Keep Calm and Carry On - Part III - Partridge Muir & Warren Ltd (PMW)

Keep Calm and Carry On – Part III

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Keep Calm and Carry On – Part II
19th March 2020
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Have Faith in Victory
8th May 2020

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Simon Lewis, CEO of Partridge Muir & Warren, provides the latest instalment of his ongoing commentary regarding the global pandemic, the economy and financial markets.

I want to start with an apology that this article is a little longer than I first intended. However, there is a lot of ground that I wanted to cover to keep you up to date with our thoughts about the world and your investments, so please forgive me for taking advantage of the fact that I have a (literally) captive audience!

Spring is here but there seems little to celebrate at the moment. Rather than ‘springing’ forward, life in lockdown is already starting to seem leaden footed and many clients are asking me whether I think there is “light at the end of the tunnel”.

I remember the novelty of being driven through tunnels when I was a child and the urge to guess when we reached the halfway point, followed by that unspoken relief when we finally emerged into the sunlight. Where, I think, we currently are in the proverbial tunnel depends upon whether I am considering the human health crisis or the financial crisis that it has caused.

I’ll start with the human health crisis, which is fundamentally based on the confluence of three factors; the biology of the virus, the resources available in the short term to combat the disease (COVID-19) caused by the virus and the measures taken by Government, both to control the spread of the virus and to deal with any shortfall in resources needed to combat the disease.

It is important to understand the science of this situation before trying to draw any conclusions or make any predictions about the economics, or indeed the human suffering that is to come. I do not think we have yet reached the halfway point, but we are well into the tunnel and I’ll explain why.

Let’s start with the biology of this novel coronavirus. It would seem that it is particularly adept at transmission because the virus has spread like wildfire around the globe, infecting almost all countries in a matter of only four months, with reported cases now exceeding 1.2 million. It is not surprising given what we now know, because the level of infectiousness is such that only 4 infected cases in a new location is sufficient to give a 50% probability of an outbreak occurring. Although the fact that the virus is able to spread exponentially is bad, its inevitable decline will also be exponential, which is good.

I think it is evident that the spread of the virus cannot now be stopped in the near term, so attention must focus on how it can me managed.

There has been a great deal of criticism in the mainstream media regarding the UK Government’s coronavirus strategy generally and its testing strategy specifically. This is frustrating as, frankly, I would rather the health of my family depend on a strategy directed by Britain’s leading epidemiologists and scientists as opposed to one led by Britain’s leading journalists. Government has sensibly, so far, followed the advice of the medical and scientific professionals and I hope that it has the resolve not to buckle under pressure and become a ‘crowd’ pleaser.

It should be obvious that there is no point in wasting resources on testing people who are displaying symptoms to simply confirm whether they currently have the virus, when the outcome of the test would be no different to not testing. Either way, a period of self-isolation is recommended. It would be a different story if you could reliably test for whether that person had previously had the virus, but such tests are not yet sufficiently reliable.

Of course, it is helpful to test front line healthcare workers but logic dictates that if testing capacity is limited, priority must be given to testing those who have been hospitalised. Testing front line workers who are displaying mild symptoms might not result in a worthwhile return on the necessary resource as it wouldn’t allow anyone infected to return more quickly and might not buy many extra days of work for those able to return.

Herd immunity is a concept that is clearly unpalatable to the media but, with a mass-produced vaccine many (12-18?)  months away, pragmatically, it might be the only viable option. Once most of us have had the virus, we will act like fire breaks to control the further spread of the infection. It is thought that herd immunity for COVID-19 would be achieved if only 60% of the population developed an immunity.

A strategy of containment through blanket testing and contact tracing is only feasible for small well-resourced countries (like Singapore) or those with an authoritarian regime and a compliant population (China). For much of the rest of the world, it is an inefficient mechanism of delay with a correspondingly high economic cost. It is a cost that we cannot afford because in the time it would take us to be free of the virus, the global economy would be devastated and we would all be impoverished.

So, how far down the road to herd immunity in the UK might we be? The official number of recorded COVID-19 cases in the UK is now over 42,000, but we should remember that primarily, as already mentioned, it is only those who are hospitalised that are tested. There are very many who contract the disease who suffer only very mild symptoms or no symptoms at all.

By extrapolating data from both the World Health Organisation and Johns Hopkins University in the US, I have reached the conclusion that in all likelihood, the actual number of people in the UK who have contracted COVID-19 is well over a million.

Studies have shown that the virus, unfettered at the outbreak in Wuhan, had a reproduction rate of 2.35. In other words, every person who became infected passed the disease to an average of 2.35 other people. If you take that sequence forward just 27 steps, the entire global population of around 8 billion people becomes infected. The virus is thought to have an incubation period of up to 14 days, so this whole process would, theoretically, take only 54 months. However, China introduced a very strict lockdown strategy that reduced the reproduction rate to an average of 1.05.

