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Embracing history over hysteria


Market turmoil sparked by the coronavirus pandemic has investors looking for answers. In this interview Jesmar Halliday, an Investment Manager at Calamatta Cuschieri tries to answer some of the questions investors are asking.

I’d like to have an explainer about why the markets have crashed?

To understand the reason why markets have been jolted by this virus, first we need to understand the basic dynamics of global capital markets. In essence, the scope of financial markets both locally and internationally, is to serve as a public domain, between willing investors with capital and needful businesses and/or Governments sourcing capital, to fund their operations and investment pipeline. It is a financial arrangement that through various investment vehicles, an investor can lend in various maturities with tiered levels of risk, as well as, participate in the partial ownership of a business which involves greater investment risk given the inherent business risk.

In simple terms, a business can be either privately or publicly owned through various corporate structures. In this case, we’re referring to public markets that are in distress which is symptomatic for private businesses. Essentially, financial markets in normal market conditions act as an agent for price discovery of various asset classes, facilitating the exchange of capital between investors and/or companies, be it fixed income/interest rates, equities, foreign exchange, and commodities, amongst others. The price discovery mechanism is central to understand this market reaction. Investment professionals and market participants around the globe continuously strive to efficiently price assets given the underlying investment structure and the myriad of associated risks. Investors will want a return which is commensurate to the risk given specific market conditions.

Narratively, the global market reaction in January 2020 to the Covid-19 outbreak in China was seen as an Asian risk at the time. Indeed, as Chinese markets re-opened following an extension to the Lunar New Year on 3rd February due to the outbreak, Chinese markets fell sharply by 7.88% in a day, albeit, clawing back into positive territory during that same week. This came on the back of expectations by markets that the Chinese government will provide the needed fiscal stimulus to replenish any productivity gap. In developed markets (most local investors tap these markets), the reaction was muted during the period as investors believed that the virus was to be contained in China and the spread was limited to the region.

Indeed, markets in Europe kept steaming ahead with a return of c. 4% from 3rd February till 21st February 2020. Then on came the rapid rise in infected cases in Italy during the 22nd and 23rd of February, which resulted in the Eurostoxx 50 Index (main European equity index) falling significantly by 4.01% on 24th February 2020. A one day tumble of this magnitude was last observed on 11th February 2016 when, at the time, markets were fearful of a global recession. From thereon, spikes in volatility was the order of the day, with intraday swings in asset prices that resemble a sailing ship battling stormy conditions. During 16th March 2020, the S&P 500 (main US Equity market index) fell 11.98% in a day, which is the third worst fall in market history. Basically, given that markets fell over 20% from recent highs, they are said to be in a bear market.

The contagious spread of the virus from China to Western Europe sent shockwaves to the business community around the world. Debt and equity markets function on the premise that a business has to be in operation in order to meet obligations and make a profit. A lot of the analysis carried out when undertaking an investment is based on the assumption that a business will be in operation unless it has a weak footing at the outset. If operations are halted (as in this case due to the global-wide closure), a business will incur operational expenditure whilst not registering any form of income. Depending on the type of business and industry, the repercussions are huge. Effectively, the decision to safeguard public health will come at a significant economic cost which will rip through economies to businesses and society at large.

The necessary draconian measures with respect to border control, travel curtailment, and in keeping people indoors to combat Covid-19, is similar to switching off the engine of a car and coming to a grinding halt. The only difference is that when a car is switched off, the costs are limited as you would not be incurring losses from petrol usage or wear and tear, other than the pro-rate insurance and road licence. However, with a business, fixed costs will keep piling up and not all can be postponed, including the wage bill. Simply put, this is a wide spread chain reaction that effects all stakeholders in an economy and society.
Markets function on the basis that they evaluate forward expectations and determine the value of a company’s share or debt price based on expected operational performance, by using historical business performance as a base.

The past is important, but the future is what’s mostly important for markets. Covid-19 can be described as a black swan event for markets, as it was not predictable. As the medical community can confirm, there is no clear indication as to when infectious numbers will plateau around the globe, with no end in sight in the short term. Markets are made up of humans, and human behaviour does not like uncertainty and the unknown. In these instances, animal spirits takes over which creates pockets of rapid selling, as fear takes over rationality and the fall in investment values are then exacerbated by market panic. The panic in markets is a mere reflection of the plight for businesses in the short term.

