Note May 1,2020: No Time To Be Coy On Capital Budgeting- Central banks like the Federal Reserve in its April 29,2020 FOMC statement and the European Central Bank have variedly emphasized zero interest rates and quantitative ease including lending to assist liquidity for businesses but solvency appears still at risk. Contrary to skepticisms at the infancy of the now three decade quantitative ease path of the Bank of Japan, major central banks appear by circumstances forced to follow. Emerging country central bank policies face both domestic weaknesses and debt – currency mismatch risks. While sharp economic global recovery would relieve many stresses, a plodding path remains a risk. We see the potential for currency volatility amid political acrimony and favor diversification including precious metals.
The Bank for International Settlements Bulletin 10 released April 28,2020 and titled “Covid-19 and Corporate Sector Liquidity” offers a timely perspective by globally analyzing the 2019 results of some 40,000 public and private companies. For capital budgeting now, we expect changes. Currently, urgent liquidity needs appear being addressed. Upcoming and for solvency reasons, greater credit scrutiny (not unlike the 1940s/50s) is likely to favor buildup of equity cushions on corporate balance sheets unlike the recent fervor for leverage financial engineering. From Information Technology to Communications to Consumer Discretionary to Banking and beyond, some companies have already led in building equity. Even ahead of the Covid-19 pandemic, others even in the same industry appeared lagging. As seen in banking post 2007, the competitive cost is likely to be high for laggards.
From the 1960s onward, cumulative global growth above prior decades led in capital structuring to leveraged buyout tilts in the 1980s which evolved to include concept driven financing into 2000. It in turn evolved to include record equity buybacks into 2019. Amid assumptions of backstop from quantitative ease, momentum gained. Were upcoming revenues to be more plodding as we expect, investor preferences will likely shift from momentum and towards quality of operational delivery and internal financial robustness from companies. In turn, better balance between operational and financial engineering M&A would be likely.
So far from late March 2020 amid economic weakness, the market response has appeared to be to favor momentum from record monetary and fiscal largesse. Still, events like Covid-19 demonstrate how encompassing revenue shocks can be, notwithstanding zero rates. No longer to be consigned onto the shelves of business schools, it is no time to be coy on capital budgeting.
Company results have started to flow out for Q1/2020.It is noteworthy that guidance withdrawal has included companies reporting earnings above consensus and relatively strong revenues. The corporate results for Q2/2020 will be more relevant on shutdown risk to operations and financial structure. We envisage investment environments different from financing during momentum. High market volatility can be expected.
Equity valuation appears high and expanded at the cusp of an earnings decline in contrast to such developments happening closer to the bottom of an earnings decline as recovery is anticipated. In overarch across sectors and geographies, minuscule rates may be secondary to quality. Aspirational leveraged Consumer Discretionary may be secondary to the pedantic. Logistics reconfigure favors Industrials; and in Financials, we favor banks over non-bank financials where from the last cycle, proportionately more excess may also reside. In growth, strong balance sheet Information Technology and Healthcare seem better positioned than overall Consumer Staples.
Solvency pressures seem a risk in many countries, both advanced and emerging. On central bank policy, in different ways, the Federal Reserve in its April 29,2020 FOMC statement and the European Central Bank have emphasized zero interest rates and massive additional quantitative ease. They have been addressing in various facets, financing to assist liquidity for countries and increasingly directly for businesses. The Bank of Japan after its meeting of April 27,2020 has alluded to even more expansion of direct activity in corporate instruments from fixed income to equities as well as government securities. Over its three decades of quantitative ease, the Bank of Japan policy path was viewed with skepticism by some major central banks. Events have subsequently forced similar quantitative ease measures by them. Among the major central banks also more flexibility exists for the People’s Bank of China to focus on reserve requirements rather than on minimal rates or on direct financing. For emerging country central banks, issues of reacting to domestic stress appear comingled with potential mismatch between local currency revenues versus foreign (often U.S. dollar based) borrowings by many of their major companies. At the other end of the spectrum, the Swiss National Bank has recently incurring a record loss while trying to hold its exchange rate down in order to keep its industries competitive in the European space. Amid several cross currents, we see the potential for currency volatility amid political acrimony and favor diversification via exposure to precious metals.
The capital markets have been bathed in massive increases in public fund injections (whether from central banks or governments). In turn, 10 year U.S. Treasury Note yields are at 0.6% and those of German Bunds at (0.4)%. Nevertheless, many countries face fiscal stress including within Europe buttressed by the ECB. In the United States even buttressed by the Federal Reserve, junk CCC corporate bond yields are still onerous around 16%. Meanwhile industrial commodities appear weak (with crude oil futures even being negative). Amid signs of seesawing currency stresses, precious metal prices have been in a strong upswing, such as in gold bullion. Global recessions appear in place into mid-2020 and further out, we realistically see business conditions as being tentative in terms of outlook into 2021, especially when compared to long term averages.
In the shock of the Covid-19 pandemic forcing a shutdown of activities across the world, equity prices such as the S&P 500 dropped sharply into mid-March 2020. In its reaction to additional and record public or state funding, equity markets globally experienced a sharp upswing from mid-March to end April 2020. High market volatility can be expected. Equity valuation appears high and expanded at the cusp of an earnings decline in contrast to such developments happening closer to the bottom of an earnings decline as recovery is anticipated.
