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GMO’s Ben Inker on Why Stocks Are Too Risky, and What to Buy Instead

On March 10, 2009, Jeremy Grantham published a memo titled “Reinvesting When Terrified,” arguing that stocks were substantially undervalued and that investors should get in the market, despite the pain of doing so. “Remember that you will never catch the low,” wrote the co-founder of GMO, a Boston-based investment management company.

Of course, he had caught the low; it would turn out that March 9 was the nadir of the financial crisis and the beginning of the great bull market of the past decade. Pointing out that, in 2002, Grantham had predicted that the S&P 500 index would bottom at 670 in seven years makes GMO sound more like a Las Vegas act than a financial firm, but it is no less true.

GMO has made many other prescient calls, so it’s worth noting that the $60 billion firm drastically reduced its equity exposure this past week, taking its go-anywhere institutional fund’s stock sleeve down to 25% from 58%. Ben Inker, who has been head of asset allocation at GMO for 22 years, shared his analysis exclusively with Barron’s. After announcing in mid-March that it was time to buy, Inker now says that the recent furious rally in U.S. stocks has more-than fully priced in an optimistic resolution to the coronavirus crisis, while leaving investors in a dangerous position if something goes wrong.

Inker, who has become a more public face of the firm as Grantham focuses on philanthropic efforts, says the current economic downturn will be twice as deep as the 3.25% gross-domestic-product hit the U.S. suffered in the financial crisis. We spoke with him as he prepared to alert clients to the firm’s changed stance, and have edited his comments for brevity.

Barron’s: You just more than halved the stock allocation in your flagship funds. What’s worrying you?

Ben Inker: We were getting very nervous about how much the markets had gone up. The risk/reward trade-off for equities had really gotten a lot worse than it was in March. Value stocks at this point are trading at some of the widest spreads we have ever seen.

The optimistic scenario is: We get a vaccine relatively quickly, or some affordable, very effective treatment for Covid-19 that allows us to go back to a normal economy. With the extraordinary rally we’ve seen from March, stocks are priced for that outcome. But in the event of that outcome, we expect that the stocks that will go up the most are the ones that got hit the worst on the way down and have not fully recovered. If people are willing to get in airplanes and go to restaurants and to concerts again, well, those companies that took the huge hit should be the biggest beneficiaries.

The less optimistic scenario is: We don’t get something that enables us to bring the economy back to life, and it takes a few very difficult years before we’re back to anything approaching normal. As of March 23, stocks around the world were priced for that. Since then, we’ve seen a rally of 25% to 30%-plus. To put that in perspective, a group of stocks trading at fair value deserves a real return [after inflation] of about 5% a year. So we’ve gotten somewhere between four and maybe as much as seven years’ worth of returns from stocks in seven weeks.

But you still own some U.S. stocks—in case the optimists are correct?

In early April, we were buyers of stocks with a cyclical focus. Certain industries have been hit very hard: hotels, airlines, energy, autos, and certain industrials. Even if the economic problems last a long time, the strongest companies in those spaces will make it through. Now, we’ve just shorted the market against them.

How overvalued are U.S. stocks?

We thought the S&P 500 was really quite overvalued coming into this. Our best estimate of fair value for the S&P is something a little bit south of 2000. [The S&P 500 closed at 2955.45on Friday.] So even at the March lows, it didn’t look cheap to us, but it had just fallen 33%, and the market seemed to be taking the pandemic pretty seriously. So in late March and early April, we were buying risk assets—international large- and small- caps, emerging market stocks, cyclical stocks, high-yield credit. There were a lot of risky assets that were priced with a reasonable margin of safety. And then they all went up.

By your methodology, the S&P 500 has spent most of the past 20 years above fair value.

Yes, that is true. The S&P got cheap in 2008-09. It was reasonably priced from 2000 to 2003. But in most of the period, it has been somewhere between moderately and significantly overvalued.

Does that cause you to wonder if you should tweak your model to take secular changes into account?

Over the course of those 20 years, we have done a lot of digging into our assumptions, to understand where things have played out differently than we expected. One of the striking [observations]: Profitability around most of the world has been stable. Profitability for U.S. small- and mid-cap stocks has been stable. The one place that was absolutely not the case is U.S. large- caps, which have seen profitability, and their apparent return on capital, move up in a way that is fairly unique.

What’s going on?

Some of it is indeed driven by secular change: Health care and tech have structurally higher returns on capital. The U.S. market has more of them than other markets, and their weight in the U.S. has come up. But even more striking is that in the U.S., a tremendous number of industries have become more concentrated—and the profitability of those industries has gone up. One difference between the U.S. and everywhere else is that we have tolerated—perhaps even encouraged—an amount of consolidation that would not be allowed elsewhere. We’ve created oligopolies, and oligopolies have a pretty good return on capital.

They sound like great investments.

One thing you could say—which is almost certainly a bad idea—is, “Well, that’s the trend; let’s assume it continues.” And that would be ever-more industry concentration, and more and more profit would accrete to the very largest firms. That kind of trend is never sustainable, and it’s always dangerous to assume it’s going to continue.

What’s a more likely outcome?

Over the next 20 years, the world will probably be less friendly to the giants than it is today. And I would bet that the next 20 years see a slowly deteriorating return on capital for U.S. large-cap stocks. But it’s not going to be a natural occurrence, driven by competitive capitalism, because we have thrown sand in the gears of competitive capitalism.