Let’s not forget that markets put pressure on Governments and policy makers around the world to obtain desired results. World economics and markets are intertwined to achieve sustainable growth. Without a functioning market, economies cannot grow. Therefore, as markets fall due to anticipated losses for businesses; government and policy makers find themselves resorting to all sorts of fiscal and monetary measures to assist businesses to mitigate layoffs that will have a negative long term impact on consumption which is a key factor (c. 60% – 75% in developed nations) for economic growth.

Around the globe, the US has been at the forefront to act decisively and swiftly in economic policy as Trump faces the biggest challenge to date, with elections looming large on his radar. On 17th March, US Secretary Mnuchin and Trump announced an ambitious proposal that includes more than $1,000 payment to all US adults, excluding millionaires and billionaires, $50 billion bailout to the airline industry and more than $500 billion for small businesses and other expenditures. On the rates front, the Federal Reserve cut interest rates to a range between 0% and 0.25%, boosted liquidity by $1.5 trillion in the banking system for them to provide cash flow funding to businesses and around $700 billion in quantitative easing.

These are commonly referred to as “bazooka” measures given the short time span upon which they were formulated. Similarly, the ECB boosted its asset purchase programme to protect sovereign yields and maintain borrowing costs at a minimum. Admittedly, on the fiscal front much more needs to be done, as Italy took the first shot to cushion the blow by announcing a fiscal stimulus of €26 billion, whilst other nations, namely Germany are yet to disclose their fiscal measures. All these measures around the globe are intended to calm markets and ensure the proper functioning of markets. The balance remains between policy intervention and the anticipated virus impact. If the virus impact remains higher than policy intervention, then uncertainty will keep reigning in the short term.

Has Malta’s stock market been impacted?

Local market participants have often observed turmoil in international markets with minimal impact on local investments. However, this time has been different, as Malta (in line with other countries) got directly hit by this event risk and problems for local businesses are tangible. On a year to date basis, the Malta Stock Exchange Equity Total Return Index is down c. 16.22% (till 18th March 2020). On the news that Malta had its first Covid-19 case on 7th March 2020, the local equity market traded lower, with a fall of c.13.70% over the course of 8 trading days. The share value of companies mostly hit by this fall operate in the tourism industry and other cyclical industries. When comparing the total market capitalisation for local companies that are listed on the local stock exchange, €783 million have been wiped out in corporate equity value. On the local corporate debt front, there has been selling pressure on various issuers, as investors fly to safety given the periodic uncertainty. The short term measures announced recently by the Government to provide guarantees to businesses should hopefully provide a degree of relief for debt issuers.

How are we seeing this play out when it comes to the economy here?

Malta is not immune to the virus, and as we all know, significant measures have been adopted by local health authorities to stem the spread. Intuitively, social distancing, inbound and outbound travel curtailment and closure of large to small non-essential businesses have a negative impact on the economy. Let’s not forget that, this economic cost is for the benefit of reducing the human cost of this pandemic. This is societal responsibility at its best, as governments around the globe are prioritising the health and well-being of their citizens over businesses, at least in the short-term. As previously discussed, there is an economic cost for these measures that will have an immediate social impact, as businesses will have to face mounting costs with minimal, to no income during this ‘social distancing’ phase.

In finance, we term the word ‘sustainable’ for businesses that provide an attractive level of income given the corresponding operational costs, known as the profit margin. This unfortunate event obliterates the possibility for businesses to meet short term costs given the non-essential business closure, especially in specific industries in Malta. This is why the European Central Bank boosted short-term liquidity (via the significant quantitative easing) so that it filters to banks that are central in providing short term funding gaps for local businesses. The financial system will be central to fund cash flow requirements for businesses. However, this is only part of the story. Cash flow is essential in normal market conditions, but in this case, cash flow for most businesses is funding solely costs which means losses.

