Dear Friend:
We are living in extraordinary and unprecedented times. COVID-19 has altered our realities, changed our behaviors, and created new social norms. We very much understand the pain all of you are enduring.
We owe a debt of gratitude to our clients who have sent words of appreciation, encouragement, caring, and support during this very tumultuous market period. Thank you for your understanding as we continue to serve you, all the while taking care of our loved ones and practicing social distancing.
Noesis remains fully operational during the outbreak. Our headquarters is in the heart of hurricane territory, so we have experience operating during a crisis such as this. We also want to thank our custodians for helping us continue to operate, despite people in those organizations working remotely and facing a myriad of challenges of their own. While we have several people still working in our office because our business is deemed essential, the rest of our staff works remotely, all around the world in Silicon Valley, Amsterdam, Madrid, and Asuncion, to ensure our operations run smoothly and that our clients’ cash flow needs are met.
What Happens Next?
We are reminded that while COVID-19 is unique, the market selloff unusual, and life in general altered, the discipline, philosophy, and style of how Noesis invests has not changed.
We are in an event-driven bear market caused by the transitory and exogenous shock of the worldwide pandemic. These differ from cyclical market declines, where economies go through the cycle of growth, overheating and recession, or structural declines, where economies become impaired longer term from too much leverage or financial bubbles. Event-driven bear markets on average last only nine months, decline 29%, and recover back to previous levels in 15 months. In comparison, cyclical bear markets last longer (on average 27 months), the recovery back to previous levels takes longer as well (on average 50 months), however the decline is similar (on average -31%).
There were five event-driven bear markets since the 1800s based on research from Goldman Sachs, the last one in 1987. Some of you may remember the Flash Crash/Cuban Missile Crisis period in 1961/62; the financial crisis and credit crunch of 1966; or Black Monday in October 1987, caused by overheating markets and program trading.
If we believe the market will return to the prior peak and we stay invested in high-quality names, the annualized return over the next few years could be desirable. For example, if we can return to the prior market peak in two years, the annual return from the end of March equals 16% per year compared to the 20 years average of 6.1%.
What is the Global Governments’ Response?
The central banks’ and governments’ responses worldwide were as swift as the sudden stop in economic activities. Governments adopted public health measures, income support, bridging programs for affected households and firms, loan guarantees, and active stimulus measures. The US government released a fiscal package of nearly $2 trillion and another stimulus package might follow soon. Germany passed various measures totaling around Euro 720 billion ($783 billion), Japan announced on April 7 a combined package of Yen 108 trillion ($992 billion), and while China has not issued anything yet, strong fiscal support is expected there as well.
To put those large numbers into perspective, the direct fiscal stimulus, excluding any loans and loan guarantees, amounts to around 7% of the US Gross Domestic Product (GDP), close to 4% of UK’s GDP, around 2% of each of the four largest Euro economies, approximately 5% of Japan’s GDP, and an estimated 5% of China’s GDP. Worldwide, including emerging markets, direct fiscal easing totals over 4% of global GDP and this number will very likely increase in the near term. Government loans and guarantees make up the larger portion in many countries’ stimulus packages. For the US they represent an additional 19% of its GDP, for the UK and Japan approximately 15% of their respective GDPs, and for Germany even 28%.
What Should We Do?
Before we discuss any prediction, let us review the investment themes that drove our decisions during the past decade:
- The growing middle class in the emerging markets
- Healthcare needs for the aging population in developed countries and Asia
- eCommerce and cloud computing
- Strong global brand names, competitive advantage
Are these themes at risk in the long run with the COVID-19 threat? We don’t think so. Investors do not like uncertainty. COVID-19 continues to bring a lot of unknown with the global infected cases still rising. However, if we look deeper, those worries are relatively short-term in nature: the duration of the pandemic, the total infected cases, or the economic impact in 2020 and 2021. Typically, investors are overly pessimistic in the worst times. The important thing is to recognize this behavior and not to act out of fear.
When will the certainty start to return? Once the newly infected cases begin to decline, we can see the light at the end of the tunnel. We also believe when social distancing is no longer needed, economic activities will return rapidly. For example, in China, the economy is recovering fast now that the cities and factories have reopened. There is enough reason to believe that the other countries will go through a similar pattern after the pandemic is under control, businesses opened, and the stimulus/relief efforts get implemented.
We also recognize that not all companies will bounce back at the same speed, and some of them will take longer and may have to adjust their business practices to grow again. We use these measurements to judge the risk level of our holdings:
- The ability to absorb the shock based on their business model, balance sheet strength, and cash flow generation.
