Comments from: David Ragan, Director, Portfolio Manager and Christian Deckart, Chief Investment Officer, Portfolio Manager.
Throughout the week, governments around the world have continued to take more significant measures to contain the spread of COVID-19 including travel restrictions; prohibiting large public gatherings (e.g., conferences, sports, and entertainment); closing schools and, in some cases, forcing the closure of businesses (e.g., Italy). These escalating restrictions, combined with the ongoing oil price conflict, has fueled considerable stock market volatility and steep declines. Given the magnitude of the market impact and the ongoing COVID-19 uncertainty, we wanted to keep you informed on Mawer’s current thinking and investment approach during these challenging times.
Humans are social. In restricting the socialization of humans to contain the virus, there is a significant economic impact. The cancellations/delays/deferrals/closures ripple through the value chain of the economy, temporarily impairing demand. In short, companies make less money. As these events have unfolded, the resulting impact to our complex economic system has been analogous to a car crash pile up. And the longer socialization is suppressed to contain the virus, the more severe the accident and the more significant the backup in traffic.
If current containment measures continue or worsen, it should be expected that companies will require greater working capital. Accounts receivables will stretch out, bad debts will increase, and inventory or key components may be unavailable. Virtual products/services will likely have an advantage over physical goods/services that are sensitive to supply chain complexity, human logistics, fixed operating costs (such as high rent costs) and those which have revenue that is more discretionary or one-off in nature. It is reasonable to conclude that this chain of events may lead to a cash crunch for many companies, especially smaller businesses or those possessing fragile business models.
This may explain why the Federal Reserve and other central banks cut their key policy rates early, anticipating the need for liquidity. Still, in observing fixed income markets in recent days, corporate spreads have widened out and some companies are reported to have drawn down on their credit lines in anticipation of required cash. The March 12th announcement that the Federal Reserve is restarting its quantitative easing program (repurchasing bonds) should support the core plumbing of the financial system.
The bad news is that nobody knows how long containment measures will be required. Monetary policy will have little impact on lifting suppressed demand. The oil market is in difficult shape, post the Saudi decision to flood the market with crude, when demand was already constrained due to COVID-19 containment efforts. Credit markets, especially high yield markets, will remain highly sensitive, anticipating restructurings in the energy sector. It is likely a second shoe may drop, such as the drying up of private equity markets or changes in the recycling profile of petrodollars. Managing liquidity will be important for many actors.
Here’s the good news. The drop-in demand is not a permanent impairment! Once the virus is under control and containment policies are lifted, humans will once again socialize. We will live, love, dance, eat, travel, inspire, learn and do all the wonderful things that make us human and drive the economy. It might take time to clean up the accident site, but traffic will eventually resume.
Despite recent “once-in-a-decade” price swings, Mawer’s portfolios are well-positioned. We’ve stuck to our long-term investment philosophy, emphasizing companies that have strong business models. In general, these companies tend to generate more recurring revenue, are less discretionary in nature, and are typically highly cash generative.
Like others, we have no crystal ball to predict the future. Containment of the virus may come quickly, and markets may rebound. Or we could be facing a longer-term issue that will leave a deeper economic impact and inflict further losses in financial markets. What we do recognize is that despite the accompanying emotions, corrections and volatility are natural parts of financial markets. It is important to remember that the mathematical function of compounding wealth remains intact for those with the patience and time horizon to invest wisely.
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