In six short weeks Covid, initially a regional epidemic confined largely to the Hubei district in China, has become a global pandemic. The brutal, and in this case ruthless, power of exponential growth has been on display for all to see. At the time of writing it is present in 155 countries, with 198 000 confirmed cases and 8 000 deaths. Although the initial reaction from most governments, healthcare authorities and financial markets was a complacent one, this has changed dramatically. Panic is now widespread, as more and more countries move into lockdown, travel around the world grinds to a halt and governments pass laws enabling them to take control of private healthcare facilities, as they recognise the likelihood that public facilities will be overwhelmed in the weeks and months to come.
This is all deeply unsettling, with intense disruption at both a personal and societal level.The strain caused by the humanitarian crisis will be deeply aggravated by the economic fallout to come.We understand that the decline in market value of nearly all long-term investment portfolios over the past weeks is difficult to bear.
Why is Covid such a big deal?
The number of confirmed cases and fatalities at this stage from Covid may seem relatively benign (certainly relative to seasonal influenza, which severely infects three to five million people and causes 250 000 to 500 000 deaths per annum, globally), and is therefore difficult to reconcile with the dramatic responses we have seen globally. But these numbers belie the potential damage the virus could do if it continues its exponential spread.
Covid is an entirely new virus. Thought to have originated in bats, it is a novel virus to the human population. As such, unlike influenza and many other endemic viruses (i.e. that circulate amongst humans), we have no herd immunity against it, no proven drugs to treat infection by it, nor any vaccine against it.
Scientists are still learning about it, but it is already clear that it has (complementary) characteristics that make it devilishly effective at spreading:
• The first are properties intrinsic to the virus that likely make it highly contagious (e.g. its ability to get a foothold upon entry into its host).
• The second is that it looks likely that the virus’s latent period (time from infection to becoming contagious) could be shorter than its incubation period (time from infection to displaying symptoms). This would mean that infected individuals can spread the virus before becoming symptomatic. This is in stark contrast to the 2002-2004 SARS outbreak, which saw ‘peak infectivity’ in a patient occur later, when the person was typically quite ill and thus already in hospital or sick in bed.
• The third is that even once infected c.80% of cases are mild, meaning that many infected individuals display little to no symptoms. This means large swathes of the infected are unaware of their infection and unknowingly spread the virus before realising that they’re ill or without ever having realised that they were ill.
• The fourth factor is its low fatality rate. For a virus to transmit effectively between humans, it ideally needs its host to remain alive and/or to give the host enough time to spread it before succumbing to the virus (this is in contrast to Ebola, which makes most of the people it infects very ill, very quickly and kills a large percentage (>50%) of them, making it ironically easier to contain).
The case fatality rate (CFR), or the percentage of infected people that die, for Covid is not yet known. The World Health Organisation (WHO)’s current estimate is 3.4%. It is still too early to know what the real number is, but many epidemiologists argue that the true CFR is closer to 1%.
We think it likely that the actual CFR will:
1) be lower than the WHO’s 3.4% estimate due to undercounting of the true number of infected in the denominator (bearing mind that c.80% of cases are mild, with many carriers displaying little or no symptoms);
2) be manyfold higher than that of seasonal influenza (0.1%), a severe flu pandemic (0.2%-0.4%), or the 2009 H1N1 swine flu pandemic (0.01%-0.08%);
3) skew significantly higher for the elderly and those with underlying diseases/conditions that comprise their immune systems; and
4) likely be higher in regions less well equipped to control the spread of the disease and/or care for the infected.
Taken together, these factors make for a virus that has the potential to infect large swathes of the population and be fatal to a meaningful number of those infected. The CFR also doesn’t tell the whole story. Although c.80% of cases are mild, the remaining c.20% will experience severe illness, a large proportion of whom will require medical intervention. And, given the ease and speed of the virus’s transmission, if left unchecked, the growth in case numbers will rapidly overwhelm healthcare resources. This will likely mean even greater transmission rates and worse health outcomes for the infected.
That is why we are seeing the drastic measures taken by governments around the world to slow the spread of the virus (to ‘flatten the curve’). Encouragingly, these drastic containment and social distancing strategies are yielding positive results, with the virus spreading much more slowly in some countries (e.g. China, Taiwan and Singapore).
