Recorded on April 3, 2020

In Episode 6, Bryden Teich and Bill Harris discuss the impact that COVID-19 has had on the markets and the global economy through the first quarter of 2020. They discuss some of the policy reaction from governments and central banks around the world as well as recent moves in the US Dollar and the dynamics that are causing it. They also touch on the movement in gold prices so far in 2020 and the broader outlook for stocks for the coming months.

Information relating to investment approaches or individual investments should not be construed as advice or endorsement. Any views expressed in this podcast are based on information available at the time and are subject to change without notice.

Bill Harris (BH) | Bryden Teich (BT)

BT: For today’s conversation, I thought it would be good to go through and summarize a lot of things that we’ve seen now, given that it’s quarter end. It’s been obviously a very busy first three months of the year. The view we had at the beginning of the year coming in was that we were going to be in a low-interest-rate world for longer. I think in some ways it’s just been even further confirmed but maybe walk through some of that outlook and then what you’ve seen really the last couple of months.

BH: Yeah, I think even what we’re here today just to talk about specifically, you know on this Friday, of what’s happening, what are we doing about it? But it still requires some context in terms of how quickly we got here and how much is changed – not even in the last month, in last three weeks – which has been extraordinary. So the battle that we were fighting was that we’ve come from a market that was at all-time highs with the US Federal Reserve and central banking system injecting just incredible amount of money in the system and interest rates were incredibly low; and valuations were high. So, we were getting in a position – and we had been in position for several months – of trying to get as defensive as we could, and then you’ve got hit with shutting down, and now we’re at the point of shutting down the planet, we’re shutting down continents. It’s not just a recession, where recession is 10% of the economy will slow down or 20%. You’re just taking the consumer out.

BT: Totally offline.

BH: Yeah and understanding that. So really, all the issues that we were dealing with before -and I think this is our main message- is that the problem of the virus in the economy being shut down is the incredible injection of money into the banking system, in the economy, actually makes the previous problem that we were dealing with even worse.

BT: Yeah, I think the other thing that’s happened too, really in the last three weeks -the latter half March- is given that you now move to a point where you’re shutting down the world economy for an extended period of time to try and fight the virus, you then have this sudden flight to cash across all assets. So, what happens is the correlation or the relationship between all kinds of different asset classes spikes higher and basically what it means is that everyone is trying to rush to the exits, to get their cash as quickly as possible. And when you have stress on the financial system, the cash that people run to first is the US dollar.

BH: Just to explain that so an individual can understand, that’s saying “I’m dealing with my mother who’s older and she’s got to make sure she’s got money to pay the woman that comes in and helps her with food and cleaning.” But that’s just in a microcosm and then you see how that affects businesses; getting people to really understand -when you’re running for cash- the scale of the problem.

BT: Yeah, I think the important thing to keep in mind is in a global economy both on a trade front and a capital market front, the flow of capital all over the world has been really magnified the last decade. Absolutely. And so, what’s happened is you have a record amount of US dollar denominated debt that is offshore -so in other parts of the world- I think the number that we’ve looked at is somewhere between 13 and 15 trillion. So, if you’re a company in Asia or Africa or South America, you probably have at least half, if not more than that of your capital structure in US dollar-based debt. And so what happens is you have shut down big parts of the global economy, which means that a lot of companies, and businesses, and even governments for that matter, revenue goes to zero but the debt doesn’t go to zero. So you have this funding problem on the very short term and you have this rush to say “Oh I need to make sure I have enough US dollars for the next six months, so I can pay my debt, rent, employees. What was interesting is in the midst of the storm in March you saw stocks getting hit but bonds got hit too. There’s a lot of liquidation in bonds, both government and corporate; other asset classes like commodities or gold were also being sold. It was really saying “I don’t care what my longer-term view is. I just need cash over the next three months to make sure I can keep the lights on with my government or my business or my global company.” So, you had that initial rush into the dollar that put that upward pressure on it. The central bank in the US, the Federal Reserve, then tried to decrease some of that pressure with some of these swap lines. So basically it means they swap currencies with other global central banks and you try to flood the system with US dollars to alleviate some of that pressure but the problem is it doesn’t fix the bigger issue that a lot of the revenues for these companies have gone to zero. So, you can lend dollars to another central bank, but if a company in Asia has revenue that just went to zero how are they going to be able to pay their debt? So, you’re in the midst of this cash shortage in the system as long as the economy remains shut down.

