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Delusional

Mar 30, 2020

• Despite last week’s rally in the equity market we see risks substantially to the downside
• Remember that COVID-19 has only laid bare the problems of the global economy
• We see no quick and easy way out of the challenges facing the markets
• Listen to the medical specialists – the virus will be with us for several quarters
• The Fed has provided a prop of sorts for parts of the bond markets
• Equities at significant risk from dividend cuts and de-rating on earnings cuts

In some senses, last week’s unprecedented rise in the equity market was to be expected. After all, asset prices don’t typically fall in straight lines. However, if anyone believes that we are out of the woods, they must be delusional.

Remember this crisis, is not just about the virus. The virus has just laid bare the previous precarious state of the global economy and financial markets. Cheap credit has led to a widespread delusional belief that economic growth would be “great” forever and that financial market returns could continue to be extra-ordinary. I remember back in February one millennial investor arguing with me that equities were a great asset class because they had given a 13% return per annum over the previous ten years!

The global economy has not structurally improved since the end of the Global Financial Crisis; it has got worse. The Fed had encouraged a massive mortgaging of the future, and now the global economy is paying. As one example, US federal debt before the COVID-19 crisis was 105% of GDP, twenty-five percentage points higher than at the end of the 2007-9 crisis.

Too many people kept hoping, beyond reason, that economic growth and asset class returns would go back to where it was in years past. However, that was never going to be possible on a sustained basis. The authorities managed to give the illusion that it could happen; the Federal Reserve started to target unnaturally low levels of bond yields. On the first sign of problems, Ben Bernanke pulled back from reducing quantitative easing. President Trump made an equity market bull market a measure of his success of his Presidency. Unfunded tax give-aways ensued driving Federal Debt ever higher.

When companies couldn’t make earnings grow, they would use cash flow and borrow money at incredibly low interest rates to buy back shares to make it look like there was growth in earnings. When investors couldn’t achieve 7-10% returns on their portfolios, private banks were more than willing to supply the drug of leverage to make it appear like they were delivering the returns they desired. Ensuing margin calls and panic selling as investors have tried to unload leverage is now contributing to the most extreme asset price volatility seen since Lehmans.

So, what of the future? We have said since early February that investors should listen to the medical opinions, and not the economists and strategists when trying to guess at when the world might be clear of the shadow of the virus. Nothing has changed. The WHO still believe a vaccine is still 12-18 months away.

There’s simply too much loose talk in the financial community that we will have a second-half recovery. We may have a recovery from extreme levels of shock and fear and the complete closure of countries, but if the virus is still out there, we would assume that economic activity will still be substantially curtailed at year-end.

Unless there is a vaccine, how will any country allow in foreign visitors given the economic impact of a further outbreak of the virus? Also, there is no assurance that people can’t get the virus twice. There is a hope that people will build a resistance to the virus after a first infection, but the scientists say that might only last from a few months to a couple of years.

The good news is that policymakers continue to be engaged in providing relief. The Federal Reserve stepped in last week to assuage the liquidity fears that were threatening to turn a sudden stop in markets into something even more severe. Towards the end of the week, the potion started seeping into the decimated high-grade bond market, for one. For another, the US dollar gave up some of its recent dramatic gains. Both these developments are indicative of a slow easing of the near-catastrophic liquidity constraints that had developed in currency and bond markets in the past month.

Despite the best efforts of the Fed, we warn investors that it is overly simplistic to believe that any asset market will now progress serenely to normal. We continue to advise investors to be wary of equity investment, particularly when compared with bond investing. Bond coupons are generally much more secure than dividend payments. We are already starting to see dividend cuts in the US and UK markets. Analysts are expecting possibly as much as 20% cut in S&P500 dividend. In the UK market, the FT reports that companies have already cut GBP1.5bn from dividend payouts in the FTSE350.

Bonds may be more secure than equities, but they come with their risks. As mentioned above, the Fed has essentially provided a new put – the credit put – to the US bond market. It is not likely to be extended universally. Oil drillers face an existential threat with or without the virus due to the drop in the oil price. It also cannot extend forever. We believe the Fed’s idea is to provide general support to tide over as much of the market as possible until the effect of the virus has worn off. A very crude approximation is that investment grade is the safe part of the market for now, but that several areas of the high yield market could still head lower.

In a Creditsights report published last week, they estimate that the implied default rate in both US and EUR high-yield bond markets are around 8%. This means the current spread levels in these markets will leave the investor at breakeven if they invest blindly in the market portfolio; they earn the yield spread but have to accept the defaults that happen over the following 12 months. This is higher than the commodity plunge of 2015/16 (which was quite sector-specific) but still lower than the number in the Lehman episode when the rate spiked into double digits.

So, the answer is that from now on, assuming the Fed continues to be the buyer of last resort, there is a better backstop behind bonds than equities. The trick is to avoid the areas that will not attract support if things take a turn for the worse.

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