- The stock valuation: how much of the risk has been discounted in the prices already
- The impact of the government’s actions
These are our guidelines for taking action. They could lead to an increase or decrease in our existing positions. Although we have experience, the difficulty of evaluating these criteria has increased substantially.
Where are the Opportunities?
Clients who joined us before the internet bubble in early 2000, or before the financial crisis in 2008, have confidence in our judgment during difficult times and recognize Noesis always follows its principals and philosophy. They are also aware that we will be looking for top quality companies to invest in at a discounted price.
Among those themes that we focus on, two areas will withstand the impact of the pandemic better than the others: e-commerce and cloud computing. Investors may not realize that an extensive supply chain has to be in place for e-commerce and cloud computing to work. The supply chain involves both hardware and software companies. With this pandemic, business owners and workers become fully aware of the importance of working remotely. Our client coordinator Andreina has been working remotely from home for several weeks now, and her children have begun distance learning, which requires bandwidth and software. Companies will invest and spend more in this area to ensure business continuity. Google, Amphenol, Taiwan Semiconductor, as well as several component companies in the IGV software ETF are in the supply chain. Tencent is a key player in the Chinese cloud computing market. Its VOOV on-line meeting app has more than 100 million of active users in the first three months since introduction in December 2019. Furthermore, some secular trends in the IT industry will continue to progress and be developed; for example, the 5th Generation of the mobile communication standard. Qualcomm is the direct beneficiary of the 5G implementation.
The impact on healthcare companies is not uniform. We believe the temporary delay in medical device surgeries is creating an excellent opportunity to invest in companies like Medtronic and Stryker. Our pharmaceutical exposure in Roche and Gilead is relatively stable in this environment, mainly because they are producing critical products and treatments, especially with Roche’s testing kits for COVID-19, and Gilead’s Remdesivir as a potential drug for COVID-19. After this pandemic, we believe there will be increasing interest in the healthcare sector after underperforming the growth stocks for so long.
Leisure related names will suffer the most and might take longer to recover. We are closely monitoring these companies’ actions, balance sheet liquidity, and cash flow control during this time. Disney and Royal Caribbean were performing so well before the pandemic started, and we can be sure their management teams are not sitting idle to see their business fade away. Depending on what actions they have taken, these businesses could become more robust and dominant when the pandemic is over.
Other consumer names might suffer in the short-term because of store closings or disruption in the supply chain. However, if their products and services remain top quality, we believe these companies are on sale at these price levels. Nike already showed us a recovery path with its strength in online and direct channels, and the increased traffic in reopened Asian stores.
Asia remains the most critical market for our emerging market middle class theme. Our diversified investment related to the Chinese consumer has performed well during this time. Furthermore, China still has unused capacity in its monetary and fiscal tools, which can help to revive the economy. This pandemic is a speed bump, not a car crash. We remain optimistic about the opportunities in China and across Asia.
What Happened in Credit Markets?
Volatility did not stop at bond markets. Price declines were exacerbated by forced selling as investors had to unwind their trades which used borrowed money or other forms of leverage (so-called carry trade). Pre-programmed trading strategies that react to moves in market volatility and are run by various large hedge funds were others that had to sell. At the same time, buyers became more skittish with rising uncertainty. As a result, liquidity, the oxygen of every financial market, already low in bond markets during normal times, evaporated quickly. For a few days it looked like the beginning of a replay of the 2008 credit crunch. However, the Federal Reserve (Fed) was quick to intervene in the corporate bond market via an unlimited purchase program, thereby embracing the role of market liquidity provider of last resort. This is a first for the Fed and follows a similar program initiated by the European Central Bank (ECB) for its local corporate debt market. Since then prices have stabilized and began to normalize starting with short-dated investment-grade bonds, the Fed’s targeted area for its direct purchases. To illustrate the wild market swings, we use the largest investment grade corporate bond exchange-traded fund (ETF LQD) as an example: in only nine trading days its price dropped 22% and it partially recovered by 17% in another four trading days.
We have been and may continue buying in the affected bond markets, taking advantage of mispricing and the temporary lack of liquidity in a measured way. We thereby apply the same standards for quality which we use for our equity investments. The Fed’s intervention has reduced further downside risk but did not eliminate it in the short run. However, with the return of certainty we have described earlier, bond prices should continue their path of normalization. Investors are fearful at the moment and willing to pay high prices for the safety of treasuries. The value of quality corporate bonds and preferred securities should become apparent over time, especially in the new reality of a close to zero Federal funds rate which was cut by 150 basis points within only two weeks.
In Conclusion
Despite the pandemic and associated market pullback, Noesis remains committed to you and to the management of your families’ life goals. We are actively looking for and researching new ideas to implement in the portfolios to take advantage of the event-driven bear market.
Sincerely yours,
Research Team