Where Do We Go From Here?
A powerful question. Usually asked not after a triumphant moment but in a period of distress or uncertainty. Amid a health pandemic that appears to have caused the most abrupt shock to the global economy in modern history, most of us are likely asking this very question, or a similar version, right now.
A deluge of information has been thrown at us, and we are all left to sort it out as best we can. Watch too much TV, and you may become frozen with fear. Read too many articles, and you may become overly confident that a solution is right around the corner or, conversely, that the health crisis we are facing today will never end. Another likely possibility is that you become thoroughly confused at the conflicting messages being presented. Most of what we have today is conjecture, which is tilted either positively or negatively (depending on the author’s biases and views). The array of opinions and the range of possible outcomes is enormous.
Questions about our new reality abound. How long will our current way of life last? When will we get back to normal? What will normal look like when we finally get there? What permanent and lasting effects, if any, will occur in our everyday lives as a result of this pandemic and its aftermath?
As investment managers, we must think probabilistically and focus on the scenarios that we view as most likely to occur. We must also keep in mind the states of the world that are somewhat likely and making allowances for the “fat tail” possibilities, such as the one we are currently experiencing.
As individuals, we usually separate how we address optimal health and financial well-being. Experiencing this unprecedented situation with COVID-19, we agree with the professionals at McKinsey & Company that we are now “safeguarding our lives and our livelihoods.” Meaning, “we must solve for the virus and the economy. It starts with battling the virus.”
With that in mind, and to help provide additional perspective on the situation, we would like to outline different potential scenarios that may play out and what the corresponding recovery may look like. For ease of reference sake, let’s name them Base Case, Optimistic Base Case, Pessimistic Base Case, Worst Case, and Best Case.
Scenario 1 (Base Case—most likely)
The Base Case scenario is the scenario we envision as most likely to occur.
Global GDP growth contracts in the first half of the year and rebounds toward the end of 2020. Unemployment levels stay below 15%; many businesses struggle, but weather the storm and, ultimately, remain open. Corporate bankruptcies occur but not at an unprecedented rate. In short, the recovery takes on more of a U-shape.
The Federal Reserve and other central banks around the globe take drastic steps to halt the economic decline. Interest rates will be “lower for longer,” and The Fed will do whatever it takes to keep markets functioning, ensuring low borrowing costs.
As far as the virus is concerned, widespread testing becomes available and helps to more quickly identify those that are infected, helping to slow the number of new cases. The curve flattens and then bends downward. America gradually “opens for business” and operates at 75-85% capacity by Q3 of 2020 as we adjust to the “new normal,” which includes more social distancing measures, better basic hygiene levels, and a renewed focus on physical, financial and mental health.
Corporate profits decline substantially in the first half of 2020, strengthen in Q3 and recover better than expected in Q4 of 2020. During the first half of 2021, we return to 95-100% economic capacity, which approaches or possibly exceeds 2019 levels.
Scenario 2 (Optimistic Base Case—somewhat likely)
This scenario contains only minor negative surprises in the next month or so, followed by good news later in the spring. The virus is brought under control at some point in the Q2 of 2020. The number of new cases flattens and then begins to decrease. Widespread testing becomes available and accessible. The virus is contained.
The economic toll and physical pain caused by the disease will be deep, but the duration will be brief. The recovery is more U-shaped bordering on V-shaped. GDP goes negative but only for a few months. Unemployment peaks in the low double digits and recovers to high mid-single-digit range before the end of the calendar year. Corporate earnings in 2021 will exceed what they were in 2019.
Scenario 3 (Pessimistic Base Case—somewhat likely)
This case consists of countries not doing a good job controlling the virus, which leads to undue damage to the economy that otherwise could have been avoided. Social distancing must be continued throughout the summer months. Unemployment spikes to 15%-19%; many businesses must shutter their doors. The recovery takes longer than expected, and 2019 levels of GDP and corporate earnings are not achieved until at least 2022.
Scenario 4 (Worst-Case—low probability)
This case is built around the economy contracting at a record rate combined with minimal government intervention. Unemployment spikes to 20 percent or higher; many businesses close; GDP in the 2nd quarter of the year has the steepest decline in history; the profits of the 500 companies in the S&P 500 decline by more than 100 percent. That would mean that the entire S&P 500 goes from profits to losses in one quarter. Many companies that went into the crisis highly levered claim bankruptcy. On top of all of that, the healthcare system becomes overwhelmed. All of this leads to a vicious cycle of fear that suppresses spending and dries up demand.
