Peering Beyond the Crisis
We at Alvarium are deeply concerned about the pandemic and of course the impact it is having around the world, on humanity, on our employees and our clients. First and foremost, we want you to know that we are operating safely, interacting and thinking about your investments daily and using our global network and deep access to some of the best minds in finance to guide us through this crisis.
As a business, moreover, we have a strong balance sheet, the deep financial backing of our large family partners and the staying power and resilience to stay the course as a business, no matter how bad the crisis becomes.
As stewards of family capital, however, we also recognise the need to peer beyond the devastating headlines and turbulent markets, the ‘here and now of the gloomy’, and think ahead. How might this crisis affect the global investment and economic landscape and what investment opportunities might accrue to long-term, patient capital.
We should begin by saying that bear markets and recessions are not new. Looking back over the last roughly100 years since 1926 (using the S&P 500 index as a measure), we have had 14 bear markets, coinciding with a recession. The severity and causes differ but what we do know is that once the crisis is ‘seeming to wane’, even when the economic news is poor and fear still palpable, markets will begin to discount a recovery and move higher. However, which markets and asset classes assume leadership and which investments do best depends on a host of factors: the severity of the declines, beliefs that emerge during the crisis, the shape and nature of the recovery, the policy response and often significant changes in technology or innovation that fundamentally alter consumer and/or corporate behavior. Patient long-term capital that can identify these opportunities and take advantage of value, growth and pricing anomalies through these periods will be rewarded with superior returns.
This pandemic has brought a series of interlocking crises wrapped into one event, with attendant negative global economic implications: a health crisis whose only solution has been an almost complete cessation of economic activity, an economic crisis as both demand and supply shocks have wreaked havoc on global economies, a liquidity crisis as large part of the economy face draining levels of cash and/or access to liquidity and a solvency and credit crisis as severely leveraged companies and market players have been driven into varying forms of technical default, forced liquidations and/or debt forbearance. Lower tier credit markets are seeing price declines as much as equities. For some issuers, these are forced redemptions in the face of low liquidity; for others, these declines are likely to reflect a permanent diminution of value.
Hence, in the midst of Covid-19, we want to begin sharing with you some of our current thinking. This as you can imagine is an evolving process and dialogue. Living through a phenomenon which no-one has ever experienced before and whose duration and second-order effects are still unknown remains a challenge for all investors.
However, one of the fundamental advantages of our global network and research capability is multiple lenses through which to view this complex landscape. As we debate and hone our views of the future, we want to share with you our evolving thoughts.
This piece is divided into:
- Near-term, where do we see opportunities to gently rebalance client portfolios where appropriate for their investment objectives?
- Medium-term, how might the policy response alter the future investment landscape?
- Longer-term, what are some of the emerging bigger, investible themes?
- Diversification, why is research at the core of what we do?
Rebalancing: As we know, in bear markets safe-haven assets such as bonds do better than riskier assets such as equities. This has been true in 2020 as global stock markets have declined in excess of 20%, the definition of a bear market, while government bonds as measured by US 10-year Treasuries are up for the year. Hence, the first question we ask ourselves is if and when to rebalance clients strategies; in other words, should and when do we reduce the outperforming asset class, bonds, and re-invest in underperforming equities to bring clients back to their target weight.
We have been debating this since the crisis began. Up until now, we felt that given the global spread of the pandemic and the multitude of known unknowns, that the crisis, economic declines and hence stock market reverberations, would likely get worse. Hence, we have waited. And, while we have no way of knowing how or when this crisis will end, we now think we may be getting closer to a final capitulation process.
Equity markets may move lower from here; indeed, we suspect that they will retest the lows of this year (that is common in bear markets). We also believe that policy makers will need to do more to stabilise economies, particularly as the crisis spreads across the US and other parts of the emerging world. However, the Covid-19 pandemic will end at some point. Some combination of more wide-spread testing, social distancing to help to flatten the curve, reduction in the ‘R naught’ rate of infection, herd immunity or a vaccine are all possible palliatives ahead. Moreover, the amount of fiscal and monetary support already announced (or likely to come in the days and weeks ahead) should help economies to recover, at some point. Our best guess is more of a slower U-shaped recovery in the latter half of 2020. Recession downsides are always quicker than recoveries as wealth destruction, consumer fear and businesses take time to adjust and regain in confidence, and we think this will be the case here.