How have we thrown sand in the gears of competitive capitalism?

It’s pretty straightforward: We used to have a world where we would not have allowed four wireless companies to turn into three, or seven major airlines to turn into four, because we wanted to maintain enough players to have competition, which is good for consumers. We allowed Facebook [ticker: FB] to buy up companies that could have plausibly become future competitors. That probably wasn’t a great idea. It’s not too late to change our treatment of future potential mergers, and change the way we regulate the companies.

If it is truly the case that social media and search are “natural monopolies,” we understand how to treat natural monopolies. Utilities are a natural monopoly, and we regulate their return on capital. U.S. large-cap companies have been able to get away with profitability that nobody else has, because they don’t have many competitors. Over time, you want a world where there is competition. If there are situations where competition is not possible, society should have another way of dealing with the fruits of that dominant position.

You’ve recommended emerging market stocks since 2017. That hasn’t panned out. Why do you still like them?

The average emerging stock is trading at half the valuation of the average U.S. large-cap stock. We’ve seen in emerging the same thing we’ve seen in the developed world: A relatively small handful of growth stocks have outperformed the indexes hugely, and half of the universe or more has been left behind. As a result, you can put together a portfolio of decent companies trading at about one times book value and seven times trailing earnings, with a trailing dividend yield of over 6%. That’s pricing in a really bad outcome, which is comforting. If you think earnings are merely going to be stable, you have an earnings yield of 14%. You don’t need to imagine good things happening to get good returns out of companies trading at those valuations.

Why are they so cheap?

One reason is the disappointment that came from having substantially overpaid for them in 2007 and 2011. The other is that their currencies got substantially overvalued, and have been falling ever since. Today, that’s a nice benefit. Undervalued currencies make the emerging world a really cheap place to make stuff and provide services.

What are you doing with the fixed-income sleeve of your portfolio?

We used to own some government bonds, but yields fell to the point that we didn’t think they offered much, relative to cash. Cash has the nice feature that you can turn it into something else very easily. We own high-yield debt. Credit spreads are still meaningfully wider than average. We’re also seeing pretty good opportunities in emerging sovereign debt, where again, spreads have blown out. And also in asset-backed debt, there is some quite low-risk paper priced as if it’s high-risk; we like opportunities like that. They are pricing in not so much the V-shape recovery but the U-shape recovery. You have to make sure you can live with what happens if we get the L-shape instead.

Your concerns about risk and uncertainty remind me of recent comments from Warren Buffett.

It does seem to be one of those times when a lot of people who have spent a lot of time studying history and have lived through a bunch of cycles all seem to have more agreement than I’m used to. Stan Druckenmiller is an extraordinary investor. I don’t normally find myself agreeing with him that much, but today he seems to be saying what is in my head.

We always have in the back of our mind that very bad things could happen. What seems very different today is that tail events no longer seem like such a low probability.

Thanks, Ben.

Adecco Group derives 86% of its sales from providing temporary workers to clients—a business that has fallen off a cliff due to coronavirus.

Shares in the Swiss-listed recruitment firm have plunged 24.2% in the past year but picked up 3.3%, to 42.87 Swiss francs ($44), over the past month, due to a strong first quarter and signs that companies in France, Italy, and Spain could start hiring again.

Adecco’s stock (ticker: ADEN.Switzerland) is close to an all-time low—the business has tended to be cyclical, bouncing back fast in times of uncertainty. Clients have powered their companies to growth using temporary workers.

The discounted stock is worth a gamble for investors betting on economic recovery. Analysts at Frankfurt-based MainFirst Bank have forecast a 23.6% rise, to CHF53, while Konrad Zomer, an analyst at Abn Amro, marked it a Buy with a CHF50 price target.

In a May note Zomer wrote, “Management states that weekly temporary-staffing volume trends confirm that those countries that entered lockdown earliest are showing signs of stabilization…that is relatively positive.”

Adecco, which is based in Zurich and employs 34,000 workers, fetches 15.5 times this year’s expected earnings and is valued at a 10% discount to its peers. It posted gross profit of CHF4.5 billion for 2019, up from CHF4.4 billion a year earlier on sales of CHF23.4 billion.

In May, the company reported a net loss in the first quarter. But its 9% decline in organic revenues beat a consensus drop of 12.6%.

CEO Alain Dehaze told Barron’s that the company entered the pandemic “from a position of financial and operational strength with a strong balance sheet, good liquidity, and robust information-technology infrastructure, due to the transformation work we have undertaken over the past few years.

“As we manage the crisis, we have not lost sight of our long-term strategic priorities, so that we are well positioned when the recovery comes,” he said.

The company will remain focused on delivering more growth and value for stakeholders, “allowing us to take advantage of the megatrends shaping the future of work,” he added.

Adecco was created by a merger between two firms. Adia was started in 1957 in Lausanne, Switzerland, by Henri Lavancy, while Ecco, based in Lyon, France, was formed by Philippe Foriel-Destezet in 1964.

Adia expanded abroad, while Ecco grew to become France’s biggest temporary-staffing agency. By 1996, they had merged, placing about 600,000 people in jobs daily.

This year is likely to be tough for Adecco because temporary workers were the first to face the axe as firms cut costs.

