, however, these businesses should recover strongly and prove defensive in the face of an economic downturn. Each of them has a strong drive-through business that is likely to remain open.
Magellan is carefully monitoring these investments closely given the unusual nature of this situation, which will severely impact their businesses over the next two to six months.
Hamish points out that the portfolio holds few or no investments across industries that are the most vulnerable to this crisis including banks, energy companies, airlines, travel-related companies or property trusts, and has no direct exposure to emerging markets other than China.
Never miss an update
Stay up to date with my content by hitting the 'follow' button below and you'll be notified every time I post a wire. Not already a Livewire member? Sign up today to get free access to investment ideas and strategies from Australia's leading investors.
You will either be the hero outperformer or miss the biggest bounce in emerging markets and beaten down stocks. I suppose you have to be cautious with that much money on the line.
With all due respect to Hamish Douglass, he was blindly bulled up on 'disruptive technologies' and other fragile trends in the lead up to the 2020 crash and was caught napping as much or even more than the average fundie. Now he's assuring investors that developed markets (his fund) over emerging markets (competitor fund) have stronger recovery prospects. I'm not sure why his analysis is being held up at a time when surely his 'fallen angel' story is more fitting. I realise that it is akin to blasphemy around these parts to criticise the good ship Magellan, probably because so many folks got aboard.
Hamish, Sound and logic thinking, the options available to Governments and major world Bankers as you pointed gives a clear path for recovery (i.e. best or worst). To democracy governments as to the correct and best recovery path, maybe the best choice would probably tip a government out of a majority control. Thank you for your educated comments. R.S.
John, Magellan don't post official 1-month performance figures, so these are my own calculations and should therefore be taken with a grain of salt. Looking at their NAV of their Magellan Global Fund (unlisted and unhedged), it fell by 3.43% in February and 3.95% in March. For a long-only equities manager who can't hold more than 15% cash, I reckon that's a pretty good effort in this environment.
I really admire Hamish's ability to admit when he's misread a situation and change course quickly. It's one of the tougher balancing acts for an investor, maintaining conviction in your ideas and work but also being humble enough to realise either you were wrong or the facts have changed.
LVMH not likely to do well in a depression
John Derry - I don't disagree with the thrust of what you're saying. When you consider that in early March, a number of investment banks were upgrading stocks, it's difficult to not become jaded. If I go back to Nov. 2007 when they were the cheerleaders, they seemed oblivious to what was on the horizon, let alone the consequences of what had happened - HSBC's problems in the US, the collapse of IndyMac, the securitisation markets ceasing, debt margins blowing out.....and then 15th Sept 2008 hit. Patrick - with no disrespect, I think you proved John's point in his comments. We're sure Magellan can look after itself.