The World After Coronavirus

Erik Knutzen: Last year we were talking about late-cycle dynamics that had already been in place for some years. We saw the potential for recession over the horizon, but we did not see any clear reason for it to appear in 2020. Well, the reason turned up early in the first quarter. The coronavirus pandemic brought global recession forward by perhaps a year or two and was met by a monetary and fiscal policy response that would have been unthinkable 12 months ago. Now, 2021 is likely to exhibit early-cycle dynamics, as we recover from the deep troughs put in place this year: that means above trend-line GDP growth, rising corporate earnings, rising prices, declining unemployment and rock-bottom interest rates. I think we would agree on that basic pattern of facts, and also that the two major modulators of those facts will be the timing of progress on coronavirus and the degree and type of additional stimulus we get.

Let’s start with the stimulus factor. It seems clear that the baton has passed decisively from central banks to governments. This is largely due to the demands of the pandemic, but also because monetary policy is at or near the limits of its effectiveness. But the size of the stimulus is important. We have just emerged from the U.S. elections: what might the results mean for fiscal policy?

Joseph Amato: It’s important to recognize that the Trump phenomenon was not a fluke. The Trump presidential era is over, but would anyone be shocked to see Trump TV capitalizing on the populist movement he tapped into? He still has almost 90 million Twitter followers.

Brad Tank: If he’s not consumed by lawsuits, he could even run for office again in four years’ time. In the meantime, it looks like two Senate elections will go to a run-off early in 2021. The equity markets have priced for a Republican majority, but 50-50 is very different from 51-49.

Amato: Right, and if Republicans in the Senate are not responsive to the issues of inequality that arguably led to the Trump era, if they behave like the traditional conservative elite, they risk being thrown out in two years’ or four years’ time. And while the left wing of the Democratic party has been deflated a little by the closeness of the election, that may not stop it from pushing for a more aggressive tax-and-regulate agenda. In other words, populism is here to stay. The same is likely true in Europe: the pandemic and some steps towards a common fiscal response have taken some of the shine off of populist movements there, but they remain potent and the underlying causes have not melted away. In the U.K., opinion polls indicate some trepidation about Brexit, but it is still going to happen.

Tank: In most cases, populism arises when the masses are dissatisfied with the job the elites are doing, and one of the easiest ways for the elites to ease that pressure is to borrow and spend and redistribute. We have a situation that we haven’t really seen in our working lifetimes: governments are not only willing to spend massively now because of the impact of the virus—we think they’ll be under pressure to maintain that course beyond the pandemic.

Amato: I agree, the persistence of populism and substantial fiscal stimulus will be important for the next several years. But progress on the virus is perhaps more important for the next 12 months. As we anticipated, we’ve had encouraging news from trial data on one mRNA-based vaccine, where effectiveness was reported at the top end of the expected range, and there are others in development. We will learn more about the scalability and distribution challenges over the coming weeks and months. It is not our base-case scenario, but significant logistical delays could threaten another year of intermittent restrictions, stop-start economic growth, business failures and job losses. A lot hangs on this outcome.

Knutzen: Whatever the outcome, coronavirus is likely to result in longer-term changes to the way we do things, creating new forces and adding impetus to existing ones. Just to pick two examples, we have the remote working phenomenon, and I would also argue that it is amplifying the development of a bipolar economic, trade and technology superstructure, split between the U.S.-led system and the China-led system.

Amato: We are already seeing businesses respond by diversifying their supply chains, many of which had become concentrated in China. Geopolitical uncertainty, economic nationalism and simple wage and cost convergence have been pushing that trend for some years already, but coronavirus added impetus. If your supply chain is deeply embedded in China, you may not necessarily change it, but you are almost certainly re-thinking it, for a number of reasons. That implies having a thorough understanding of your supply chain, which is an important aspect of our environmental, social and governance (ESG) analysis and our engagements with company management.

Then there are the more visible changes accelerated by the pandemic. Digital transformation of business models is coming whether you are in the technology sector or not. A capital goods manufacturer will need increasingly to leverage the Internet of Things to enable machine-to-machine communication; virtually all industry is moving its data to the cloud; retailers will need to embrace ecommerce; and while lockdowns may have represented the peak of the phenomenon, many of us are likely to do more remote working than before the pandemic.

