Covid mutations the biggest risk to markets: Hamish Douglass

Magellan’s Hamish Douglass warns that the assumptions underpinning record share prices leave little margin for error.

Magellan’s Hamish Douglass warns that the assumptions underpinning record share prices leave little margin for error. Picture: Britta Campion / The Australian

Hamish Douglass has defended the recent performance of his Magellan Global Fund after it failed to keep up with a sharp rise in the market in the final two months of the year, and warned that the assumptions underpinning record share prices leave little margin for error.

In his latest global strategy update, the chairman, CIO and lead portfolio manager of Magellan said he wouldn’t “lose sleep” after “missing out on some of this short-term rally”.

Since inception in July 2007, the Magellan Global Fund has returned 11.5 per cent per annum versus 6.8 per cent for its benchmark MSCI World Net Total Return in Australian dollars.

But in the year to December 2020, the fund was flat while its benchmark rose 5.6 per cent.

The second half was worse, with a net underperformance of 10 per cent versus the benchmark.

But it would have turned out quite differently if COVID vaccine developments hadn’t gone so well, causing investors to reprice risk — particularly for economically sensitive stocks — while the US election outcome also helped by raising expectations of fiscal stimulus, with Georgia senate run-off elections in January giving the Democrats control of congress and the presidency, but only just, giving a “nirvana outcome” of more fiscal stimulus but nothing radical.

But many investors “seem oblivious” to the ongoing risks from the pandemic.

“The way we see it, the pandemic is an event of huge scientific complexity and many investors seem oblivious to these risks,” Douglass says.

“Due to the challenges the world still faces, our priority is protecting investors from losses.”

In particular, he’s concerned that the COVID vaccines may not work on mutations of the virus, and that the biggest risk the world faces is that the virus might mutate in a way that reduces the effectiveness of vaccines.

“There is the possibility of an escape mutation developing during a prolonged vaccination process,” Douglass says.

“No one can accurately gauge the probability of whether or not the current mutations or an escape mutation might make the vaccines we have ineffective.

“Now is not the time to be oblivious to the pandemic risk, especially given infections we are seeing in Latin America, the UK and the US. Hold on to your chairs if investors suddenly decide that a mutant strain has rendered ineffective the vaccines that drove the November rally.”

Magellan typically has half of its portfolio in cash and high-quality defensive equities, giving it defensive characteristics that should see it hold up relatively well in adverse markets.

The Democratic sweep of congress and the presidency should have net positive implications for the 60 per cent of Magellan’s portfolio in US domiciled stocks.

Douglass sees a stronger US recovery, more stable US foreign policy — especially with China — which is important for Magellan given its focus on US businesses with Chinese exposure.

With Democrats set to have 50 of 100 US senate seats plus a casting vote for Vice President-elect Kamala Harris, Douglass doesn’t see radical change since most legislation needs 60 senate votes to overcome the filibuster rule which moderate Democrats have said they will not vote to remove.

He does concede that higher corporate taxes are likely, but notes that the US utilities which comprise about 13 per cent of the portfolio can pass on tax hikes to customers, and most of Magellan’s US holdings are multinationals that derive only part of their earnings from the US.

Moreover a potential rise in the US corporate tax rate to 28 per cent from 21 per cent should have been priced into the market.

If COVID vaccines are distributed widely and mutations don’t make them ineffective, then “extremely large” US fiscal stimulus should spark economic growth that might cause some inflation, but Douglass feels central banks won’t lift rates in response to the “first signs of inflation”.

With Joe Biden proposing a $US1.9 trillion increase in public spending, a rise in bond yields amid surging bond issuance is another risk, but Douglass argues that the Federal Reserve will increase its bond-buying program if there is a large jump in yields.

Magellan has increased its regulatory risk weighting on Chinese companies after Alibaba and Tencent came under the scrutiny of regulators, and the proposed IPO of Ant group — 33 per cent owned by Alibaba — was blocked after founder Jack Ma was critical of financial regulation.

Still, Douglass maintains that his investment thesis for Alibaba and Tencent still holds.

“These companies are incredibly advantaged and are strategically important to China,” he said.

“We don’t think the regulators focusing on antitrust measures will materially change that.”

Overall, Douglass remains confident that the quality, growth and defensiveness of the funds’ portfolio will deliver attractive returns while protecting capital.

“Markets are at all-time highs (and) the assumptions underpinning record prices leave little margin for error,” he says. “We think it appropriate to focus on protecting the downside, especially given the scientific uncertainty with the pandemic.”

Originally published as Covid mutations the biggest risk to markets: Hamish Douglass