But the company has a strong balance sheet and a flexible cost base, and it felt confident enough to maintain its dividend even though it stopped share buybacks. Adecco said in early May that it has CHF1.4 billion in cash on hand.

Dehaze said the company “executed well” in the first quarter, and while the second quarter will be difficult, “we expect it to be the trough.”

Abn Amro analyst Zomer wrote in his note that weekly trends confirm that countries that entered lockdown early are showing signs of stabilization.

An investment in Adecco is all about the timing. If Dehaze is right that the pandemic peak has passed, then clients will begin to rehire temporary staff to ramp up production and services.

If not, then Adecco stock is an opportunity for bullish investors who are aware that a full recovery will take time.

If stockpickers have a chance of salvaging their reputations, this is it. A violent selloff and equally rapid ascent in the stock market has caused mispricings and created massive disparities among sectors and stocks, giving actively managed mutual funds an opportunity to beat the index’s return, after lagging behind badly throughout the long bull market.

Some financial advisors, including longtime skeptics of active management, are moving money into these strategies. They believe that the market is acting irrationally enough to give good managers the chance of beating their benchmarks, and that a longtime trend toward lower fees has lowered the hurdle to outperformance.

“It makes sense to be surgical now more than ever,” says Ron Carson, CEO and founder of Carson Group, an Omaha advisory, which last quarter added an active strategy to U.S. stock allocations and is in the process of switching all of its developed international allocation to active funds from about a 50-50 split.

“When the economy is humming along, the rising tide raises all boats. But we’re going to see a major contraction this quarter and massive volatility,” Carson says. “To find companies gaining market share even if their prices are going down takes a manager digging into a company’s debt structure, free cash flow, fundamentals. Talking to suppliers, looking upstream and downstream. Hours of homework.”

The move by Carson and other advisors is a fresh vote of confidence for actively managed mutual funds, most of which trailed passive strategies throughout the long bull market. In August, the amount invested in passive funds hit $4.3 trillion, exceeding assets under active management among individual investors for the first time and cementing the dominance of indexing. For some advisors, however, pruning passive and adding active exposure began before the February stock market pullback, as they prepared for what they thought would be an end to the 11-year bull market and lower returns in 2020.

“The markets were overbought, and there’s no cerebral cortex to a passive approach,” says Andrew Rosen, an advisor at Diversified in Wilmington, Del. “We use passive to grab big swaths of the market, but added active managers to tilt portfolios and use rationale to increase and decrease positions.”

Rosen says that he continued to add active managers as the market pulled back sharply in response to Covid-19. “We wanted to both protect on the downside and position for a recovery,” says Rosen, who switched 10% of his passive holdings to active, including all international stock investments and some U.S. stock and fixed-income holdings. He particularly likes T. Rowe Price Blue Chip Growth (ticker: TRBCX), Federated MDT Small Cap Growth (QASGX), Invesco Oppenheimer Developing Markets (ODMAX), and Baird Aggregate Bond (BAGIX).

For years, active managers have been making the case that they would shine in a market downturn, using human intelligence and financial analysis to assess stocks that were unfairly punished. The logic is sound, but the execution is tough.

Among active U.S. stock funds, winning managers are almost always in the minority. Consider that there was no rolling five-year period over the 22 years from 1997 to 2018 in which more than 50% of managers beat their Morningstar category, according to Morningstar research. For the rolling periods ending in each of the five years from 2014 to 2018, less than 20% of managers had success.

The data cast a better light on U.S. stock fund managers during periods of unrest in the markets. The high-water mark for actively managed U.S. stock funds was after the technology bubble burst in 2000, when more than 70% of active fund strategies beat passive counterparts.

“It was a turkey shoot in the sense you had this extreme divergence between growth stocks and value, large and small, domestic and foreign,” says Jeffrey Ptak, global director of manager research for Morningstar. “When you have those kinds of spreads, it’s a boon for active investors. Success rates went through the roof.”

In the recent V-shape downdraft and bounce in stock prices through April, 48% of U.S. active stock managers outperformed their category indexes. During the downswing from Feb. 19 to the trough on March 23, 53% outperformed, according to Morningstar.

Looking ahead, advisors say they expect the climate to continue to be tough for stockpickers in the large-cap space.

“We had a major market break, but the leadership in large-cap stocks hasn’t changed—the Big Five ( Amazon.com [AMZN], Alphabet’s Google [GOOGL], Apple [AAPL], Facebook [FB], and Microsoft [MSFT]) account for over 20% of the S&P 500 index,” says John Apruzzese, chief investment officer at Evercore Wealth Management, who is in the process of shifting all international exposure to active strategies. “People would think it would be active managers’ heyday, but it’s very difficult to outperform the S&P 500 when the megastocks are still leading.”

Those who are adding active management in U.S. large-cap allocations are nibbling rather than making big changes, often choosing concentrated portfolios of 30 to 40 stocks so the manager has agility and flexibility—theoretically, at least—to dodge risks and snap up opportunities.

Judith McGee, chairwoman and CEO of McGee Wealth Management in Portland, Ore., has long favored active managers but has held about 15% in passive options, primarily in U.S. stocks. She recently reduced that to 5%, adding a high-conviction U.S. value manager, American Funds American Mutual (AMRFX) and an active ETF with a focus on technology called ARK Innovation (ARKK).

