In the Coming Critical Month, It’s Time to Re-engage Equities: Co-CIO, Senior Co-Portfolio Manager Michael Grant

In a turbulent period for the markets, Calamos is hosting a CIO Conference Call Series for financial advisors. Below are notes from a call Wednesday, March 25, with Michael Grant, Co-CIO, Senior Co-Portfolio Manager of the Calamos Phineus Long/Short Fund (CPLIX). To listen to the call in its entirety, go to www.calamos.com/CIOlongshort-3-25

The comments made by Michael build on what he had to say on a call last Thursday, March 19. He comments on that call below and see this post for the full commentary. To listen to the March 19 call, go to www.calamos.com/CIOlongshort

One Fat Pitch

For the first time in years, the math for equity investors makes sense, as equities have returned to attractive valuation levels not seen in years. Michael Grant is preparing for a rebound in equities and his team has increased the Calamos Phineus Long/Short Fund net equity exposures to reflect this shifting risk/reward. Specifically, they are reducing shorts and adding to long positions where the valuation reset appears overdone. Below he provides “one fat pitch” for long-term investors.

Observations and Interpretations for the Coming Month (and Beyond)

Michael provided the following guidance for moving beyond the shock of COVID-19:

• Markets have arrived at a critical juncture. The first phase of this crisis—the phase of equity market collapse driven by the need for liquidity and the absence of proper price discovery—is over.
• The virus disruption will rapidly diminish into mid-year, he believes. He does not see successive or returning waves of infection for the remainder of 2020. This disruption is massive but will not be prolonged. This is the team’s assumption, while acknowledging they may be guilty of wishful thinking.
• The implication is that the profile of this crisis is likely to be V-shaped rather than U- or L-shaped. There is a chance that economic growth has predominantly been delayed and not destroyed. This implies equity markets can recover at least half of their losses by mid-year, and our portfolio is positioned accordingly.

The remainder of his comments addressed these three questions:

1. How is this different from a recession?
2. What is the enduring feature of the virus?
3. What does it mean to be an equity investor at this point in the cycle?

How Is This Different from a Recession?

• The economic consequences of the virus are largely being viewed through the traditional lens of economic recession. Nevertheless, this is not a recession. This is a massive shock due to the shutdown of cash flows across the economy. Historically, recessions emerge slowly as deficits in one area of the economy, triggered by higher rates or oil prices for example, and roll gradually into other sectors of the economy.
• Today’s shock is more akin to a natural catastrophe, such as an earthquake, that wipes out portions of the income-producing economy. It might better be described as “recession by proclamation” as the government has intervened in the normal ebb and flow of the economic body.
• The range of potential outcomes is vast, compounded by the statistical methods that are designed to capture a more normal recessionary setting. Rather than presume this narrative, all forecasts are simply dependent upon how long the economy remains shut down.
• Financial markets are accustomed to addressing the complicated and complex, but struggle much more with chaos. In the chaotic domain, the framework of cause and effect is no longer clear. That is why the recessionary playbook may not be as useful a roadmap this go-around.
• With a chaotic shock like the coronavirus, markets can be expected to anticipate all of the worst-case outcomes, regardless of likelihood. This explains the rush for liquidity and the absence of proper price discovery of the past three weeks. Many investors are too confused to wait for a proper or knowledge-based response.
• The good news is that policymakers are much more tuned in and warmed up after battling the 2008 financial crisis. They are going large and they are going early. There was an alphabet soup of programs that were implemented to nurse the credit markets back to health.
• The Fed’s latest measures to backstop U.S. corporate credit should provide tremendous relief, taking the worst-case scenario—dysfunction of corporate credit—off the table. It implies that the secondary effects of the shutdown can be contained, and this income shock is unlikely to develop into a balance sheet recession along the lines of 2008.
• Moreover, if it is assumed that the U.S. banking system remains functional, a more normal recovery can be assumed once the consumer shutdown is lifted.

What Is the Enduring Feature of the COVID-19 Pandemic?

• What is obvious: The medical community does not yet fully understand the coronavirus. That said, Michael believes the combination of auto-immunization, vaccines and adaptive behavior will significantly reduce its virulence in coming months.
• The good news is that fatality rates (as a percentage of cases) continue to be lowered everywhere. Initial reports from Wuhan, China estimated a fatality rate of 2%–4%, which compares to the 1918 Spanish flu pandemic of 2.5%. However, the current estimates of the ultimate fatality rate in Wuhan is less than 0.4%, or a fraction of the initial reporting. This is more consistent with a bad flu season.
• This would be a critical development as the economic context is dependent upon the dynamic and trend of the virus itself, as well as the choices that politicians make to mitigate the crisis. Michael offered healthweather.us as a source of data.
  

  “For the first time in years, the math for equity investors makes sense…Investors stand to be paid to engage equity risk once again.”