BH: Right now as we said, we’ve seen the incredible three week panic, we put in a low that was on the 23rd of March and we see this incredible policy response -we can talk a little bit about that in a minute as a sort of breather- but as I said the work you’ve been doing and showing us is that there’s still this other whole part of the world, it needs dollars in their hands and that might not have happened yet.

BT: Yeah we talked about this earlier in the week saying there’s actually some great reporting on this both on The Wall Street Journal side and Financial Times starting to highlight a lot of the international countries – I guess you’d say developing countries – that were really starting to have debt problems and that need for dollars. But I think a lot of this comes back to: how long is the economy going to remain shut down? And I think that the initial thought was that this is maybe two weeks to a month; we’re now almost three weeks into this so we probably are at least another month, and then there’s even scenarios where it goes longer than that and I think that these debt issues become much more prominent the longer that this lasts. So, there’s the immediate desire to get the health situation under control, but a lot of the economy globally needs to get back to work or else these issues are going to remain now for the next several months. I think in a lot of our meetings and in communicating with clients, our view is still similar and hasn’t changed that the longer term pressure on the US dollar is going to be much lower but you’re now in this very short term period where there’s a rush to fund your liabilities that are based in US dollars and so you’re getting a little bit of a push higher. One of the charts that we like to look at in the office and our meetings is the relationship between the budget deficit in the US and trade deficit combined and overlay that with the US dollar with a six-month to a year lag. You have mentioned the stimulus package of two trillion for this one; I think the Federal Reserve now is going to end up to six trillion dollars; I think the Federal Reserve balance sheet increased by almost one and a half trillion in the last three weeks. So, these huge levels of fiscal spending in the US but they were already running a five percent of GDP deficit; it’s going to fifteen really easily, it might even go to twenty. So our view on that basis is still the longer-term pressure on the dollar is going to be lower but you’re in the middle of this storm right now where until these funding issues get settled, there’s still going to be some of this pressure in the system.

BH: Clearly, we were in a world a month ago where I’ve got my stock investments, I’ve got my bond investments, and then what I need right now is cash in my pocket. Specifically, as you’ve just pointed out, is the world uses the US dollar. So, we can even say, what’s the strength of the Canadian economy we’re in? It’s kind of irrelevant. The US dollar gets stronger because we’re thinking if you’re going to flood the system with money, but the need for dollars overwhelms that in the short term. So first I have to sell my bonds, but a week ago there was nobody to sell the bonds to; so then the central bank has to come in to buy the bond so that you can get dollars in your pocket; also if you have stocks, it doesn’t matter. A lot of times it’s just that you have an investment, “Great, I was owning this for the long term. Oh, but I actually need the money now.” So, the money comes from being invested in bonds and stocks. So much trading has gone on and we put sort of levels on these things. Going forward, once everybody has this money and it gets distributed, it solves that problem but the central bank is doing its damndest  right now to actually devalue the dollar to get themselves out of it; and we’re right back where we started this conversation, which is saying why we want to own hard assets, dependable businesses, essential businesses, so the money goes sweeping into the US dollar but at some point the money has to come back into the stock market, and buy hard assets because there’s a big potential that the dollar could be devalued over time.

BT: Yeah, I think the amazing thing sitting here, watching this, talking about it, thinking about it every day, is really just the speed and the ferocity of how quickly this is all coming together and so we put a lot of thought into where our view is at the beginning of the year, and how we’re going to prepare for what this outlook is going to be now. Our view always is a much longer-term view of saying what are the next two to five years going to look like, and how do we want to invest around that? But then you have these very short-term intermittent periods where it’s just storm and all these clouds are brewing and everything breaks loose, and it’s just saying the long-term view and outlook hasn’t changed, it’s just that you’re right in the middle of the storm. I think the unique nature about this is that everything got sold in those particular bad days.

