Market Thinking March 2020
April 2, 2020
March was to February 2020 what October was to September 2008, the Tsunami that followed the earthquake and, to continue the metaphor, it was, as then, down to liquidity. A wave of forced selling, induced by margin calls turned our earlier view on a shift by long term investors to sell the rally rather than buy the dips and thus a period of weakness into something of a rout. In this it had echoes of 2008, when regulators, perhaps stung by criticism of their earlier (in)actions, became zealous in their impositions of mark to market rules, while bankers called in margin and previously MIA risk managers aggressively applied the failed Value at Risk (VaR) trading models in an inappropriate fashion to buy and hold investments. A large part of the market was forced to sell while an equally large part was prevented from buying. Not surprisingly markets struggled to clear. In effect, almost all the ‘solutions’ simply made the illiquidity situation worse, mainly it seemed in an attempt to avoid blame.
Unlike 2008, this began In Real Life (IRL) and spread to the markets rather than the other way around and the markets’ concern is now, rightly, on the economic impact of the measures taken in March by western governments to contain the spread of the virus. While fiscal measures have been put in place to try and offset the impact of lockdown, the size of the gig economy, particularly in the UK and the US, is such that the sheer number of people affected is huge. Earnings have been downgraded across the board, but particularly in the ‘obvious’ areas, by which we mean the ones the market had been targeting since January; tourism, cruise ships, energy, cyclicals in general. This means that in fact most markets and sectors, despite having fallen sharply are not ‘cheap’ on a one year forward earnings basis – albeit well off their highs. Indeed, only areas like consumer staples are close to the lows seen in the q4 2018 selloff. Our equity model portfolios that switched to cash in late-January/early February remain so, while the bond portfolios remain in long bonds and a move back into TIPs.
When the dust settles, the winners will be those with cash, cash flow and sound balance sheets, the losers will be those unable to sustain a debt reckoning.
Short Term Uncertainties.
Obviously, the short-term uncertainties are almost entirely based around the virus and the extent to which governments will ease back or double down on the economic restrictions imposed during March. As with the virus itself, the companies and sectors most at risk are those with ‘pre-existing conditions’ of poor financial health. A strong balance sheet can survive a short term hit to cash flow, a heavily indebted one can not, especially if the debt has been taken on to acquire non productive assets such as the company’s own shares. Similarly, the extended supply chains that have developed over the last two decades of globalisation are only as strong as their weakest link. Government policy needs to focus on economic triage – the weakest links in the extended supply chain need to be stabilised and, where necessary taken into quarantine, while rational and clear eyed decisions need to be made about the sustainability of some of the structurally weakest companies.
Of course, the likelihood of that actually happening is low, except perhaps in China/Asia. In the west there is already intensive lobbying from the financially weak; at the country level, Italy has been most vocal for changes in EU debt financing, while the usual suspects on Capitol Hill have been lobbying on behalf of airlines, tourism and travel, beverages, manufacturing and multiple other businesses for a slice of the ‘stimulus fund’. As we saw in 2001 and again in 2008, the support tends to go to those with the most powerful lobbyists rather than those most in need. The pressure to go back to work however will intensify and the timing we suspect will hinge on the balance between being blamed for the virus and being blamed for the collapsed economy.
Medium Term Risks
The near term risks to the economy are thus policy risks – how western policy makers deliver a V shaped recovery versus a flat line. Here we would expect the political expediency that saw the widespread lock-down to also drive its removal sooner rather than (too much) later. Beyond the immediate short term issues around Covid-19 and government response, it is worth remembering some, only slightly earlier events, in particular the activity in the Oil markets. As we noted on the blog, there is an old adage that when a bar fight starts you don’t punch the person who started it, you punch the person you always wanted to hit and one thing that has emerged from this Covid-19 bar fight is that Russia has punched both Saudi Arabia and the US. The failure of the Saudis to persuade the Russians to cut oil production in the face of a (hopefully temporary) drop in demand of around 20% has, not surprisingly, led to a collapse in oil prices, with Brent dropping to the mid 20s having been threatening $70 only two months ago. Both Saudi Arabia and the US fracking companies have very poor financial health and as such are highly vulnerable. Saudi was projected to run a $50bn deficit even at $63 oil prices. At these levels it is going to be hitting well over 20% of GDP. Meanwhile, the US oil patch is broadly assessed to be break even with prices in the mid 40s and is thus in a lot of pain right now. The issue with Oil prices is that due to these poor balance sheets, the laws of economics tend to go into reverse when oil prices drop below a certain level. With high fixed costs the cash flow needs dominate so that rather than low prices reducing supply, they actually increase it. To this we need to throw in the Canadian Tar Sands, where prices are now so low as to actually cost money to produce and distribute.