• Michael believes that today’s narrative is dominated by the over-precautionary, sensationalized media. Not intending to be dismissive, he believes it’s apparent that COVID-19 is not exceptionally deadly by historical standards.
• China’s experience supports this conclusion and cannot be attributed solely to its draconian lockdown. Some argue that the end of the epidemic in China must be attributable to some autoimmune response in the general population. In Iceland, the similar is being experienced, as more than 80% of positive cases are asymptomatic or mild.
• In Michael’s view, the striking feature of this virus is the response of Western societies and their unprecedented intervention into social and economic life. What should be viewed as a health crisis has been transformed into an existential event for Western economies.
• The obvious question is why the extraordinary measures? The scale and breadth of the policy response—monetary and fiscal—is breathtaking: comprehensive, extensive and open-ended. Some estimates of their impact approach 20% of GDP.
• The monetary culture of “do whatever it takes” and the relentless rise of debt, encouraged by central bank policies of the past decade, have removed any sense of accountability among Western policymakers, Michael says. We have been asked to believe these policies are “cost free.” And now governments everywhere, through the use of fiscal tools, are following the example of the central bankers.
• All of this represents an acceleration to a new investment regime for the coming decade, one that is far more reflationary in nature—and this could be the lasting impact of the coronavirus.
• In its most simple sense, this represents a rapid erosion in the value of money as governments rush to create debt unless and until they are confronted with inflation. Reflation and fiscal activism will ensure that yield curves begin to steepen and produce a rotation across equity styles.

What Does It Mean to Be an Equity Investor at this Point in the Cycle?

• Since October of 2018, Michael has viewed the equity world through the lens of transition. The investment regime of the post-2008 era gradually gave way to a new investment era, one whose contours were not immediately visible.
• These transitions often occur around “end-of-cycle” downturns, but not always. The team’s most important view was that the risk/reward for equity investors was unfavorable.
• Today, that view has been reversed. For the first time in years, the math for equity investors makes sense. Equities have returned to valuation levels that are attractive for the long-term investor. Investors stand to be paid to engage equity risk once again.
• As the crisis unfolded, Calamos Phineus Long/Short Fund has increased its net equity exposures to reflect this shifting risk/reward. The team has reduced shorts and added to long positions where the valuation reset appears overdone. Specifically, the focus is on quality balance sheets and robust free cash flow yields.
• In the short term, some crucial uncertainties remain. Michael suspects the absolute floor for the S&P 500 Index is around 2100. The team’s hedging strategy reflects this presumption. For those who lean more bearishly, the remaining downside can be measured. For those who believe the worst is inevitable (not this team), the scale of risk between the team’s view of downside (S&P 500 Index: 2100) and the full trauma of a bear market (down 50% from peak) is about 1800 on the S&P 500 Index or about another (14%) of downside.

Conclusion: Can the Equity World Stage a Comeback?

• What has been “different” in this cycle is the excessive liquidity driven by passive and quantitative strategies that mistakenly presumed that liquidity would always be available when needed. In the end, this has been as much a crisis of liquidity as anything else.
• A common risk of chaotic-type shocks, especially in the equity world, is both underreacting and overreacting. This initial stage of market collapse and price discovery is coming to an end. Debate over a further relapse is inevitable, perhaps in April, but recovery can be sustained into summer. It is certainly too late to sell. Investors must decide—as the team has—whether it is too early to buy.
• The next interesting debate will be turmoil associated with a rotation of market leadership, perhaps later in the year around the time of U.S. elections.
• For now, Michael thanks advisors and their clients for their support. He expects investors to be confronted by discouraging news in the weeks ahead and thanks advisors for encouraging their clients to look beyond the panic in the air.

Recap of the March 19 Call

The team expects the U.S. recession to be sharp but short. This implies that equities have largely discounted this outcome to around 2500 on the S&P 500. The resilience of the Western consumer combined with substantial policy support will minimize financial stress so that by mid-year, the global output cycle should regain its pre-virus capacity. Investors should see some sense of normalcy returning in the coming months and possibly weeks.

A “typical” recession argues for an S&P 500 low between 2100 and 2400, although a sharp and short shock points to the less extreme level of about 2500. Of course, “fair value” for equities is a moving target, but we can make assumptions about the depth of the earnings recession and the trajectory of recovery. For 2020, the team assumes 0% revenue growth and a decline of 10%–20% in earnings for corporate America.

The team anticipates a six-month U.S. recession that began in February. Historically, the S&P 500 leads a recovery by four months, which implies we may be close to the bottom. While the Fed can do little to offset the first order impacts of social distancing, it can mitigate the second order effects of financial stress. The S&P at 2400 has probably already discounted much of the fallout from social distancing.

Michael sees the U.S. recession in 2020 as marking the end of the cyclical bear, not the beginning of one. To put the current destruction in perspective, the average stock, particularly the average cyclical stock, entered a bear pattern back in 2018. For the S&P 500, the average stock has now declined 42% from its 52-week high versus declines of 57% and 41% in the bear markets of 2009 and 2002, respectively.

This interpretation argues for seeing further equity declines as opportunity and the team has acted on that premise. The initial wave of forced selling and price discovery is likely complete, Michael believes. Between April and early May, he thinks equities will have fully discounted the distress across the transatlantic economies.

This forecast includes some back and forth testing of the lows over the next six weeks. Some relapse in April brought on by discouraging fundamental news is possible, but he encourages investors not to be overly cautious.

Between April and mid-May, anxieties around the virus will dissipate. Investors will start to discount a recovery in the global economy from mid-year. For the S&P 500, 2800 is the team’s minimum upside target for the remainder of 2020.

We stand ready to help, let us know what you need. For more information, contact your Calamos Investment Consultant at 888-571-2567 or caminfo@calamos.com.