“We’re not just looking at offense; this is for defense, too,” McGee says. Both active funds have a strong record: Each trounced benchmarks and at least 90% of peers in the past one, three, and five years.

The shift to active strategies has been more aggressive in small-cap U.S. stocks, international stocks, and fixed income, where actively managed funds have a higher success rate and many of the indexes are structurally unappealing to advisors. “We are moving from a mix of active and passive in international developed stocks to all active,” says Evercore’s Apruzzese. “The international indexes [are] full of things we don’t want.”

For example, banks have been weakened by negative interest rates and dividend cuts, Apruzzese says. Auto manufacturers are grappling with weak sales and the high cost of switching to electric vehicles, and oil companies are facing major restructuring needs and dividend cuts, he adds.

Last year, 46% of U.S. small-blend managers beat their indexes compared with 35% of U.S. large-blend funds. The benchmark-beating rate among international stockpickers was significantly higher: 58% of foreign large-blend and 68% of diversified emerging markets managers.

Obviously, switching to active management is successful only if the advisor picks the right mangers. Academic studies have shown that it’s difficult to predict which managers will outperform, but one good indicator is fees. Lower-fee funds produce the highest returns across every asset class. Other factors that advisors prioritize are low turnover (to keep taxes down), easy access to managers, and a high active share. Low active share means that a fund looks just like the benchmark—owning the same stocks in roughly the same proportion, making it hard to justify higher fees.

Lori Van Dusen, founder and CEO of LVW Advisors in Pittsford, N.Y., acknowledges that even if you invest with the best manager, moving away from index investing comes with a risk. “If you get a big broad-market bounce, you might miss it,” she says, but adds that the dislocations in some major global markets have been extreme and are best analyzed by seasoned stockpickers. She has shifted assets to active managers in U.S. small-caps, emerging markets, and fixed income.

That’s completely different than her approach through the 2008 market rout. Coming out of 2008, stocks were cheap and bond interest-rate spreads blew out so dramatically that investors couldn’t go wrong in index funds, Van Dusen says. “Now, with a rolling gradual opening of the economy, you have to have a lot more skill in small-caps and debt to understand the difference between solvency and liquidity issues,” she says. “A lot of companies today are financially fragile, and some are not. There’s opportunity for people who can understand which are which.”

Active fixed-income funds haven’t had a great track record lately in beating their benchmarks. Among corporate bond funds, just 26% did last year and 48% in 2018. But with interest rates so low, index funds in fixed income don’t seem poised for a big bump this year, so many advisors are selecting unconstrained fixed-income managers, who can pick and choose where to invest across fixed-income asset classes and internationally.

“With the 30-year Treasury paying around 1.5%, it’s almost impossible to make money passively in bonds right now,” says Steve Podnos, a principal at Wealth Care in Cocoa Beach, Fla., who recently raised his active allocation in fixed income from 70% to 90%. “And what happens when interest rates start to go up? Passive medium- to long-term investments will get hammered. Being active allows us to invest both domestically and internationally in a number of different areas of fixed income.” He favors Pimco Income (PONAX), DFA Five Year Global Fixed Income Portfolio (DFGBX), and Fidelity Total Bond (FTBFX).

Some advisors who traditionally avoided active managers because of high fees say that a steady, yearslong decline in fees has been a game changer. “We’ve always been extremely fee conscious; fees have compressed enough that active fees are justified,” says Leon LaBrecque, chief growth officer at Sequoia Financial Group in Troy, Mich. He has fully embraced active management in fixed income and is considering adding active managers to his mostly passive stock portfolio.

U.S. stock funds charge an average 0.7% compared with passive funds’ 0.1%. Taxable-bond fund average expense ratios are 0.53% for active and 0.12% for passive.

A broad shift from passive to active isn’t glaring in fund-flow data, but some trends are notable. The cheapest active funds steadily saw inflows throughout the bull market, according to Morningstar. The firm also notes that in January and February of this year, a net $24 billion went into active funds. Sure, that’s significantly less than the $78 billion that went into index funds, but it ended a 10-month trend of steady net outflows.

Investors reversed course in March and yanked massive assets out of both active and passive funds. Jitters continued in April, but a more granular look shows that investors pulled far less out of actively managed U.S. stock funds than passive, and that actively managed stock sector funds had net inflows.

The emphasis on active strategies goes beyond mutual funds and ETFs. Some advisors say the pullback in asset prices has prompted them to allocate more to private investments and other nontraditional asset classes.

“We’re looking at some private-equity and venture strategies that we passed on in the fall because of pricing, but now pricing has come down,” says Deb Wetherby, founder and CEO of Wetherby Asset Management in San Francisco. Real estate and private lending are among the areas of interest, she says.

Some advisors say that while they haven’t expanded active allocations, they’ve been elbow-deep in assessing their current managers.

“Moving forward, active managers will be able to add the most value in areas such as technology, health care, parts of finance, and consumer,” says Kent Insley, managing director at Tiedemann Wealth.” He particularly likes Akre Focus (AKREX), which has more than 75% in cyclical stocks such as financial services and real estate, and has beaten its benchmark and at least 90% of its peers in the trailing three-, five-, and 10-year periods through May 12.

