Quarterly investment review
Economic data starting to indicate the gravity
The coronavirus outbreak which began in China but has since spread to encompass over 140 countries worldwide continues to wreak havoc in the global economy, and looks set to continue to do so for some time to come. There remains a great deal of uncertainty regarding the global consequences. All major economies now look set to be afflicted by their own localized outbreaks. Italy, Iran and Korea have the highest number of reported cases after China, but there have been rapid spreads in the US, Spain, France, Germany, and many other key markets also. The growth outlook for these countries was already fairly lackluster, and it seems fair to say that this crisis has come about when the global economy was not in a position of particular strength from which to endure it. Many countries are recession-bound in 2020, and the negative impact will take many sectors to breaking point.
Central banks have shot their bullets
In such an extraordinary environment, it is little surprise that there has been an extraordinary response from central banks, most notably from the Fed. On March 15th, the Fed made its 2nd irregular 50bps rate cut in 2 weeks, taking the Fed funds to 0.25%, equaling the lows of the global financial crisis. Other countries to have implemented cuts include the UK, Canada, New Zealand and Australia. China cut its one-year prime rate to 4.05%. The notable outliers are the ECB and the BoJ, which have both maintained their benchmark rates at -0.5% and -0.1% respectively. However, that is not to say that they have not been active. The BoJ is buying more assets, double the pace of its ETF purchases, and introduce a new zero-rate loan facility. The ECB has widened the TLTRO – for 3 years at -0.25% -, implemented a temporary envelope of additional net asset purchases of EUR 120bn until the end of the year and launched a EUR 750bn Pandemic emergency purchasing program. In its surprise March 15th move, the Fed decided to boost bond holdings by at least USD 700bn.
Strategy and Macro
- A traumatic, multi-angle, crisis
- An acid test for liberal capitalism and western democracies
- A contained credit crisis, for now
- A transitory ¨No-flation¨ regime
- Towards impotent financial and volatility repressions
- From asset price reflation to a global re-pricing of risks
- A serious test for passive investing strategies and products
The “State” is back. For good!
When elected President, Trump promised to “drain the Swamp”. Actually, he reduced significantly the size of several departments of the US administration, namely that of the Foreign Office (diplomats) and Health. Layoffs in both prove today problematic, in the context of international political tensions and of the sanitary crisis. Anyway, this is barely reversible now! Beyond this, Trump accused the US State of being fundamentally unproductive and flawed. Therefore, for “ideological” reasons, the US administration has been downsized, and its scope reduced. But the emergence of the Covid-19 / sanitary crisis features a tipping point. Trump and Co no longer want to dismantle US State, quite the opposite… In short, we are ahead of tentative nationalizations, if not of sort of a TARP 2.0. The Fed is logically taking part to this process, featuring a major shift from its – poorly aborted – normalization of interest rates (2018-9). For now, their joint action against a major threat is a priority. Logically, the current crisis relegates the issue of the central bank’s independence to a later stage.
Central banks were the only game in town
Now, the State is making a dramatic come back. Europe is also at the cross-roads. Maastricht treaty’s criteria just exploded. Talks are going on about the mutualization of risks, i.e. euro-bonds. The ECB is expanding gradually the scope of its purchase of private assets (like commercial paper), up to – ultimately – banks’ bonds? The political barriers against a green new deal diminish, thanks to a dramatic shift in the German political landscape. The support for austerity is weakening in sync with Merkel and her governing coalition in polls.
State bailouts are broadly contemplated, including in the capitalist bastions
Helicopter money and New Monetary Theory are no longer anathemas
Covid-19. A major threat for top leaders
Up to early 2020, China and Xi were the spotlight, as the epicenter of the sanitary crisis. An existential challenge for the Chinese politburo was considered. A quarter later, things seem to have dramatically changed. China seems not only on the verge of containing Covid-19, but also of re-igniting its economy / supply chains with “limited” damages.
