IWMC 2020: Impact of COVID-19 Crash on Investors by Mr. Rob Arnott

Speaker: Rob Arnott, Founder & Chairman, Research Affiliates

Moderator: Rajeev Thakkar, CFA, CIO & Director, PPFAS Mutual Fund

Contributed by:  Gaurav Kaushik, CFA, Member, Professional Learning Committee, CFA Society India

COVID-19 pandemic will have a lasting behavioural impact in the way we interact, meet, work and travel. Rob in his presentation on the inaugural day of the 5th India Wealth Management conference covered this impact in great detail as below

Impact of bailouts on Companies and Individuals  

Bailouts cushioned the lockdown blow on companies but have also propped up zombie companies. Mostly established and politically connected companies have benefitted from the bailout money rather than small businesses that actually needed that support.

The income of individuals got cushioned too during the lockdown when they were unable to earn. However, the majority in the US ended up getting a raise in pay (those who signed up for unemployment benefits).US national debt breached the 20 trillion USD mark three years back, and now it is likely to breach the 30 trillion USD mark in the upcoming years. The fiscal & monetary stimulus money doesn’t create new goods and services. Unlike the global financial crisis(GFC) which hit the market in 2008, a good chunk of the stimulus this time is going directly into pockets of individuals leading to inflation and asset bubbles.

Policy Mis-Steps

Locking the entire global economy down was a policy misstep considering a very low mortality level of 0.25% vs the impact on companies, jobs, livelihood and mental health.

Race to Zero Interest Rates Accelerates

The US joins Japan and Europe towards near-zero short term interest rates. Central banks now seek a long term average inflation of 2%, i.e. inflation in future will be higher than the ~1% level seen in the last decade. Inflation will affect the dollar’s ability to act as a store of value.

It has also affected the pensioners quite badly. As an example, a typical 60:40 pension portfolio in Q1’20 lost 10% in value, and the net present value (NPV) of liabilities went up by 15% (basis market interest rates) leading to a net drop of 25% in the net funded ratios. Even though markets have rebounded, actuaries have not adjusted for the potential forward returns of the market. Instead, they expect a 7% blended return from the market, which given the current interest rates and <2% yield of equities and a Shiller PE of 32x looks highly unlikely.

The zero-interest-rate has created a problem of misallocation of the capital where lending is available to those who don’t need it (like government or high-quality companies) but isn’t available to borrowers who actually need it, even at higher rates. The former then end up using it for buybacks rather than business development or long-horizon innovation and productivity enhancements. Approx. 2/3rd of the 3 trillion USD stimulus, as per popular belief, went waste and only 1/3rd was put to fair use.

Anatomy of a Bubble 

Higher supply of money is leading to the creation of asset bubbles. A bubble can be defined as a situation where if you are using a valuation model like DCF, then it will require implausible assumptions to justify the current price whereas a marginal buyer has zero interest in any kind of valuation model (because the stock is on a roll). Let’s compare two stocks-Tesla Vs Apple. Tesla is 2x the valuation of Toyota, which sells 30x more cars and has been considered a company that has been innovating and hasn’t lost money. Tesla is valued at $400k/car ever produced by it vs Toyota @ $20k/car. Clearly, the growth assumptions to justify the valuation of Tesla are implausible, and the marginal buyer isn’t interested in valuation models. Apple, on the other hand, at $2 Trillion valuation is expensive, but it has 100s of billions in cash reserves and vast global sales. The growth assumptions are aggressive but not implausible. And the marginal buyer is doing analysis and using a valuation model.

Most FAANG (Facebook, Amazon, Apple, Netflix, Alphabet(Google)) and BAT (Baidu, Alibaba, Tencent) kind of stocks qualifies to be a bubble. Stimulus encourages the formation of bubbles which get aided by Robinhood kind of investors. When such bubbles burst, they bring much pain to such investors.

Anti-bubble, on the other hand, is a situation where you need an implausible set of assumptions to NOT earn a risk premium on an asset, and the marginal buyer isn’t interested in valuation models. E.g., Emerging market (EM) value stocks, trading at a Shiller PE of 11x & a yield of 5% and State-owned enterprises with a Shiller PE of 8x and a yield of 5%.

Spread between growth and value globally is currently the widest in history. FAANG stocks comprise 25% of the entire US stock market but only 4% of the economy in terms of sales, profits, book value, etc. Such spreads are 30% more stretched now than what they were in the peak of the tech bubble.

EMs have witnessed a financial crisis every few years, and people have become relatively resilient and hence would be able to shrug off the impact of the current situation sooner. In contrast, developed economies that have been otherwise stable and haven’t faced such a crisis in a long time will find it hard.

Risk Premium & Expected Returns 

Assetallocationinteractive.com estimates long term forward real returns of around the 130 different world asset markets by adding the yield and growth in earnings and dividend of a stock adjusted to change in valuation levels over the next decade. Using such a metric, he expects a 7% real return in EMs over the next decade vs nil real returns in stocks in the US. In bonds, you get yield adjusted for inflation and default risk. EM bonds currently yield slightly below US junk bond and have historically seen just ~1% default risk; yield spread of 3-4% is quite attractive. A patient investor should make good returns in EM bonds and equities.

Indian equity market can generate a mid-single-digit real return only if valuation holds the current high levels. While India will grow 4-5% in real terms, individual companies may grow slower owing to the high level of competition. Turkey & Russia are relatively cheap and can provide good returns in future.

He doesn’t expect real rates to be positive for the developed world for a long time.

Rob believes that fundamental factor-based indexing produces better results than other factors like quality, momentum, low beta or value. But investors need to be patient as any single factor can have a long dry spell, e.g. Low beta strategy didn’t work post-90s and momentum has been flat since 1999.