As markets continue to roil, many advisors say they’ve been spending days conferencing from their home offices with colleagues to discuss strategies for the next few quarters. Gary Hager, president and founder of Integrated Wealth Management in Red Bank, N.J., is a big believer in passive investing, but is prepared to move about 10% of his portfolios to active management if the market delivers another pullback. “Because of the speed and violence of the market’s move down and up in the first quarter, there was never an opportunity to implement our plan,” he says. Given continued economic duress, he adds, “I suspect there will be.”

Trump administration discussed conducting first U.S. nuclear test in decades

The Trump administration has discussed whether to conduct the first U.S. nuclear test explosion since 1992 in a move that would have far-reaching consequences for relations with other nuclear powers and reverse a decades-long moratorium on such actions, said a senior administration official and two former officials familiar with the deliberations.

The matter came up at a meeting of senior officials representing the top national security agencies May 15, following accusations from administration officials that Russia and China are conducting low-yield nuclear tests — an assertion that has not been substantiated by publicly available evidence and that both countries have denied.

A senior administration official, who like others spoke on the condition of anonymity to describe the sensitive nuclear discussions, said that demonstrating to Moscow and Beijing that the United States could “rapid test” could prove useful from a negotiating standpoint as Washington seeks a trilateral deal to regulate the arsenals of the biggest nuclear powers.

The meeting did not conclude with any agreement to conduct a test, but a senior administration official said the proposal is “very much an ongoing conversation.” Another person familiar with the meeting, however, said a decision was ultimately made to take other measures in response to threats posed by Russia and China and avoid a resumption of testing.

The National Security Council declined to comment.

During the meeting, serious disagreements emerged over the idea, in particular from the National Nuclear Security Administration, according to two people familiar with the discussions. The NNSA, an agency that ensures the safety of the nation’s stockpile of nuclear weapons, didn’t respond to a request for comment.

The United States has not conducted a nuclear test explosion since September 1992, and nuclear nonproliferation advocates warned that doing so now could have destabilizing consequences.

“It would be an invitation for other nuclear-armed countries to follow suit,” said Daryl Kimball, executive director of the Arms Control Association. “It would be the starting gun to an unprecedented nuclear arms race. You would also disrupt the negotiations with North Korean leader Kim Jong Un, who may no longer feel compelled to honor his moratorium on nuclear testing.”

The United States remains the only country to have deployed a nuclear weapon during wartime, but since 1945 at least eight countries have collectively conducted about 2,000 nuclear tests, of which more than 1,000 were carried out by the United States.

The environmental and health-related consequences of nuclear testing moved the process underground, eventually leading to a near-global moratorium on testing in this century with the exception of North Korea. Concerns about the dangers of testing prompted more than 184 nations to sign the Comprehensive Nuclear-Test-Ban Treaty, an agreement that will not enter into force until ratified by eight key states, including the United States.

President Barack Obama supported the ratification of the CTBT in 2009 but never realized his goal. The Trump administration said it would not seek ratification in its 2018 Nuclear Posture Review.

Still, the major nuclear powers abide by its core prohibition on testing. But the United States in recent months has alleged that Russia and China have violated the “zero yield” standard with extremely low-yield or underground tests, not the type of many-kiloton yield tests with mushroom clouds associated with the Cold War. Russia and China deny the allegation.

Since establishing a moratorium on testing in the early 1990s, the United States has ensured that its nuclear weapons are ready to be deployed by conducting what are known as subcritical tests — blasts that do not produce a nuclear chain reaction but can test components of a weapon.

U.S. nuclear weapons facilities have also developed robust computer simulation technologies that allow for modeling of nuclear tests to ensure the arsenal is ready to deploy.

The main purpose of nuclear tests has long been to check the reliability of an existing arsenal or try out new weapon designs. Every year, top U.S. officials, including the heads of the national nuclear labs and the commander of U.S. Strategic Command, must certify the safety and reliability of the stockpile without testing. The Trump administration has said that, unlike Russia and China, it isn’t pursuing new nuclear weapons but reserves the right to do so if the two countries refuse to negotiate on their programs.

The deliberations over a nuclear test explosion come as the Trump administration prepares to leave the Treaty on Open Skies, a nearly 30-year-old pact that came into force in 2002 and was designed to reduce the chances of an accidental war by allowing mutual reconnaissance flights for members of the 34-country agreement.

The planned withdrawal marks another example of the erosion of a global arms-control framework that Washington and Moscow began hashing out painstakingly during the Cold War. The Trump administration pulled out of a 1987 pact with Russia governing intermediate-range missiles, citing violations by Moscow, and withdrew from a 2015 nuclear accord with Iran, saying Tehran wasn’t living up to the spirit of it.

The primary remaining pillar of the arms-control framework between the United States and Russia is the New START pact, which places limits on strategic nuclear platforms.

The Trump administration has been pushing to negotiate a follow-on agreement that includes China in addition to Russia, but China has rejected calls for talks so far.

Trump’s presidential envoy for arms control, Marshall Billingslea, warned that China is the “midst” of a major buildup of its nuclear arsenal and “intent on building up its nuclear forces and using those forces to try to intimidate the United States and our friends and allies.”

One U.S. official said a nuclear test could help pressure the Chinese into joining a trilateral agreement with the United States and Russia, but some nonproliferation advocates say such a move is risky.