BH: Oh, we could talk about gold then, specifically. So, we own gold because we want to own a hard asset. We think this devaluation is finally this thing that’s probably coming around but in the last two weeks, just run through how did gold actually behave as a defensive strategy.

BT: Yeah so the amazing thing is that right up to the end of February, gold was actually outperforming almost everything, maybe other than some parts of the longer term bonds that had done well for the first two months of the year. But gold had done well and then all of a sudden you got into first two weeks of March where everything got sold. Everything got liquidated from both gold in the futures markets or the price that you look at on the screen, gold miners got sold, the gold ETF’s got blown out, which then created other liquidity issues. I think the other problem that happened -and it was very clear a couple of those days where we just had mass liquidation of everything- is we’ve moved into such a financialized world and there’s just so much money sloshing around that a lot of bigger market participants will take their positions and lever them to three four or five X and so that works when the market’s moving in your favor, but as soon as that train stops you instantly have to de-risk. It doesn’t matter what you’re selling it’s just as instantly that these computerized trading programs are set up to just de-risk everything and what’s going to happen in six months, or a year or two years doesn’t matter. It’s just what’s going to happen the next six hours. Just sell everything.

BH: So, another way of saying this in stock market terms is this is the largest margin call in history and with interest rates being so low which means you can borrow money so cheaply. Which means, I bought the Canadian gold company and I borrowed money because it didn’t cost me any money to own it yeah because it was absolutely going up until this cash thing happened, which means I need cash more than I need my gold stock. Gold stocks collapsed along with everything else but when they went up, I mean it was just stunning to watch how fast they recovered. I think it was two or three days.

BT: Oh, you can always feel the margin call because it’s just indiscriminate selling, pause, and then you instantly bounce back to where it was before. I think to your earlier point of saying we’ve now set a couple of different ranges in the market where the initial force liquidation margin selling panic low. There was a low put in a week and a half ago, rallied off that low pretty hard, both in Canada and the US and now we’ve kind of set up a tradeable range going forward and then going back to what the outlook looks for the on the health side going forward but maybe talk about that from a perspective of what we see over the next couple of months in terms of what the market may or may not do.

BH: I think one of our big takeaways today – to make sure we hit our conclusion – is that we think we’re in much better shape for where we think the world is going to be going forward and we’ve had a number of transitions, and all our conversations, our research, in the last three weeks has been around transitioning the portfolio as fast as you can to these essential businesses in the economy. I think you can make the immediate assumption that this wouldn’t be a great time to own a cruise ship. That’s the simple conclusion but the other one, if this goes longer and we’ll make sure we touch base on this, is the length of time of this because that is the unknown. Everybody’s saying that it started out with an impression that this might be two-three weeks, but this is longer and which case, as it gets longer it’s just the consumer is where the problem is. So, we’re making sure we’ve transitioning the portfolio into much more essential businesses. You always think about Bell telephone going through 2008-2009, we just watched how Bell telephones business grew. There are certain businesses that we can own that just don’t get shut down – actually can nobody function without them. So, transitioning the portfolio into those sorts of things, but we still own businesses we just don’t run to US dollars and run back; it’s just something we don’t do. We can protect at the margin but really, we have to find these businesses that are going to do well in the next one, two, to three years.

BT: And you’ve done a lot of work on just putting a certain percentage number on what you would consider to be essential businesses within what we’re doing outside of our cash or gold position. Was it almost 65 percent of the portfolio?

BH: Our quarterly report – which is going to come out shortly and will be on the website as well – shows that there’s almost two-thirds of what we own which is in cash, gold, bonds, and mortgages, and then essential businesses. And when we’re talking about the stock market, we’re sweating it every minute every day, but it’s really a much smaller percentage of the portfolio. And the essential business is what we’re talking about – Bell is an easy one. But things like CP Rail – nothing gets around without it. It’s the guts of the economy, the transportation, the essential businesses, and these are not being shut down as opposed to it’s really hard to understand where you’re going to be when you come back. It’s just such an unprecedented event to shut everything down.