While the above seems scary and insurmountable, we can reasonably view this worst-case scenario as unlikely. As central banks around the world confirm their pledge to use every tool at their disposal to combat this virus and limit any further damage to the economy, we view this worst-case scenario as having a low probability of occurring.
Scenario 5 (Best Case—least likely)
This case relies on widespread containment of the virus along with a strong governmental response, which leads to a rapid recovery to pre-COVID-19 levels of corporate earnings, GDP growth, and general economic momentum. Essentially, this means the virus is suppressed, then controlled, and then eliminated.
Non-governmental forms of stimulus also help the economy. That is, low oil prices, increased refinancing activity, and the higher savings rate in the U.S. act as stabilizers and help us recover more quickly than would otherwise be anticipated.
The recovery takes on a V-shape, and we are already on the right side of the V. In other words, we have already seen the worst of the health effects of the virus in most parts of the world. We have seen the worst of the effects of the virus in financial markets. The high unemployment numbers are temporary in nature, and the country is back to full employment before the end of the summer. Businesses struggle for a short period of time and are back to 2019 levels in less than a year. The Federal Reserve and other global central banks ride to the rescue and provide as much liquidity as is needed without causing rampant inflation. The banks have much less leverage than they did back in 2008, so financial contagion is not an issue, and the financial system as a whole remains healthy. Life as we knew it in January of 2020 comes back virtually the same in the 3rd quarter of 2020.
Portfolio Management Takeaways
As you can see from the above possibilities, the range of outcomes is extensive. With the many unknowns present today, we recommend that we all focus on controlling the things we can control. With the range of outcomes so wide, we must not be so cautious as to be myopically focused on protecting from the worst-case scenario, thereby giving up a potential return and ensuring a non-productive use of financial assets. Alternatively, we must not be overly optimistic as to be positioned for a seamless economic recovery. Such an aggressive approach can lead to reckless risk-taking, which, in turn, can lead to underperforming assets and unnecessary frustration. Discretion is often the better part of valor.
In uncertain times, such as those we are facing right now, there are multiple techniques and strategies we can employ to reposition client portfolios to give each client the highest probability of achieving their goals. Those include but are not limited to:
- Rebalancing away from a relatively overvalued asset class into a relatively undervalued asset class.
- For example, selling fixed income and buying equities with the intention to get a client’s portfolio back in line with their strategic asset allocation.
- Selling a relatively overvalued security and buying an undervalued security
- There may be individual companies that we own or areas within an asset class (e.g., the high yield area of fixed income) that we would view as being less/more compelling due to valuations, spreads, or general business conditions.
- Changing our growth/value positioning to better reflect market leadership as it relates to which style is in favor.
- Changing where we have a relative overweight and relative underweight in terms of large, medium, and small market capitalization equities.
- Changing our sector weightings as they relate to a benchmark
- For instance, we have been underweight energy and overweight technology for the past few years.
- Uncovering possibilities in the less liquid areas of the market if we view the compensation for the additional illiquidity to be appropriate.
As investment managers and stewards of our clients’ capital, we must weigh the likelihood of each potential scenario as well as the inherent risks and then move forward accordingly. With that mandate, we diversify away uncompensated market risk while also making sure to take on enough risk to achieve the optimal return in a client’s portfolio aligned with their stated acceptable level of volatility.
Therefore, at Wolf Group Capital Advisors, we believe the way forward begins with a common-sense approach, a caring mindset, and an attitude of cautious optimism. Common sense in that we continue to be vigilant about hygiene and continue social distancing. A caring, positive mindset means that we are kind to others during this stressful time, especially those less fortunate, and remember that things will eventually get better.
We need to focus on healing and getting back to three-quarters strength and then full-strength, focusing on the opportunities that lie ahead. We have a unique opportunity to come back a stronger, more united, more caring and more responsible global citizenry, where we look out for one another, give back to our communities during a crisis realizing the whole is much greater than the sum of our parts. When we are all pulling together in the same direction, with all our might, there is nothing that can stop us, not even the deadliest virus we have seen in over a century.
By Charles Verruggio, Chief Investment Officer & Senior Financial Advisor