“If this administration believes that a nuclear test explosion and nuclear brinkmanship is going to coerce negotiating partners to make unilateral concessions, that’s a dangerous ploy,” Kimball said.

Pandemic forces upmarket brands to rethink pricing, store locations and supply chains

With sales clerks wearing face masks and ubiquitous bottles of hand sanitisers around, the effect of the coronavirus pandemic is impossible to miss at Paris department store Le Bon Marché.

But perhaps the most striking evidence is in a top floor lounge where customers from outside the EU process their sales tax refunds. Before the pandemic, the world’s oldest department store, owned by luxury group LVMH, would have 12 counters open for tourists to reclaim taxes. Last week, the lone clerk on duty said she had handled just three refunds that day.

As the fashion capitals of Paris, Rome and Milan stir back to life, the luxury industry faces a stark reality: Chinese tourists, who accounted for two-thirds of the sector’s sales in Europe before Covid-19, are absent and unlikely to return any time soon. 

Now brands such as Chanel, Gucci and Louis Vuitton will have to cater more to their local clientele while also seeking to understand just how deeply the public health emergency has altered customers’ desires and shopping preferences.

Remo Ruffini, chairman and chief executive of Italian luxury brand Moncler, expects the demand shock will spark changes in everything from design to sales tactics. “Normality at the moment remains on the distant horizon,” he told the Financial Times. “When business as usual is not possible, it is the perfect time to reframe a new normal.”

For Moncler, best known for its high-end quilted jackets, it was, he said, “the time to boost digital, to redesign the retail network, to establish a closer and more supportive relationship with the supply chain, to invent new ways to present and sell the collections, and to reconsider how to engage with clients”.

But Mr Ruffini warned that some aspects of the business cannot be changed: “The fashion industry is very physical, we need designers, tailors, fittings, fabrics, not everything can be managed remotely.” To encourage staff back to the office in Milan, Moncler is offering them bicycles, free doctor consultations and Covid-19 antibody tests.

As workers return, an immediate priority will be selling stock, especially of clothing in department stores. Luca Solca, analyst at Bernstein, has predicted “the mother of all end-of-season sales”. At Le Bon Marché, jackets from Isabel Marant and Tod’s loafers were already marked down by 40 per cent. 

“Consumers are expecting discounts as a new rule of the game,” said Claudia D’Arpizio, luxury analyst at Bain & Co.

Brands that have their own stores, however, will limit such discounting and use less visible outlet stores to sell down inventory. Some, such as Chanel and Louis Vuitton, have even raised some prices by 5 per cent to 17 per cent to offset higher costs and protect margins. 

There are signs that shutdowns have turbocharged online sales of luxury goods, despite misgivings about how to replicate the high-end experience virtually. A survey of 1,000 luxury customers in the US and Europe found that 24 per cent had shopped online for the first time while stores were closed, and 76 per cent said the experience was positive, according to a study by McKinsey for the National Chamber of Italian Fashion and Pitti Immagine, a trade event organiser.

Bain has forecast online sales, which accounted for 12 per cent of luxury sales last year, will reach 28 per cent to 30 per cent of the market by 2025. 

London, Paris and Milan are preparing to hold online fashion weeks in June and July to showcase new collections despite travel bans. “The rationale behind the online fashion week [in Milan] is that we must support the supply chain,” said Carlo Capasa, president of the National Chamber of Italian Fashion. “We need to launch a sales campaign to make sure orders come in.”

Italy is home to about 67,000 small manufacturers of leather goods, fabric and cashmere, and Mr Capasa warned that many will go out of business without more government support, putting 100,000 jobs at risk.

As boutiques reopen, Kering, whose largest brand is Gucci, said the initial signs from the first week after lockdown in France were encouraging. “Traffic in stores has been higher than we expected and more customers are buying, which speaks of the strength and loyalty of our local clientele,” said the company.

While Moncler, LVMH and Kering have reported strong demand in China since stores began to reopen there in late March, few in the industry expect a quick recovery. Richemont’s chairman has warned of “grave economic consequences” that could last up to three years.

HSBC has forecast sales to fall 17 per cent this year, while Bain has predicted a decline of 20 per cent to 35 per cent. It will take until 2022 or 2023 to return to €281bn in sales seen last year.

As long as international travel remains restricted, getting more Chinese consumers to buy luxury goods at home will be crucial to any recovery.

On Friday, Burberry said its Chinese sales had bounced back in recent weeks because more consumers were shopping at home rather than overseas.

Ms D’Arpizio said brands would have to tailor more products for China, and continue to narrow the price gap between China and Europe, which has long been a key reason why Chinese often buy when travelling. 

Erwan Rambourg, an analyst at HSBC, predicted that the repatriation of sales to China would lead luxury brands to reconsider store locations and sizes as leases expire. “I don’t think you’ll see more stores overall, but there will be fewer in Europe and more in China.”

As the industry navigates the downturn, a group of independent fashion designers led by Dries Van Noten has called for the production calendar to be revamped to align deliveries with the seasons and stop early discounting. In an open letter, they proposed that cold-weather clothes be delivered to stores from August through January, and warm-weather clothes February through July. 

Mr Ruffini said brands should not chase sales at any price. “The biggest risk I see today for a company is making choices that can damage brand perception in an effort to anxiously recover revenues,” he said. “Not me. Not Moncler. I am not willing to make a long-term vision hostage to a short-term mindset.”