BT: Yeah, I think the other side on that respect is now with what the market has done the last couple weeks. I think the difficult part is that our view and how we approach it is as business owners is, we like to invest in long-term businesses, things that we think can protect and grow capital over long periods of time. But then there’s also you get into this short-term period where all everyone thinks is what the technicals are saying, how much have you retraced of the previous low. This is why our view is that it’s so important to own a portion of the portfolio in these essential businesses because to try and take a fundamental view or predict what earnings are going to be like over the next year, or even close to the next two years, is really difficult. So, then a lot of these shorter term technicals and ranges become more important at least as a ring-fence where the markets are likely to trade. So maybe talk to that a little bit, about this idea of we put in a low, a couple weeks ago now, and that there’s likely still to be another test of that, and then what the outlook might be for the next few months on beyond that.

BH: Okay I’ll set that up by touching on the first point which is really what we’ve been doing here is that you’re trying to analyze your business normal and say okay how probable can it be? Is there any growth? Now it’s actually completely flipped on its head. You still read the newspaper during the day but you’re not making investment decisions off the newspaper; you’re making investment decisions off solvency. So, we’re going through all our companies and saying okay, actually a number them are net cash. All of our businesses have been great about getting that information out to us. And then the question is do we think our dividends are safe? Because really what we’re hoping to do is we’re still collecting our dividends, and we’re able to keep investing our way through this. Instead we’ve got a strong portfolio and we just keep picking away as we go along patiently, and we’ll talk about the levels because that’s exactly what the question is in today’s call. But really, there’s no way to know -if this goes longer- are your dividends safe? A company might just say “It’s better for me to have that money in my pocket than it is to dividend-it” but you also know your company is stronger because it’s made that decision. So far other than a couple companies that we’re watching closely, we actually think that with most of our dividends, we should be able to get through this, and we’ve touched on the length of time, but the stock market always looks out six to nine months. So, everything we’re doing today is looking into the Fall; and the stock market looks into the Fall. That’s the hardest part about investing: you can just be incredibly uncertain about today, but the stock market is always judging how the Fall is going to be. But the problem is how much business goes on in the Fall really depends how deep we go, and then can we get back to work, can the consumer get back, and all the people in the hospitality industry pay their rent, and get back to work. So that that sets up the context. Specifically talking about today -that was a long-winded set up- So we’ve had that incredible steep severe pullback and depending on the market -the Dow Jones industrial average was at 30,000 and fell just below 20,000, so it was down a third- what we found was almost everything across the board, if it was a financial asset, it went down about a third. We’ve had a recovery since then so what’s really important about this is we’ve now set that bottom a week and a half ago, we have that low point in the market then we had sort of a relief rally which came to a technical resistance line. You’re not telling anybody this, everybody’s looking at the same point on the chart. So now you have a rebound rally in a high and you’ve got low from a week a half ago and we’re just sort of trading in that band. Right now, we actually don’t have to do anything we have to watch and see how this resolves itself. If we gradually break up, and everybody hates the market, and it’s over and the market can see through the Fall, or if we fall to a new low, then we’re going to be more patient sit on our hands and again we’ve got 12 to 13 percent cash. We’ve got our list of things we’re waiting for to buy and this is our playbook. We’ve got the market setup that’s going to tell us what we’re going to do going forward. I would say the next time we have this conversation we’re going to know where we tested those two points.

BT: There’s more clarity, yeah. It’s amazing how much is happening, and how much news flow, and how much market action two weeks will tell you. I think the other thing I’m adding is that one of the things that’s really blown out the last couple weeks is the volatility index (VIX) which examines the level of panic in the market based on…

BH: I want you to talk about the VIX because you’ve done all the work on this but having followed this, it measures the amount of volatility in the stock market, and we’d actually gone for a period incredibly low volatility. In 30 days’ time, what is the probability that 30 days will be the same as today? And so, the amazing thing was that we spent three years of most days, a month from now is going to be the same as today. Like almost the same. There was no volatility in the market and then you have almost zero probability that a month from now is going to be the same. So, you go from an it’s a unit of volatility of 10 and we had it almost as high as it’s ever been which sort of it ramps up around 80 or 90.