Europe has then become the next epicenter of the sanitary crisis. Solidarity among EU members has been limited to say the least. As a collateral damage, Maastricht treaty has collapsed and existential questions are reappearing, like risk mutualization, banking union, fiscal transfers, etc. A – much – more fragile Germany holds the key to engineer the revisiting of the basic nature and structure of the Eurozone. Will it proceed? A political status-quo would probably spell major dislocations in the EU over next couple of years. US is gradually taking over the leadership in terms of magnitude of the viral infection. The initial denial of Trump administration might ultimately backfire and play a role in next Fall Presidential elections. The US society is particularly divided, and inequalities have risen a lot in past decade. Serious social unrest might occur should the economy / employment were to suffer long lasting and dramatic developments.
The current crisis is particularly threatening Western politicians
A new investment framework
The eventual involvement of the State to bail out private companies will spell at least medium-term interruption (if not the end) of the hyper-active financial engineering of corporates. Share buybacks, special dividends, stock options have become political evils. The fiscal advantages linked to debt versus equity, as a means of corporate financing, might even be reconsidered. A long phase of corporate deleveraging might open-up. This might spell structurally lower EPS growth, namely in the US.
Passive management and investment vehicles have probably past their Nadir. The dysfunctional trading of fixed income ETFs, where discounts to NAV have become the norm, are a symptom of the mismatch between their theoretical and practical liquidity. The Fed, in a well-targeted emergency move, is intervening by purchasing such investment vehicles. Let’s hope it will manage to address the issue!
This is nevertheless reminiscent of what happened with the financial engineering linked to subprime mortgages during the last crisis. The incriminated investment products and derivatives (CDOs, CLOs, etc.) experienced a long phase of delusion following the 2008/9 crisis.
Asset Price Inflation regime is over
Resurgent volatility will result in higher risk premiums
The omnipotence of passive investment strategies and products is under a serious test
Unstable macro regime
The longest ever US business cycle ended up abruptly late 2019. A global recession, possibly of short duration but high magnitude, is unfolding. The conjunction of two external shocks, a sanitary and oil crisis, finally won over the latest phase of Great economic Moderation. By chance, the world economy is not in a situation of major imbalances (like over-investment, or high inflation). But the – very – important debt burden amassed last decade, renders it clearly vulnerable. As well as the entrenched lack of consumer price inflation and the unusually high wealth and income inequalities. Contrarily to last crisis, over-indebtment neither comes from households, nor from the financial sector. We are rather facing a Corporate debt indigestion. This is therefore a precursor of an inevitable credit crisis. The crucial question is about its ultimate magnitude.
A “contained” credit crisis would of course trigger corporate defaults, massive layoffs and reinforced disinflation. It would primarily impact on investors’ wealth and portfolios. As long as the banking system remains ring-fenced (this is a bold assumption in Europe), a brand-new cycle, à la Schumpeter, would take place in 2021. This seems the most likely scenario at this stage, considering the quick and strong involvement of policymakers in G7 countries plus China. But still, this is contingent to the Covid-19 not proving too severe in a few countries having delayed their protective measures (say the US and UK). A severe “uncontrolled” credit crisis would indeed result in (debt) deflation. This is a worst-case scenario resembling the 1929-32 episode.
The bad news is the lack of global cooperation, in our G-Zero world, where unilateralism definitely prevails. Still, there are early signs that we are shifting towards a currency truce, courtesy of the US and China.
A global recession and a “contained” credit crisis are inevitable
A U shape recovery is quite possible, but a more severe crisis too (lower odds)
Expect unstable inflation developments
It’s all about the king USD
The music for risky assets has abruptly stopped and concerns about the USD funding markets have rekindled FX volatility. One of the features of recent market carnage was that investors sold anything they could, including gold and Treasuries. Deleveraging relative-value trades also led to a malfunction of the Treasury market. On top of that, risk parity unwinds led to selling of both equities and Treasuries. That left the USD as the go-to asset to buy i.e. the only one safe-haven asset. Because most market participants fund in USD, it has triggered $12trn of margin calls. Incredibly, the 8-day USD change around March-end was the largest on record. The DXY has rallied nearly 6% since its annual lows in early March, and close to 10% at the top. According to all the classical metrics (PPP, REER, NEER), the king dollar remains the most expensive currency in the world.