The consequences of this strike us as threefold. First, the consumer will benefit from an initial fall in the price of energy which will help offset some of their fixed or essential costs. This will also help emerging markets and China and we suspect that the latter may take the opportunity to build strategic reserves and make longer term arrangements, including paying in Yuan. Secondly, the contango in Oil markets is such that the cost of storage is going through the roof, making large windfall profits for owners of aging tankers. Apparently it is currently possible to get an annualised return equal to four times your initial capital from renting out storage capacity. While the Baltic Dry Shipping index remained flatlined, the Baltic Dirty Index of tanker rates doubled in March, and the price of stocks in related companies like Frontline rallied over 70%. Third, the holders of debt issued to the US alternative energy sector are almost certainly going to have to take a haircut. The price of the non-conventional oil and gas ETF, FRAK is down over 2/3rd year to date and while the big oil companies are hoping to pick up the assets for cents on the dollar and the US taxpayer may, as usual, end up picking up the tab to protect some well paid lobbyists, the disruption to the junk bond market will be serious, as will the likely waterfall effect of bond downgrades flooding the much smaller and soon to be distressed junk bond market with currently wishful thinking BBB rated debt.
It is also worth peering behind the scenes a little amid all the theatre of the virus and remind ourselves of some of the geo-politics. At the start of the year the concern we had was the US attack on Iran and by extension Iraq via the drone assassination (which had caused the spike to $70 oil) and the constant low level attacks on the US following this, reminiscent of the Afghan war of attrition against Russian occupation, combined with the resilience of the Syrian regime makes a US withdrawal look increasingly likely. Meanwhile, the continued US sanctions against not only Iran in this time of crisis, but also Venezuela should be monitored. The former is clearly driving Iran but perhaps much of the middle east towards a China/Russia grouping, while the latter, reminding us of the US desire for regime change, suggests the next theatre of (proxy) war may be shifting to Latin America. We note that Rosneft is avoiding US sanctions by selling its Venezuelan assets to…the Kremlin.
A second medium term risk has to be Europe and the Euro. During the liquidation period at the beginning of March, Sterling fell from 1.20 to 1.06 against the Euro, but has now bounced back to 1.13 at time of writing. While the noises from Italy, France and Spain about breaking fiscal compacts and issuing CoronaBonds might not be enough to break up the EU, the pressure on the tight money advocates in Germany, Austria and the Netherlands is intensifying. In our view the risk is less that the Italians leave than that a country like the Netherlands does, offering to form a different fiscal bloc. This then takes us back to the 2011/12 concerns about cross border debt, Target 2 balances and the rest. Not surprising that European banks stocks are at their lows.
The third risk is escalation of government interference in corporate cash flows. The announcement by the UK government that Banks and insurance companies should not only suspend dividends but also cash bonuses to staff amounts to an effective nationalisation on many levels. When cashflows and business decisions are taken by unaccountable regulators and ministers the shareholders have effectively been stripped of their asset. This is not unprecedented, back in 2006 the UK government effectively nationalised Eurotunnel and many politicians have been angling to nationalise a lot of the utilities since then. This is undoubtedly and increased risk, not just in the UK, but across Europe
Longer Term Trends.
The longer term consequences of this, most dramatic, start to 2020 will be a reset of a number of behaviours. First, from a markets’ point of view, the extension of cheap debt to all-comers will slow and may even halt completely. Markets are already punishing those companies with weak balance sheets, notably those that borrowed in debt markets to buy back equity. The discussions in the US to allow the Fed to buy in corporate bonds may (stress may) be a good idea to help stabilise markets, but risk merely being another tax-payer funded transfer to bail out insiders. Political pressure to slow stock buybacks – as well as perhaps to reset all management stock options to a high watermark of the stock’s previous all time high will be a likely consequence.