Our base case for the pandemic and how it all ends
There have been several pandemics of global significance over the past hundred years. Although each is different and many occurred in a different time with less biomedical technology at our disposal, they can offer us some guide to what lies ahead. In general, past global pandemics have lasted for almost two years and taken almost a year to peak. Many have also been characterised by multiple ‘waves’, with the virus subsiding and resurging in affected areas (with weather seasonality a significant driver of this).
Should relief from this current pandemic come sooner, it would have to be for one of the following reasons:
1) The first is a drug to combat the virus. There are currently trials underway of existing antiviral and antimalarial drugs. These are drugs that are already on the market to treat other diseases and, as such, would not require the large-scale trials and lengthy regulatory approval process required for entirely new drugs. If they prove efficacious, these drugs could be made available relatively quickly. However, without clinical trial data (expected in the coming weeks), it is still too early to get our hopes up that this will prove to be the case. We are closely monitoring this and remain hopeful.
2) The second is a vaccine. There are currently over sixty investigational vaccines in development. Vaccines typically take years to develop and, even with modern advancements and intense focus and resources directed at it, a vaccine against Covid will, in all likelihood, take at least 12 months to develop. There are bottlenecks (the main one being the large human clinical trials necessary) that pose hard limits to being fast-tracked.
3) The third is mutation of the virus to a more benign form (this is what happened with SARS). Covid is a kind of virus that has a relatively high mutation rate, and there is arguably an evolutionary push for viruses to become more transmissible, at the expense of their virulence. If a virus can kill fewer of those infected and thus spread more widely, then it is likely to evolve in that direction. However, this virus is already not far off the evolutionary sweet spot of transmissibility versus virulence. Also, its mutation rate is such that it is unlikely to evolve rapidly enough over the next year to become less virulent.
4) A fourth is herd immunity. This is the premise that if enough people have been infected and recovered, they’ll be immune to reinfection and the virus will struggle to spread through the population. We cannot rely on this as a short-term strategy though. First, we don’t know if being infected will confer immunity, for how long and to what degree (if it does). There are some reports of recovered patients being reinfected. Second, in order to achieve herd immunity, as much as 60%-70% of the population would need to have been infected with the virus. As such, it is not clear how to achieve herd immunity without exposing the vulnerable segments of the population to the virus.
Our base case is therefore that this ends only when a vaccine becomes available at scale, and that this is, at best, a year away. If this proves to be too pessimistic, we think it will be because one/some of the antiviral drugs currently being tested end up meaningfully improving the prognosis of patients infected with the virus.
The next 12 months will see massive and widespread measures by governments to control the spread of the virus. The economic fallout from putting human lives first will be devastating. Many small businesses will not survive, and the more vulnerable parts of society will suffer the most. We are particularly concerned about the obvious risks here in South Africa, where the economy was already in recession and the healthcare system was already failing.
Early market reaction
In early January it felt like nothing could stop the longest equity bull market in US history! The market peaked as late as 19 February, more than a month after Covid had emerged in China. This initially complacent reaction anchored off the limited disruption and the buying opportunities that SARS, MERS and H1N1 had all proven to be. By the middle of March, however, equity markets around the world were setting records for the speed at which they were collapsing. Pain has been universally felt across equity, credit, property and commodity markets. Some of the price moves are difficult to explain. For example, gold, which is typically viewed as a safe haven, has fallen. The price declines have also been fairly indiscriminate, with the market drawing little distinction between those businesses that should prove defensive and those that are more exposed. We believe that much of this is due to the explosive growth in passive and quantitative funds over the last few years, a phenomenon that we think has damaged the price-discovery process across many markets.
An early casualty of the pandemic was the OPEC+ alliance, with members moving from cartel-like behaviour to a mutually destructive price war within just a few days. There will no doubt be further casualties to come. And, while global central banks and treasuries attempt to pump liquidity into markets, until confidence returns, based on medical discoveries, economic growth will be under immense pressure.
