Note March 27, 2020 – Authorities Reflate but Restructuring Next: In the eye of crisis and dependent on the economic philosophy of the period, some cycles have emphasized restructuring and others focused on reflating. With global fiscal and monetary measures announced to late March 2020 nearing $10 trillion, it would appear that response in the midst of Covid-19 currently involves both. Now as compared to 2008/9 in G20 pronouncements, coordination seems loose.
Practically irrespective of cycle, market liquidity dries up in crisis and thus lays bare suppositions in the investment philosophy behind the black box of the day. One example from the mid-1960s was over econometric modelling based on rational behavior, another that on assumptions behind portfolio insurance into late 1987 and then again (especially in mortgages), on the slicing of credit risk into 2007.
Current capital markets are dealing with elements akin to portfolio insurance of 1987 via risk or volatility arbitrage and of elements akin to slicing of credit risk of 2007 via leveraged collateralized loan obligations. Amid over a decade of low administered rates in advanced countries, there has appeared stretching of portfolio structures to deliver yields. Into March 2020, businesses also seem to have made implicit assumptions of stable revenues via a pronounced debt tilt in capital budgeting structure even among major corporations. Common practice has been to in engage in record share buybacks and add corporate debt obligations. Both appear to have accentuated risk via illiquidity. Massive public funding has appeared for reflation but restructuring seems inevitable.
Hard data on economic impact of Covid-19 pandemic is scarce but anecdotal recent announcements underscore revenue stress. It appears for instance in small but open Singapore on GDP or on industrial production in China or on jobless claims numbers in the United States. The pandemic has brought about a massive fiscal and monetary response. The underlying message accompanying trillions in government rescue is that balance sheet structure needs to change and become more conservative. It took place for the banks after 2007. However reliance on reflation seems to require ever larger sums as seen comparing that after 1987, that after 2007 and that now that proposed in early 2020. Businesses should not assume such ease to be recurring as panacea as it is likely draining reservoirs.
Compared to widespread prior assumptions, upcoming corporate releases are likely to focus on restructure for a different environment. The operational restructuring of businesses and their capital structure has further to go. Especially in quarterly results, even in diversified markets like the United States, earnings declines from prior peak to trough of over 50% are not unusual and even appear as being greater in cyclical and resource areas like Canada. As experienced from 2009 in global banking, now and irrespective of sector or geography, those businesses restructuring earliest and most thoroughly are likely to pick up long run competitive advantages.
Severe business cycle downswings usually culminate in spectacular failures in some of the last cycle’s marque organizations. Post 1999, it was in high flying Technology, Media and Telecom services. Post 2007, it was in Finance. In response, Basle III leverage and other constraints did result in a major bolstering of banks. Currently, the risks of excess in Finance likely lie within the non-bank financials wherein portfolios were structured internally or for clients on assumptions of leveraged returns perforce dependent on liquidity. Overall and even on smoothing, we still use 16x earnings and 7% long term earnings growth for the S&P 500 as useful fair value benchmarks. By contrast, the recent cycle has appeared to focus mainly on interest rates and beating consensus, however low.
Pending misalignments coming to the fore, volatility in markets is likely to remain intense. In overarch across sectors and geographies, we favor strong balance sheets and demonstrable operational leadership over reliance on minuscule rates. Consumer discretionary fervor was especially so in aspirational spending built on leverage in the last cycle so . In cyclicals, we favor Industrials over Consumer Discretionary; and in Financials, we favor banks over non-bank financials where proportionately more excess may also reside from the last cycle. In growth, strong balance sheet Information Technology and Healthcare seem better positioned than Consumer Staples
The medical pandemic of Covid-19 has brought about a massive fiscal and monetary response. The pandemic has been widespread, intense and sudden in impact, irrespective of wealth. Its impact can be seen to be in the form of expanding self-isolation and now increasingly de-facto curfews on movement in country after country, from the large as in China earlier in 2020 to now India, the United States and ever more in Europe as well as in smaller advanced and emerging countries alike. Aggregate hard data on economic impact is scarce. The most recent anecdotal announcements underscore revenue stress for instance in the small but open economy Singapore with Q1/2020 GDP data of a (2.2)% drop year-over-year, in the February 2020 decline of (13.5)% in industrial production in China and in the record 3.3 million jobless claims in the United States in the last full week of March 2020. Nationalism was on the rise prior to the flaring of pandemic.