Since then, the Fed has addressed these issues with its unlimited QE following the ECB Pandemic Emergency Purchase Program announcement. But restoring confidence will take time. Have we entered another round in the currency war? For sure, the White House does not welcome the USD strengthening. However, it may be reluctant to intervene to weaken the USD too. In the current context, no intervention is better than a failed one. Furthermore, the US administration has passed an historic $2trn stimulus bill. Fiscal and monetary measures and signs of reducing USD funding squeeze suggest that FX markets may be about to exit the period of profound, indiscriminate moves, where the USD appreciates abruptly. Speculative pressure on the USD intensified. The USD sentiment soured significantly following the Fed announcements amid rising financial market turmoil. This led investors to run the first overall bearish USD positioning since mid-2018. The aggregate USD position went from flat to a net short.
Funding squeeze pressure fading should benefit to healthy currencies
The EUR/USD and USD/JPY basis have fully normalized. Following the Fed FX swap programs implementation, the EUR and JPY should rebound. The unlimited Fed QE will take a toll on the USD in a better functioning market environment. The CHF remains “penalized” by its still strong fundamentals. The NOK has been the key victim of the latest market and oil rout as the NOK low liquidity heavily exaggerated the currency downfall. Oil prices will remain depressed for some time suggesting that a meaningful NOK rally is unlikely. The GBP suffers from the worst current account position in the G10 FX space, and the external funding needs lets the GBP vulnerable, despite its cheap valuation.
Central banks aggressive support will keep markets functioning
The Fed wishes to avoid a credit stress contagion to the real economy
The longest economic expansion has ended abruptly. The end is not a surprise; but the exogenous shock, its speed and its magnitude are. The US economy will enter a recession this year, but the latest Fed announcements may help avoid longer-term damage and accelerate the recovery. The recent risk aversion spike and unprecedented volatility in Treasury markets – the ultimate safest asset – exacerbated the search for liquidity, and propagated price dislocations in credit markets.
Fed goes nuclear
The Fed announced an open-end program to buy unlimited amount of Treasury and MBS. Unlike 2008, the non-financial corporate sector is the epicenter of this crisis. The Fed announced it will create a SPV to provide medium-term loans directly to corporations, buy existing high-quality corporate debts in secondary markets, and make loans against ABS held by a broader range of investors. These measures will further support short-term corporate lending and ensure that money market funds have ample direct access to liquidity to fulfill redemptions. The Fed balance sheet has already exceeded the $4.5trn maximum level reached after the 2008 crisis and should surpass $6trn. This came in the wake of the €750bn ECB bazooka to stabilize credit markets.
From search for liquidity to search for yield… again
IG and HY spreads moved from late bull market tights to recessionary levels within just 4 weeks. We have seen true capitulation in the last weeks, with massive outflows across ETFs and funds. Credit curves have inverted. Short-end spreads have widened more than long-end ones as short-dated papers were used as a cash proxy. Since investors needed cash, they have sold them. The key problem, unlike 2007-08, is liquidity rather than leverage. So, markets are clearly dysfunctional. Liquidity is poor and it is challenging to assess where market prices really are. Current spreads levels have been seen only 3 times since the 1930s, in October 2008-June 2009, October 2002, and the early 1980s. Investment grade spreads have doubled in less than 3 weeks.
Everything is happening faster, including monetary and fiscal responses. Authorities have learned from the 2008 experience and were prepared to go further and faster. The Fed announced two facilities – the Primary Market Corporate Credit Facility and the Secondary Market Corporate Support Facility – which could translate into $200bn IG corporate bond purchases before September-end skewed to the front-end. This will reduce refinancing risks and lower non-performing loan risks for US banks. This is a risk transfer from the private to the public sector at the expense of huge fiscal deficits, funded by central banks. Such public sector risk sharing is exactly what stopped the 2008 crisis. The recent dislocation in corporate credit markets will reduce.
Over time, credit spreads should compensate for default, downgrade and liquidity risk. Spreads already compensate for huge illiquidity premia and recession. In a severe downturn scenario, HY default rates should spike to 10%, with recovery rates as low as 20%, translating into a default loss of 8% per annum. A 1’000bps spread on a 5-year maturity horizon generously compensates for such case. Spreads equate to those of late September 2008 – a few weeks after the Lehman failure. Valuations are clearly cheap. We are close to the widest in spreads. It is rare to see these spreads levels in any category. It is time to adopt a contrarian stance and to add risk. Furthermore, given the banks capacity to replace bond investors by printing loans, as they were doing before the financial crisis. This could create a bond shortage and support credit.
