Note March 13, 2020 – Markets Call a Spade a Spade: For months amid warnings by the IMF, OECD and other institutions about slowing global growth, market participants appeared focused on the singular polarity of the cycle since 2007, namely quantitative ease and solace from central banks. With the now WHO designated pandemic of Covid-19 as catalyst, current capital markets have called a spade a spade via bear phase behavior.
Junk bond yield spreads have risen. According to the Wall Street Journal and despite low Treasury yields as benchmark, CCC rated yields are onerous at close to 15%. Credit and liquidity pressures exist. For years, equity markets have been momentum driven, rationalizing that low interest rates offer little alternative. However, equities do involve a balance between market alternates and intrinsic valuation of growth. Currently, equity valuations have been broadly dropping, a classic response when erstwhile assumptions appear wanting, albeit for different reasons. Using the S&P 500 as benchmark, using 16x earnings as fair value indicator on its actual operating 2017 earnings would mean fair value of 2,000; on 2018 earnings of 2,400 and on 2019 of 2,600 with none being recession nor distant years. Attributed to Covid-19 pandemic stress and other factors, slower global growth of say 2- 2 1/2% per year or less in being close to recession have yet to be fully worked into revenues and cost pressures, including credit, loom and are likely to be a factor in imminent corporate releases.
The Financials are likely to remain a crucial link for market pressures and direction, already being globally experienced. By contrast in recent years into 2020, it has often appeared as if markets considered Financials only to be ancillary. The banks and their capital structures have undergone strengthening in response to the credit cycle risk revealed into 2007. However, current issues are likely to relate to non-bank financials via investment portfolios such as leverage accrued to build income yield in an era of ultra-low interest rates driven quantitative ease and via volatility driven active asset allocation trading tactics dependent on liquidity but which could prove ephemeral in crisis as occurred in extremis into October 1987 which had as a backdrop, international official currency policy discord in the aftermath of the 1985 Plaza supposed accord.
Election and trade pressures remain. Compared to the political co-ordination that led in 2008/9 to Washington/London summits by the United States, Britain and Canada among the G-7 as well as China, India and Brazil among emergent G-20, the present financial and Covid-19 pandemic responses appear more individually oriented by nations. Certainly large but not coordinated appear the $ 1.5 trillion liquidity injections announced on March 12,2020 by the Federal Reserve, the ECB bank loan ease with Euro 500 billion in domestic corporate funding being made available by Germany and $79 billion banking lending ease from the People’s Bank of China as well as actions by other central banks. As well, the Covid-19 pandemic response appears more ring-fence oriented rather than holistic. Emergency and border closures appear. Its success compared to a tried and true policy co-ordination approach can only be assessed in retrospect. Irrespective of liquidity injection announcements, corrective volatility still looms in capital markets.
In prior market sequences of misplaced assumptions being reviewed such as in energy, physical real estate or for that matter information technology and clearly mortgages worldwide in the runup to 2007, a spectacular collapse of marque entities have been part of bear market culmination followed by restructuring. So too have equities in being not at but well below fair value. It occurred geographically as well, for instance in emerging markets in Asia compared to Japan into 1998. Neither development appears present as yet in an admittedly fast moving environment.
We espouse diversification including above benchmark cash and precious metals. Despite having been latent before, currency volatility seems a risk now, with less coordination appearing in the G-7 era of ultra-low administered rates. A quality balance sheet and business tilt seems appropriate across sectors and in geographic allocations in capital market holdings. On sectors, we see the direction of Financials as critical. Rather than Consumer Discretionary and Staples areas, we would focus on Industrials in cyclicals and Healthcare in defensives. In Information Technology and Communications, strong balance sheets and business acumen appear in both new era and in long pedigree companies. Strong Energy companies are used to adversity and offer opportunity.
The present financial and medical crises have flared in the aftermath of trade and tariff wars that have been brewing for several years. Elections and other stresses exist globally in many areas and not least in the United States as well as Europe. Compared to the political co-ordination that led in 2008/9 to Washington/London summits by the United States, Britain and Canada among the G-7 as well as China, India and Brazil among emergent G-20, the present financial and Covid-19 pandemic responses appear more individually oriented by nations. The national emergency declaration and border closures on March 13,2020 in the United States continues the ring fencing approach taken by many nations, emerging and advanced alike. Its success compared to a tried and true policy co-ordination approach can only be assessed in retrospect. Irrespective of the central bank liquidity injection announcements, corrective volatility still looms for capital markets.
In overall development since 2007, alongside quantitative ease and ultra low administered rates, low quality corporate fixed income yields accompanied lower sovereign fixed income yields, especially those of U.S. Treasuries as benchmark. Now, corporate junk bond yield spreads have risen. According to the Wall Street Journal, CCC rated corporate fixed income yields are close to 15% which is onerous for capital budgeting and taking place despite low Treasury yields as benchmark. Certainly and even if not coordinated, the $ 1.5 trillion liquidity injections announced on March 12,2020 by the Federal Reserve, the ECB bank loan ease with Euro 500 billion in domestic corporate funding being made available by Germany and $79 billion banking lending ease from the People’s Bank of China as well as actions by other central banks are large. When combined with share buybacks earlier in financial engineering and now with potentially lower revenue growth, credit and liquidity pressures loom in capital budgeting management as already seen in Energy.
For years, equity markets have been momentum driven that had as rationale, low interest rates offering little alternative. However, equities do involve a balance between market alternates and the intrinsic valuation of growth as well as corporate stability. In current developments in March 2020, equity valuations have been dropping broadly, a classic response seen before when erstwhile assumptions appear wanting, albeit for different reasons. Using the S&P 500 as benchmark, using 16x earnings as fair value indicator on its actual operating 2017 earnings would mean fair value of 2,000; on 2018 earnings of 2,400 and on 2019 of 2,600 with none being recession years nor being distant. Attributed to Covid-19 pandemic stress and other factors, slower global growth of say 2- 2 ½ % per year or less being close to recession have yet to be fully worked into the extent to which revenues could slow. Cost pressures, including that of credit especially for lower quality companies loom. Management discussions of such are likely to be a broad factor in imminent corporate releases and well beyond those well known for Energy.
In prior sequences of misplaced assumptions having to be reviewed such as in energy, physical real estate or for that matter information technology and clearly mortgages in the worldwide runup to 2007, a spectacular collapse of marque entities have been part of bear market culmination, followed by restructuring. In such a sequence, equities broadly have experience in being not at but well below fair value. It has occurred geographically as well, for instance emerging markets into 1998. It including restructuring change in Asia for instance which was then more successful in emerging countries than in Japan that had opted for a slow and process with massive quantitative ease. Neither condition appear present as yet in an admittedly fast moving environment.
We espouse diversification in investment portfolios, including being above benchmark cash and precious metals. Despite having been latent before with periodic flaring in emerging countries, now currency volatility seems a risk with less coordination appearing in the G-7 era of ultra-low administered rates. A quality balance sheet and business tilt seems appropriate across sectors and in geographic allocations in capital market holdings. On sectors, we see the direction of Financials as being critical. Despite low administered rates, banks with weak management and credit controls seem under pressure as seen in Europe and Asia recently. Rather than Consumer Discretionary amid uncertain emerging and advanced country prospects and Staples faced with more brand pruning, we would focus on Industrials in cyclicals and Healthcare in defensives. In the broad areas of Information Technology and Communications, strong balance sheets and business acumen appear in both new era and in long pedigree companies. Weak oil prices are being experienced and likely to adversely affect weakly financed companies. Strong Energy companies are used to adversity and offer opportunity. Amid adverse exernality, they are likely to have asset purchase opportunities.
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.