2020 Annual Letter – Interest Rates and Economic Risk

Executive Summary

  • Real interest rates are low and will stay low for the foreseeable future (think years);
  • COVID-19 has hijacked the year 2020, and the risk associated with it is real and still not quantifiable;
  • COVID-19 will be contained with a vaccine at some point, likely 12-14 months from now;
  • Upon the containment of COVID-19 and the resumption of normal economic activity, equity markets will snap back due to pent up demand and significant monetary stimulus.

2020 – The Year Ahead

We started writing this letter in January, and back then we were planning on discussing a recent academic paper about long-term real interest rates. You will have to take our word for it; the paper was riveting (all 123 pages of it). While we will still incorporate our thoughts on this academic study, the spread of COVID-19 and its impact (both socially and economically) has taken over the stage.

Today is March 8th, and there is still a lot of uncertainty regarding COVID-19. We will do our best in this paper to highlight facts from conjecture. However, investment is always based on both facts and the expectations of the future. If we could always invest with 100% conviction of the right answer, every investment would be risk-free… That is not reality; there are always unknowns. COVID-19 was an “unknown unknown” up until December of 2019. Now it is a “known unknown”, and we must take it into account.

2020 BC (Before COVID-19)

Prior to COVID-19, the market was doing just fine. Riding a wave of optimism following a stellar 2019, market talk centered around the US election. If you haven’t forgotten, the US is electing a President at the end of the year… Additionally, interest rates had seemed to find support, with the 10-year UST rate bottoming at around 1.6%. Historically speaking, 1.6% is rather low. Only a few times in history had the 10-year UST reached such levels. One would logically assume that rates would revert to their historical mean (i.e. going back up). However, a recent academic paper by Paul Schmelzing actually argues against this. Instead, Schmelzing, in his paper titled “Eight Centuries of global real interest rates, R-G, and the ‘suprasecular’ decline, 1311-2018” shows a trend decline of real rates between 0.6-1.8 basis points per year.
Having read this paper, we found ourselves wondering, what if the real risk-free interest rate did keep going down. How would this affect the construction of a diversified portfolio? The only reason to diversify is to obtain a different source of return, but what’s the point if that different return is zero? Finally, why would anyone buy bonds when their real return is effectively nothing or even negative?

2020 AC (After COVID-19)

The first report of a “pneumonia of unknown cause” in Wuhan, China was made to the WHO on December 31, 2019. On January 30th, 2020, the outbreak was declared a Public Health Emergency of International Concern. While the FED minutes from their January 28-29th meeting prominently discussed the emerging risk caused by the novel coronavirus, FED officials did not express a preference to provide additional policy accommodation and reaffirmed the FED’s intention to taper Treasury bill purchases. Now called COVID-19, the virus and its associated risk has finally started to impact the financial markets with the FED making an emergency 50 bps cut to the FED Funds Rate on March 3rd and the S&P 500 sliding 11.6% from 02/24 – 03/06.

COVID-19 is an unexpected risk that has taken over the headlines, financial markets, and our day-to-day lives. While the mortality rate of the virus seems relatively low, the ability for the virus to be spread via asymptomatic carriers makes it hard to contain. Currently, there is still much we do not understand about the virus. Thus, we would like to think about the possible outcomes in the form of scenarios:

  1. Best Case – media reports are overblown, and the virus is not nearly as bad as it seems. Morality rate is close to that of the seasonal flu, and warmer months slow its spread. In this case, China’s economy recovers without a respective rebound in the number of new infections. Financial markets return to normal by April or May. Global GDP growth is positive for 2020, and the S&P 500 gets back to 2,900 during the summer.
  2. Base Case – while dangerous, the mortality rate comes in around 1% (about 10x as lethal as the seasonal flu), with most deaths occurring to those over 70 years of age. Therapeutic drugs (such as Remdesivir) are found to reduce the severity of infection, providing a means to treat critical cases. Available therapies reduce panic and allow economic activity to return by the summer, albeit at a lower level than normal. A vaccine is discovered and produced by March 2021, with global economy returning to full capacity shortly thereafter. Global GDP growth is flat for the year, S&P 500 earnings fall to about $120 with the price finding support around 2,400-2,600 range.
  3. Bad Case – mortality rate is greater than 1%, and with no good means of treating the disease, the world must wait for a vaccine. In the meantime, “social distancing” becomes the prescribed method of reducing infection rates, and global economic activity grinds to a halt. S&P earnings give back a few years of growth shrinking to about $100 and multiples contract, causing the S&P 500 to fall to 1,600-2,000 range (about where we were 4-5 years ago).

These are just three simplified ways to think about what might happen. Obviously, the Bad Case (and hopefully most unlikely case) is a disaster. We do not think this will happen, but we at least need to recognize it as a risk. The Best Case would be a welcomed surprise. The Base Case is what we think will happen. It is based on the discussions, conference calls, and research we have participated and reviewed including contributions from:

  • Luciana Borio – Vice President of In-Q-Tel and Former Director of Medial and Biodefense Preparedness Policy National Security Council (2017-19)
  • Barry Bloom – Joan L. and Julius H. Jacobson Research Professor of Public Health Harvard T.H. Chan School of Public Health
  • Eric Feigl-ding – Visiting Scientist of Epidemiology and Health Economics at Harvard T.H. Chan School of Public Health

While these people have impressive resumes and experience, all three at one point or another said “I don’t know” or some similar phrase. No one knows exactly how bad this virus is, and that is why the world is practicing/preaching the only known defense: social distancing/isolation. Unfortunately, the act of limiting our interaction with others dramatically slows the economy. This fact is showing up in the financial markets as investors rerate stocks (i.e. they are paying lower multiples for future earnings).

Lower growth leads to lower interest rates. This is because interest rates are basically the cost of money. If you have lower growth, there are fewer opportunities requiring capital. Thus, the competition to borrow money is less, and lenders must lower rates in order to encourage borrowing. The downward trend of yields is further exacerbated by investors fleeing to safety assets (i.e. increasing the supply of available capital for lending). This concept brings us back to original discussion before COVID-19. Going forward, a zero (or even negative) real risk-free rate makes sense, and the downward trend of the real risk-free rate also makes sense. If you think of the storing and protecting of your money as a service, then you should be willing to pay for it. A risk-free security does just this; it stores your money and gives it back to you. For years, people were actually paid to receive this service through a positive real interest rate. However, with improvements in liquidity and information, we believe “riskfree” has become less risky. For example, do you think the US Government today is less risky to lend money to than the Italian Government of 14th Century or the British Crown in the 15th and 16th Centuries? Back then, those governments were the “risk-free” borrowers. We would argue that the ability to monitor governments and the liquidity provided by the financial markets have effectively lowered the risk associated with such borrowers.

We bring this up to highlight an outcome we believe will occur after COVID-19 is under control. While we believe interest rates will rebound, we believe that the real risk-free rate will remain at or near zero. Thus, the interest rate that people commonly discuss, the UST 10 year, will reflect nothing more than the expected inflation rate during the term of the loan. And if inflation is low, expect nominal interest rates to remain low.

So, we are saving our money to invest in equities. As panic selling subsides, and cooler (healthier) heads prevail, equities will rerate back up. The monetary easing that many central banks will provide over the coming months will amplify this rerating. Additionally, the hit to S&P 500 earnings is transitory. It will go away, and the pent-up demand of millions of former “social distancing practitioners” will hit the stores, restaurants, theatres and airports near you. So, if there is a silver-lining to this note, it is that the equity markets will come back, and when they do it will happen quickly!


David E. Andrew
Autumn Lane Advisors, LLC

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