Consumers and businesses are increasingly looking to work, shop and access services remotely. Coronavirus has accelerated these themes, but as they were already in place before, they will likely still be in place five years from now, when hopefully the virus is a bad memory.

Knutzen: All of this raises another big question: Will the real-world application of Modern Monetary Theory and central-bank financing of government deficits, together with the early-cycle dynamics of a post-pandemic recovery, lead to reflationary growth? Or will we settle back into the post-financial crisis pattern of secular stagnation, low rates, low growth, low inflation and low expected returns? If progress on the virus will largely determine outcomes over the next 12 to 18 months, this question is likely to determine them over the longer term.

Tank: Depending on how quickly we come out of the coronavirus pandemic, global economic growth could surprise on the upside. If it does, there is a greater probability of higher inflation. Our thesis is pretty simple: inflation is not an issue for the next six months, but people are likely to be talking about it a lot from the middle of next year.

Fixed Income: Static Yields, Volatile Currencies

Anthony Tutrone: What does that mean when the major central banks are unwilling to let interest rates rise? Volatility will surely arise from fiscal largesse and the resulting inflationary pressures—which could be eased by some of the long-term forces we are describing but compounded by others. It has to show up somewhere. If it’s not allowed to show up in bond markets, is it not likely to be expressed through currencies?

Tank: I completely agree. Will the Federal Reserve go below zero? No, we’re 98% confident that it won’t. But will it deploy yield curve control in the manner of the Bank of Japan? Absolutely, we think that is a real probability. With rates close to or below zero all along yield curves just about everywhere in the developed world, growth and inflation differences worldwide are indeed likely to be manifested in the currency markets.

My team looks at inflation from four different perspectives: supply, demand, structural forces and central bank policy. There are structural forces, such as a globally aging population and increasing automation, that are disinflationary. But the other three are likely to be inflationary for the time being. There is pent-up demand to come, supported by fiscal looseness. Central bank policy is to keep real rates below zero far out along the curve for the foreseeable future. And on the supply side, companies are restructuring themselves and their supply chains to focus on profitability rather than market share—and that means higher prices, all else being equal.

At the same time, we believe the era of persistent U.S. dollar strength is probably over. With higher volatility in currency markets at large, and markets beginning to anticipate relatively higher inflation in the U.S., we think dynamic currency overlays will become a much greater focus of attention.

Knutzen: These forces also make a strong case for gold and precious metals in portfolios, as a potential hedge against the devaluation of fiat currencies.

Tank: This also means that the hunt for yield and depressed spreads will likely be a dominant theme in fixed income for yet another year. The blowout in credit spreads at the height of the coronavirus crisis was very short-lived, particularly compared with the 2008 – 09 financial crisis. Investors will likely continue to look for government bond proxies, from credit markets to income-generating equities, and we would counsel a much more flexible and opportunistic approach to the fullest range of credit markets possible.

Equities: Cyclical Opportunities, Long-Term Themes

Amato: It will be interesting to see these tensions between early- and late-cycle dynamics, and between cyclical recovery and secular stagnation, play out in equity markets. An early-cycle backdrop could prompt investors to question how long secular growth stocks can continue to outperform. On the other hand, rates are low, overall growth is likely to be modest and return expectations are muted. Whether we find ourselves in an environment of post-pandemic recovery or drawn-out pandemic resolution, secular growth stocks, many of which are highly geared to the business transformation themes we’ve identified, will likely remain attractive. There may be cyclical rotations, but we think those are likely to be relatively short-term, tactical opportunities. Nonetheless, if 2020 has taught us anything it is to expect the unexpected and maintain humility. The entire market has been buying mega-cap technology, but it is a good idea to remain diversified and not let portfolios tilt too decisively to one sector or factor.

Tutrone: We see this same tilt toward resilient growth in private markets. It’s about coronavirus, of course, but also much more than that. In many cases the pandemic really just exposed weak business models, whether we are talking about digital readiness, supply-chain diversification, workplace flexibility, operational efficiency and nimbleness, or ensuring there is the right slack in the system to cope with unforeseen circumstances. We see the same resilient-growth tilt in another major theme in private markets, which is more capital moving to Asia, especially China. While the pandemic appears to have originated there, the crisis has shown China to be a very hardy growth engine, and there is huge growth opportunity in China’s private companies. We have seen a host of deals, some involving companies that are near monopolies, growing 50 – 70% a year.

