A BRIGHTER FUTURE, with Laidlaw – Episode #7 Laidlaw Five with David Garrity

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“Laidlaw Five” Podcast – Monday 4/6/20 – SCRIPT.

1. QUESTION: After last week’s developments (e.g. March 2020 Employment Report, Oil Price Spike, COVID-19 Coronavirus (“COVID19”) spread), what are the near-term factors driving the markets?

ANSWER: Right now, there are estimates that the U.S. economy is operating at 75% of its rate prior to the onset of the COVID-19 Coronavirus (“COVID19”). One item from the March 2020 employment report released Friday 4/3 is that the broadest U-6 measure of unemployment rose +1.7 percentage points to 8.7% of the U.S. workforce from 7.0% in February 2020, the largest month-to-month change in the history of the data series (starts in 1994) and a clear indication of the magnitude of COVID19’s shock to the economy.

If sooner is better for the stock market in terms of economic recovery, then “V-shaped” (quick down, quick up) is better than “U-shaped” (quick down, slow up) recovery. The fact that Fed Funds Futures are not pricing in a “V-shaped” recovery means it is likely the stock market doesn’t have a “V-shaped” recovery priced in either, so the likelihood of further rapid stock market collapse may be diminished.

That said, there are bulls out there who may be premature in their recovery timing. Apart from how quickly the healthcare policies to contain COVID19 are relaxed (note this is expected to be gradual, not rapid, hence the “U-shaped” recovery expectation), the other critical variable markets will have to deal with is the global price deflation caused by the protracted demand destruction COVID19 wrecks upon leveraged corporates. More broadly, deflation taking hold will serve to raise investor concerns as to the earnings power of companies and depends on whether their business models can function profitably in this new economic environment. The market will likely have difficulty handling the wholesale rethink of corporate earnings power deflation brings.

In investing as in the land of the blind, the company with positive pricing power (an analogy to sight) is king. How well we navigate the tides of deflation depends on both finding companies with positive pricing power and, if aggressively inclined, shorting companies that do not.

For now, COVID19 remains the gating factor on the economy and the stock market. Near-term, the flattening of the infection curve will offer support to bulls. The full measure of recovery will likely be the realization of either a commercially available vaccine or reaching a level of herd immunity, something that may require 60% of the global population to be infected which would be approximately 4.7 billion people out of the estimated 7.8 billion world total.

2.QUESTION: What developments are taking place in the energy sector and are there any positives for the broader economy?

ANSWER: The effort on the part of the U.S. to stabilize the price of oil is aimed at keeping prices over the break-even $45/barrel level for U.S. shale oil producers so employment can be sustained and corporate defaults forestalled in the energy sector. Whether Saudi Arabia and Russia can reach an agreement to reduce production levels remains to be seen, but it would appear to be in their long-run self-interest to undermine U.S. energy independence.

For now, with WTI oil futures trading at $27.70/barrel, the market is apparently not putting much credence in the likelihood of the U.S. succeeding in its price stabilization plan. Separately, lower oil prices translate to lower gas prices at the pump which does provide some benefit to the U.S. economy, so it is good to be mindful of the available positives at the juncture.

3. QUESTION: Relatively low-risk investments such as bond funds have seen price declines this year. Of the 19 bond fund categories tracked by Morningstar, only 4 have seen price increases this year. What is taking place here?

ANSWER: We discussed earlier investors having to come to grips with deflation, a pricing environment that the global economy has not had to deal with for some time.

Right now, the world’s biggest source of deflation is China where producer prices registered a -0.4% decline in February 2020 compared with a year ago after rising +0.1% in January 2020. This is a drag on the price of goods being shipped overseas from the world’s biggest trading nation.

The problem with deflation for fixed income investors is that it raises default risk as loss of pricing power causes issuers to fail. Arguably, the decline in bond funds last week is a confirmation that higher levels of default risk are being priced into the market. Similarly, the widening out of credit spreads for lower-grade borrowers.

4. QUESTION: The Fed has stepped up on the monetary policy front in terms of providing support to financial markets, but clearly the economy requires substantial fiscal relief as well. With CARES I bringing $2tn in relief, to what extent will that carry the U.S. economy?

ANSWER: The Friday 4/3/20 failure to launch for the relief payments offered to small businesses under CARES I was unfortunate and indicative of the haphazard character of the current Administration’s efforts to address the COVID19 crisis. That said, the expectation is relief payments will be forthcoming over the course of April 2020 which may serve to blunt to some extent further sharp increases in unemployment.

The bigger question now is how discussions are shaping up around CARES II. With Congress not scheduled to be back in session until Monday 4/20/20, there is a slackening in the pace of relief efforts that are urgently needed to support the U.S. economy during the COVID19 crisis. Indications are that current COVID19 containment measures may be extended and so remain in place until late in 2Q20.