As seen in G20 pronouncements now compared to 2008/9, coordination does seem loose. It appears so whether in global response to medical distress or in the unveiling of urgent financial strategies to steady economies. Countries have appeared individualistic in unveiling the needed health and fiscal measures, even within strong unions like the United States or looser ones like the European Union. In the absence of published broad parameters globally, more broad G20 or even G7 coordination appears obtuse at best. Meanwhile, ongoing are wars in the Levant and sabre rattling on the Korean peninsula. New stresses over oil production levels include the bellicosity between Saudi Arabia and Russia. We see politics as also crucial and fragile at present despite it often being dismissed as exogenous while the market focus appeared singularly to be on central bank quantitative ease. Furthermore, capital budgeting by companies needs to be beyond one of assuming revenue stability. Scrutiny is likely on the efficacy of massive share buy backs in corporate financial structure.
In the eye of crisis and dependent on the economic philosophy of the period, some cycles have emphasized restructuring and others focused on reflating. With global fiscal and monetary measures announced to late March 2020 adding up to $10 trillion and counting, it would appear that in the midst of Covid-19, response currently involves elements of both reflation and restructuring. However assuming ever more leverage has its risks, despite low interest rates. Also, reliance on reflation seems to require ever larger sums as seen comparing that after 1987, that after 2007 and that now that proposed in early 2020. Businesses should not assume this round of ease to be a recurring panacea. In exchange for several months of respite, such ease has likely drained reservoirs. The underlying message accompanying trillions in government rescue is that balance sheet structure needs to change and become more conservative.
In the fixed income markets, signs of dislocation were evident even ahead of the Covid-19 pandemic but have now intensified. For countries, budget pressures in Europe for example intensified to the extent that European Union Eurobond issuance seems no longer verboten amid stress in Italy for instance. Germany has also introduced massive fiscal stimulus. However even as advanced countries focus on response to internal crisis, the impact of globally sharp slowdown is likely to be massive in emerging countries many of which have scarce resources. Much attention has been on 10 year U.S. Treasury Note yields being pushed down, now at 0.73%. However even after the announced new ease by the Federal Reserve, in the corporate fixed income markets, interest rates have been reaching 19% and are still close to 18% in CCC credits. It signals cash flow crunch acuity to be a risk clearly present in corporate finance.
Compared to widespread prior assumptions, upcoming corporate releases on operations are likely to focus on structure for a different environment. The operational restructuring of businesses and their capital structure has further to go. Especially in quarterly results, even in diversified markets like the United States, earnings declines from prior peak to trough of over 50% are not unusual and declines even appear to be greater in cyclical and resource areas like Canada. As experienced from 2009 in global banking, now and irrespective of sector or geography, those businesses restructuring earliest and most thoroughly are likely to pick up long run competitive advantages.
Severe business cycle downswings usually culminate in spectacular failures in some of the last cycle’s marque organizations. Post 1999, it was in high flying Technology, Media and Telecom services. Post 2007, it was in Finance. In response, Basle III leverage and other constraints did result in a major bolstering of banks. As seen in Europe, Asia and the United States even before the pandemic flared, some financials remained overextended even after a decade of quantitative ease. Currently, the risks of excess in Finance likely lie within the non-bank financials wherein portfolios were structured internally or for clients on assumptions of leveraged returns perforce dependent on liquidity. Overall and even on smoothing, we still use 16x earnings and 7% long term earnings growth for the S&P 500 as useful fair value benchmark. By contrast, the recent cycle has appeared to focus mainly on interest rates and beating consensus, however low. We see the restructuring of equity valuation globally to be latent issue in this environment.
In overarch across sectors and geographies, we favor strong balance sheets and demonstrable operational leadership over reliance on minuscule rates. Among sectors, leveraging for aspirational spending was in place among consumers in advanced and emerging countries alike but now has to deal with the aftermath of excess. Shopping malls have had revenue and occupational issues. Consumers appear to have borrowed extensively, especially for near luxury and aspirational lifestyle spending. Meanwhile in general, Industrial Product companies have struggled with capital spending being sedate and have been forced to restructure for years and so may offer better opportunity within the cyclicals. In growth, similar considerations apply to large and conservative Information Technology and Healthcare compared to Consumer Staples. The latter are likely still unwinding brand and market positioning from the last cycle in both core advanced economy and growth emerging economy markets. In banking, excess lending was seen in Asia and lax in restructuring in Europe and the United States have surfaced. Still, within the crucial Financials, we see the banks as having had less room for excess than was the case for non-bank financials. Currently, the risks of excess in Finance likely lie within the non-bank financials wherein portfolios were structured internally or for clients on assumptions of leveraged returns perforce dependent on liquidity.
Pending business misalignments coming to the fore, volatility in markets is likely to remain intense. The despair is yet to occur and which usually bubbles with sharply lower corporate results. It is usually accompanied by markets moving to being well below fair value. 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.