Capital Markets report: Stephen Gilmore - Into the era of unknowns

NZ Super Fund's Stephen Gilmore.

COMMENT:

Markets should be forward-looking but how can they retaintheir strength when signs of economic stress are apparent?Our key takeaway

is that it is a fool's errand to try and time the economic cycle.

You are better spending your time understanding your risk profile and testing underlying assumptions about the direction of the industry/market or economy you operate in.

In the 22 days following the 19th of February, the S&P500 index of US stocks dropped 30 per cent.

It represents the fastest decline of that magnitude ever.

Since those turbulent days, stock markets have largely recovered.

The Nasdaq is up 15 per cent since the beginning of the year and the NZX 50 is trading close to where it was at on 1 January.

Global equity markets are up 27 per cent since the end of March.

The seeming discrepancy between markets and the real economy is something we constantly think about at the Guardians of NZ Superannuation (the entity that runs the NZ Super Fund). Markets should, of course, be forward-looking.

But how can they be as strong as they are when signs of economic stress are apparent?

To understand why, it is important to understand what happened in the volatile early months of the dislocation, and what lessons were learnt following 2008's Global Financial Crisis.

In short, central banks and governments respectively worked in tandem to inject a colossal amount of monetary and fiscal stimulus into the system.

The amount dwarfed what occurred following the Global Financial Crisis, and building on knowledge gained from that event, the speed of the injection was far quicker.

But where to from here? This is where we enter the era of unknowns.

The first unknown is how long the real economic shock will continue. It is unclear how deep the recession will be and there is no consensus over what shape the eventual recovery will take.

Unfortunately the foundation of economic recovery in certain regions appears to be challenged by the on-going persistence of Covid-19.

At the same time some of the fiscal support that has been put in place is scheduled to soon end or to be scaled back.

At the present time, markets continue to price the drivers that are in front of them — interest rates remaining low for the foreseeable future, policymakers' continued determination to do whatever it takes to keep economies afloat, and the development of solutions and vaccines to the virus itself.

However, with markets pricing a strong future rebound in earnings, any undermining of these drivers is likely to put downwards pressure on sentiment and prices.

Assuming we do find a vaccine, the world faces a difficult period unwinding all the cash and other support that has been provided to the system and which has led to an increase in already high debt levels. There are three potential paths under which those debt loads can be brought down or made more sustainable.

The first path is a less-than-ideal eventual crash which sees debts written down to the detriment of savers and other creditors. A second path encompasses a more gradual redistribution of the debt load.

The typical way that happens is through unanticipated inflation, which has the effect of bringing down real interest rates, although it can also happen through various forms of financial repression. At present that higher inflation path seems some way off.

The third and final path is via sustained growth that brings values back into line with the real economy. The latter is obviously the most desirable, but it is a brave soul who predicts we are heading into a strong recovery.

Does this all change the assumptions that underpin the NZ Super Fund? Not especially.

Our long-term horizon (sizeable transfers back to the Government to help smooth the future cost increases of providing universal superannuation do not begin until the 2050s), means we have the ability to look through shorter periods of market volatility.

As a result, short-term shifts in markets translates to volatility in the valuation of our assets under management, which are heavily weighted to equities.

The Fund is positioned to take advantage of these market opportunities via a counter-cyclical strategy that enables leaning into markets when risk sentiment is at its lowest, and through constant reassessments of what constitutes fair value for the various markets we operate in.

Our key takeaway is that it is a fool's errand to try and time the economic cycle.

You are better spending your time understanding your risk profile and testing underlying assumptions about the direction of the industry/market or economy you operate in.

At the Super Fund, this means thinking about potential structural shifts and changes in trends.

Four key ones we are looking at include acceleration of the existing digitisation trend and increased uptake of new technologies, supply chain reconfiguration, medium-to-longer term shifts or developments in consumer preferences and actions, and changing political behaviour (including protectionism, fiscal impulses, heightening inequalities, regulation/tax changes, responses to the continuing rise of China and pull back of the US, and increasing regionalisation).

We also think about the higher level implications for potential growth, inflation, the longer term level of interest rates and the premium that we can expect to be paid for taking on market risk.

All of those factors influence how future cash flows and earnings will be valued.

At the same time we need to be alert to possible changes to the social contract and their distributional implications.

In an era of unknowns, perhaps the only thing that is certain is that one day things will get back to normal — at the Super Fund we call this "mean reversion" — although what constitutes normal can itself change over time.

What everyone needs to focus on is how we can best prepare our economy for that return to normal — but in a world that has likely changed forever.

- Stephen Gilmore is chief investment officer of the NZ Super Fund.