This will present a powerful blow to the private debt and leveraged loan markets that are the backbone of a lot of the ‘alternative’ investment markets. In the short term the absence of the dreaded mark to market hit that makes regulators and risk managers call high quality, soundly run equities ‘risk assets’ while encouraging long term investment capital to flow to illiquid and highly leveraged entities may encourage a ‘butterfly moment’ for the west’s shadow banking system, one last hurrah as the lack of mark to market makes the strategy look successful, but as the debt workouts and defaults come through it looks likely to trigger a long overdue restatement of what we mean by ‘risk’. The dot com crash in 2000 was the second time in a little over a decade that an obsession with minimising deviation from market cap weighted benchmarks in order to ‘reduce risk’ had resulted in a serious misallocation of capital – the first was putting over 50% of global assets into Japan at the peak of the Nikkei – and this will be the second time in a little over a decade that an obsession with minimising mark to market volatility in order to ‘reduce risk’ will have done the same thing.
Here, as with the oil patch, it is likely, indeed probable, that the taxpayer will end up bailing out a lot of imprudent private equity, private credit and other ‘alterative’ investments, while the bigger players, such as Blackstone will take the same role as Exxon and use their vast amounts of dry powder to pick up mispriced assets. It also means that the whole Venture Capital/Private Equity/Private loan nexus that was developing without the need, so they believed, for public markets will have to reset. Even before the Covid-19 induced shock, the likes of WeWork and the financial engineering behind the Softbank Future Fund were starting to unravel. Without the ‘investment capital’ flooding into silicon valley, more than half of which was going straight to big tech in terms of spending on web services like data storage, servers and advertising, the eco-systems of tech hubs will struggle. We can’t see San Francisco bay area rents going higher this year, that’s for sure.
Meanwhile, as noted, the weaker members of the EuroZone, principally the ‘Club Med’ countries are once again looking for a bailout from the stronger countries, citing the virus, but really revisiting long expressed needs to restructure their debts to the richer countries. With the principles of freedom of movement temporarily (?) set aside, the economically stronger countries who tend to favour them most may have to cut a deal to allow them to return, or as mentioned in the risk section spin themselves out.
More generally, there is already a degree of creative destruction going on, which means that while there may be a fire sale of assets and goods in the near term, medium term prices in some areas will rise, while in others overpriced assets will continue to fall. For some clue to this we can think of the aftermath of the Japanese financial crash in 1989/90. The so called lost decade in which we saw inflation switch to deflation was actually a slow, long term, price reset, not least from goods and services bought with company money (pre-tax) to being bought with personal money (post tax). Property is the most obvious one, but also luxury corporate goods such as golf course memberships, country clubs and so on. High end restaurants and certain ‘Veblen Goods’ – where higher prices encourage higher demand to demonstrate status. All suffered long term demand destruction in Japan during the 1990s.
Areas where excess capital had been ‘sunk’ such as the US fracking industry and Canadian Oil sands may lead to short term weakness but ultimately longer term higher prices as excess capacity taken out. Something similar may happen to airlines. The predict and provide model used to justify airport expansion on global trade grounds will be less persuasive post covid-19, not least because the greens will also be back. Cheap holiday routes don’t inspire much official sympathy. Similarly with cruise ships; while it is difficult to ban them in normal times for political expediency, it will equally be difficult to justify re-starting them, especially as locals appreciate the lack of crowding, pollution etc. In economic terms, we can say that the externalities of global travel have been outsourced to the broader, local, populations while the beneficiaries have been foreign tourists and, usually, foreign tour operators. Having restricted tour buses, cruise ships and cheap airlines because of Covid-19, local politicians will now be held accountable if they allow them back in. So they may not do so.
Linked to this, it looks like China is being lined up to take on the role of “Bankers’ as the fall guy for this particular crisis. Just as in 2008 the role of Bankers was, largely wilfully, misrepresented by politicians and regulators as a way of avoiding blame for the economic slowdown that followed, so China is being blamed for the Corona-19 crisis. This also suits existing agendas, particularly in the US to try and limit China’s growth. This suggests that the existing ‘New Cold War’ between the US and China will continue, possibly at an even higher level. Interesting to note however that the view is not universally shared and opinion seems to be divided along geographic lines, with few in Asia supporting the US/European view, which tends to reinforce the notion that we are splitting into a tri-polar world of Americas, Euro-Asia and China.
From an overall investment point of view we can’t help feeling that just as the post communist world was one of dis-inflation and a time to buy bonds yielding 9% or more and the post 9/11 world was a time to take on newly available cheap leverage and buy property yielding a large spread over the cost of funding, so the post Covid-19 world will be one in which to deploy cash – and ultimately take leverage- into quality companies paying out dividends (assuming governments don’t ban dividends entirely that is!)