The decline in indices has especially shocked by its speed
The equity markets established a record in decline speed: -36% for the Dow Jones between February 20th and March 23rd. But the absolute record remains -30% in 5 working days from October, Tuesday 13th to October, Monday 19th, 1987, during the bear market of 1987 which had lasted 78 days, from August 25th to November 11th, 1987. In magnitude, with the recent rebound, the decreases in indices do not go beyond -30%. On March 24th, the stock markets give early signs of a stabilization, thanks to the extraordinary monetary (infinite), fiscal and budgetary measures of central banks and governments to avoid a depression and hope for a rebound in V or in U of the global economy.
A “technical” shock for corporate profits
Of course, profits will collapse in any case during the first half of 2020, or even in the third quarter if the containment measures continue. Goldman Sachs forecasts a 33% drop in profits for the S&P 500 in 2020 and Credit Suisse -24%. With a bottom-up approach, Bloomberg analysts estimate a 14% decline in earnings per share for the S&P 500 in 2020 and Lipper Alpha by -15%. The drop in profits is accentuated by the drop in oil prices which will weigh on the energy sector. Take China, which was a month and a half ahead of the restraint and partial shutdown of production lines. Chinese industrial enterprises saw profits fall 38% in January and February, and even -87% in the electronics sector, -80% in the automotive industry and -68% in electrical machinery / equipment. Smartphone sales have dropped 56%. In March, Chinese industrial activity restarted very gradually, but demand has remained very weak, with households preferring to conserve their liquidity in the event of a second wave of coronavirus. The Chinese government is considering measures to stimulate demand.
Today, it is impossible to estimate the extent of the drop in profits. This will depend on the duration of the confinements. They will decrease, for sure, and probably beyond -20%. If we try to make estimates, it is certain that we will be 100% false. We consider a technical shock, because we expect a very sharp rebound in profits at the end of this crisis. The 2008 financial crisis was difficult for the profit cycle with a 49% contraction from the peak, but the stock market indices rose 205 days before earnings per share recovered.
To cope with a short-term liquidity problem, some companies stop paying dividends, which is easier for American and British companies that distribute them quarterly or semi-annually. They also stop share buyback programs. Bank of America has calculated that over the past 5 years, US companies have carried out share repurchases for $ 2,700 billion, mainly financed by an increase in debt of $ 2,500 billion; between the summers of 2018 and 2019, share buybacks exceeded free cash flow, resulting in a $ 272 billion reduction in cash for non-financial corporations. There is therefore a debate in the United States as to whether the taxpayer should pay for the excesses of companies, which have benefited shareholders. For the year 2018, according to Bank of America, share buybacks contributed to 20% of the increase in profits per share. In any case, the counterpart to assistance from the federal government is to stop these share buyback programs for a few years.
Stock valuations discount a recession
The correction in indices has reduced stock valuations, which are at levels of a recession. We exclude a depression thanks to the (infinite) monetary, fiscal and budgetary measures taken by central banks and governments. In addition, very low interest rates support higher stock market valuations, unless there is a depression. Signals from the Breadth indicator (number of decreases and increases), volatility and credit spread are showing signs of stabilization as the indicators were in panic mode. Investor sentiment indicators point to a higher probability that stock market indices will perform positively within 12 months. Over the past 20 years, see chart below, S&P 500 stocks have bottomed out on average 23 days after the Breadth indicator bottomed out. A strong return on the 85% of the Breadth indicator generally indicates that the bear market has bottomed out. The powerful response from the Fed, the White House and Congress coincided with the peak of panic (see the 2 graphs below), observed on several indicators, and it should allow the stock markets to react more quickly than in 2008 when the authorities had been slower to react. Authorities benefit from the experience of the 2008 financial crisis.
Favor growth, defensive sectors and companies overflowing with liquidity
In this current phase featuring the massive intervention of central banks and governments, one should obviously be tempted to buy cyclical sectors. Monetary, fiscal and budgetary measures are dedicated in the short term to sectors most sensitive to this major crisis, such as airlines, cars, tourism, hotels, restaurants, aircraft manufacturers and their suppliers, …. and also to specific companies that represent an absolute interest in national security such as Boeing or United Technologies. But still , we favor defensive bias, growth companies and those with significant liquidity in their balance sheet, such as the non-cyclical technology, health, communication and utilities sectors.