The higher the operating leverage for a company (i.e. fixed costs such as rent, maintenance costs and wages) the higher the losses that it will experience. Let’s take a simple example, if a business had total revenue amounting to €100,000 and its operating costs (mostly fixed) were €50,000, the business would make €50,000 in profit. In this instance, there is zero revenue but the €50,000 still need to be paid. This means that the business essentially wipes out its previous profit quicker depending on the amount of fixed costs. This is why businesses will naturally resort to reducing fixed costs in order to limit losses which is mostly composed of the wage bill. Let’s not forget that cash flow funding is also a form of short term debt for a business which impacts the overall debt levels that has to be repaid once things normalise. Effectively, this means guaranteed losses for businesses, unless this is partially borne by the Government itself given the duty to society at large.

The measures announced by the Maltese Government were deemed necessary as the visibility to when the problem is resolved, remains foggy at best. In terms of scale, the US is by no means comparable to Malta, however, everything’s relative. The c. $2 trillion proposal announced by the US to tackle this shock, amounted to c. 10% of GDP. The government’s Debt to GDP level for the US is c. 107% and it is currently running a budget deficit of over 4%. On a relative basis, Malta’s economic standing has been stronger in recent years given the positive output gap that led to a budget surplus of c. 2% and Debt to GDP levels of around 46%. This strong footing puts Malta’s economy in good shape to weather the storm, for as long as it materially assists local businesses at all levels. The measures taken by the US explain the magnitude of the problem for the economy. Basically, they are spending now to (hopefully) save later.

Understandably, the Maltese Government, just as Maltese businesses, has kept its’ books in order and implemented policies for the business community to thrive onwards as corporate profitability grew stronger over the years to the benefit of Malta’s economic growth numbers. This global health crisis will test the strength and foundations of economies. The Government has a duty to protect employment levels as this may spiral into a vicious cycle of unemployment which will lead to lower taxes and lower consumer spending, leading to a downturn in the real economy. In finance, there is a basic principle that goes as follows “maximise shareholder wealth”. This public health crisis destroys wealth and business executives will simply reduce their cost structure to mitigate any foreseen losses, unless the Government intervenes. On the other hand, the Government needs to find a balance between the social/health benefit and economic cost.

Is there any idea about when it might get better?

Medical experts are better positioned to determine (if any) a timeline or duration for this virus. From what I gather, best case scenario is a year for a vaccine, whilst Trump mentioned that the US is working on a treatment for severe cases. The only solace we have is that this is not a permanent state and we will come out of it stronger. One thing’s for certain though; the moment markets get a sniff that an end date is near for this event, a repricing of debt and equity valuations would be in order. Markets will have greater visibility to the problem that will re-calibrate expectations depending on the developments. Investors should embrace history over hysteria in times of turmoil as it influences the decision making process. Long sighted investors embrace periods of weakness to invest in strong business models that may be cheap during periods of market panic.

Do you think it’s a good time to invest?

Market timing is potentially one of the many pitfalls for investing, as the numerous factors impacting investment values change dynamically and instantly. Clearly, there are pockets of opportunities in the investment space given the observed fall in market values throughout the various asset classes at the investor’s disposal. A strategy that may be applicable during volatile periods for investors during this period, is averaging the entry price for your investment. Seeking professional advice remains the best advice for investors to consult investment ideas, portfolio construction and execution. Investors need to be mindful that their portfolio should complement their total net worth and life constraints which differ from one person to another. Despite observed uncertainty and the unknown, investing is a symbol of hope for what the future holds and I tend to be a positive person despite the bombardment of negative news on Covid-19.

If so, would you have any advice on what to invest in?

An investor should always have an investment strategy in place in order to benefit from periods of distress. The basic principles for investing remain the same; have a diversified portfolio with a mixture of asset classes that will perform differently in various market conditions in order to contain the overall portfolio risk. Also, investors need to understand their ability to bear risk, as well as, willingness to bear risk. In simple terms, the ability to take risk relates to the financial clout of the investor and time horizon, whilst the willingness to bear risk relates to the mind-set (mental state) in relation to market movements as observed in recent times. The balance between these two factors provide for the construction of a portfolio that is resilient in various market conditions for it to correspondent to the investor’s risk profile.

This article was issued by Jesmar Halliday, CFA, Investment Manager at Calamatta Cuschieri. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.