The population of the UK is around 68 million people. The 60% herd immunity requirement I mentioned earlier therefore amounts to just under 41 million people. If we take my assumption of a million people already infected and a reproduction rate following our more modest lockdown of, say, 1.5, I calculate that we would achieve herd immunity in 10 steps, or 20 weeks. We are already 2 weeks in, so it is feasible that the UK will be able to start relaxing its lockdown measures in 2 or 3 months’ time.

With this in mind, we should now consider the economic impact and the likely effect on investments. Going back to my tunnel analogy, my view is that the economic crisis is lagging the human health one, so there still a lot of economic pain to come. However, financial markets tend to be forward looking and I think we have already passed the halfway point.

The economic crisis is a direct result, not of the virus, but the measures taken to control its spread. The greater the controls and the longer they persist, the greater and longer lasting the economic damage. Governments and central banks around the world have acted to put economies into, what amounts to be, an induced coma and they are now throwing the kitchen sink at this crisis, to make sure that as much of our economic landscape as possible be preserved until allowed to splutter back in to life. A synchronised global recession in the second and third quarters of this year seems inevitable and the falls in economic output (GDP) could well be in double digits. However, there is every chance that a decent economic bounce back will gather pace in the final quarter of 2020.

Many governments have put in place very generous economic relief packages, for both individuals and businesses. In the UK, the Chancellor acted robustly and speedily. Given the eye watering sums involved, it is a strategy that is certain to work in the short to medium term but it remains to be seen what impact it has in the longer term. Governments have pledged to spend (and borrow) whatever they need to and central banks have in effect pledged to print as much money as is necessary to stave off a prolonged economic decline.

When looking at the likely lasting effects of this crisis it is important to understand what makes this one, at least in financial terms, different to the financial crisis of 2008. In the aftermath of that crisis central banks did the heavy lifting by lowering interest rates and printing money (quantitative easing). In contrast, governments took the diametrically opposed approach of fiscal austerity, cutting expenditure aggressively to reduce the fiscal deficits that had been created by the slowdown in economic activity.

The combined result of these approaches was to encourage a high rate of asset growth; the result of more money in the financial system chasing the same number of existing assets. As a consequence, financial markets soon soared alongside other assets such as residential and commercial property. An unintended effect of this policy was, therefore, rising social inequality. Those who already had assets (such as residential property) were rewarded whilst those without were left further behind and were also disproportionately affected by the negative side-effects of fiscal austerity.

This time the strategy is different and the results will be different also. Central banks have again acted aggressively by cutting interest rates and (in effect) printing money. However, this time, governments are borrowing heavily to finance their extensive economic stimulus packages and my view is that these strategies will counter pose in a way that is unlikely to provide much drive to asset price growth. In essence, much of the printed money will be used to purchase newly issued government debt.

Once my clients have got the “light at the end of the tunnel” question out of the way, the next one is usually “how long will it take for my portfolio to recover its previous value?” That’s a more difficult one to answer but after the abrupt falls we have seen in recent weeks, it is encouraging to see that central bank action to improve liquidity has resulted in a normalisation of market trading conditions. It doesn’t mean an end to volatility but it does mean that the extreme signs of stress and the wide spreads that had created a dysfunctional market have been corrected.

There are a number of interesting investment trends that have developed. Many investors seem to be drawing binary conclusions from events and assuming that everything is going to change as a result of this crisis. Businesses that operate in the virtual world are currently favoured whereas those that are more dependent on the physical world are not.

Is COVID-19 really going to change human nature? History has shown that we are a resilient species. When we emerge from this crisis we are not going to have lost our desire to travel the world, to mingle with friends, to try new things, to peruse the shops, to go to the theatre or cinema. I am confident that in the not too distant future many things will get back to normal and if anything, we will value more highly things we previously took for granted.

From a financial market sentiment perspective, I think that this coming week might prove pivotal. In the UK, we have now been in lockdown for 2 weeks, the estimated incubation period of COVID-19, so we should see a noticeable fall in the daily number of new infections. More significantly, from a global investment perspective, we are getting closer to the likely peak of the outbreak in the US. Once that tide turns, expect a bounce back in investor sentiment because most of the money that flows through the global financial system is owned, or controlled, by Americans.

In the meantime, back in the UK, we are so fortunate to be benefiting from the herculean efforts of our front line health care workers, who are dealing with desperately difficult conditions.  If this is a war, they are our soldiers in the trenches, selflessly risking their own wellbeing for the benefit of others.

Take care, stay safe, keep calm and carry on.

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