BT: Yeah so that’s exactly the point. When you look at the volatility index and how high we got in the middle of March up to 85-90, which is really just an incredible level to be up there and to be sustained but now that we’re starting to put in lower highs, there’s a little bit of a calming effect going on -instead of being at that panic level- but with a volatility index at 45 it’s still an incredibly high level. And I think the one chart that we looked at earlier this week that I thought was really interesting is if you put up how the volatility index looked in 2008-2009, it peaked in November of ’08, but the market didn’t bottom until March of ’09. So in our playbook for what we expect over the next couple of months is, the best thing would be to see the market try to make a new low, whether it fails or not, you know, as long as it’s kind of within that range of where it bottomed but then to see that happen with a much lower volatility index, then I think confirms that you’ve wiped a lot of that anxiety out of the market. Then at least you put in another sort of tradable bottom which you’re probably going to have a pretty significant bounce on at least into the Fall. I think I totally agree with you that the outlook beyond there is still a little bit uncertain with how deep this recession is going to be and how quick people can get back to work but at least it gives a bit of a framework for making decisions of saying, “There’s a technical way to look at really good buying opportunities” but also still having our list of companies that we’re looking at and saying “Okay this is the day we’ve been waiting for in the week” and now it’s just a matter of saying “What are we going to buy here at this level?”

BH: Okay I just want to make sure we touch on these two other key points since we did this last podcast and we wrote about it in a note that went out to clients, but really we’ve now had an extraordinary stimulus. So, this is the first time we would talk about it. Again, the problem is that we know we’re in this contraction, we know the economy’s incredibly shut down, and usually you will wait for the government to react except it looks like the government has fully reacted over and above anything that has ever happened before. The problem is we when we look at the Fall, you’ve doubled your stimulus. You were – just this afternoon – putting numbers together to put in context for people the size of what the deficit was now, what we think it’s going to be, and what is the size of the debt coming out of this. And then Canada is sort of a mirror of what’s happening in the US.

BT: Yeah, the way we thought about it this – and Matt and I talked about this on a podcast about a month and a half ago – at the end of 2019, the simple numbers are the US economy’s about 21 trillion dollars in size and they were already running a deficit of around 1 trillion dollars so debt or deficit to GDP in the US at in December was about 5% which is just that 1 divided by 21. And so the package that we saw from Congress two weeks ago is 2 trillion, but in a recession what happens is that the government revenue also collapses and you have unemployment go up, and unemployment insurance and stabilizers kick in. So, the simple way to take it is the 1 trillion dollars which was the runway from before, add 2 trillion – I would even say, generously add another half trillion is probably going to be another trillion on top of that with how low revenue is going to come down – so you’re very quickly at 3.5 trillion or 4 trillion just this year in net new borrowing in the US which is 20 percent of GDP, which is just a staggering number. It’s a number that you see in emerging markets or impoverished developing countries where they’ve got some kind of a corrupt government and they’re just spending like crazy. So the US is now faced with this situation of saying, “How do we get ourselves out of it?” Well, of course the government’s going to respond, but the level of stimulus being thrown at this is so significant and I think coming out of this, the national debt in the US is going to be somewhere around 27 trillion by the end of this year, and your economy is probably still going to be around say 20 or 21 trillion because on a full-year-basis, it’ll contract a bit, and the numbers just start to spiral out of control from here. I think that this is actually the most difficult thing about the period of time we’re in, where you have this one or two months where everyone wants to rush to cash because they just need it to get through the next six months. But then you have a government that’s going to issue trillions of dollars of debt and spending, and not even talking about what the Federal Reserve is doing. And so, through this period currencies – and just dollars – will hold in well, but then in a few months to a year probably the last thing you want to own is paper money because governments are going to do everything they can to inflate it away. And that’s the most difficult thing about the period we’re in, is that the government spending numbers just start to get so out of control, and at what point do you lose faith in that money to maintain purchasing power, and the governments are going to desperately try to create inflation or the central banks are. I just think it’s definitely a very complicated mix looking out a year or two years from here.

BH: Yeah absolutely, just how extraordinary this time is, and how you know the world is not going to look the same going forward. We keep on saying that some things would be the same and some things would be consistent but just you can’t “get that genie back in the bottle” to use that term. We’ve had discussions over the last couple days on inflation in the near term and what that looks like. I think just to share a couple of those ideas because it’s such an extreme inflation. It really helped me to visualize what this might be different about it.