However, history shows us that missing recoveries, the best days of any market return, materially reduces an investor’s long-term expected return. Hence, since no-one is able to precisely time the point of maximum investor fear and pain, it usually makes sense to slowly add to equities where suitable, once the bear market is confirmed and policy help is on the way, over a multi-timed period. Hence, we are looking to cautiously and methodically add to shares over the coming weeks and months.
Given the ferocity of the decline in economic activity, we believe it is prudent to allocate to active managers that invest in high-quality companies. Global shares with strong balance sheets, controlled debt and good cash generation, exposed to long-term secular growth trends with strong business franchises, are best able to endure a period of revenue disruption.
We are also using our research and network to refresh our buy list of coveted managers in other asset classes so that we are poised to recommend investment when the time is right. As we review alternatives and in particular private equity, venture capital, real estate and hedge funds, we believe investors need to be highly discriminate, but also opportunities are likely to emerge. As such:
- We favour private equity and venture capital managers who are focused on software, media and other niche spaces as opposed to traditional buyout (see latter sections for emerging themes) with cash balances to deploy to take advantage of likely downward valuation adjustments. The quality of private equity operational value-add will be key to long-term returns.
- In real estate, we seek managers with quality properties and strong tenant profiles, with limited leverage, who can weather the expected downturn and are not exposed to the hardest hit sectors and markets. Some areas with strong fundamentals will benefit from the crisis: digital infrastructure and e-commerce fulfillment. Senior debt with high loan to value ratios in good properties may also offer value opportunities, with good downside protection, purely as certain investors are forced to deleverage.
- We are evaluating a range of absolute return/hedge fund strategies with managers with proven track records of navigating through period of heightened volatility, uncorrelated strategies as well as managers skilled in distressed investments as the opportunity set may rise meaningfully this year. We have seen several top managers that we have been tracking for a while reopening capacity
Given the scale of the crisis, the unintended and second order effects, the global nature, and the speed of economic perturbations, policy makers have had to respond in kind. We would not be at all surprised, when this crisis ends to see a monetary response in the magnitude of $10 trillion of liquidity injections (Central Banks have already responded with $6 trillion of easing). Fiscal policy has also met the challenge, as recession-induced unemployment relief, income support and no-interest business loans attempt to stem the rising tide of displaced workers and no-revenue companies. Major infrastructure spending is likely on the way. Some estimates expect fiscal packages globally (G4 plus China) could reach 10-15% of GDP. It is currently about 7% as we write today and peaked at 6.5% during the global financial crisis.
This unprecedented and unorthodox response, so desperately needed to arrest economies in free fall, will have significant medium-term implications. Near-term, debt to GDP levels will rise for developed nations to levels never experienced in peace time in the past. These debt levels need to be financed. Given the devastating impact of the virus on economic activity, we believe that Central Banks will continue to buy bonds and thus keep interest rates low to support government finances and prevent debt deflation.
However, longer-term, ongoing financing needs could well spark a pick-up in inflation. Inflation and thus interest rates could rise for several reasons:
- Governments financing needs are so large they crowd out corporate players who need to offer higher rates to entice buyers of corporate debt;
- The crisis itself sparks a retreat from global supply chains to domestic sources leading to higher cost labour or production inefficiencies that usher higher price levels in the future;
- Large scale bankruptcies remove capacity in certain industries, limiting supply and thus putting upward pressure on prices.
Anyone of these factors, or in combination, could be inflationary over time.
Hence, we believe that the best way to protect client portfolios might include:
- Replacing nominal Government debt with inflation-linked bonds as part of the more liquid and safe-haven allocation within client portfolios. These bonds are indexed to inflation and thus better able to protect client capital if rates/inflation rise from here.
- Maintaining appropriate weighting in equities as companies that can raise prices or generate a lot of cash flows tend to outperform in an inflationary environment; inflation often favours value or growth strategies.
- An allocation to gold, which serves as an uncorrelated inflation hedge and a store of value in a world of extreme monetary debasement.
- Allocating to, or reviewing a client’s existing exposure to, real estate, as it is one of the few asset classes with tangible value in an inflationary environment and a significant positive income advantage to bonds.
Alvarium’s long-standing and proven track record in identifying both direct opportunities and managers in each of these areas will be a distinct advantage for our clients.
