The current economic upheaval and COVID-19 pandemic is certainly a human tragedy if quickly not brought under control could affect millions of people (its already affected hundreds of thousands of people). This is having severe impact on the global economy. Emma Nilsson – Group Director for Media & Communications had an exciting interview with Zinqular Group’s Co-CEO’s – Mr. Barry S. Graham and Mr. Michael Yaw Appiah. This a summarized transcript of the interview. In this conversation, both CEO’s provided their take on the evolving situation and implications for their investments, and portfolio companies. The COVID-19 pandemic is moving quickly, and this interview reflects their perspective as of March 27, 2020.
Emma: How does history confirms your investment views? How does uncertainty in economic times shape your view on investment?
Barry: Periods of financial shocks have come and gone in history. A century’s worth of economic data shows that globally diversified long-term investment strategies consistently triumph above all others, even reaching new highs after the crisis subside.
The COVID-19 pandemic; spreading on a global scale requires drastic measures designed to contain it. These in turn have triggered a profound change in economic and social activities alongside extreme uncertainty and volatility in the financial markets.
The resulting sharp fall in global sentiments is being felt across industries. The disruption of supply chains and the simultaneous decline in the consumption of goods and services have intensified it. Investors now face the question of how to proceed considering the current challenges.
The economic data of one hundred and twenty years shows how some of the most impactful economic crisis in the world started, developed, and subsided. The most significant occurrences were triggered by these events: One: Post-World War I recession going into the early 1920s, Two: Wall Street crash of 1929, including the Great Depression which lasted until early 1940s, Three: OPEC oil shock of the 1970s, Four: Technology (Dot com) bubble in 2000 and Five: Financial crisis of 2008/2009.
Michael: I think investment composure and patience pay out in the long-run. The historical data shows how troubling economic events resulted in recovery and even expansion once the crises waned. For instance:
At the depths of the Wall Street Crash, US equities had fallen by 80% in real terms. In a long-term context equity eventually recovered and gained new highs.
In the first half of the 20th century, several countries experienced extremely low returns arising from the ravages of war and extreme inflation. Once the economic downfall reversed, those countries experiencing the lowest returns during the crisis were among the best performers thereafter.
Emma: Will this crisis lead to a global depression or recession? How will this affect society?
Barry: I believe recession is probable but depression is unlikely unless the COVID-19 pandemic prolongs, becomes severe and is not brought under control. The Great Depression that began with a stock market crash in 1929 and lasted until 1933 scarred a generation with massive unemployment, wipe-out of wealth and plummeting economic output. Its reshaped America, shifting migration patterns, and spawning new styles of music, art and literature. Under President Roosevelt, however, it also prompted creation of an array of programs like unemployment insurance, Social Security retirements benefits, and bank deposit insurance that make a repeat unlikely.
The unpredictable and unprecedented path of COVID-19 has drawn parallels with the Depression, in particular with predictions that the rise in unemployment and the percentage drop in economic output could rival those seen in the 1930s. But for that to happen, the jaw dropping numbers likely to be recorded in coming weeks – millions thrown out of work, double-digit declines in gross domestic product – would need to be both deep and sustained over years, not months. In the Great Depression for example, the US shed 22% of its jobs over 3 years, four times the share lost in the 2007 to 2009 Great Recession.
Michael: I also think it a fact that over the four years of the Great Depression nearly a third of U.S. output disappeared. While some economists think U.S. annualized output in the April to June period of this calendar year may fall 14% or more, few think that type of decline will actually persist over time.
Government spending makes a difference. Unemployment claims have skyrocketed, but so has the amount of money the government plans to transfer to people and companies big and small.
Central banks matter too. Federal Reserve policy mistakes and failure to prevent a run of bank closures arguably contributed to the Great Depression. This time, as in 2007, the Fed and global central banks have moved to soak the economy in cash and enact new programs to try to limit the risk of business failures and sustained unemployment.
Barry: The most important next step, a growing body of economists and policymakers say, is fixing America’s public health response. A haphazard patchwork of restrictions across states and a slow-to-mobilize White House could make coronavirus’ impacts worse, health experts say.
