| Studies show humans have a built-in negativity bias, which means we give bad news a lot more attention than good news. Consider a couple of jarring headlines taken from the recent financial press: “Don’t even think of owning stocks unless you’re willing to buy and hold for at least 10 years”[1] “Global losses could be $10 to $20 trillion from a global economy worth $85 trillion”[2] A 2019 study reported in the Proceedings of the National Academy of the Sciences found that this bias transcends borders and cultures, and is likely rooted in our evolutionary biology:[3] Attention to negativity may have been advantageous for survival. Negative information alerts to potential dangers; it has special value in terms of “diagnosticity”, or the “vigilance” that is required to avoid negative outcomes. This account of the negativity bias is evident in literatures in physiology, neurology, and, particularly, work on the importance of “orienting responses” in evolutionary biology. And this is particularly true during periods of heightened uncertainty such as now, especially in our journalism and news coverage: Societies deal with anxiety about future uncertainties in different ways, and the extent to which members of a culture feel threatened by ambiguous or unknown situations may well affect the tendency to focus on negative information… Another dimension of variability is rooted in the institutionally coded professional practices of journalists. A strong professional requirement that journalists routinely cover politics in conflictual terms may also lead to viewers’ habitual expectation and attention to negativity. Further evidence comes from the Pew Charitable Trusts, which studied news reported over a two decade period, and found that the stories that generated the most interest from people focused on war and terrorism, despite the fact that incident rates for both were in decline to among their lowest levels in human history during the study period.[4] While negativity bias is no doubt helpful when running away from a hungry bear, it is not of particular use to an investor in dispassionately evaluating prospects for long-term portfolio selection. Equities Which brings us to a point regarding a topic we introduced last week: how can equity valuations be what they are with the economic news currently so poor? The economic data, while negative, is starting to improve now that all 50 U.S. states are at different stages of opening their respective economies. The stabilization of oil prices in the $30 dollar range is one such recent example, as supply has come down and demand has moved up. With these improvements, markets begin to price in the recovery in advance. Strategas (a Baird company) pointed out yesterday morning that P/E (price to earnings) ratios of stocks spike during recessions when earnings collapse, typically a very bullish indication, and then decline as earnings catch up. Additionally, P/E ratios tend to run higher during periods of low interest rates and inflation such as this one. Why? Consider the role of the discount rate. When looking at any future stream of cash flows, in order to assess their current value we must discount them to the present in light of risk (risk premia) and alternative options (opportunity costs) for return. If rates are lower, then the value (of the combined flows) will mathematically be higher. That’s the finance textbook explanation; a more intuitive explanation is to consider how much a stock that pays a 2% dividend with the prospect of capital appreciation might be worth to an investor versus a 10 year treasury bond that pays only 0.70% coupon rate of interest, and virtually no prospect of appreciation. While we do not expect corporate profits to recover in the very near term, the market is effectively peering through the current economic wreckage and discounting the eventual recovery in corporate profits. By not focusing on the current negative data and re-orienting to the improving data, the market is generally consistent in pricing a scenario we are projecting of a 5% contraction in U.S. GDP with an unemployment rate of around 8 – 10% by year-end (Baird Strategas), with a recovery in latter 2021. Already we are seeing this dynamic feed into the small cap and emerging market companies. On a quarter to date basis, the Russell 2000 index, a barometer of small company performance, is marginally ahead of the S&P 500, 13.6% versus 13.4%, and emerging market stocks are up 9.3% versus international developed, up a mere 6.7%. A thesis we identified a couple of weeks ago is beginning to manifest, and our tilts into both segments in client portfolios have added value. Fixed Income As the fixed income markets digest the long-term impacts of the coronavirus as well as the effects of monetary and fiscal stimulus, they continue to normalize and function more efficiently with credit spreads and yields continuing to compress since the March volatility. The Federal Reserve’s $500 billion Municipal Liquidity Facility program has opened to state and local governments. The program is designed as a last resort for municipalities, with the Fed encouraging them to find alternative forms of financing before tapping into the program. The Fed also recently adjusted their rules to allow participation in states that have competitive bid requirements such as Illinois. Accordingly, the state of Illinois announced Thursday that it is working on a notice-of-interest requirement that it will be submitting to the Fed as a precursor to applying for a loan from the program. Municipal borrowers continue to find ways to access the markets with traditional lenders but have also