Amato: I think that raises an important point about how and where investors should seek growth opportunities. If we do face secular stagnation, the premium on growth stocks could tighten, making it increasingly necessary to identify less obvious businesses that are geared to long-term transformational themes. The secular growth mega-caps are a part of that story, but themes such as the advent of 5G connectivity, the Internet of Things, next-generation mobility and the green economy are not only truly global, transcending regional markets, they also support growth deep into value chains. This is where investors and analysts with technical knowledge and experience can find little-known “hidden gems.” This is particularly true when we consider the bifurcation of U.S.- and China-led value chains; identifying key players in China’s 5G value chain, for example, calls for detailed knowledge of both telecommunications and the Chinese equity market.

Alternatives: Resilience for Growth, Nimbleness for Value

Tutrone: When we look at private market deals at the moment, they are almost exclusively in market-leading companies, with resilient businesses that benefit from strong secular tailwinds, which can show readily executable plans to generate value. In 2015, 52% of the co-investment opportunities our team evaluated had projected earnings growth rates of less than 5%. So far in 2020, 100% were projected to grow faster than 5%; and 40% were projected to grow more than 15%. Businesses negatively exposed to the impact of coronavirus don’t seem to be changing hands at all, but we also think this is a conscious, durable shift towards resilient growth. That translates into an outsized proportion of capital going to companies in sectors such as software, health care and technology—which we believe can disproportionately benefit from being held privately, by the way.

As a result, the average valuation of deals has gone up. Resilient growth does not come cheap in a low-growth world. Then again, valuation risk is prevalent across almost all markets, and private equity managers have more tools than most to mitigate that risk, from the ability to make operational improvements that enhance earnings potential to the flexibility to time exits during more favorable conditions.

I think that relates to another theme that we see gathering pace in private markets, which is opportunistic investing—it can offer some of the best ways to find value. Private equity secondaries pricing is at its lowest for a decade. That’s partly due to a surge in General Partner-led transactions. A lot want to get liquidity to investors in their own funds, but many also recognize that some of today’s best opportunities are already in their own portfolios. They are looking to recapitalize companies they own in order to play offense with those that get a tailwind in the post-pandemic environment, or to play defense to get fundamentally good businesses through the crisis. Looking beyond secondaries, should default rates climb, nimble credit strategies will be there to provide capital and liquidity to distressed sellers and fundamentally good private businesses with cash-flow issues.

In addition, private debt strategies could find their opportunity set expanding as banks pull back their lending again, as they did following the 2008 – 09 financial crisis. And our colleagues from Almanac, our entity-level real estate investment team, are telling us that they are getting more inquiries than ever from real estate managers interested in consolidating their businesses into an integrated company. In some cases, these managers have been in the business for decades without an external capital partner, but are now reassessing the benefits of a corporate balance sheet in an environment where access to capital and liquidity is so important.

Knutzen: In the Multi Asset Class team, we think the top-down themes we’ve identified also support certain liquid alternative strategies. If the expected returns from traditional assets look unpromising against this backdrop of secular stagnation, investors are likely to continue to seek out non-traditional strategies. That could cover commodities, specifically industrial metals as a potential hedge against inflation and precious metals as a hedge against fiat currency devaluation, but also uncorrelated strategies such as insurance-linked securities, strategies designed to monetize volatility, and tactical trading.

Tutrone: I agree, uncorrelated strategies still make sense. There may not be the huge dislocations of 2020 to come, but the ability of the Democrats to implement their policy agenda remains unclear, the path of coronavirus remains unclear, the tussle between cyclical recovery and secular stagnation remains unclear. We have seen certain volatility and short-term trading strategies perform well during 2020, and in our view 2021 will continue to generate similar, if smaller, opportunities. The post-pandemic environment is also likely to produce very big winners and very big losers, which ought to be conducive to active management in general and long/short equity in particular. Opportunism is the key, in our view, in liquid markets but also in illiquid or less-liquid markets. Liquid uncorrelated strategies will be useful for trading the cyclical dynamics and volatility. In less liquid markets there could be opportunities to buy into secular themes at attractive valuations due to market dislocations—or just demand for liquidity by various market players.