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Batten down the hatches

What connects the names Dolly, Edouard, Fay and Gonzalo? The answer: they are four of the 2020 Atlantic tropical cyclone names, as selected by the World Meteorological Organisation. In other words, the potential nomenclature for hurricane storms this year. The first named storm of the season, Arthur, occurred in May – before the official start of the Atlantic hurricane season – running from June 1 through to November 30. This year, forecasters at the National Oceanic and Atmospheric Administration (NOAA), part of the US Department of Commerce, have warned of an above normal 2020 hurricane season. NOAA’s Climate Prediction Centre is anticipating a likely range of 13 to 19 named storms, of which 6 to 10 could become hurricanes, including 3 to 6 major hurricanes (category 3, 4 or 5; with winds of 180 km/h or higher). To calibrate this, an average hurricane season produces 12 named storms, of which 6 become hurricanes, including 3 major. 

So, what has prompted this warning from the NOAA? Well, it is a combination of several climate factors; firstly, there will not be an El Niño present to suppress hurricane activity this year. Also, warmer-than-average sea surface temperatures in the tropical Atlantic Ocean and Caribbean Sea, coupled with reduced vertical wind shear, weaker tropical Atlantic trade winds, and an enhanced west African monsoon all increase the likelihood for an above-normal hurricane season. 

How do these storms form and grow?

Warm sea surface temperatures and fairly unstable air are major ingredients in the recipe for a hurricane. They can be considered heat engines; taking heat from the ocean and converting it to wind energy. Thermal energy is converted to mechanical energy, as plumes of warm air rise to replace cold air higher up in the atmosphere. For a hurricane to grow, more and more air is sucked in and this then spirals in an anticlockwise fashion toward the centre. As it nears the middle, the air accelerates faster and faster with these winds creating the eyewall. These are the scariest and nastiest part of the storm and in a Category 5 hurricane, can roar at speeds of 225 km/h. When conditions are right, they can sweep damaging storm surges inland across coastlines and have been known to deposit more than 1 metre of rain.

Amongst all this damaging chaos, the average hurricane eye — the still centre, where pressure is lowest and air temperature is highest — stretches 32 to 48 kilometres across, with some even growing as large as 190 kilometres wide. As the storm passes, the weather in the eye can be completely becalmed, with blue skies often visible overhead. This photograph went viral in September 2019, as a NOAA ‘storm hunter’ aircraft flew through the eye of Hurricane Dorian, one of the most powerful storms ever seen in the Atlantic. It beautifully captures the eerily calm centre of the storm.   

Reflecting on the performance of global financial markets through this quarter, we believe this stunning image could be a visual metaphor for where we have been, the position now, and what may come next. 

The eye of the storm

Quarter 2, 2020 has been a tragic 3 months for humankind around the globe. Over 10 million people have contracted the coronavirus and more than half a million people have died. As we enter this new quarter, infection rates are still increasing. Recently, the daily global infection rate has been closing in on 175,000 cases and medical professionals continue to warn the virus is not under control and remains a major risk to public health.  

The economic consequences of the shutdown have also been grave. Over 20 million people became unemployed in the United States, in the last three months, and millions more have suffered a similar experience worldwide. The US is estimated to have endured a 39% contraction in GDP in Q2, according to the Atlanta Fed. The Euro Area is estimated to have contracted at a quarterly rate of over 12%.

Yet, through this period there has been unprecedented support for financial markets and the real economy from central banks and governments. Trillions of dollars of direct and conditional monetary and fiscal policy has been provided. As a result, in Q2 we have barely seen any asset class record a negative return. Chaos and panic has been followed by a serene period of calm, as investors have literally looked up and seen nothing but blue skies. It seems the predominant fear that has existed in financial markets has been FOMO, the ‘fear of missing out’.

This disconnect with the real world has been stark; concerns related to the virus, losing a job and struggling to make ends meet are now commonplace in many parts of the world. Meanwhile, most asset prices have more or less recovered from their March lows and US tech stocks have risen to new highs.  
Is the next eyewall now on the horizon?

There is, of course, a sense we have been here before. A global emergency unfolds, spurring the Fed and other key central banks to cut rates and underpin asset prices. Post the Global Financial Crisis (GFC), policymakers can rightly argue they successfully averted an economic depression, which would have caused misery and suffering for millions of people. The unintended consequence of that action taken, has been a period of low growth and disinflation as zombie companies – those that would have failed in a ‘normal’ economic downturn – have continued to operate and finance themselves. This has harmed productivity, competition and lead to a period of misallocated capital. In truly competitive economies, those who do well should prosper, while those who offer inferior goods and services, should fail. Increasingly, this does not happen.

Here we are, 12 years after the GFC with the same policies – this time supercharged – being deployed again. The Fed is buying not only government bonds, but also corporate debt – including low-quality issues, mortgage obligations, municipal bonds and exchange traded funds. Its balance sheet has already swollen by an astonishing $3tn to more than $7tn since the start of this year. Perhaps, the most dangerous aspect of these policies is financial markets have come to expect the Fed, or its peers, to intervene in response to any sharp decline in risk assets. According to Mohammed El-Erian – chief economic adviser at Allianz – this results in unfettered risk taking as ‘zombie investors’ drive the ‘zombie market’ ever higher. A similar assessment, written by Henry Kaufman (former Senior Partner, Salomon Brothers) appeared recently in the Financial Times and concluded “capitalism is being rapidly replaced by statism — a form of political economy in which the state exercises substantial centralised control over social and economic affairs.

In the same way as being prepared can help minimise the impact of a hurricane, having a plan is key for protecting portfolios. How to invest for this environment? First and foremost stay diversified – by asset class, geography, sector, style and foreign exchange. The second key component is being mindful of liquidity and keeping some powder dry. Thirdly, be primed for the consequences of currency devaluation and its associated loss of purchasing power. The latter necessitates a larger allocation to gold than has typically been seen over the past decade. Whilst all this is hardly original thinking, the framework enables us to be confident around our positioning, despite the challenges approaching. 

Recessions, like hurricanes, are largely inevitable and vary in their intensity. What is important is emerging from the aftermath intact. 

This VFTD is dedicated to the memory of Guy Rushton, formerly of Polar Capital. A talented manager, who thought differently and with whom we were privileged to invest alongside. 

Please do contact us with any questions 

Julia Warrander and Russell Waite

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