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GMO Commentary- Asset Allocation: Covid-19 Update

Dear Asset Allocation Investor,

Facing turbulent markets and concern for the health of our clients, colleagues, families, and friends, I'd like to provide you with an update on how we are managing our Asset Allocation portfolios through the current environment.

Summary

  • We believe that COVID-19 need not materially change the fair value of equity markets, although this belief assumes that governments will take appropriate steps to help economies and companies make it through the current period.


    We believe that COVID-19 need not materially change the fair value of equity markets, although this belief assumes that governments will take appropriate steps to help economies and companies make it through the current period.

  • We continue to follow our long-term, patient, valuation-sensitive process.

    We continue to follow our long-term, patient, valuation-sensitive process.

  • Equities are meaningfully more attractive than they were at the start of the year, given the large fall in their price.

    Equities are meaningfully more attractive than they were at the start of the year, given the large fall in their price.

  • We stand ready to act as liquidity providers to capitalize on market overreactions and dislocations.

    We stand ready to act as liquidity providers to capitalize on market overreactions and dislocations.

  • The opportunity set for dynamic asset allocation today remains one of the best we've ever encountered due to the dispersion in valuations globally. COVID-19 does not change that.

    The opportunity set for dynamic asset allocation today remains one of the best we've ever encountered due to the dispersion in valuations globally. COVID-19 does not change that.

  • Assessing Fair Value (Which Has Been Remarkably Stable Historically)

    Assessing Fair Value (Which Has Been Remarkably Stable Historically)



Assessing Fair Value (Which Has Been Remarkably Stable Historically)

We use a long-term, valuation-based perspective to consistently rotate our Asset Allocation portfolios into what we believe are the most attractively priced areas. As with any valuation exercise, the assessment of long-term, fundamental fair value is critical to determining current attractiveness. While there will be a severe short-term economic toll (whether it is officially a recession will depend on the length of the economic shutdown, which is unclear at the moment) resulting from COVID-19, we do not believe it will have an enduring impact on the fair value of global equity capital. The fair value of equity markets has been remarkably stable historically; the only events in our experience to truly impair it have been major wars, the Great Depression, and, for global banks, the 2008-2009 Global Financial Crisis (GFC). Most recessions, even deep ones, do not leave a lasting mark on the economy or the financial markets, nor have previous global pandemics.

Case Study: Spanish Flu Pandemic of 1918-1919

The most severe pandemic that may be in any way comparable to what would be a very bad scenario for COVID-19 was the Spanish Flu pandemic of 1918-1919. Given that it occurred more or less simultaneously to the end of World War I and was followed by a serious depression in 1920-1921, it would be difficult to determine exactly what fair value loss was driven by the pandemic, the war, or the depression. But at some level it doesn't matter which we blame, as the loss of "clairvoyant" fair value for the S&P 500 from the peak to the trough was 1% from 1911 to 1918, as seen in Exhibit 1.

EXHIBIT 1: S&P 500 CLAIRVOYANT FAIR VALUE



Source: Robert Shiller, GMO. Clairvoyant fair value is based on the next 50 years of dividends and earnings. The red series is an approximation of clairvoyant fair value given a shorter history. The dotted series is our best guess as to what fair value has been over the past 20 years.


This is admittedly an understatement of the impact of the combined war and pandemic, as the trend growth of fair value from 1911-1918 in real terms would have been 8%, making for an aggregate loss of fair value versus expectation of a little over 9%.1 Attributing all of this to the pandemic seems unfair, however, as it implicitly assumes that World War I and the 1921 depression had no impact. For what it is worth, the U.S. stock market seemed to think the war was a bigger deal than the pandemic, as the S&P 500 fell 46% in real terms from the end of 1915 to the end of 1917 (when World War I was certainly an issue, while Spanish Flu had yet to emerge) against 5% from the end of 1917 to the end of 1919 (the period of the Spanish Flu pandemic).

Simply put, it takes an awful lot to change the underlying fair value of the market by more than a few percent. An acute event causing all companies to forgo dividends for a year would reduce fair value by the amount of the expected foregone dividends (2-4% or so at current valuations). Practically, an event has to either change the path of future return on capital for the world or cause a significant dilution event for shareholders. Widespread bankruptcies are a simple way to cause that dilution and the primary way a depression reduces fair value. Historically, we have not found any events that look to have had a long-term impact on return on capital globally.2 However, we have seen an event that caused both dilution and a return on capital fall within a major sector, and it seems instructive to look into that case to see if there are any potential parallels.

Case Study: Banks and the GFC

The 2008-2009 GFC constituted a large loss of fair value for the banking sector. First, banks were forced to issue significant numbers of additional shares to recapitalize themselves, and they had to do so at depressed valuations. But even beyond the dilution during the crisis period, increased capital requirements and suppressed net interest margins associated with ultra-low interest rates have impaired their return on capital. We can see the aggregate impact on their returns in Exhibit 2.

EXHIBIT 2: MSCI WORLD AND MSCI BANKS TOTAL RETURN SINCE 2007



Source: MSCI, GMO


This Exhibit looks at total returns instead of clairvoyant fair value given that we haven't had anywhere near enough time elapse since the GFC to be able to calculate clairvoyant fair value. But the combination of substantial dilution (16% net issuance by global banks from 2007-2011 versus net buybacks of 2% for the overall market in the same period) and the unique damage to bank business models stemming from regulatory change and monetary policy does give us a template of how fair value can be destroyed. Exhibit 3 shows return on economic book for the MSCI World Index and banks before and after the GFC.

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This article first appeared on GuruFocus.