The pandemic may well give rise to a range of interesting and powerful longer-term trends. We are currently researching what might be multi-decade investment themes.
Theme 1: Digital Working and Social Interaction
Working from home has set off an explosion in demand for Zoom and Microsoft Teams. We think we are in the early stages of a transformational trend where digital working and online leisure are likely to grow exponentially in functionality and importance. The ability to collaborate remotely in work and play will be positive for:
- Digital infrastructure funds, which satisfy insatiable demands for connectivity, bandwidth and the emerging move to 5G in a ‘no-off-peak’ world;
- Innovation companies or direct venture opportunities focused on emerging trends in enterprise collaboration software, privacy and cyber protection for a world where worker productivity extends seamlessly from office to home;
- Real estate offerings which cater to a mixed-use work/living/social environment or where workers more ideally combine work with remote or more distance living;
- Education software business and training models which cater for on-line learning for professionals and students; and
- Information technology businesses, favoring on-line entertainment over games and movies, powered by improvements in virtual reality, augmented reality, hologram technology and collaboration tools. (Note, it may also mean fewer flights and hotel stays in business).
- Other business likely to benefit from growth in online: host of new e-tailers and e-delivery services.
Theme 2: Health Care Infrastructure and Remote Diagnostics
Covid-19 has elevated awareness of the shocking lack of investment in health care infrastructure across the developed and developing world. Governments will have no choice but to move funds earmarked for defense or other areas to revitalise large parts of the world’s creaking health care infrastructure. Many will be left emotionally scarred from this crisis. There could be a range of powerful investment themes:
- Direct investment opportunities in mental health and e-wellness applications;
- Health care focused or specialist infrastructure funds;
- Med technology focused on critical care needs;
- On-line health care and telemedicine as video and digital diagnostics improve;
- Artificial Intelligence (AI) developments to yield faster analysis of large quantities of health care data; and
- Health care companies and labs working on virus prevention vaccines and testing equipment.
Theme 3: A Cleaner World
Before Covid-19, climate change was considered the world’s greatest humanitarian challenge, where globally rising temperatures threatened a decline in GDP per capita by the end of the century. The ‘shelter in place’ order has had a vastly dramatic impact on reducing emissions and creating noticeably cleaner air. Upcoming fiscal packages could well target infrastructure spending focused climate improvements and help get soaring unemployed back to work. A range of investments might become more attractive:
- Continued investment in renewables, and advances in energy efficient applications;
- Improved insulation for buildings as well as green designs;
- Smart grid and more investment in electric vehicle charging stations; and
- Expansion of public transport to more energy efficient formats.
Theme 4: Domestic Champions
As China turns to both Huawei and ZTE to build out the lion-share of its next-generation 5G mobile network, we think more and more countries will be thinking the same: finding ways to support domestic suppliers to satisfy critical telecommunications build. We expect to see further support for national champions.
- Interesting implications for private equity players specialising in this area;
- Positive implications for VC firms focused on advancements in data analytics, telecommunications software and chip design;
- Supply chain software companies to improve just in time logistics of domestic players.
These are just some of the emerging themes and potential areas of opportunity. As part of our model, we are evaluating a range of investment expressions from specialist funds to direct strategic investments.
But most importantly the Covid-19 crisis reminds us of the importance of diversification. Over the last 10 years, leading up to 2019, investors were rewarded by seemingly ‘risk-less’ concentration. Stocks and developed market bonds were by far the only thing investors needed to own to enjoy not only strong returns, but at low risk. Volatility was at historical lows; and with interest rates similarly suppressed, investors enjoyed a relatively ‘low risk leverage’ environment. 2020 may we be viewed as this bull market’s Minsky Moment: referring to the inevitable end of aggressive speculation and increased credit risk on any sudden decline in market sentiment; in this case, it was the pandemic. Leverage, algorithmic trading and forced redemptions exacerbated its downward effects.
The pandemic reminds us with a vengeance that diversification across asset classes, sectors, style and vintages is the best way to preserve wealth over the long term. At Alvarium, we are strong believers in this multi-asset class approach—not only for the assets we are responsible for, but for ensuring we consider and understand our clients’ overall position, to provide the best and most suitable advice. Moreover, we believe that our global network and research capability will help us to identify the right trends in what is likely to be a vastly different investment landscape of tomorrow.