Nest builds up reserves in anticipation of further market uncertainty

Britain’s biggest pension fund has hoarded cash reserves in anticipation of further market uncertainty as companies and countries grapple with the fallout of coronavirus.

Nest, the UK state-backed pension scheme with 9m members, making it Britain’s largest, said its allocation to cash in its main investment funds stood at about 5 per cent, compared with 1 to 2 per cent normally.

Mark Fawcett, chief investment officer at the £10.5bn pension fund, said that while he did not know “which direction the market will go”, there was a “bunch of risks the market seems to be feeling fairly benign about”.

These risks included the possibility of a second wave of outbreaks and the rapid spread of the virus in emerging markets such as Brazil, as well as a lack of clarity about the pace of recovery and whether people would continue to stay at home even if economies were opened up.

“We just don’t believe a V-shaped recovery is very likely,” he said, referring to a fast uptick in growth. “Clearly if a viable vaccine is found that changes things and reduces those downside risks. But it will take a while to vaccinate the world.”

He said the pension fund had taken the opportunity to reduce some holdings, such as in high-grade credit, to build cash reserves. The pension pot has a steady stream of money coming into it from members and has chosen to put some of that aside rather than invest.

Mr Fawcett added that the allocation to cash at 5 per cent was “probably as high as we would ever get”.

“If we see some of these risks manifest themselves, we have the ability to increase holdings where we think we need them,” he added.

Jan Erik Saugestad, chief executive of Storebrand Asset Management, the Nordic fund house that oversees large chunks of pension assets, shared Mr Fawcett’s concerns, saying a U-shaped recovery was more likely.

He said that while economic stimulus from governments would work, it would take time. “We are cautious, given the levels and risks we are seeing right now,” he added.

According to a survey of fund managers from Bank of America this month, just 10 per cent expected a V-shaped recovery, while 75 per cent anticipated a U- or W-shaped one.

The poll found that managers were holding large amounts of cash, with allocations at 5.7 per cent, well above the 10-year average of 4.7 per cent.

But others struck a more optimistic note. Elliot Hentov, head of policy research with the global macro policy research team at State Street Global Advisors, the world’s third-largest asset manager, said he was “slightly more optimistic than the consensus” and in line with how equity markets were pricing a recovery.

He added that he expected significant breakthroughs over the summer, whether in treatments, contact tracing or other areas that could help prevent a second lockdown.

Nest’s Mr Fawcett said it was a challenge to run the fund during such market uncertainty. “It is clearly tough, because we have to make sure our members have enough exposure to growth assets that we can build a good pot for them over years, but we don’t want to give them excessive volatility,” he said.

Downing Street under pressure over national security after allowing Chinese telecoms group a limited role

Boris Johnson is drawing up plans to force a full phase out of Huawei from Britain’s 5G networks within three years, government officials have confirmed.

Downing Street has been under pressure from senior Tory MPs to ensure that UK’s telecoms networks — including 5G mobile phone infrastructure — do not contain equipment from the Chinese company beyond 2023 because they believe this could compromise national security.

Mr Johnson in January granted the Chinese telecoms equipment maker a limited role in supplying kit for the UK’s 5G networks, while confining Huawei’s market share to 35 per cent. The rules also banned the use of the Chinese company’s equipment in the critical core of mobile networks where data is stored and routed.

In March the government only narrowly defeated a Tory rebel amendment designed to ban Huawei from UK networks completely — after 36 of its MPs rebelled and 22 abstained.

Now the prime minister has instructed officials to tighten restrictions on the involvement of the Chinese company in the new system to zero by 2023, according to a report in the Daily Telegraph which officials have confirmed. The newspaper reported that Mr Johnson always had “serious concerns” about the 5G agreement, initially brokered by his predecessor Theresa May, and now wanted it to be “significantly scaled back”.

One official told the FT that circumstances had changed in recent months: “The landscape is different and it’s right that we re-examine this immediately.”

Mr Johnson is under pressure from Tory MPs to reset relations with Beijing after the coronavirus pandemic which originated in Wuhan, amid accusations that the Chinese government did not disclose the initial scale of the infection.

Donald Trump, the US president, made clear his displeasure at Mr Johnson’s decision to press ahead with the Huawei deal — albeit in a scaled-back form — in January. Mr Trump threatened to restrict the UK’s access to the Five Eyes intelligence system.

EE, Vodafone and Three use Huawei equipment in their 5G networks. Switching to a rival supplier such as Ericsson or Nokia would slow down the roll out and add costs for companies that need to replace Huawei equipment. BT has estimated that the cost of complying with the 35 per cent cap would be £500m.

Telecoms Executives are frustrated that despite an 18-month review and the imposition of limits on the use of Huawei equipment that the issue is still being debated politically. One said that a 2023 timeline was “too aggressive” for a full phase out, raising the issue of how such a switch out would be paid for.

Huawei declined to comment.

The telecoms industry has warned that a full ban on Huawei equipment would undermine the prime minister’s election pledge to deliver gigabit-speed broadband to the entire country by 2025.

Mr Johnson signalled last week that he would accelerate long-expected legislation which will expand the number of foreign deals that are called in by the takeover authorities. He is also stepping up plans to make the UK more self-sufficient in products such as personal protective equipment.