BT: Yeah, it’s actually not that hard to create inflation. I mean the government can just say “wire ten thousand dollars to everyone’s bank account tomorrow or a million dollars.” There’s no amount of money that will impact it and I think in the US they’re doing what we would call helicopter money – basically mailing checks out to people and that’s good for the next month or two to get you through but now everyone’s going to expect a cheque from the government every couple months. The mental effect or that the psychological effect that this has on people’s behavior going forward, I think it’s going to be significant but to that point, it’s not that hard for a central bank or a government to create inflation. Once you do that, it’s incredibly hard to slow it down, but at the same time you can’t just create growth overnight. So, if you’re ever moving into an environment where you create inflation and there’s no growth, it’s actually the worst environment out of all – which is stagflation.

BH: Well even just to walk through this: you’ve got money in your pocket, you’re going to the store, but the problem is there’s only a few things in the store.

BT: Yeah there’s a shortage. It becomes a shortage of goods. You can create as much money as you want – paper money or in people’s bank accounts – but there’s a fixed amount of goods and you have supply chains breaking down and you have all these issues now of getting goods across the world. So, there’s a shortage of everything and what happens when you create more money is everything gets more expensive.

BH: Yeah even shutting down the economy is an extraordinary thing and we talk – having been a base commodity investor for most of my career – extraordinary situation we’re in now which I’ve never seen before. And you might get positive on the commodities because you’ve shut down all the mines and it looks like now oils in its own very much its own universe – that’s a whole other day going into that. Just in terms of copper, uranium, or you’re talking even about gold, you’re shutting down all the mines, but there’s a need for the actual product. And you’ve created all this money so that the money chases all the products that have already been created but people aren’t in business creating new supply. So, it’s this short-term inflation that we have never seen in our generation.

BT: I think a lot of that comes down to: how quickly can the health situation get under control, and how quickly can people get back to work, and how structurally are you changing people’s psychology and behavior once they go back to work? And I think that there’s a short-term period that you keep reiterating that is a rush to cash but then cash is probably the last thing you want to own in that inflationary or stagflationary environment because the purchasing power of currency gets eroded very quickly.

BH: So, let’s just conclude on that then. We still envision that we’re in it now – this rush to cash – we believe that you still have to come back to the stock market and we’re trying to invest for where the world is going to be six months to two years from now.

BT: Yeah and I think the idea too is: you still got dividends coming in all the time, every month, we have 12-13% cash positions in the accounts, and to be buying things through this, I think there’s another you know couple maybe a couple weeks to a couple months where the market chops around, probably put in a low, and then you probably bounce significantly higher into the Fall, but there’s still this outlook going forward, and saying “with interest rates going to be low, if you’re going to have a more inflation, you absolutely want to own gold, you absolutely want to own real estate.” I mean, we’re very light right now in the commodity side. There’s an argument to be made that you actually want to be more into commodities and that kind of environment, but we’re not quite there yet but I still think these essential businesses – utilities, infrastructure companies that we own – all of them are still vital in that kind of a period of time. It’ll be fascinating to see how we move through these next three months. We’re now at the end of the quarter so we’ll have a quarterly report out in the next couple of weeks, and then look forward to the next conversation from there.

BH: Yeah, most of our business is hard asset type investing and we like doing tangible businesses – bricks and mortar is sort of the way it is historically – but again maybe we’ll touch on this because this would be for another podcast… The way the economy is evolving is that – especially going through this – an essential business is your health insurance, an essential business is your software provider, not your product, not your consumer technology device. It’s much more the systems that we have to run our business that are actually becoming essential. We can shut an off a lot of our business down but there’s somethings that we just cannot shut down.

BT: Yeah, it’s the same for most businesses that your critical software and infrastructure aren’t going to get shut down. So, really the focus remains trying to find these certain parts of the economy that we think will actually become even more crucial through this period and bouncing out of it.

BH: There you go. Thoughts to talk about next time.

BT: Look forward to it.