We remain cautious on emerging stocks, with the exception of China, which is gradually emerging from its confinement. Europe and the United States are in an exponential acceleration phase of the crisis. Most of the emerging countries of Asia, Latin America and Africa are late and will be in the European and American situation within 2-3 weeks. India confined 1.3 billion people last week. Brazil and South Africa are entering a critical period. The World Bank and the IMF have asked creditors to suspend payment of the debt of the poorest countries and, with WHO, fear that the developed countries will concentrate only on their national problems. The damage in emerging countries could be harder and longer. India is one of the most vulnerable countries; during the 1918-19 Spanish flu, India had the most deaths in absolute terms and as a percentage of its population.
The worst oil crisis in the last 100 years for oil-producing countries
The oil output reduction agreement, starting in December 2016, between OPEC, especially Saudi Arabia, and Russia, has not withstood the increase in U.S. oil production, which stands at 13 million barrels / day, allowing the United States to be the world’s leading producer. The deal was supposed to support prices, but it didn’t work, as the United States was gaining world market share in exporting. Unbearable for Russia, which in addition, is attacked by the United States on its Nord Stream gas pipeline connecting Russia to Germany. Russia and Saudi Arabia will increase production. The watchword is “Gain market share”. It was a really bad time in the midst of a health crisis when demand for oil will drop. Normal demand stands at 100 million bpd, but the latest estimates anticipate a decline between 10% and 25%, -10.5 million bpd in March and -18.7 million bpd in April. Russia cannot close its wells because it could damage them. In the short term, some analysts predict a crude price of around $ 10 or even lower, which could lead to a permanent destruction of supply capacity.
In the longer term, the price situation is not as hopeless. It resembles that of 2008. Today, the oil industry is in contango, that is to say that future prices are higher than spot prices, thus favoring the storage of oil (as long as the costs of storage are not too high) on land and at sea to resell the crude later at a better price. The problem is that there will not be enough storage capacity and the most expensive productions will have to stop and the weakest producers will disappear. This situation suggests a strong rebound in oil prices when demand returns.
The United States is pressuring Saudi Arabia to stop this new price war, but at present, no producer is able to reduce supply to cope with such a shock in demand. The shock will affect shale gas and oil in the United States, in particular Texas, North Dakota and Pennsylvania (gas). Many shale oil producers are on the verge of bankruptcy and US production will fall if prices stay at these levels. The price of WTI must be between $ 35 and $ 55, depending on the region, for the US shale to be profitable. Analysts predict US production will drop 3 million bpd in 2021. Investment spending is expected to fall by half to $ 60 billion in 2020. The US oil industry is very clear: it does not want any financial aid from Washington; it wants to remain independent according to the sound foundations of American capitalism: we live well, we survive or we die!
The oil majors will try to save dividends, as they did in 2015-2016, with a reduction in investments and the end of share buyback programs. But BP has understood, the priority today is not to protect dividends, but the need for new perspectives, such as accelerating the energy transition. In the short term, the oil majors’ dividends are protected by the significant generation of free cash flow, except for Exxon Mobil. But it is not the high dividend yields that drive oil majors’ share prices, but oil prices; and in the short term, the environment is unfavorable to them. Above all, petroleum service and equipment companies should be avoided.
An environment very favorable to physical gold
In March, the price of gold suffered from profit-taking driven by margin calls and a panic that favored liquidity. Then gold recovered following the Fed’s announcement of an infinite asset purchase program and a weaker dollar. Interest rates will stay low for a long time. In the current shock of flooding of liquidity to support the global economy, gold reinforces its character of safe haven in a potential currency debasement shock.
There is a physical gold disruption, as the refining factories are closing (Switzerland, South Africa, Singapore) and the means of transport have stopped (planes, boats). Even though the London and New York markets remain confident that the physical gold supply will be sufficient, traders report that the market is squeezing, seeing supply disruptions. Future gold prices higher than spot prices are a signal that there is a risk of a supply shock as demand increases.
If there is a lack of physical gold, investors could turn to physical silver. The recent widening of the Gold / Silver cross could favor the silver metal, while bearing in mind that gold metal is the ultimate financial safe-haven asset.
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