“The test of a first-rate intelligence is the ability to hold two opposed ideas in mind at the same time and still retain the ability to function.” (F. Scott Fitzgerald)
The above quote by F. Scott Fitzgerald, originating from his collection of essays The Crack-Up published in 1935, is the perfect description of the mental state required for a successful investment strategy in these confusing times. We are experiencing the biggest economic recession since the Second World War, and at the same time the financial markets have just had one of the strongest quarters of the last 30 years. How can these things be reconciled? And what does this mean for the future?
1) The invisible hand
The extent of the economic recession we currently face is unclear. Will it be an economic decline of ‑5%, ‑10%, or who knows, even ‑20%? And will the recovery be V-shaped, U-shaped, or W-shaped? It is impossible to provide a clear-cut answer to these questions. There are too many uncertainties on the short term, relating to the health crisis, the economic crisis and the political and social consequences. The initial reaction of the financial markets could therefore be perfectly explained from this perspective, with the most obvious effect being a 35% drop in equity prices over the course of a few weeks.
Adam Smith’s “Invisible Hand” was in full swing until mid-March. But we have learned from past mistakes. “History never repeats, but it rhymes”. A long time ago, in the 1930s, we learned that the invisible hand occasionally needs support. Studies carried out on the causes of the Great Depression of the 1930s revealed that Central Banks and governments worldwide were too confident that the economy and markets would recover by themselves. The lack of action by the Fed, the Reichsbank, the Bank of England, and the Banque de France at the time saw a recession evolve into a depression that only came to an end when the Second World War broke out. Current policy-makers have not made the same mistake again.
Central Banks, led by the Fed and the ECB, reversed the downward spiral by restoring confidence among investors worldwide. The Fed lowered its short-term interest rate to 0%, a level we have been accustomed to in Europe for several years now. Moreover, both Central Banks have guaranteed liquidity for Government Bond markets and Corporate Bond markets. Governments and businesses now know that they can continue funding themselves at extremely low interest rates for a very long time. Is this ideal? No, because companies will be kept afloat that may not deserve it. Governments have supplemented the monetary stimulus by flexing their fiscal muscles, which we have rarely seen. Is this ideal?
Again no, because abuses are inevitable in this scenario. But let’s make one thing clear, the alternative of not providing guidance for the economy and financial markets would be much worse. It’s all about trust. If that is lost, consumption will stall and investments will be put on the back burner. The message from the Central Banks, fully interwoven with Government finances, is clear: “this virus shall be overcome, our economies will recover and we will provide the time needed to make this happen”.
In other words, there is no great divide between the real economy and what is happening on the financial markets. Investors are forward-thinking. Supported by the Central Banks and the fiscal measures implemented by the various Governments, investors are confident that the economic recovery will be strong from 2021 onwards. And that our society will also be more robust. Better equipped to deal with the challenges of the future, such as sustainability and safety.
2) What does this mean for your assets?
The classic reaction, like Pavlov’s dog from the well-known conditioning experiment, of investors in the past when a crisis or recession loomed, comprised three reflexes:
- Shares and bonds were sold in favour of cash. Let’s ensure we understand each other well: cash is a loan that you give to a Bank. It offers little to no diversification.
- Purchase of Government Bonds. Let’s ensure we understand each other well: Government Bonds provide a loan to highly indebted Governments. Choose wisely.
- Purchase of Gold, to a lesser extent.
A fourth category has now emerged. Today investors may feel most secure investing in companies with strong balance sheets, such as Apple, Google, Microsoft, Amazon, Alibaba, Tencent, etc. They invest in the balance sheets of these companies by purchasing corporate bonds or shares. Many look on in amazement at the ever-rising share prices of these companies. But here too we would dare to advocate serious rationality among investors. These companies are characterised by:
- Strong balance sheets. Instead of debts, they have tens of billions in cash on their balance sheets.
- They generate billions in profit, even in this crisis.
- Their profits are increasing, even in this crisis.
It cannot be ruled out that we will be dealing with rising inflation in the coming years. The best solution would be to resolve this mountain of debt. Low interest rates in combination with an inflation rate a few percentage points higher. The perfect investment portfolio for such a scenario is a combination of companies that have pricing power and can therefore maintain their margins in a world with higher inflation, supplemented with inflation-linked bonds, of which the yield is linked to future inflation.
In conclusion, it is well worth reflecting on the following, almost philosophical idea: “Financial markets are a way to funnel savings into corporate spending, harness the wisdom of crowds to set prices and make long-term holdings liquid”. In other words, your assets contribute to creating this safer, more robust and future-oriented society for yourself, your children and your grandchildren.