Tory MPs have been planning a renewed guerrilla strike against the government’s Huawei policy this summer.

David Davis, the former home secretary, said the rebels would try in the coming weeks to block Huawei if the government did not do so itself.

“This bill may give us a chance to bring Huawei’s role in the network from 35 per cent to zero,” he said. “If the government doesn’t put it in, it would be hard-pressed to prevent someone else putting an amendment in.”

Critical MPs could alternatively seek to amend an imminent Telecoms Security Bill in the early summer, according to Tory MP Bob Seely. A third potential battlefield is the Telecoms Infrastructure Bill, which — although it has cleared the Commons — will face rebel amendments in the Lords.

“There is a growing consensus over China, to want trade but to have no illusions,” said Mr Seely. “We can want trade but we want fair trade, not intellectual property theft and espionage.”

Mr Davis said the coronavirus crisis had changed the political weather significantly. “The Huawei policy may have been arguable pre-corona but I don’t think it is any more, that may not be rational but the zeitgeist has changed.”

Coronavirus contributed to woes; company enters chapter 11 with no deal in place from creditors

Hertz Global Holdings Inc., one of the nation’s largest car-rental companies, filed for bankruptcy protection Friday, saddled with about $19 billion in debt and nearly 700,000 vehicles that have been largely idled because of the coronavirus.

The Estero, Fla.-based company entered chapter 11 proceedings in the U.S. Bankruptcy Court in Wilmington, Del., hoping to survive a drop-off in ground traffic from the pandemic and avoid a forced liquidation of its vehicle fleet.

The Wall Street Journal reported earlier Friday that Hertz had failed to reach a standstill agreement with its top lenders and was preparing to file for bankruptcy as soon as that evening.

The company’s collapse marks one of the highest-profile corporate defaults stemming from the pandemic’s impact on air and ground travel, though Hertz also had challenges before the current economic crisis. Even before the Covid-19 outbreak, Hertz had been struggling with competition from peers including Enterprise Holdings Inc. and Avis Budget Group Inc., as well as from ride-hailing services such as Uber Technologies Inc. and Lyft Inc. The company lost some $58 million last year, its fourth consecutive annual net loss.

But Hertz’s business was hammered by the onset of the coronavirus, as people world-wide bunkered in at home and global travel shriveled up. Going forward, as businesses adapt by conducting meetings remotely, business travel may not return to prepandemic levels, according to bankers and analysts who follow Hertz.

Hertz didn’t reach a deal with creditors before entering chapter 11, heightening the risk of a full liquidation of the fleet, although the company and investors have several weeks to work out an agreement avoiding that outcome, people familiar with the matter said.

Hertz has spent years trying to restructure its business, and has blown through four chief executives in less than a decade. Most recently, former Chief Executive Kathryn Marinello was replaced Monday by Paul Stone, who previously served as the company’s executive vice president and chief retail operations officer for North America.

Hertz has also had a debt problem that can be traced back to a 2005 leveraged buyout by private-equity firms.

Founded in Chicago in 1918 and originally known as Rent-a-Car Inc., Hertz opened its first airport car-rental facility at Midway Airport in 1932. The company’s owners have included RCA Corp. and later Ford Motor Co., which sold Hertz to a buyout group led by Clayton Dubilier & Rice in 2005 for $5.6 billion.

The company went public in 2006, and activist investor Carl Icahn, who started acquiring Hertz shares in 2014, now owns more than one-third of the company and has placed three of his representatives on the board.

The pandemic has diminished automotive traffic in the U.S., squelched car sales and cut into rental reservations at Hertz. The Wall Street Journal reported in early May that Hertz, the nation’s second-largest rental-car company by fleet size behind Enterprise, was preparing for a bankruptcy filing.

The bankruptcy is expected to be complex given the company’s vast debt and corporate structure, which includes $14.4 billion of vehicle-backed bonds at subsidiaries that aren’t part of the chapter 11 filing.

Like Avis and some other rental car companies, Hertz doesn’t own its vehicles. The company leases its rental-car fleet, nearly 700,000 vehicles in total, from separate financing subsidiaries. The lease payments are earmarked for investors that own bonds backed by the fleet.

Now that Hertz has filed for bankruptcy, investors with rights to the vehicle fleet have to wait for 60 days before they can foreclose on and sell the cars. Hertz and its creditors will likely aim to prevent a complete liquidation and strike a deal to downsize the fleet while keeping some vehicles in operation, said people familiar with the matter.

With the $14.4 billion in vehicle-finance bonds so widely held—by pension funds, mutual funds and structured-credit funds—the company has faced difficulty coordinating with bondholders, people familiar with the matter said.

Rental-car companies play an important role in supplying newer models to the used-vehicle market. Hertz also is a major customer for U.S. auto makers, purchasing about half of its fleet from General Motors Co., Ford Motor Co. and Fiat Chrysler Automobiles NV in 2019, according to a financial filing.

Analysts were concerned that Hertz could be forced to sell part or all of its fleet into an unusually weak market. But the possible liquidation would come at a time when demand for used vehicles is rising slightly, and pricing in the market is showing signs of recovery after hitting historic lows in April.

“Any ripple effect will be less than it was six weeks ago,” said Zo Rahim, an analyst for Cox Automotive, which owns vehicle-auction operator Manheim Inc.