increased their use of private placements, bank loans and direct lines of credit as alternative funding vehicles. A number of municipalities with lower credit quality, including states such as Illinois and Connecticut, as well as several university systems, were able to come to the market this week and price bonds with healthy demand. The corporate market has seen new issuance volume increase over 88% compared to a year ago, including participation from some of the hardest hit industries such as travel and leisure. Many corporations have come to the market to issue longer-term debt to pay down the revolving credit they took on during the height of the crisis. Overall, we continue to see the fixed income markets positively react to improving market dynamics and Fed support, and we remain focused on maintaining higher quality in the core fixed income portfolios, with a tactical shift into high yield in Diversified Fixed Income. Past performance is not indicative of future results and diversification does not ensure a profit or protect against loss. All investments carry some level of risk, including loss of principal. An investment cannot be made directly in an index. |
Covid-19 Crisis: Markets and Valuations (Chris Merker)
| COVID-19 Crisis – Week Ending May 15, 2020 How can stocks be trading at current levels when the economic data is so abysmal? That is the theme for this week and it is a fair question when looking at the data: GDP is expected to contract between 4 and 6 percent this year, and near-term unemployment rates may attain a level of 17%, a level not seen since the Great Depression. When you consider how much economic value will be lost from GDP contraction (what we define as a recession), the reality is quite staggering. A 5% contraction would result in an estimated $1.1 trillion in reduced GDP. In order to offset this, the Federal Government has provided about $2.7 trillion in direct support to households and businesses through the CARES Act and other programs. The offset to the loss ratio is 2.45 to 1. This does not include the additional monetary support provided to companies and municipalities by the Fed, which is now in excess of $6 trillion. In total, the combination of fiscal and monetary stimulus represents approximately 40% of GDP, or about $8 of stimulus for every dollar loss of GDP. Even with this offset ratio, the concern remains regarding how much dislocation will occur in the process due to business bankruptcies and unemployment. In other words, what job losses will be made permanent? If we accept that a large portion of the April layoffs were indeed temporary, then we should see those jobs come back relatively quickly. The Bureau of Labor Statistics in a recent survey found that 78% of respondents believe their job loss is temporary.[1] If we find that there is more structural damage from the shutdown, then this could prolong the recovery both in the economy and in corporate profits. It is forecast that 94% of the country will begin to emerge from shut-down by Memorial Day and each day that businesses are able to get back up and running will mitigate this permanent loss. But what about the path of virus and the effect this will have on consumption? Clearly, certain areas of the economy will lag as we come out of this. We don’t anticipate travel and leisure industries to rebound immediately. Restaurants, bars and theaters, for example, will only slowly come back due to social-distancing restrictions. We are watching closely as states such as Georgia, Texas and others re-open to get a gauge of these areas. For other sectors, it will depend on the speed and resumption of consumer activity, and if the housing market is any indication, a recovery is already clearly underway.[2] Finally, and as the Wall Street Journal recently noted, price to earnings measures only get you so far, but they do provide some guidance.[3] Strategas (a Baird company) forecasts that earnings on the S&P 500 could be around $110 by year-end, approximately a 31% decline since year-end 2019. Applying a simple price to earnings (P/E) ratio of 18 would suggest a level on the S&P 500 of just under 2000. The S&P in March bottomed around this level, suggesting that the damage to corporate profits was realized and priced in at the bottom end of the cycle. As markets undergo recoveries they tend to look out six months to a year. [4] Today the S&P is at 2,820. The Street consensus is that earnings will recover by the end of 2021 at around $170, and again, applying an 18 P/E multiple would have the S&P 500 pricing at 3060, still well below where the market peaked in February of this year at 3409.[5] Furthermore, as we noted last week, it’s been a lopsided recovery with a handful of very large tech stocks driving much of the recovery in the S&P 500 index. If we priced the S&P 500 on an equally weighted basis (where every stock in the index receives equal treatment, and not based on how the large the company is), the index would be down below 20%, still in technical bear market territory. This is why having proper positioning in the portfolio will be very important as we lead into the recovery, regardless of the path or speed. |
New assessments of risk and the new world order (Gillian Tett / Ian Bremmer)
This week Gillan Tett (Financial Times) describes how approach to risk is evolving under the crisis, and Ian Bremmer (Eurasia Group) calls what we are living through our first modern Depression. I find his view on how things will evolve on the geopolitical stage more interesting than trying to apply an old name to a new problem.
Is it safe to go to the shops, see a friend or get on a plane?
