Fidelity - The three phases of investing through a global pandemic

Key points

• The coronavirus pandemic can be thought of as evolving in three phases: escalation, consolidation and recovery, which map onto the stock market in various ways.
• It is important is to understand the resilience of companies to the current challenge, and their long-term franchise value, in order to take advantage of opportunities.
• New names have been added to the portfolio, including staples and healthcare companies, putting cash to work while maintaining a reasonably balanced profile.

Recent weeks have been one of the most eventful periods in markets that I can remember since 1987. Never mind what was happening in the real world, the normal market dynamics were breaking down. As it happens for brief periods from time to time, there was a real sense of panic. Nothing was behaving as it should. This is what happens in highly volatile periods of the market - few movements can be justified by fundamentals, and nearly everything can be explained by positioning and forced actions by participants who cannot or choose not to hold their ground. The Fidelity investment team (nearly everyone working from home) were busy with company calls, talking to senior management to try to understand what they had been seeing in the effects of the coronavirus first in China and now in Europe, how they gauged the challenges of both supply and demand factors and how strong their cash positions really were.

Mitigation and suppression strategies

The recent Imperial College report talks of two basic approaches to deal with a pandemic - mitigation and suppression. In mitigation, the progress of the epidemic is slowed down so that health systems are better able to cope with the outbreak. In this approach, eventual herd immunity is achieved, but at a huge cost. Suppression is the more drastic approach that aims to reverse the epidemic and aims as far as possible to eliminate the transfer of the virus once the outbreak has been identified. We know that China fairly swiftly moved to this approach in Wuhan. This was very painful for the citizens of Hubei province for a period but appears to have been highly effective so far. European countries are now rapidly moving to the suppression approach. Assuming there is a reasonable degree of success in suppressing the virus, the question is what happens next and what measures will be taken to ensure that the epidemic does not break out again. At this point I am thinking of this as evolving in three phases: escalation, consolidation and recovery.

Phase 1: Escalation

The first escalation phase is upon us where we see huge increases in reported new cases. While the curve may still look exponential the “second derivative” appears to be improving. Given the draconian containment measures now in place in Italy, this should mean that here the active infection rate should peak soon. The same should follow in the rest of Europe, and then the US some time later.

How does this map on to the stock market?

This escalation phase has caused huge volatility which produces an extraordinary amount of noise and wild share price movements. In my opinion there are many shares that have gone down more than their fundamental outlook would warrant. This is most clearly visible in defensive areas such as utilities and healthcare companies, which are likely to see only short-term profit deterioration even if the economy fails to bounce back quickly. Some other companies which are more economically sensitive arguably have fallen so sharply that they have rebound potential even before full economic recovery is evident. What is important is to understand is how resilient companies are to the current challenges (in balance sheet and cash flow terms) and to judge their long-term franchise value. In any case, the massive dislocation we are seeing inevitably throws up opportunities.

Phase 2: Consolidation

The next phase which should be upon us shortly is what we may call (perhaps somewhat optimistically) the consolidation phase. This is when the virus appears contained but measures will still be in place to keep it that way. There will be medical advances to better treat people and perhaps make them more resistant to infection, for example through the antibody cocktail now being tested by Regeneron Pharmaceuticals. In this phase we will get a much clearer idea of who will bear the costs, how much bad debt will be recognised and how much long-term damage has been done to the economy. Clearly there is a concern that job layoffs will cause a negative spiral which will potentially lead to full scale depression. In this regard, the measures announced by the UK government are being echoed elsewhere and this is encouraging. It is clearly of massive importance that jobs are retained through the escalation phase so that consolidation afterwards does not become a slump.

Phase 3: Recovery

The final phase of the coronavirus saga should then be recovery, likely marked by decisive medical prevention of further spread and a full return to normal social interaction. As far as the market is concerned, this is unlikely to go in a straight line since the markets will already have anticipated economic improvement. As this comes, there are likely to be revelations of unexpected bad debts that have been hidden in the crisis period. There will also be an element of “payback” for government support given. Will governments have printed too much money in order to support economies? Will there be inflationary consequences? And will taxes have to rise substantially? I would guess that at least we should expect rises in tax rates, not least in the US (especially if there is a change in the administration) where the fiscal position has already deteriorated significantly as a result of the last round of tax cuts.

Portfolio positioning

We started the year with relatively low cash levels and relatively high economic sensitivity. When the outbreak started in China, we started to change this position, raised cash and brought down sensitivity to market moves by reducing high beta positions. As the market fall accelerated, the risk in these positions was further accentuated. In the past several weeks, we have further reduced exposure to financials (mostly banks but also some insurance positions), transport-related names and also energy companies most exposed to the sharp fall in the oil price, which we do not expect to recover meaningfully in the near-term. In contrast, we have added to companies that are clearly going to be most resilient and those that should see a near full recovery after the current downturn. With the huge volatility we’ve seen, we have added new names in areas like staples and healthcare, as well as increasing our ecommerce exposure.

Looking forward

There is a still a huge amount of noise and returns can be expected to swing around in the short-term. Nevertheless, we are confident that we have significantly reduced exposure to weaker companies and increased exposure to long-term winners at reasonable prices. Over the coming weeks, we will be channelling most of our efforts into staying close to our investee companies to understand their strategies and current challenges whilst at times providing our feedback to management. This is key to our approach to active management. We can assure investors that in this regard whilst we may be working from home, we remain highly active.

Important information

This information is for investment professionals only and should not be relied upon by private investors. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. The Fidelity Global Special Situations Fund uses financial derivative instruments for investment purposes, which may expose it to a higher degree of risk and can cause investments to experience larger than average price fluctuations. Changes in currency exchange rates may affect the value of an investment in overseas markets. Investments in small and emerging markets can also be more volatile than other more developed markets. Reference in this article to specific securities should not be interpreted as a recommendation to buy or sell these securities, but is included for the purposes of illustration only. _______________________________________________________________________ For more information about Fidelity International visit www.fidelityinternational.com/