The US President push to “reopen” the economy quickly carries risks. Lifting lockdown restrictions too early could cause a second wave of the disease, according to a China-focused study published this week in the Lancet Public Health Journal. The higher the toll of the virus, and the longer the outbreak lasts, the more damage to the economy.
Emma: What is the state of private equity and the new reality of COVID-19 pandemic and the current slump in the global economy?
Barry: It is clear that Institutional investors, Private equity (PE) firms and their portfolio companies come into this pandemic and economic slowdown riding a decade-long wave of growing transaction volumes, valuations, and fundraising. That position of strength may prove as a defense in the months ahead, especially for firms that have exercised prudence recently. But there are also fault lines in private markets: deal leverage recently reached a new high, and multiples paid in recent months reached a multiyear high.
Recently, our Co-CIOs in a letter to their front-line portfolio managers recommended making some adjustments to their family of assets in light of this current climate. Among other things, the Co-CIOs recommended managers to for e.g. Revisit or assess their investment strategy for their portfolios; Review their asset financing & allocations; Prioritizing their portfolio; Support their limited partners & stakeholders; and Ensure continuity of critical & essential processes. Finally, they should prioritize the health and safety of their staff.
Michael: I agree. In Zinqular, this crisis is an uncharted territory. This COVID-19 outbreak is fundamentally un-usual in its disruption of core working processes to our portfolio companies. For this reason; our portfolio managers wrote to their respective portfolio companies animating them to bold actions and priorities in this crisis. For instance, portfolio companies were asked to:
1st: Create a ‘cash war room’ to manage financial & liquidity risk,
2nd: Stabilize operations i.e. assess operational risk rapidly and, when necessary, stabilize their operations. Manufacturing firms are moving swiftly to create visibility into their supply chains. Service-based firms must reconsider capacity planning and demand management.
3rd: Prepare for recovery & growth e.g. portfolio companies may consider customizing product or service offerings to help clients weather the downturn. Prepare for M&A and divestitures and by building a pipeline of potential strategic targets. Readjust budgets and management incentives for the new environment.
Emma: When you analyze the bear markets back to 1835, what’s the bad news — and the good — about this crisis?
Barry: We all know the economic decline was certainly triggered by the COVID-19 pandemic as in previous slumps, there’s both good and bad news. First, the bad, “event-driven” bear markets, on average, result in over 32% declines. Therefore, we are in bear market – a bear market is typically defined when major stock market indices drop at least 20% from a high.
We’ve never before entered a bear market due to a viral pandemic. The good news, however, is that bear markets triggered by exogenous shocks typically regain their previous levels within 15 months. Not all bear markets are created equally. We analyzed bear markets going back to 1835, and then classified them as structural, cyclical or event-driven.
Michael: For example, structural bear markets, on average, see drops of 57%, and cyclical bear markets see drops of 31%. Structural bear markets as those created by imbalances and financial bubbles, very often followed by a price shock like deflation. Cyclical bear markets are typically a function of the economic cycle, marked by rising interest rates, impending recessions and falls in profits. “Event driven” refers to things like the war, oil price shock or an emerging-market crisis.
At Zinqular, we do see differences, however, between the current situation and other “event-driven” declines. They’re all different, but typically it has been market driven, so a monetary response that has often been more effective, we believe will not work in this crisis. This is partly because interest-rate cuts may not be very effective in an environment of fear where consumers are forced, or just inclined, to stay at home.
Emma: As an asset manager which sectors are attractive for investment in this downturn?
Barry: With cities all across the world shutting down in the wake of COVID-19 pandemic with public and private assets prices lower, Zinqular is pursuing several investment sectors. As a case in point, we are interested in social bonds that support high growth emerging market-based companies hit by the pandemic.
Currently on our radar are a number of good quality social bond targets companies in emerging markets that are involved in the production and delivery of medical equipment and pharmaceuticals. Social bonds in companies that aims to ensure that supply chains can be maintained as the virus continues to spread. We are investing through the International Finance Corporation (IFC). The IFC is part of the World Bank group that targets the private sector in emerging markets issues those kinds of bonds. The bond forms part of the World Bank’s $14B pledge to support countries and corporations hit by the outbreak of the virus.