Gillian Tett on how to assess risk in the age of coronavirus
https://www.ft.com/content/a69afc14-904a-11ea-9b25-c36e3584cda8
Last month, Dayna Polehanki, a Michigan state senator, posted a tweet from the capitol building in Lansing that might have seemed unimaginable only recently. “Directly above me, men with rifles yelling at us,” it read, next to a picture of armed protesters standing in the building, demanding an end to the Covid-19 lockdown in the name of “freedom”. “Some of my colleagues who own bulletproof vests are wearing them.” It might be tempting to see this as just another sign of American political polarisation. But that would be a profound mistake. Over this bizarre and frightening scene hang questions that will affect us all in the coming months, be that in Lansing, London, Lagos or Lisbon: how do we define and measure risk? Who gets to do that? And who deals with the implications?
Ian Bremmer: Silver Linings in the COVID-19 Pandemic
Even though a lot of our institutions are structurally broken or eroded, the orientation and weighting of capital coming out of the COVID-19 crisis will be much more able to address and fix those problems, he said.
Bremmer also described how the crisis will affect the world’s three superpowers: the U.S., China and Europe. In the sense of the crisis, China has an advantage of being a surveillance state that can make huge, strategic investments to help the country recover economically much faster than the U.S. and Europe. But the caveat is that as China’s economy recovers, it is going to be dominant with all of the weak and poor-performing economies of the world while at the same time being decoupled from the U.S. and Europe, he said.
The Bearer of Good Coronavirus News (WSJ)
https://www.wsj.com/articles/the-bearer-of-good-coronavirus-news-11587746176?mod=opinion_lead_pos5
In a March article for Stat News, Dr. Ioannidis argued that Covid-19 is far less deadly than modelers were assuming. He considered the experience of the Diamond Princess cruise ship, which was quarantined Feb. 4 in Japan. Nine of 700 infected passengers and crew died. Based on the demographics of the ship’s population, Dr. Ioannidis estimated that the U.S. fatality rate could be as low as 0.025% to 0.625% and put the upper bound at 0.05% to 1%—comparable to that of seasonal flu.
Letter: Perhaps the New Mantra Should Be ESG Materiality (FT)
https://www.ft.com/content/7de1b83c-7752-11ea-af44-daa3def9ae03
David Stevenson, in “Are ESG and sustainability the new alpha mantra?” (FTfm, April 6), identifies an important paradigm shift: rather than using environmental, social and governance considerations as an “add-on” to a typical investment process, many are discovering that investors can use ESG concerns as a screen to avoid future poor-performing companies. But this suggests that ESG screens can also be used to find attractive companies to short. Indeed, as some past studies of mine and others show, negatively linked ESG can generate even greater alpha than positively linked ones. I liken this principle to the observation that we tend to like good companies but hate bad ones. In addition to avoiding bad companies, ESG screens can also help find excellent companies. For example, approximately 40 per cent of large US companies now explicitly compensate their top executives for various ESG outcomes. These executive contracts tend to increase both future ESG and financial performance.
Marquette Business Continues to Lead in Sustainable Finance and Investment Education (Marquette Business)
“Sustainable finance and investing are taking off- and the world’s top business schools are climbing on board” — Wall Street Journal, 6/10/2019
An article in the Wall Street Journal recently declared that sustainable finance and investment education is making its way into higher education curriculum. But at Marquette, that change happened over a decade ago.
In the 2005-2006 academic year, Dr. Sarah Peck developed and taught the course Investment Ethics. Dedicated to understanding the central role that ethical concepts and consequences play in the practice of finance and specifically investments,this course was one of the first of its kind across the country. Taken up and taught by Dr. David Krause, director of the Applied Investment Management program thereafter, the course eventually landed in the capable hands of Dr. Christopher Merker, Instructor of Practice for Marquette University who has taught the course since 2009.
“War Powers” in a Time of Corona: Learnings for the Climate Crisis (Chris Merker)
In light of significant and rapid changes occuring across the globe, arguably climate change and environmental impacts should be approached with similar urgency. Activists have been saying this for years, and now we have an opportunity to see how humanity reacts during an all-out crisis. In and throughout, the world has become in effect a laboratory for responding to a massive – and entirely global – economic shock, and every government has taken a range of a policy approaches with differing levels of efficacy.
Encouragingly we have seen a “can do” and “nothing will stop us” attitude that has crossed political divides as both the public and private sectors joined hands to resolve the crisis.
However, a major point of difference, is the absence of any similar level of intensity in addressing the climate crisis. This is in marked contrast to how the world addressed ozone depletion a generation ago, which, while not reaching “coronavirus” levels, did rally substantial, coordinated and targeted response globally in resolving that crisis. One commentator suggested that if carbon emissions came with a bad smell or turned the skies purple, we would see a more ready and visceral reaction from everyone. Because we can’t see, taste or feel carbon emissions, while no less damaging, the perception of immediate threat is not present in this instance.
