It is not possible to know exactly how institutional investing will change in a post-coronavirus world. We suspect that no new lessons were taught during the market’s response to the global COVID-19 pandemic, but it’s been such a long time since these truths were exposed that there may be plenty to learn after all.
There are several things we know. The expected return coming from U.S. Treasuries is now zero, or at least very close to it. Global Equities are confused about how to be priced as earnings and subsequent multiples are close to impossible to discern. We know that strategies working off of narrow, predictable spreads can get hurt badly in times of high volatility and uncertainty (a lesson that has been taught many times), and while we have not yet seen it, strategies dependent on high leverage and cheap capital can be downright dangerous.
There are also several things we don’t know but suspect to be true. Free capital and travel flow across countries will likely be curtailed. Ease of efficient capital formation will likely be more difficult, credit spreads will likely remain structurally higher for some time, and consumer behavior could see permanent or lasting changes. Over the past few weeks, people have received a crash course on what a primarily virtual life entails; big shifts towards remote work, telehealth, and an even greater reliance on online shopping and food delivery could structurally shift behaviors and economics even after the pandemic ends.
A world gone virtual is bad for real estate in the long run. We suspect that if lockdowns drag past the June 1, 2020 date the market seems focused on, the added uncertainty will likely drive the global economy into a protracted recession. We have viewed volatility and equity risk as transient, but we must be open to the idea that it can become the norm.
As we sit here today, the conventional wisdom suggests the virus will be brought under control over the next three months in a handful of ways:
- Improved testing, enabling us to efficiently separate the infected, unaffected, and immune
- People adhere to guidelines regarding social distancing, hand washing, and other mitigation recommendations
- The benefits of herd immunity as thousands of COVID-19 patients recover from the illness
- Warmer weather that slows the virus’s proliferation
- Treatments to reduce the effects of the disease
- Vaccines are developed and deployed
Yet even if the expected case plays out and the pandemic is a 6-month event, the ensuing structural shifts will likely have major impacts on how an institution should invest. The “expected case” could be much worse. A simple go-to strategy for institutional investors may be fraught with danger. Instead, we recommend rethinking your core tenets of investing on the whole.
Fixed Equity Allocation
A protracted recession will make equities volatile and have much lower return expectations, more uncertainty, lower multiples, and structurally higher volatility. To solve, we must work harder for alpha from stock picking and prudent timing. We must calibrate risk relative to risk tolerance more thoughtfully.
Fixed Core Fixed Income
A zero interest rate environment virtually ensures little-to-negative returns almost definitionally as a “return to normal” equates higher rates and losses. While this may provide some VERY small market shock protection (structurally lower volatility and convexity that works against diversification), these allocations should be cut dramatically. Needed cash and liquidity should be in cash.
Private Equity and Credit
The uncertainty cost of having money tied up and stuck in a prolonged recession could make this dead money for a very long time. Concentrate efforts on the best distressed investors you can find, focus more on credit and less on equity, and renegotiate fees to reduce the negative carry of a prolonged investment profile.
It is likely that the death of retail which has been broadly espoused may in fact be hastened by this virus. However, if virtualization accelerates, many types of real estate could suffer. At a minimum, cap rates MUST go higher and will likely remain so. It’s important that investors carefully discern the long-term need for real estate investments and accompanying cap rates.
The higher volatility and greater uncertainty will likely create broader opportunities and wider spreads for relative value investing. This should replace Core Fixed Income, allowing institutional investors to focus on strategies with no or negative correlation to equities.
The Great Unknown
If there was ever a time to have greater concern about the impact of deficits and deficit spending, this is it. The long-term structural effects on the dollar’s reserve currency status could be at risk. While we don’t predict this, it is a clear possibility. If we are faced with this scenario, the ability to borrow to fund our deficits could be much more difficult and could ultimately lead to much higher rates and inflation. Investors should be looking for strategies that naturally address this risk.
While this is a new and unique economic shock, we have seen shocks of all different forms since the industrial revolution began. You do not have to be a historian to know that droughts, famines, wars, and pandemics have existed since the dawn of mankind. This too will pass. The global economy is driven by man’s insatiable nature to grow and progress – that will not change. There will be new investment opportunities just like there always have been. The uncertainty created by COVID-19 will be replaced by new uncertainties as well. It is important to never tilt away from convention in too aggressive of a fashion. Remember that uncertainty forces investors to over-discount the downside and, as that uncertainty clears, there will be a more balanced discounting of good and bad expectations. We will emerge from this bruised, but not beaten.