By Renato Klarnet
Founding partner, Executive Committee member and Head of the Wealth Management Group of G5 Partners
An investment manager’s life is not easy. We are expected to always make the right moves – even for “black swans”. Although Covid-19 took almost everyone by surprise, we should not have been surprised with the correction in stock market prices. Before the Covid-19 outbreak, markets already seemed tired. The United States was experiencing a bull market for over 11 years! Despite the S&P having increased by 30% in 2019 (and by more than 350% in 11 years), the real concern in 2019, as our management team had already mentioned in our annual letter, was the expected global slowdown and how central banks would respond since 2019 recorded the lowest global GDP growth since the subprime crisis in 2008 (2020 will replace this record). S&P companies had ‘flat’ profit growth in 2019 versus 2018. In Brazil, we had years of economic recessions and a timid 1% annual growth rate recovery in the last 3 years. Despite the system’s enormous liquidity at the end of 2019, and an extremely low opportunity cost, it seemed the bull market would lack the foundation and strength for 2020.
2020 had an encouraging start, with S&P reaching a new high (historical record) on February 19, but the Covid-19 outbreak influenced asset prices from March onwards. This strange virus effectively became a pandemic with overwhelming effects on global demand and, differently from past crises, the solution seems to be harder this time. This is a health crisis. Although we do not know it dimension and magnitude, the consequences of the forced quarantine on the real economy will be unprecedented.
This crisis also came when global economies were more leveraged. According to the International Finance Institute, the strong liquidity in recent years took debt levels to over 300% of global GDP, or a few hundred trillion dollars. What mainly increased in recent years was the debt levels of non-financial companies. This leverage, along with the strongest expected fall in economic activity in decades and current liquidity restrictions, resulted in great discomfort to the corporate debt and equity markets.
Flight to quality led the 10-year US treasury bond to trade at almost 0.5%, a historic record. More than 25% of companies listed on the S&P withdrew their earnings guidance in the face of such an uncertain scenario. PE and EBITDA metrics took a back seat as liquidity and short-term debt metrics became more relevant due to the expensive and scare access to capital at this time.
As the virus testing in the United States and western economies became more frequent, and the number of infections and fatalities increased, panic and volatility took over all asset classes in March. Stock market movements were massive and the historic records and statistics for the month will be written in future books. After years of stable volatility, the S&P volatility index (VIX) during the month recorded 4 of the 10 highest levels in history, some being close or even higher than the levels recorded in the 2008 crisis. The S&P fell by 34% over its record highs in February and, despite a recovery at the end of the month, it was the worse March since the Great Depression of the 1930s! On March 12, US markets recorded their worst performance since the 1987 crash. On this date, the USA officially entered the bear market (dropping by 20% from its peak). This 20% drop occurred in only 16 trading sessions, which was also the fastest drop in history. And to make investment managers even more confused, the market has increased by over 20% from its lowest point in March – so can we say we back to the bull market again?
Amidst the challenging, uncertain, and unprecedented scenario, Governments and Central Banks acted quickly and implemented extreme measures. Central Banks increased their already expansionary monetary policies and cut low interest rates even further, in addition to announcing several repurchasing programs for public and private securities aimed at stabilizing the unbalanced global credit market. And Governments announced what is perhaps an even more relevant measure: a trillion-dollar tax incentive which was not seen since World War II. The US deficit is expected to reach roughly 20% of GDP in 2020. The primary deficit in Brazil is expected to reach nearly 10% in 2020. And, just as in the 2008 crisis, we will need to learn to deal with higher sovereign debt/GDP levels and see if this will increase inflation over time.
But what about investment managers? How do they position themselves in this scenario? Since this is a health and confidence crisis, differently from others in the past, which where “merely” financial ones, Brazilian investment managers are practically unanimous that this scenario will be short lived, with an expected end date and everything will adjust in the long run. But how long is short-term? It is still too early and hard to determine the damages Covid-19 caused to the Brazilian economy. Or whether the recovery curve will be shaped in V, L or U. We do not have a government plan or strategy to end the quarantine and there is still no control of the number of infected individuals in Brazil since very little testing has been done. So, can short-term be a one-year period? Easily so.
The Government announced excellent measures which have been difficult to implement. And we are also in a very politicized environment due to the municipal elections at the end of the year, making it hard to reach a consensus. The focus needs to be on credit, which has not reached the end client efficiently. It is hard to estimate how many small and medium businesses will survive and make it to the medium term.
As we manage a multi-family office, our mandates are similar to Foundations – diversified and focused on long-term capital allocations. We identify trends and strong market movements. But obviously, current market conditions require extra attention and allocations require additional caution and diligence. We are still far from a final solution and from understanding how the quarantine will affect the Brazilian population (75% of the country’s GDP derives from services!). Despite the reduction in market volatility, they are still well above historical averages. However, we must be opportunistic in these situations.
Market movements in March resulted in the fall of many attractive assets, representing a clear global deleveraging trend in a new scenario of illiquidity. However, despite all the uncertainties, and without focusing on identifying the market’s lowest price, we increased our exposure to risk over these past weeks. Extremely attractive valuations are available. This pandemic scenario does not mean all assets have gone bad! If someone had told me, back in February, that I would have the opportunity to buy Bovespa at 70,000 points but a Covid-19 virus was on the way, I would have certainly made a purchase order! And that Petrobras would have a debenture at 160% of CDI, with a duration of 4 to 5 years? I would have definitely bought that also.
Building a diversified, long-term portfolio with premium assets includes periods of market uncertainties and adjustments. Those who do not need to sell quality assets at these times and who are de-leveraged will have the opportunity to build quality positions with excellent returns for the next 5 to 10 years.
We have invested in equity funds that were previously closed and purchased several credit assets that were poorly priced. High Grade assets are currently trading at the same level that High Yield assets traded 2 months ago. Many newly structured credits and short-term High Yield options are coming to the market under much better return risks.
Covid-19 will transform how we relate and interact. We will face many changes in our habits and values. Some businesses will change forever, others will be redesigned.
The recovery from this crisis may take long, despite the amount of money and global efforts that are being allocated to the war against the virus. But it will certainly not change the way we invest and perpetuate our clients’ assets since there are many good and cheap assets available in this buyers’ market.
Anticipating and adjusting the downward market trend caused by the Covid-19 crisis, a pandemic that happens every 100 years, is a difficult task. But having a well-positioned, de-leveraged and diversified portfolio, as well as room for smart and profitable risks during these times is what differentiates a good wealth manager. This is the challenge of an investment manager.