As things stand, the S&P 500 Index has declined 25% (which compares to c.48% in the Global Financial Crisis [GFC]). The JSE All Share Index has declined 28% (which compares to its 46% decline in the GFC). Meanwhile, global developed market bonds, already at multicentury lows, have rallied, while SA 10-year bonds have sold off almost 200 basis points.
Although we came into the new year with equity and offshore multi-asset class portfolios that were reasonably well positioned for the, as yet unsighted, black swan, this was not the case for our South African multi-asset class funds, which were overweight equities. While our weighting in global equities was comfortably low, given our view that global equities were fully priced, a higher weighting in domestic equities offset that. Fortunately, protection bought in the multi asset class portfolios in the early stages of the pandemic ended up compensating for that initial position.
I have been at Coronation for 20 years, and in all previous crises we have been early buyers of assets that we felt had sold off to levels meaningfully below our assessment of underlying intrinsic value. Fortunately, this time was different. Although our initial instinct was to anchor off the buying opportunity that other viruses had proven to be in the past, our first call with an international epidemiologist on 6 February made us more cautious. Numerous calls with other disease experts reinforced that view. As a consequence, our key portfolio actions were as follows:
• In our multi-asset class portfolios:
o We did not buy equities into the sell-off. In January and February, we actually bought protection through equity puts across most of our SA and global multi-asset class portfolios. At that point in time, protection was still reasonably priced.
o We then followed this up by selling S&P futures in global mandates in early March.
• In our SA equity portfolios:
o Early on, when the price action was more indiscriminate across stocks, we reduced exposure to some of the more exposed industries and to businesses with weak balance sheets.
o Examples include reducing exposure to Richemont, MTN and Sasol (where our exposure was low to start) in our local funds.
o We also actively recycled low-quality into high-quality businesses. Our domestic Houseview portfolio currently has 73% exposure to what we define as high-quality businesses. This is significantly higher than any time in the last decade. It is not often that one is able to buy high-quality companies at attractive prices.
• In our fixed income portfolios:
o Our low allocation to credit across our funds has allowed us the opportunity to increase our allocation to very attractively priced SA nominal government bonds.
o The valuation on many listed-property stocks have also started to look attractive. Despite this, however, given the subdued growth outlook, we have instead chosen to increase our allocation to duration assets on SA Government bonds.
• In our Global Emerging Market portfolios:
o A select number of Chinese stocks have held up well. We have reduced our positions in some of these and recycled the capital into more defensive businesses (with strong balance sheets) that have under-performed materially and which represented a good buying opportunity in our view. A good example is FEMSA.
o We have also sold some positions to zero where we believe the risks continue to be high or the relative upside was no longer compelling in an environment where many quality stocks are down 30%-40%. We continue to be circumspect about all the positions in the fund and weighing up the risk/return characteristics of each before taking action.
Concluding thoughts and playing the long game
At the time of writing, we draw some comfort from the fact that the performance of our funds through the crisis has been reasonable. It is very tempting in these difficult times to reduce one’s stress levels and prioritise near-term capital preservation. However, we do feel that the market is increasingly pricing in the economic consequences of this virus. Equity markets are also becoming less indiscriminate – sectors that find themselves in the eye of the storm and stocks with weak balance sheets are now being punished.
In times like this we need to remind ourselves that, as devastating as the humanitarian and economic fallout from the virus will be, it will not last forever. A few years from now, when we assess our own actions in this crisis, not taking advantage of deeply discounted stocks trading at fractions of their underlying value will, in all likelihood, be deeply regretted. This too shall pass. Out of every crisis, markets rally when we all least expect them to.
In all of this rather depressing commentary, I must emphasise that a large number of risk assets out there are stunningly cheap, both in South Africa and in global markets. For this reason, our stance has started to shift slightly. As of this week, we have increased the pace at which we are recycling shares that we think have come under pressure. We have also started to take off the equity market puts that we bought earlier in the crisis. The next step will be to physically buy equities. In every decision, we will attempt to judiciously weigh up return against risk. We will never reach for return at the expense of risk. But our guiding light throughout will be the long term, as difficult as that may be.
Article by Karl Leinberger and John Parathyras – Coronation Fund Managers