Through this investment, we contribute to both mitigate the negative effects of COVID-19 pandemic and to create security for society, companies and their employees. This type of investment in social bonds benefits both communities and our clients in the long term. We want to support various (organizations) and countries to take measures to minimize the tragic effects of COVID-19 as far as possible. In the long-term, private capital can complement (public capital), and help secure jobs and reduce the health and economic effects of the virus outbreak.
Emma: Where does the capital market go from here after the worst drop in over 30 years?
Barry: In my opinion we have moved on to a new world. Only a few weeks ago, global equity markets were at fresh all-time highs. How rapidly things have changed. We have clearly moved into an entirely new world. Investors are fleeing risky assets, seeking shelter in safe-haven investments like government bonds. Oil, already under pressure in light of the growth setback, additionally fell victim to the inability of the major oil-producing nations to agree on additional supply cuts.
Michael: We do not participate in public markets but can offer some insights. We believe it is too early to broadly re-enter the equity market. Markets remain highly volatile and investors would be ill-advised to time the market. This is why we consider it prudent to stay neutral equities until confidence is restored and fundamentals, which continue to speak in favor of equities, return to the fore. Even though government bond yields have declined further amid safe-haven buying, we believe that they will reverse course once containment measures and economic policy responses are successful.
Emma: What tools is Zinqular taking to mitigate this massive market decline in their investments?
Barry: Frankly, we don’t have a crystal ball to tell you how long this pandemic will last. There’s no clear picture of the impact COVID-19 will have on the economy and the global financial markets. It is difficult to gauge or forecast, and we should expect economic slump & market volatility to continue.
The most important things Zinqular is doing is to stay vigilant; address clients concerns & reduce impulse to panic; prepare for industry consolidation, and carry out our long-term strategy.
For example, our portfolio managers and relationship managers have an all-round view of our client holdings with detailed knowledge on the portfolio and ability to simulate and re-balance portfolios in real time to ensure safeguarding and sustainability of the client assets. We also make sure our clients have guidance from tax experts to address their concerns in specific situations, such as tax-loss harvesting benefits. In addition, we fast-track deployment of portfolio-management tools and mechanisms to ensure relationship managers are updated in real time on client portfolios. As a digitally enabled organization, it is our fiduciary responsibility to pressure-test relevant digital infrastructure, such as automatic re-balancing tools.
Another example is our portfolio managers have made sure all of our portfolio companies have “recession proof” contingency plans in place. These companies have revised annual planning in anticipation of prolonged reduction in customer activity; identified portfolio of mitigating actions including securing debt lines and ways to preserve cash to weather a potential slowdown.
Emma: What’s your take on the scope of major stimulus launched by several governments to address economic fallout and COVID-19 pandemic. Are these measures going to be effective?
Barry: The effects of the COVID-19 have cascaded through financial markets and the global economy, leading to steep declines in equity markets and the cancellation of major business, entertainment and sporting events.
Low inflation gives central banks considerable headroom to ease monetary policy. Several central banks have lowered their policy rates and launched billions of bond program. A key task of most central banks is to keep inflation low and stable, with many targeting 2% annual consumer-price growth as optimal. When it is well below that rate – as it is now or may be soon in most advanced economies – central banks can ease policy dramatically through interest rate cuts, asset purchases and other measures to address economic fears without triggering a pandemic of inflation.
Critically, the short-term effect of the coronavirus will likely be for inflation to fall even further as the steep drop in oil prices funnels into reduced prices for petrol and other types of energy. That would be good news for consumers. But there is a distinction between declining prices in some categories like petrol stations – which raise consumers’ disposable incomes – and persistently falling prices across the board, known as deflation, that may lead to wage cuts that make it hard for households to service debt. To guard against this risk, we see scope for further stimulus from central banks particularly in the form of asset purchases.
However, governments must play an active role too with their tax and spending policies. Ultimately, a lot of the hard work is going to have to be done by fiscal policy.
Emma: What are the broad economic scenarios including range of possible outcomes due to current crisis?
Barry: In our analysis, three broad economic scenarios might unfold: a quick recovery, a global slowdown, and a pandemic-driven recession. We believe that the prevalent pessimistic narrative (which both markets and policy makers seem to favor as they respond to the virus) underweights the possibility of a more optimistic outcome to COVID-19 evolution.
