Jeroen Kakebeeke Sr. Investment Risk Manager at PGGM Informs on After the Storm
Jeroen Kakebeeke is the Senior Investment Risk Manager at PGGM Investments. In this white paper he reports on the Corona Pandemic, the Economy and the Financial Markets as of April 30, 2020. He also deep-dives into Fixed Income and Equities.
Summary
At the end of January I strongly recommended to sell equities because of the Corona outbreak. Financial markets completely overlooked consequences for the economy and companies. Because of earlier scenarios and analyses I was prepared and partly protected. In my second investment letter of March I gave a road map to rebuild the investment portfolio, you can also have a re-read of that here. On this Part 3, I share the latest insights to get almost back to Strategic Asset Allocation.
Crisis Management
The Corona pandemic is first of all a global health crisis. World leaders, often in close cooperation with government and epidemiologists, took bold action with lockdowns. Cities and companies had to close or keep their operations running with a minimum workforce and available cash. People and firms were focused on survival in the short term. The financial markets were taken by surprise and panicked. Big rotations took place in asset classes and sectors, all towards Risk Off. Many were trying to understand the situation by reflecting on history. Currently, after the shock, we start looking with ambition to the future again. We can plan and make investment decisions on qualitative arguments and facts.
Corona
It is necessary to understand the Corona pandemic better to make any forward looking statements on the economy or financial markets. Although we know the numbers of infected and dead are incomplete (underreported), they give direction. Globally, all countries are infected. The growth in Corona infections is no longer exponential. The basis of sick people becomes larger, but the percentage of new confirmed sick is coming down. Society has adapted and we can cautiously conclude the Corona outbreak is not clogging the health care system. Still, the development of confirmed sick and dead looks grim, with no apex in sight.
Around the globe governments implemented lockdowns in accordance with their countries’ culture, habitat and earlier experiences with a virus outbreak. Asia had most limitations. There, society is more valued than the individual, and Asia has the most multi-million cities, moreover with highest population density. The (relative) freedom in the West gave Corona more room to infect people making it longer to contain the virus.
The longer duration has to do with the nature of the Corona virus, and was confirmed by:
- US Centers for Disease Control on April 21st they said that the next wave in winter 2020-21 could be worse than we have experienced this spring.
- WHO Director-General Dr. Tedros cautioned on April 23rd that “we have a long way to go. This virus will be with us for a long time”.
- German Chancellor Angela Merkel has said on April 23rd her country must remain "clever and cautious" in handling the Corona crisis, as it is "not the end phase but still just the beginning. We'll have to live with this virus for a long time."
The deaths are a tragedy, the confirmed sick are a bellwether for economic damage. Looking at the four waves, the confirmed sick in China were concentrated in the city Wuhan, in the province Hubei. The Pacific does not show in the graph as a curve, it has a remarkable low number of infections, but still smoldering. South-Korea has the most successful combination of extensive testing, patient isolation, and an open economy. Europe and the USA are longer on a plateau, it takes them considerable more time to bring the number of infections down.
Emerging Markets are so diversified, literally the rest of the world. Generally, they lack test material, education, hospital beds, and relief funding. Some developing countries had already worries in food shortage, refugee camps, migrant workers without income and no way out. Some countries are even plagued by (religious) leaders who downplay the Corona threat.
My calculations for the Corona deaths have not changed since January and March:
- Minimum of 2.500 for the Netherlands and maximum of 30.000, probable in the middle; and
- Minimum of 42.500 for the USA and maximum of 500.000, probable in the middle.
What has changed though, is the expected duration of the pandemic:
Financial Markets – Equity
In four weeks’ time the stock market lost about 33% in value, and volatility quadrupled! For the time being, the market reached a bottom at March 23rd. Thereafter the market rose 20% and volatility halved. Equity markets made the following judgments on Sectors and Factors:
Source: MSCI, returns in USD ending 28 April 2020
Year-to-date sector performance is understandable, since the trend towards digitalization is accelerating. Online shopping, home cinema, or working from home benefits technology stocks, enhancing their lead. The five biggest U.S. companies by market cap – all of them technology – make up more than 20% of the S&P 500. Facebook, Amazon, Apple, Netflix, Google, and Microsoft were already dominant players. These megacaps have established almost a natural monopoly, are cash rich, not expensive, and have a scaleable business model.
Brick and mortar retail lose, together with real estate firms for shops and offices. I like sector neutral dividend strategies, without overweight to financials or energy. The jump in volatility makes option writing more rewarding. It was part of my strategy anyway, and after the crash selling covered calls gained importance. I stay away from cyclical value. In a world of secular stagnation overcapacity will be the norm, thus holding a lid on inflation and cyclical profits.
Headlines tracking the scope of the Corona pandemic have driven investor sentiment. In January I expected 40% to 45% downside for equities. Thus, after the crash in March I had bought back most of my equity exposure, and expected a last 10% downside, when the virus would take over the U.S. Obviously that did not happen, since panic or a liquidity crisis were averted by Central Banks & Governments actions. FactSet analysts see US earnings over 1Q come down with 15% and 2Q will be much worse. Financial markets look further, into recovery.
The March low will probably hold. EPS for the S&P 500 might fall to 105 and come back to 130 or 140 in 2021. Profit growth per share will be smaller because of less buy backs and secular stagnation. Equity demand is driven by a lower interest rate. Medium term, attach a historic 20 to 22 times PE ratio and the S&P target is between 2.600 and 3.100 ultimo 2021. Indeed a bold prediction with such a narrow bandwidth, but my best estimate. It is also a mediocre return expectation, with small return for the risks, but there is no alternative.
To see the full white paper with Jeroen's insights on Fixed Income, global economy, as well as conclusions and comments on Brexit, cyber security, US-China trade war, and more click here or download as a PDF below.
drs Jeroen Kakebeeke RBA is an Advisory Board member of Institutional Investor working as Investment Risk Manager for a large pension fund. The views expressed in this paper are his own. The author thanks Kiemthin Tjong Tjin Joe for his valuable ideas.To discuss the content of this article and further engage with him, comment below.
