Creeping virus: Unprecedented exogenous shock

For those who know me closely, or have been reading my thoughts on this blog, know how disinterested I have been in Equity investing for over two years now. Every time someone pitched a stock idea to me -some IPO name, some midcap winning business, some consumer sector stock which I track professionally- I would find some or the other reason to not passionately believe in that idea. And the underlying reason many times was not just about the business, but more with valuation for broader markets, and euphoria around India equity story. In the process, some of my friends have labelled me ‘skeptic’, ‘mandodi’ (bear), ‘veteran who is scared’, ‘pessimist’, etc. Many times those stock ideas would go higher by 30-40% in matter of few weeks, only making me more vulnerable to their follow-up questions, and sometimes even laughter.

Following brutal market correction in the last 1 month, this post is not to claim victory, as honestly I did not initially envisaged the novel corona virus problem to become so big. It is also not to say that I made huge money by going short (rather made some money by going Long on back-to-back Fridays, and lost some when I was short this Friday). But thankfully by staying Underweight in equities when I had ample liquidity, I am not losing significant wealth or confidence in this downfall, and importantly I am ready with ammunition to make investments in this distress times. So this post is about understanding the implications, market expectations now, etc., and discuss Equity allocation. Despite trying to be as concise and as objective as possible, this post could be long- given that we are in unprecedented situation, I am full of opinion, analysis, and ideas that necessitate penning down for the blog

The Event

• What started as being known as a virus problem in one region (Wuhan, China) in late Jan (23^rd Jan), that would create supply-chain issues, possibly lower demand from China and have negative implications to only few sectors (travel, luxury, autos, metals, etc), soon percolated into a global problem, as the virus spread to Europe (20th Feb) and to US (mid-March). 

• To contain this virus, government in China, and later in most other infected countries have announced lockdowns (restricting movement of people/ businesses), leading to reduced economic activity across the world, and dampening consumer and corporate confidence.
• Amidst this health scare, we saw oil price collapsing (25% on single day, down >60% YTD now) on ego clashes between Saudi & Russia over a production cut amidst potentially weaker demand. While the lower oil price will eventually be good for consumers, it is creating havoc among global Energy producers, some of whom have high leverage, which will negatively impact global credit markets as well.

The implications

• Under this context, investors have fled risky assets (Equities, corporate bonds, commodities), seeking shelter in safe-haven investments like Government bonds, Gold, and US dollar. US equities took just 16 days from peak to enter bear market (>20% fall), quicker even than in 1929 Depression & 2008 GFC, & only second to 1987 selloff.  Currently, SPX is down 25% from its recent peak, after hitting a trough of 34% fall from its peak earlier this week (i.e we did see 13% rally this week from the lows, perhaps first signs of stabilization or selling exhaustion). The spike in VIX index, yield spreads, ETF discount to NAVs, all indicate we are in panic territory, albeit less so than earlier this week.
• In India, the fall has been similar (Nifty@8650 now is -30% from its highs, trough was 7600 making it -38% from highs) and is highly correlated to overnight US market closing and US futures trading during the day. While some may believe India is better positioned (lower crude, lesser covid cases ‘so-far’ helped by proactive response, less reliant on exports), in reality, the screen doesn’t reflect that, and we are acting just as a ‘derivative’ of  mother market in US. Nifty hit 10% lower circuit twice, on 13^th March (albeit it recovered intra-day and closed positive) and on 23^rd March, when it made a bottom (at least for now).
• This ‘shutdown’ and not ‘slowdown’ in economic activity, means it is unanimous now that we are heading into a global ‘recession’, and is reminiscent  of memories of 2008 financial crisis, and some have started viewing it similar to 1929 Depression too. However, what I see as the big difference this time compared to past crisis is that policy has reacted before, not after, a credit event (eg: Lehman bankruptcy)- an epic $7trn of QE and $5trn of fiscal stimulus has already been announced, with almost all major central banks (including India) announcing rate cuts. In fact, Fed’s emergency 50bp rate cut on 03^rd March (later another 100 bp on 15^th March) , when the markets had not even started falling scrupulously, raised some doubts if Fed knows more about the infections, than what was being officially announced by US govt. then.    

What is the consensus (fund manager, brokers, peer group) thinking now?

• Markets will not stop falling until the infection case ‘curve’ doesn’t flatten out globally, particularly in US. The general belief is that virus will be ineffective as weather turns warmers globally (in 2-3 months), and new case curve will flatten much before that.
• Unlike past crisis, which were mostly driven by financial problem, this time we are facing health scare, and therefore markets will recover only when we have ‘healthcare solution’ (low-cost speedier test kits, effective treatment, vaccines, etc).
• Albeit short-term markets could fall more (everyone say no one can predict the bottom), for long-term investors with 3-5 year horizon this is a great entry opportunity. I think the underlying assumption here is the age-old belief that Equities perform well in the long-run.
• The big gets bigger, so buy into Large Caps, Quality, and Defensive Growth stocks, and avoid Leverage. 
• While above points are unanimous, what remains debated is Fed’s unlimited QE (in other words privatizing losses) and fiscal stimulus will bring the much required financial market stability and importantly economic recovery later.

My view on consensus: As more number of investors start believing the above assumptions, the more likely markets will NOT follow that path. To my experience, consensus rarely gets it right in such situations. Last two weeks gave some signs that markets are losing their faith in central bank's expansionary policy, and if it had not responded to fiscal stimulus then the future would have been even darker. Also remember while recent news flow will be terrible, which could lead to further substantial downside on near-term economy and earnings, remember it is not how much bad it gets (depth) from here, but how long the bad will stay (duration) that will have bigger implication for markets. 

As always, Mr. Markets cannot be easily predicted- it is overwhelming to see that just when even the die-hard bulls got nervous (heard on CNBC in last 2 weeks), and with analysts getting very concerned over 21-day lockdown (announced on 24th March, 8pm) that will have hard impact on the economy, the markets have just found a bottom. While reasons to be cautious on India is justified, I would be watchful on global markets, more so than the local developments over the next few weeks. I think India has it own challenges beyond the near-term infection cases, from languishing GDP growth, population, unemployment,  and continued banking/NBFC problems. 

Read my next post to know how to position yourself under this circusmtances