No longer to be consigned onto the shelves of business schools, it is no time to be coy on capital budgeting. It seems likely equity markets are reflecting expectations of a repeat of the sequence after the credit crisis of 2007. The post-2007 sequence was indeed that quantitative ease led globally to a fairly crisp recovery in economic activity even if the peak economic growth rates of the early 2000s were not attained. Still revenue conditions were competitive even then, with GDP global growth trends into 2019 still well below prior averages, let alone the prior peaks in many countries. Even in the earliest portions of that recovery from credit crisis, while the revenue environment remained competitive and growth stressful into 2009, share buybacks and the suppressed costs of debt leverage did result by 2010 annually, in S&P 500 earnings as benchmark reaching the prior earnings heights of 2006. As an influence on capital structuring by companies into 2019, this development likely reinforced perceptions favoring higher leverage that developed from the sequence of leveraged buyout tilts in the 1980s which evolved to include concept driven financing into 2000 which in turn evolved to include record levels of equity buybacks into 2019. Furthermore, quantitative ease as backstop for financial engineering likely played a role in momentum. It could now be a fast changed investment environment.
For today, no investment analogy is perfect but we would consider the late 1940s into the early 1960s. Albeit for different reasons but much as in the 1950s and after fracture, current global cooperation has to be reaffirmed and rebuilt in upcoming years. Then in the 1950s, the aftermath of war and of decolonization threw up obstacles. The shock effect of withdrawal of war spending also meant stronger equity oriented capital structure were then in order for many companies. It meant more care was taken by consumers and companies on developing cushions for a rainy day. Pandemics and power politics could play a similar role today, as seen in the currently widespread activity shutdowns and even in the turmoil in crude oil markets.
If as a result of caution after interrupted employment, consumers were to be slower to return to prior aspirational activity or if stymied due to a second wave of Covid-19 pandemic for instance, corporate revenue growth could be more stuttering after the early 2020 slowdown and not be as sharp as markets appear to expect the result to be from additional quantitative ease. In that environment, cushions of reserves and less corporate complacency about leverage would expand in capital markets. For investment portfolio preferences, quality of operational control and delivery as well as in financial structure would likely be imperative over leverage.
A salient study in Bank for International Settlements Bulletin 10 released April 28,2020 by authors R. Banerjee, A. Illes, E. Kharoubi and J. Serena titled “Covid-19 and Corporate Sector Liquidity” examines some 40,000 private and public companies worldwide and their 2019 reported results to highlight “…Corporate financial statements from 2019 suggest that 50% of firms do not have sufficient cash to cover total debt servicing costs over the coming year. Credit lines could provide firms with additional liquidity. On average undrawn credit stood around 120% of debt servicing costs at end 2019. However, access is uneven and banks may be reluctant to renew or extend them in the current environment. Sticky operating expenses result in many firms running operating losses, placing an additional burden on cash buffers….”.
Amid the Covid-19 pandemic and the widespread shutdown therefrom, certain capital structure weaknesses have already been exposed with more likely to come. Already with for short term urgency to cushion whole populaces, public finances have been stretched to levels for existential crises like war, famine and yes the uncertainty of pandemic. In turn, both individuals as well as large companies have, where possible, garnered financing. Uncertainty about revenue stability has raised issues that include circumstances unfolding that favor strong balance sheets.
Upcoming and for solvency reasons, greater credit scrutiny (not unlike the 1940s/50s) is likely to favor buildup of equity cushions on corporate balance sheets unlike the fervor until recently for leverage financial engineering. From Information Technology to Communications to Consumer Discretionary to Banking and beyond, some companies have already led change by building equity. Even ahead of the Covid-19 pandemic others even in the same industry appeared lagging. As seen in banking post 2007, the competitive cost for laggards is likely to be high. In turn, better balance between operational and financial engineering M&A seems be likely.
The Covid-19 pandemic has forcefully demonstrated the vulnerability of assuming revenues being stable enough to assuage liquidity and solvency risks, including the servicing of debt as well as the other operating costs of being in business. Company earnings and discussions of results have started to flow out for Q1/2020. Not surprisingly, guidance has been withdrawn in many cases. It is also noteworthy that guidance withdrawal has included companies reporting earnings above consensus and relatively strong revenues. The corporate results for Q2/2020 will be more relevant on shutdown risk to operations and financial structure. In our opinion and unlike the momentum fervor of the past two decades, the upcoming environment is likely ripe for greater credit and balance sheet scrutiny. While companies have recently been focused on tapping credit lines and raising debt finance to address revenue shortfall budgeting pressures, the next stage is likely to be to add to equity cushions in a volatile environment of as yet unknown duration. It would be quite different from financing during momentum.
In industries like airlines and energy the differentiation between business risk and aggressive capital structure is again acute. Many more industries likely face similar challenges that were obscured in the last decade and which may not be assuaged by the current public finance programs. Across sectors, it would mean greater quality differentiation quite at variance from the last cycle and appearing not fully reflected. Valuation does expand as earnings weaken during a downswing but recently, S&P 500 P/E ratios have appeared expanding even as earnings reports are merely commencing a cycle of weakness. We believe that these positionings do not support complacency about upside momentum being stable in equity markets but are instead suggestive of volatility which behooves a quality tilt.
In investment portfolio preferences in overarch across sectors and geographies, minuscule rates may be secondary to quality of operations and financial strength. Aspirational leveraged Consumer Discretionary may be secondary to the pedantic built on new technology like online offerings. Logistics reconfigure within industries favors Industrials; and in Financials, we favor banks over non-bank financials where from the last cycle, proportionately more excess may also reside. In growth, strong balance sheet Information Technology and Healthcare seem better positioned than overall Consumer Staples. StrategeInvest’s independent consultancy operates as Subodh Kumar & Associates. The views represented are those of the analyst at the date noted. They do not represent investment advice for which the reader should consult their investment and/or tax advisers. Any hyperlinks are for information only and not represented as accurate. E.o.e