Complex Made Simple

Exclusive: If a COVID-19 vaccine is ready today, who will survive the post-pandemic era, and how?

In light of the latest COVID vaccine prospects, James Athey, Investment Director at Aberdeen Standard Investments, a global asset manager managing almost $670 billion of assets worldwide, said in a market commentary:

“The November 10 announcement from Pfizer suggesting their vaccine is highly effective has brought that reality so close investors can almost touch it. The reaction of markets has been dramatic. A big risk-on move, with huge rotation out of the companies deemed to thrive in a COVID-disrupted world and into those companies whose businesses have been decimated. Market participants are starting to seriously think about a normally functioning global economy and how to position for that normality. There are still many questions around the time it will take to widely distribute a vaccine, its efficacy among a population-sized sample, the starting valuation for many financial assets, the gargantuan stock of debt which has been added to this year, and the outlook for both fiscal and monetary policy from here. Those questions are for another day it seems.”

They may be, but we chose to have some answers today and in an exclusive with Athey, AMEinfo asked:

1.  On which basis are financial assets (bonds, stocks, trusts) evaluated today, and what’s their long-term outlook? 

“Current valuations across almost all financial assets are extreme by historical comparison. Government bond yields are historically low, credit spreads are historically tight and equity market multiples (price to earnings, price to sales, price to book, CAPE Shiller, market cap to GDP – the “Buffet ratio”), particularly and most egregiously in the US, are high. The most concerning of these would certainly be US equities and Big Tech in particular. History suggests that from such starting valuations the long-term returns of the market are likely to be low or negative in nominal and real terms.

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2. Are you referring to stimulus packages when talking of gargantuan stock of debt? What is the outlook for both fiscal and monetary policy for the GCC, the UAE, and Saudi in particular?

Debt unfortunately is everywhere. Consumer debt is high (in the US, unsecured debt, such as credit cards and student loans, is historically high in absolute terms and relative to GDP). Corporate debt is high and government debt even more so. The credit cycle has become de-anchored from the economic cycle and the interventions of central banks over the last 20 years or more meant that debt is never significantly reduced during a recession but is built up heavily during the economic upswings. The peak in outstanding debt at each cycle peak is getting higher. It is only the fall in interest rates that has made this sustainable. But now interest rates will struggle to fall significantly absent a severe financial market shock. Increasingly debt has been used for non-productive means such as financing stock buybacks. This hollows out productive capacity in the long term.

The Middle East faces a difficult outlook as the oil market remains oversupplied relative to the oil demand outlook and there is an invigorated global focus on renewable energy technology which will continue to eat away at fossil fuel demand – coal and oil in particular, regardless of the economic cycle. Parts of the Middle East, such as the UAE, have recognized the risks to over-reliance on oil production for many years and have taken steps to diversify their economies reducing this risk. Saudi, unfortunately, has not done so, and given the social contract it has with its people, it sees rapid budget deterioration when the oil price falls precipitously as it has done recently. In the short term, this budget shortfall can be covered with debt but that solution is not sustainable in the long term. Saudi will have to seek a wider revenue base and must consider whether it can continue to provide the population with the support and services that it has historically done. A tricky rebalance is necessary but one that I believe MBS recognizes. 

In a global context, many of the GCC countries remain low debt nations with solid credit ratings. 

3- Let’s talk as if the vaccine is in place today and massively being distributed in the region: What is the first order of business for:

a. SMEs in need of cash to capitalize on a recovery period?

This obviously depends on many factors – not least the type of business. Businesses providing local services will have been hit very hard but should not need massive injections of cash or investment to begin providing a “normal” service. 

b. Large corporates whose revenues were hurt or decimated by inactivity, especially those in travel and hospitality?

It is likely that these businesses have used debt to bridge the gap. It is unlikely therefore that those businesses will be in a position to immediately begin behaving in a normal, pro-cyclical fashion. Balance sheet repair and cost control will likely form part of their strategy even if they are seeing an increase in demand for their services/products. The reality is that some services may not bounce back quickly or easily – cruise ships are an obvious example as, potentially, are movie theatres that may need to run at reduced capacity for a period. 

c. Real estate developers who clang to life offering discounts, delayed payments, and likely suspended construction activities?

Construction activity has actually been strong in a number of countries. The reality is that this has been a K-shaped recovery where a certain proportion of the population, like white-collar remote workers and homeowners, have not been adversely affected. And with interest rates very low and further support from governments (stamp duty holiday here in the UK as an example), house prices have risen and house moving activity has been high. 

Landlords are a different matter. Both residential, and most significantly commercial, landlords have seen big declines in income as tenants have taken advantage of government schemes to allow forbearance and restrict evictions. This is a problem that has built up and will further slow the recovery (as tenants are forced to pay the backlog of rent). But the vaccine driven relief should improve the situation for developers and landlords. Commercial property, however, particularly retail and in big cities, will likely not recover quickly. 

d. Banks who offered debtors a number of payment options that delayed dues and installments, became less liquid, and saw their profits dwindle?

High street banks have already been tightening lending standards and leaning heavily on central bank liquidity. Profitability is an issue largely because interest rates are low, curves are flat and capital requirements (even though loosened) are relatively constraining. Much of this reality is not going away. Investment banks have fared better as market volatility has allowed them to make significant profits in market making and trading activities.   The deterioration of assets remains an unknown. How much will non-performing loans rise and how much will this constrain lending activity in the future. As always there is a regional divergence with the Eurozone banks likely faring worse than US banks. 

e. Regional stock market investors unsure which shares to invest in or divest from, following a period that saw digitally-based service companies thrive. Will this trend continue as more people feel less threatened by Covid-19 and become more present in physical retail environments?  

To some degree yes. I think there is permanence about some of the shift to online activity that we have seen. That being said, many of the big tech names with which we are all intimately familiar are already priced for global dominance in the segments of the market that they operate in – when many of them have little to no protection for such a dominant position. The future will have to go perfectly for current valuations to be realized and justified. The threat of anti-trust action from various governments around the world is also a threat to some. 

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4. What are the best sustainable growth vehicles for Saudi and the UAE post-COVID-19 in terms of both financial and tangible assets?

The starting point makes that question very difficult to answer. The global economy has been hugely damaged by shutdowns and negative income shock. That is deflationary. The growth in debt – and unproductive debt in a large proportion of cases – is also deflationary. However, the response from fiscal and monetary authorities has been huge and has the potential to be very inflationary. We, therefore, face two possible futures – one of stagnation and/or deflation and one of reflation and inflation. The choice of assets in either scenario can differ greatly. As always it is wisest to invest in a diversified portfolio which should include real, as well as, financial assets. I would recommend that government bonds still have a role to play in such a portfolio. If one is investing in equities, I would suggest that valuation in Japan makes Japanese equities a more attractive long term proposition as do commodity-linked equities. Commodities themselves – in particular, base and precious metals –should also be a part of such a portfolio as they offer inflation protection as well as cyclical exposure.