In the Quick recovery scenario, case count continues to grow, given the virus’s high transmissibility. This inevitably causes a strong public reaction and drop in demand. Working-age adults remain concerned about their parents and older friends, neighbors, and colleagues, and take steps to ensure their safety. Older people, especially those with underlying conditions, pull back from many activities.
In this scenario, our model suggests that global GDP growth for 2020 falls from previous consensus estimates of about 2.5 % to about 2.0 %. The biggest factors are a fall in China’s GDP from nearly 6 % growth to about 4.7 %; a one-percentage-point drop in GDP growth for East Asia; and drops of up to 0.5 percentage points for other large economies around the world. The US economy recovers by the end of Q2. By that point, China resumes most of its factory output; but consumer confidence there does not fully recover until end Q2. These are estimates, based on a particular scenario. They should not be considered predictions.
Michael: I think in the Global slowdown event; most countries may not able to achieve the same rapid control that China managed. In Europe and the United States, transmission is high but remains localized, partly because individuals, firms, and governments take strong countermeasures (including school closings and cancellation of public events). This scenario sees moderate spread in Africa, India, and other densely populated areas, but the transmissibility of the virus declines naturally with the northern hemisphere spring.
This scenario sees much greater shifts in people’s daily behaviors. This reaction lasts for eight to twelve weeks in towns and cities with active transmission, and three to four weeks in neighboring towns. The resulting demand shock cuts global GDP growth for 2020 in half, to between 1 % and 1.7 %, and pulls the global economy into a slowdown, though not recession.
In this scenario, a global slowdown would affect small and mid-size companies more acutely. Developing economies would suffer more than advanced economies. And not all sectors are equally affected in this scenario. Service sectors, including aviation, travel, and tourism, are likely to be hardest hit. Most Airlines have already experienced a steep fall in traffic on their highest-profit international routes (especially in Asia–Pacific). In this scenario, airlines miss out on the summer peak travel season, leading to bankruptcies (an e.g. FlyBe, the UK regional carrier) and consolidation across the sector. A wave of consolidation was already possible in some parts of the industry; COVID-19 would serve as an accelerant.
In consumer goods, the steep drop in consumer demand will likely mean delayed demand. This has implications for the many consumer companies (and their suppliers) that operate on thin working-capital margins. But demand returns in May–June as concern about the virus diminishes. For most other sectors, the impact is a function primarily of the drop in national and global GDP, rather than a direct impact of changed behaviors. Oil and gas, for instance, will be adversely affected as oil prices stay lower than expected until Q3.
Barry: The 3rd scenario is Pandemic and recession. This scenario is similar to the global slowdown, except it assumes that the virus is not seasonal (unaffected by spring in the northern hemisphere). Case growth continues throughout Q2 and Q3/Q4, potentially overwhelming healthcare systems around the world and pushing out a recovery in consumer confidence to Q3 or beyond. This scenario results in a recession, with global growth in 2020 falling to between –1.5 % and 0.5 %.
Michael: I will also add that – Unsurprisingly, sectors will be affected to different degrees. Some sectors, like aviation, tourism, and hospitality, will see lost demand (once customers choose not to eat at a restaurant, those meals stay uneaten). This demand is largely irrecoverable. Other sectors will see delayed demand. In consumer goods, for example, customers may put off discretionary spending because of worry about the pandemic but will eventually purchase such items later, once the fear subsides and confidence returns. These demand shocks—extended for some time in regions that are unable to contain the virus—can mean significantly lower annual growth. Some sectors, such as aviation, will be more deeply affected.
In the pessimistic scenario, case numbers grow rapidly in current complexes and new centers of sustained community transmission erupt in North America, South America, and Africa. Our pessimistic scenario assumes that the virus is not highly seasonal, and that cases continue to grow throughout 2020. This scenario would see significant impact on economic growth throughout 2020, resulting in a global recession.
In both the base-case and pessimistic scenarios, in addition to facing consumer-demand headwinds, companies will need to navigate supply-chain challenges. Currently, we see that companies with strong, centralized procurement teams and good relationships with suppliers in China are feeling more confident about their understanding of the risks these suppliers face (including tier-2 and tier-3 suppliers).
Emma: Thank you for your time.
Barry & Michael: Our pleasure.