So, after the dust has settled on the corona crisis, how can we apply recent learnings and experience to the climate crisis?
- Understand that collective actions can make an impact – Social distancing doesn’t work without everyone’s participation. What has slowed the spread of the coronavirus was everyone opting in and participating in this radical change in behavior. Similarly, we will need to change our behaviors in a number of ways: what we do and how we do it as we transition to a low carbon economy.
- Governments must overcome political divide to create effective policy solutions – While our leaders argued over some of the details as we worked to construct the largest fiscal stimulus package in history to mitigate the economic impact from COVID-19, no one disagreed over the objectives or need for immediate action. We need similar cohesion in addressing the climate crisis. This is still not present, and will be key.
- Countries must coordinate their actions – The coordinated actions of leaders and central banks has been key in addressing this crisis. Such multi-lateral coordination must take place in a way that we haven’t seen to date, despite attempts through agreements such as the Paris Accords, which has clearly been absent major countries – and the largest carbon contributors – in particular the U.S. and China. Just as important are the coordinated plans and execution of those plans following such agreements.
- Allow the experts and technicians to lead, and recognize that technology and innovation will play a role – Anthony Fauci, director of the National Institute of Allergies and Infectious Diseases, and others, who understand health policy and pandemics have been given license to act and lead in ways that are critically important on setting us on a path to mitigate the effects of the pandemic, and get on a path to recovery. Similarly we must turn to those who understand the climate and impacts to the environment to mitigate further damage, and put us on a transition path to sustainability. We must fund and incentize businesses to continue developing and expanding critical products and technologies to pave the way to the transition, just as we are seeing during this crisis.
- Plan the transition – How do we get from A to B? In this case the strategy was to “flatten the curve” to ensure our health system has the necessary capacity to respond to reduce the human cost, and delay the impacts to allow time to develop a vaccine. What will be our strategy for the climate crisis, and how do we get from A to B, to at the same time minimize disruption and minimize human cost?
In the final analysis, everyone has to agree to do whatever it takes – In this crisis, everyone has come together and responded, together. This collective purpose and global spirit of cooperation must pervade to the same extent to take on the monumental challenge of transitioning from a carbon-heavy to a carbon-neutral economy, an entire shift in the way our civilization operates today.
In recent days I have been encouraged, with commitments by companies that include those from the energy sector, including some major oil and utility companies. I believe we can get there, but it will take all of us working together to help assure a better future for us and the generations that follow.
A fiasco in the making? As the coronavirus pandemic takes hold, we are making decisions without reliable data (STAT)
The current coronavirus disease, Covid-19, has been called a once-in-a-century pandemic. But it may also be a once-in-a-century evidence fiasco.
At a time when everyone needs better information, from disease modelers and governments to people quarantined or just social distancing, we lack reliable evidence on how many people have been infected with SARS-CoV-2 or who continue to become infected. Better information is needed to guide decisions and actions of monumental significance and to monitor their impact.
Draconian countermeasures have been adopted in many countries. If the pandemic dissipates — either on its own or because of these measures — short-term extreme social distancing and lockdowns may be bearable. How long, though, should measures like these be continued if the pandemic churns across the globe unabated? How can policymakers tell if they are doing more good than harm?
Q&A: A Harvard Expert on Environment and Health Discusses Possible Ties Between COVID and Climate (InsideClimate News)
https://insideclimatenews.org/news/11032020/coronavirus-harvard-doctor-climate-change-public-health
Doctors and public health researchers are getting an increasingly accurate and nuanced picture of the many ways climate change damages human health.
Now, questions have arisen about whether climate change contributed to the outbreak of COVID-19, whose spread the World Health Organization declared a pandemic on Wednesday. For example, did habitat loss, driven in part by climate change, make it easier for pathogens to spread among wildlife and for the virus to jump to humans? Does air pollution, mainly from the burning of fossil fuels, make some people more vulnerable to contracting the illness?
Climate Change Has Lessons for Fighting the Coronavirus (NYT)
“Alarming levels of inaction.” That is what the World Health Organization said Wednesday about the global response to coronavirus.
It is a familiar refrain to anyone who works on climate change, and it is why global efforts to slow down warming offer a cautionary tale for the effort to slow down the pandemic.
“Both demand early aggressive action to minimize loss,” said Kim Cobb, a climate scientist at the Georgia Institute of Technology who was teaching classes remotely this week. “Only in hindsight will we really understand what we gambled on and what we lost by not acting early enough.”