We wanted to share a story we heard to better explain what is currently going on in the world. It’s a entitled ‘The Tale of Two Sinks’. It revolved around a well-known bond manager who has a large kitchen in his home, and who is fortunate enough to have two sinks. Although living there for the past decade, he favoured the sink across from the stove and in fact it was the only sink he used to wash his hands. Last month, a leak began from the tap at his favorite sink. While he was fortunate enough to get it to a slow drip, he had to wait a week for the plumbers to arrive. In the meantime, he began using his other sink to wash his hands. What he noticed was that this sink, which he never used before, had better views of the garden and a better sightline to his TV. The plumbers arrived the next week and fixed his sink. However, the realization came to him that he liked his newfound sink and has kept using it, not going back to his ‘old sink’.
With the lockdowns, quarantines and social distancing much of the world is following to combat the COVID-19 Pandemic, the world that we knew at the beginning of this year has now changed. In some cases, for the worse, and in many cases for the better. However, what we need to realize and accept is that we are not going back. Many companies are going to find that while office space is still needed, it may be less so. Working remotely can allow many to reduce or eliminate commuting times by a multitude of hours over a month. This increases the amount of time that can be dedicated to work if one wishes or to other personal pursuits such as family or fitness. Many meetings that always were done face-to-face may now take place through video conferencing. While there have been hiccups with internet bandwidth due to high demands, many who have never experienced this technology are enjoying its benefits.
From an investment viewpoint, the uncertainty faced by individuals and financial markets in these times are uncharted and unprecedented. While we can debate over the best way to have handled the virus, (border lockdowns sooner, more testing, public mask wearing, protection of high risk individuals such as the elderly vs. lockdowns) we need to deal with the current economic and market conditions. What we have seen is that this crisis is being met with equally unprecedented monetary and fiscal stimulus around the world. Central banks have lowered interest rates to close to zero, while fiscal stimulus by governments in the trillions of dollars is being pumped into economies. Thus far, this combination appears to have stabilized equity and credit markets.
Over the past decade, we have experienced a bull market in risk assets such as US stocks, fixed income and Canadian residential real estate. Valuations, while maybe not in ‘bubble’ territory, were excessive in many cases as they left no margin for error. These valuations were due to a combination of factors which include the secular decline in interest rates, stock buybacks which were financed by debt, and easy borrowing conditions. In general, many asset classes needed a correction. It was the pandemic combined with the lockdowns that was the pin that popped the balloon. The result was unprecedented daily declines in both credit and equities which was brought on by massive margin selling and panic which exceeded levels seen in 1929.
What is becoming clear is that although markets have declined and rebounded to some degree, the broader economic impact is only beginning to be realized and felt. Mainstreet - small family owned businesses and those employed by them, especially those which focus on service industries, will be hardest hit. Depending on which numbers one looks at, up to 80% of the North American economy is service based. In many cases, these workers live pay-cheque to pay-cheque, spending what they earn each month, with typically less than a month's savings for emergencies such as we are experiencing now.
With the curve flattening and countries and/or states beginning to re-open on a case-by-case basis, we are carefully examining how various regions react. Globally, massive stimulation programs have been enacted rapidly and the proceeds are beginning to be distributed through economies. We are hopeful that this stimulus will offset the huge jump in unemployment numbers and the economic contraction in North America and Europe. In North America, the decline in the first quarter will be matched by an even greater decline in the second quarter of as much as 14%.
In Canada, things have been made worse by the oil price war between Saudi Arabia and the Soviets. With the virus slowing economies and the need for oil, the oil supply surplus will explode. This played out recently with oil prices for delivery trading for a short time at MINUS $38 USD/barrel as volumes surpassed storage! Unfortunately, this will put additional pressures on Alberta and Saskatchewan, already reeling from misguided federal government policies, will suffer additional economic decline.
With the distressed selling behind us due to exhaustion selling and government intervention, credit and equity markets are seeing good quality companies recover from their recent lows. In the U.S. and Canada, the passing of measures that provide significant fiscal stimulus are a major positive to the economies in the short to medium term. The risks will then shift to when and how to remove this additional stimulus. Who and how will we (re)pay these massive increases to our debt? It is likely that governments try to monetize these away as they did in the 1970s.
For those who were around in the 1970s, although it appeared the nominal return on stocks was positive, the real (after inflation) returns were negative for more than a decade. In this type of environment, the modest addition of a store of value such as gold and digital gold (bitcoin) may provide some hedge against the debasement of fiat money by governments.
In regards to current investments that are held in our families’ portfolios, Northland has been in contact with all of the underlying alternative investment managers, and participated in numerous conference calls with banks, economic strategists and some of the world's leading investors, to better understand how they view the current situation as well as the future risks and opportunities.
While we expect economies and markets to recover over the medium to longer-term, we do believe that equity investors who were used to good returns with low volatility may have begun to understand the risks involved in not having a well-diversified portfolio which utilizes both traditional as well as alternative asset classes. While alternative investments such as private debt, private equity, and real estate do not have the same liquidity as public markets, given the multi-generational investment horizons for many families, these longer time horizon investments provide better alignment and the potential for improved return with less volatility.
Looking further into the future one must conclude that this pandemic is a world-altering event. The march to globalization may well end – fragile supply chains that depend solely on external sources will need to become more robust or, to quote Nassim Taleb, anti-fragile. There are costs associated with this, which will reduce economic efficiencies but also reduce the chances of a mission critical failure. Like the ‘Tale of Two Sinks’ we will adapt to the new normal.
Arthur C. Salzer, CFA - CEO & CIO