Earlier this week, I highlighted some excerpts from a note penned by SocGen’s Andrew Lapthorne, who addressed what is perhaps the most vexing dilemma for market participants struggling to formulate a strategy at a time when, presumably, opportunities exist in the wake of one of the most spectacular equity routs in modern history.
Remember, it wasn’t just the scope of the decline last month that was so “impressive” (and I’m note sure “impressive” is the right word there). Perhaps even more remarkable than the depth of the selloff (the MSCI World was down 34% at one juncture) was the rapidity with which it unfolded.
Thanks in no small part to the liquidity-volatility-flows feedback loop (activated and precipitated by what might very fairly be described as the biggest VaR shock in history), stocks went from delirious peak to utter despair in the space of what seemed like just a handful of sessions.
Normally, this would mean that irrespective of how bad things were (i.e., regardless of the proximate cause of the selloff and whether it had or hadn’t run its course), opportunities would abound.
And yet, the current situation has no precedent. There is no analogous historical episode where the entire global economy was simultaneously subjected to an engineered shutdown. As I put it on Friday afternoon, it’s hard to invest in an environment where, for many firms, it is literally impossible to generate operating income by virtue of decrees mandating that businesses cannot operate. You can’t base an investment thesis on earnings because as things currently stand, it’s possible there will be no earnings (or next to no earnings) for lots of businesses, at least over the next month (or even two months).
One is reminded of the moment when Donald Trump, while announcing his candidacy for the office he now holds, attempted to lampoon Barack Obama’s economic record. “The last quarter, it was just announced, our gross domestic product was below zero”, Trump exclaimed. “Who ever heard of this?”
As John Oliver later quipped: “Nobody’s ever heard of it. Because it’s not possible”.
What Trump meant, of course, was that GDP growth was negative, but the irony is that the US (like many countries grappling with the tragic COVID-19 epidemic) is on the verge of a situation where economic activity, and thereby earnings, simply ceases to exist.
While a cafe in Italy, for example, can’t serve a negative number of espressos, it’s possible that same cafe can serve zero espressos. That cafe’s fixed costs and debt servicing burden (if it has debt) won’t simply disappear, though, which means it will lose money and then, eventually, go out of business. The final read on IHS Markit’s services PMI for the beleaguered nation suggests that’s how folks are feeling about the situation at present.
Simply put, it isn’t possible to “price this in” when it comes to equities, and even if it is, we’re nowhere near “fair” value for companies which aren’t allowed to operate. It all depends on the length of the lockdowns, and the jury is still out on that.
SocGen’s Lapthorne on Monday noted that consensus estimates for corporate profits are likely being artificially inflated by the fact that only some companies have withdrawn or altered their guidance to reflect this new, stark economic reality. That, in turn, means EPS forecasts are probably falling “at twice the headline rate”, he said.
Read more: ‘Sudden Declines’, ‘Gone In A Flash’
In his latest note, Lapthorne revisits the point. “Companies are struggling to provide guidance and many consensus forecasts pre-date the crisis”, he reiterates, adding that “at the same time, the assumed rebound in 2021 is growing ever larger”.
Here’s a visual:
“Rarely does a market rebound whilst valuations are elevated, and downgrades are accelerating”, Lapthorne goes on to say.
The worry is that the bottom could fall out completely for corporate profits, at which point a dramatic de-rating would be in the offing. As Lapthorne puts it, “if valuations are cheap and the decline in EPS expectations stabilizes, then equities can find a floor; otherwise, continued volatility and further downside is likely”.
But, from where I’m sitting, the more interesting bit from Lapthorne’s latest is his brief discussion of the extent to which corporate behavior may change after this episode runs its course.
Coming into the pandemic, leverage was high thanks to years of central bank largesse facilitating voracious appetite for corporate issuance, the proceeds from which could be plowed back into share repurchases, which inflated bottom lines. Here’s Howard Marks, from his latest memo:
Many companies went into this episode highly leveraged. Managements took advantage of the low interest rates and generous capital market to issue debt, and some did stock buybacks, reducing their share count and increasing their earnings per share (and perhaps their executive compensation). The result of either or both is to increase the ratio of debt to equity. The more debt a company has relative to its equity, the higher the return on equity will be in good times . . . but also the lower the return on equity (or the larger the losses) in bad times, and the less likely it is to survive tough times. Corporate leverage complicates the issue of lost revenues and profits. Thus we expect to see rising defaults in the months ahead.
Perhaps – just perhaps – the crisis will make management rethink the “correct” debt/equity mix when it comes to financing themselves.
“The point of equity funding over debt funding is it does not need to be repaid and coupon payments (dividends and buybacks) can be skipped without major ramifications, while the same cannot be said of debt”, Lapthorne notes.
(SocGen)
As alluded to above (and discussed here countless times over the past two months), peak leverage was an issue anyway and would have eventually come home to roost, pandemic or no pandemic, oil shock or no oil shock.
If you ask Lapthorne, “once we move beyond this crisis, authorities will move to put in place programs to encourage a greater use of equity over debt, just as they did to the Financial sectors post the GFC”.
In the meantime, though, the Fed will simply buy corporate debt in a last-gasp effort to prevent the credit bubble they helped inflate from bursting.
As JPMorgan pointed out Friday, short interest on LQD (the IG ETF) now sits at just 1.48%, according to data from IHS Markit. It was 17.6% on March 12.
“The short base collapsed in speculator fashion… after the Fed’s credit backstop programs”, the bank’s Nikolaos Panigirtzoglou remarked.
I remember when the banks were told to re-capitalize during the GFC. It was the secret code to sell stocks. That was a big downleg in the market. Was it Paulsen? Geithner?
While the trigger for this crisis was not the banks nor a self reinforcing loss of confidence, there may be similar outcome if the cheap money window closes.
To lever up was always to lever down, it’s just that the two sides of the same coin relationship was convenient to ignore, if not essential to ignore for CFOs trying to progress in their careers. Let it be noted that no real small business entrepreneur in the US could ever get away with the kind of irresponsibility that passes for good stewardship in these board rooms. They would be forced into bankruptcy, their homes would likely be seized, and they’d essentially be banished into credit purgatory for at least a decade. So, perhaps some of the systematic moral hazard is now coming home to roost, as it should, unless we desire to live in a plutocracy forever.
If you invest in an over leveraged company trading 20%+ above historical norms, I suppose a 33% drop could inspire utter despair if your assumption was moral hazard did not exist. For most nvestments in 2008, it did not exist; the question of the day today is whether or not this assumption holds true again.
The very first rule I learned in my first fiance principles class, the rule that should guide all firms managing their capital structure was: “Always issue the weakest security first.” The weakest security from a company’s perspective is common stock because it carries no legal obligation to pay anyone one anything, unlike debt which is generally entangled in many obligations and often presents a veritable minefield of contractual provisions which can overpower even a well meaning firm. While financial leverage may partially magnify the return of net income on equity, when overdone it can be a disaster. Low interest rates don’t pay bills. Even at low interest, too much debt can reduce a firm’s financial flexibility a great deal. Something like a third of our outstanding IG corporate debt is rated just above “junk.” The rating agencies were generally too generous before the “great unpleasantness” in 2008. I suspect they are again and the junk bond market is about to become a growth market.
One can only hope, it makes so much sense in a technology driven environment to be as nimble and agile as possible, but as long as boomers insatiable demand for fixed income persists and executive comp is stock price driven, I don’t see much changing.