As it now stands, the CARES I relief program is thought sufficient to support the U.S. economy until early May at best. With GOP leaders such as Senate Majority Leader McConnell indicating a reluctance to move forward on CARES II until having the opportunity to examine the full benefit of CARES I, the risk is that Congress will fall behind the curve in trying to get out ahead of the COVID19 impact on the U.S. economy.

5. QUESTION: In all the focus on the COVID-19 Coronavirus response attention has been diverted from the 2020 elections. Any developments there to note?

ANSWER: Due to COVID19, Democratic presidential primaries have been postponed in 15 states and the Democratic Convention has been moved back to August 2020. The main effort to keep the 2020 elections on track will be to make sure that voting by mail is a viable option.

CARES I contained roughly $400mm in funding to develop the option further, but Congressional leadership has stated publicly that the full amount required is closer to $2bn. To that end, prospects for the 2020 elections going off as planned may depend significantly on the passage of CARES II.

6. QUESTION: COVID19 clearly meets the definition of a “black swan” event, an “unknown unknown” for investors. While COVID19 was in the news at a low level in early February, there was no one who was sounding the alarm. Is this just what happens with a very speculative stock market, at the peak where there is a new normal that things are wonderful?

ANSWER: Going into 2020, the stock market was riding high on hopes that the Trump trade wars were dying down as the Phase I agreement had been reached with China and the downward pressure the tariffs had imposed on the global economy was beginning to be lifted.

The possibility of a global pandemic such as COVID19 was clearly a long-tail event, an “unknown unknown” that no one expected, much less factored into their near-term forecasts. It is likely to result prospectively in investors opting to have some type of hedge protection in place. The days of being an unhedged long investor are over.

7. QUESTION: We have discussed macro ideas, but how should investors implement these insights with some portfolio ideas. For example, the playbook says when fundamentals begin to deteriorate, you head towards defensive sectors such as consumer staples, health care, utilities and real estate investment trusts. Do you ascribe to a similar playbook? As well, I understand you have been building a new COVID19 Portfolio with Laidlaw Head of Asset Management Ken Mathieson, maybe you can offer a “sneak peek” here.

ANSWER: The traditional defensive investment playbook is undergoing revision as deflation is beginning to be factored in. Pricing power is a far more scarce commodity these days. Meanwhile, structural shifts to a more distributed workforce and increased levels of automation as organizations right-size their operational footprint to achieve sustainable profitability have implications that are negative for overall employment and consumer spending levels and highlight the likelihood of excess capacity in the commercial real-estate sector that may take a protracted time to clear.

That said, we have put together some thoughts on which companies are likely to prosper in the current environment as well as become more central to the global economy henceforth. Please find the list here:

Technology
Microsoft (MSFT, $160.68, market cap $1.2tn),
Amazon (AMZN, $1,956.15, market cap $974bn),
Nvidia (NVDA, $260.58, market cap $160bn),
Zoom (ZM, $119.05, market cap $33bn),
Atlassian (TEAM, $134.41, market cap $33bn),
Slack (WORK, $24.82, market cap $14bn)

Healthcare
Abbott (ABT, $80.69, market cap $142bn),
Regeneron (REGN, $508.05, market cap $56bn),
Teledoc (TDOC, $150.11, market cap $11bn),
Moderna (MRNA, $34.49, market cap $11bn)

Leisure
Netflix (NFLX, $369.17, market cap $162bn),
Activision (ATVI, $61.88, market cap $48bn),
Take-Two (TTWO, $121.09, $14bn)

Food
Walmart (WMT, $122.52, market cap $347bn),
Costco (COST, $297.12, market cap $131bn),
Uber (UBER, $24.64, market cap $43bn),
Campbell (CPB, $49.05, market cap $15bn),
Dominos (DPZ, $334.36, $13bn)

Technology

Microsoft (MSFT, $160.68, market cap $1.2tn),

Amazon (AMZN, $1,956.15, market cap $974bn),

Nvidia (NVDA, $260.58, market cap $160bn),

Zoom (ZM, $119.05, market cap $33bn),

Atlassian (TEAM, $134.41, market cap $33bn),

Slack (WORK, $24.82, market cap $14bn)

Healthcare

Abbott (ABT, $80.69, market cap $142bn),

Regeneron (REGN, $508.05, market cap $56bn),

Teledoc (TDOC, $150.11, market cap $11bn),

Moderna (MRNA, $34.49, market cap $11bn)

 Leisure

Netflix (NFLX, $369.17, market cap $162bn),

Activision (ATVI, $61.88, market cap $48bn),

Take-Two (TTWO, $121.09, $14bn)

Food

Walmart (WMT, $122.52, market cap $347bn),

Costco (COST, $297.12, market cap $131bn),

Uber (UBER, $24.64, market cap $43bn),

Campbell (CPB, $49.05, market cap $15bn),

Dominos (DPZ, $334.36, $13bn)