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A rain check on where we are

Apr 27, 2020

• Global economy beyond its worst shock but that doesn’t mean an easy recovery
• Second quarter Global GDP forecast to contract at 20%+ on an annualised basis
• Bond and equity markets slowly absorbing the scale of the damage but we are only part way through
• Crucial will be the scale of the drop in the markets expectations for long-term growth
• Equities are probably discounting the hope of an early exit from lock down and not the long term damage
• Higher quality bonds are supported by central banks
• Be careful in high yield – rating agencies probably only part way through their rating downgrades
• Strong balance sheets are favoured in both the bond and equity markets

After a rollercoaster journey through economic collapse and the significant market volatility, we thought it worth the effort to take stock on where we are in the global economy and asset markets.

Global economy – searching for the lowest point and a definition of life beyond

It feels that we are in the midst of the worst phase of the economic collapse. Economic confidence is hitting all-time lows, and many of the major economies of the world are in some form of locked down; this should be the worst point. Some countries are getting sight of easing of the lockdown conditions which should enable economic activity to improve but unlikely to normalise. However, the scientists are warning us that in the absence of a vaccine or the virus just dying out as did SARS, it is difficult to see that life can go back to normal for some quarters to come.

Economists forecasts have a 20%+ hit to second quarter GDP growth and then assumption of a consistent recovery from there. If there is a positive it is that the inital shock and global lockdown is probably the worst phase of what can be thrown at the global economy. In time people adjust and sentiment will improve even if the economy is still in recession. We still intuitively worry that economists are overestimating the rate at which the global economy will recover. With so many people out of work, so many companies facing major cash flow challenges normalizing could be a long way off.

The economic aftermath

We can already see that the burden of debt will be materially higher. Governments have largely provided some debt guarantees and one-off payments. Still, in the absence of debt forgiveness, many households, businesses and governments will suffer a sizeable deterioration in their balance sheets. Such weak finances must restrict future investment and consumer spending growth. Also, someone will have to pay. Otherwise, government deficits will continue to rise. We expect the sting in the tail will be increases in taxes on capital gains and wealth in the years to come. In addition the aftermath of the crisis will almost certainly see significant retrenchment in capacity in certain industries as well as a shrinking supply chains.

Asset Markets- Back to Basics

Equities – near term earnings downgrades but what about future profitability?

Equity markets had their worst point in March well ahead of the lowest point in economic activity. The jury is still out on whether another collapse will take place before we can put this crisis to bed. The US equity market has been helped off its lows by Fed action to support the bond markets and the basic functioning of financial markets. However, analysts’ corporate profits forecasts are still collapsing. Analysts have cut their estimates for S&P500 corporate profits by 25% since the start of the year. The level of estimated profits are now down to the 2018 estimate. In Japan the cuts have been a more modest 8%. In Europe analyst expect corporate earnings for the eurostoxx50 to fall to the lowest level seen in 15 years. To be quite frank, we doubt that we have seen the lowest point yet in estimates for current year corporate profits.

However, the valuation of equity markets it’s not just about the current year but about how analysts will come to see the future. I remember back to building dividend discount models where the next two years earnings numbers are mostly irrelevant or at least minor input to the valuation of an equity which is more sensitive to market expectations for long-term profits growth. And this is the nub of the problem for analysts: to what extent are the long-term prospects for profits damaged by the events of recent months: the airline and real estate sectors or two such examples of industries going through potentially significant structural change. In the airline industry, people are wondering just how quickly will passengers be free to move around the world in the absence of a vaccine; secondly, the crisis has shown that businesses can communicate effectively internationally via video links and not just in expensive face to face meetings. With every industry appearing likely to be looking at cost-cutting measures in the wake of the damage that the virus has done to their business, executive travel may be seen as a luxury.

Strong balance sheets have become an essential factor in distinguishing good from bad in the equity market. That was not so much the case a few months ago where companies were able to leverage up with near impunity.

Bond markets – significant support but for how long?

In bond markets, there is the contrast between worries of massive supply required to support businesses, set against the substantial support that has come from central bank action. Do the past few months make us feel that bonds are a safer or riskier investment than they were at the start of the year? We tend to believe that high yield bonds have become riskier and that most sovereigns have slipped closer to long term downgrades.

As COVID-19 sweeps through the globe and wreaks havoc in financial markets, a notable difference between today and the Global Financial Crisis (GFC) is the speed with which the rating agencies have addressed companies’ credit standing. In the GFC and its aftermath, the agencies came in for significant criticism for the market perception that they were asleep-on-the-job. Their critics, among regulators and users, raised two particular issues; firstly, the agencies in the run-up to the crisis had supported a universe of misrated structured credit. The agencies downgraded them belatedly, and many defaults occurred. Secondly, even on the corporate credit side, agency action was lamentably slow on occasion. There was even talk of legislating the function of the agencies.

On this occasion, there is no evidence of credit rating agency tardiness. The big two agencies have been fast and transparent in their downgrades in the corporate and sovereign bond markets. Importantly, the rating actions are very discerning about the impact of the virus by industry. The extreme effect on end-product or service demand and supply chains will be helpful to some sectors and destructive to others. In the airline industry, a near-total collapse in demand has put some out of business already. With most flights cancelled, many more are likely to follow. In the oil market, global oversupply is threatening the very existence of large parts of the US oil sector.

Moody’s Investor Service reports that since the 1st of March its rating actions have been concentrated in automakers; lodging; gaming and airlines. With retail, there is an evident resilience of food retailers over non-food retail. Since the middle of March, Moody’s deemed a whopping 22% of companies under coverage to have high exposure to the fallout from the virus. Out of the 929 companies under coverage, a full 26% (240!) have been the subject of rating actions.

We believe that there is much more action to be seen from the rating agencies before they are done. Rating agencies have put many companies on watch for further action if there is no improvement, or if things worsen. Had agencies been too aggressive in the first instance, they would have left themselves open to the (legitimate) criticism that it is using a rating as a prediction. Many argue that the agencies should only change a rating grade to reflect an actual change in risks, not a predicted one. With the spread of the virus and its economic impact still the subject of speculation among the scientists, it is by no means sure that the first wave of downgrades will suffice. Furthermore, both agencies are quite transparent in communicating that many further reviews are to come.

In emerging market bonds, a similar dynamic is at play, except that the coverage universe is much smaller than corporate bonds. There is another difference. Unlike US high-grade and some high-yield issuers, emerging market sovereigns need help from external parties – World Bank, IMF or regional supranational entities. This creates a wrinkle in the status of existing debt. If conditionality is written into any facility granted to a country, it technically introduces a level of subordination to the existing debt, which could, strictly speaking, be viewed as an event of default. Also, in private debt arrangements, some countries have approached creditors intending to ease payment terms temporarily. Again, most bonds include cross-default language and however benevolent the intention of the creditor, such actions may be interpreted as a credit event.

To try to accommodate the market, Standard&Poors will take the view that they will judge such actions in terms of the potential losses that a senior bondholder is likely to suffer. A rule of thumb in this context is that a 5% diminution in the capital value of a bond is equivalent to a one-notch downgrade. For many countries, this is no longer relevant, as bond prices have dropped to reflect anticipated downgrades fully.

Tying all this in with our equity view: strong balance sheets, whether from the point of view of the equity holder, bondholder or at the sovereign level, are the new game in town. A brave new world.

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