Magellan Warns of “Known Unknowns”

Few people in the Australian finance industry are respected more than Hamish Doulass, founder and chairman of Magellan Financial Group with nearly $100 billion of funds under management, and their listed entity in the top 40 of the ASX200.  In an insightful and honest investor letter he addresses the economic “known unknowns” abounding today and how their funds are handling them.

Magellan Warns of “Known Unknowns”

Few people in the Australian finance industry are respected more than Hamish Doulass, founder and chairman of Magellan Financial Group with nearly $100 billion of funds under management, and their listed entity in the top 40 of the ASX200.

Funds managers such as Magellan are paid to know where best to put your money and few do it better than them.  What makes their latest investor update so remarkable is not just its content but it’s refreshing honesty in effectively saying ‘we don’t know’ given how unprecedented these times are.  They quote the famous Rumsfeld “known unknowns” speech as basis for outlining what they/we know now and what we don’t know.  It’s a long piece and we try to keep it short so in the context of our own trademark “Balance your wealth in an unbalance world” let’s just look at their economic unknowns.

“HERE’S WHAT WE DON’T KNOW ABOUT THE ECONOMIC IMPACT:

• What is the true level of unemployment? Millions of people remain employed with their wages being subsidised by government-funded job-protection programs. How many more people would be unemployed in the absence of these programs? For example, 10 million people in the UK are receiving state wage subsidies as are millions of Australians, Americans and Europeans. How many people will businesses let go when government wage-subsidy programs expire? Will these programs be extended and, if so, for how long? Australia has announced that it will not extend these programs outside of a few heavily hit industries such as tourism.
• In many countries, there are supplemental unemployment benefits being paid to people out of work. What is the stimulus impact of the supplemental unemployment benefits? What will be the economic impact when unemployment benefits are reduced to normal levels?
• What will be the economic impact if there is a material second wave of infections?
• How will consumers and businesses change their behaviour post the pandemic? Will the pandemic shock lead to a prolonged increase in the savings rate? Will consumers stop travelling even after the reopening of borders before a vaccine is widely distributed? Will business substantially reduce expenditure on travel and conferences and adopt video conferences and virtual conferences? Will business reduce their real-estate footprint by adopting work-from-home practices?
• Will increasing tensions with China lead to a material pull back in expenditure by Chinese nationals on tourism and education in certain countries?
• As the economic fallout from the pandemic becomes clearer, will governments continue to run extremely large fiscal deficits for prolonged periods or will they wind back spending? Will there need to be other fiscal adjustments such as increased taxes?
• How will banks respond at the end of servicing holidays? Can they continue to ‘extend and pretend’ or will they need to foreclose on borrowers? How long will they hold off on foreclosing? How many businesses and consumers will go bankrupt?
• What will be the impact of credit downgrades of borrowers from investment grade to sub-investment grade? Could this lead to the ‘fallen angel crisis’ resulting in substantial losses for debt investors? How will central banks respond to such a crisis?
• Notwithstanding unprecedented central-bank support, there are limitations on what central banks can do. What is the risk of an emerging-market currency crisis? The Fed is providing US dollars to many emerging countries via cross-currency swaps secured via US Treasuries held by the emerging country seeking US dollars. What is the risk of emerging countries running out of acceptable US-dollar collateral to obtain US dollars from the Fed? Could this trigger a collapse in the currency of an emerging market? How will the Fed be able to provide US dollars to emerging countries without acceptable collateral? The acceleration of the virus in many emerging markets may be increasing this risk. Other risks that may be hard for central banks to contain include large defaults or credit downgrades in the high-yield markets and defaults of structured products, particularly collateralised loan obligations.
• What is the risk of a European sovereign debt crisis if the situation deteriorates?
• Will commercial and retailing rents collapse? What will happen to property prices?
• Will inflation and interest rates remain low for the foreseeable future as expected or will the large government deficits financed with large increases in the size of central-bank balance sheets lead to inflation?
• How will the pandemic influence domestic and global politics, particularly given the erosion of globalisation and increasing sensitivities around trade?”

In summing up they go on to outline their risk appetite of which the following are a couple of excerpts:

“We remain cautious and have positioned our portfolios to withstand a further downturn in the economic outlook and markets. We don’t know whether the world is on a bridge to recovery or on a bridge with a cliff at the other end. As we don’t know, we will not speculate or gamble with our clients’ money. We understand the limits of our knowledge. We have no fear of missing out. We feel it is prudent to be cautious when we cannot assess the probabilities of the pathway forward. The events of the past six months are without precedent and the way forward is subject to a multitude of highly uncertain, complex and interdependent variables. This means the range of potential outcomes remains vast. Due to the extreme uncertainty pertaining to so many critical interconnected variables, we have no reasonable way of assessing what the economic impact will be in the next 12 to 18 months. There is a tendency for people to simplify highly complex matters.

This is understandable. Many investors have been gaining in confidence following the massive government stimulus and central-bank support, the move by many countries to reopen their economies, the strong recovery of equity markets from the nadir in March and the positive headlines on numerous vaccines and therapeutics. In simple terms, it could appear the worst is over. Unfortunately, the current situation is highly fluid and we don’t believe there is any way of assessing whether the worst is behind us. There are simply too many known unknowns with material consequences. As Albert Einstein said: “Everything should be made as simple as possible, but no simpler.”

And

“Even if we get an early breakthrough and we get an early vaccine or therapeutic, investors need to assess what might happen at the end of the government-funded ‘economic bridge’. There are vast numbers of people and businesses that are surviving on government support. Once this pandemic passes this support will inevitably be removed and it is difficult to predict what will happen when this support is taken away. This will depend upon many variables that are almost impossible to predict. These include the scale of the lost economic output, the extent of change in consumer behaviour as a result of the pandemic (and again this will also be interdependent on the duration of the pandemic and the scale of economic loss), actions taken by business to cut costs as a result of losses suffered from the pandemic (the extent of cuts will be a function of the duration of the pandemic, the scale of loss, the level of unemployment, the propensity of consumers to spend and other changes in consumer behaviour; for example, an acceleration of online commerce could result in permanent job losses at many traditional retailers) and the extent of business failures. The extent of business failures will depend upon, among other things, the duration of the pandemic, the level of ongoing government assistance, changes to consumer behaviour resulting from the pandemic, and forbearance by banks and landlords in response to financial stress.

Investors should not take any comfort in the fact that world markets rallied 39% by the end of June from their nadir in March nor take comfort from the reopening of economies around the world or apparently positive news on the development of a vaccine or cure. There are simply too many interdependent uncertain variables in play at present. It isn’t unusual during an extended crisis for markets to bounce strongly followed by a second sharp sell off. While we do not know how things will play out, investors should be prepared for a wide range of potential outcomes in the next 12 months. There is a real possibility of a collapse in equity markets, just as there is for a continued grind higher in equities supported by low interest rates. These aren’t predictions but warnings that such outcomes are foreseeable at present.

Given the complexity and uncertainty of the situation, we are taking a cautious positioning until we can more clearly assess the probabilities on the pathway forward. We feel it is best to heed the sage advice of Warren Buffett when he said: “To finish first, you must first finish.”

Sage words indeed.