March 27, 2020
By Steve Blumenthal
“We entered into the current crisis with a whole financial system that had been incentivized
by policymakers to take on excessive levels of debt and leverage.
The turmoil we are seeing right now is the result of the unwinding of this leverage.
The primary catalyst of the turmoil is the collapse in economic activity due to the COVID-19 shutdown,
but the fact that funding and trading markets are not functioning well is due to excessive leverage needing to be unwound in the financial system.”
– Scott Minerd,
Global Chief Investment Officer of Guggenheim Partners
and Chairman of Guggenheim Investments,
The Great Leverage Unwind
We’ll win the coronavirus battle. The curve will flatten over the next two to four weeks. Today, let’s break for a moment from the immediate health crisis and focus on the economy and the markets. A two-month global business shutdown drops global growth an estimated 7% to 11%. A three-month shutdown hits the global economy somewhere between 10% and 20%. I’ve heard better and worse. In any event, we are in recession and those most susceptible to an economic virus are the companies and governments overleveraged in debt. And those invested in them.
The photo on the front page of The Economist sums it up: the world economy is closed for business (hat tip to Felix Zulauf for sharing):
The House passed the $2 trillion rescue package today—a good start. It is likely that the Fed will put another $4 trillion on its balance sheet in the coming months. But make no mistake, we are not facing a mild recession; we are fighting to prevent depression. My back-of-the-napkin guess is the U.S. will need $5 trillion in financial support, or 25% of U.S. GDP, to get back on its feet. It could be more. I could be wrong. Problem remains.
At the crux of the issue is this: We sit at the end of a long-term debt supercycle and find ourselves extremely leveraged and swimming in debt. The financial system is unstable. It is the biggest investment challenge we face.
The recent disruptions—especially in the bond markets—are due to leveraged investors racing for the exit doors. This from Scott Minerd:
BBB-rated corporate bonds, which make up a majority of the investment-grade corporate universe, are also a major concern. Many of these BBB-rated companies don’t pass the criteria to be rated BBB by the rating agencies. The rating agencies, however, have shown forbearance by adopting a more liberal interpretation of either cash flow coverage or asset coverage, and accepting promises that these companies will de-lever. Kraft-Heinz is a good example of what happens when the rating agencies, confronted with the fact that Kraft-Heinz wasn’t making the progress it promised, downgraded the company to BB. There are approximately $1 trillion worth of investment-grade corporate bonds that are in danger of being downgraded like Kraft-Heinz. Currently, the high-yield market has approximately $1 trillion outstanding; meaning the size of these possible downgrades would double its size. I do not believe that the current concessions on high yield in terms of their spread to Treasurys or absolute yields is sufficient to clear that supply.
Ultra-low rates incentivized corporations to buy back their shares, bidding up stock prices and engineering better earnings. Bottom lines haven’t been growing. Earnings per share went up because the denominator went down (there were fewer shares in the markets). Yet, all the new debt used to fund share repurchases continues to sit on the balance sheets.
Moody’s and other rating agencies provide us with ratings so we can gauge the quality of the bonds we own or may wish to own. The agencies look at things like cash flow, stability of business, debt-to-equity ratios and much more. Basically, they’re asking, “Can a company pay its debts?” The range goes from AAA down to D. Higher-rated companies can borrow money with better financing terms (lower interest rates). Lower-rated companies have to pay their bondholders higher rates. Bonds rated BBB or higher are called investment-grade bonds. Certain institutional investors are only allowed to buy investment-grade bonds. If a bond is downgraded from BBB, it jumps into the “junk” category, and those institutions, by mandate, are forced to sell. Will the U.S. government want to buy the debt? Maybe, though I have my doubts. This is a ticking time bomb.
The Red Line in the Sand. First the chart, then the explanation:
In recession, growth suffers and, if cash flow decreases, the ability for a company to cover its interest payments or pay back the bonds at maturity goes down. And if Moody’s, S&P or Fitch downgrade a bond below that solid red line in the chart, the bond market reprices.
Currently, the high-yield bond market is approximately $1 trillion in size. If $1 trillion gets knocked down to junk status, the high-yield junk bond market will double in size. Not a typo. A double in size! And that is when things will get even more interesting. Market makers and other intelligent investors will see it coming and step aside. The sheer size of the wave of downgrades will reprice the bond market. Witness the last four weeks. We have yet to cross the red line in the sand. What flips the switch? Recession. And we are in recession.
To get a sense for the size of the debt binge since the Great Financial Crisis, there was $2 trillion in the investment bond space in 2008. Today, there is $5.29 trillion in total outstanding U.S. investment-grade corporate debt. $2.6 trillion, or half of it, is BBB-rated debt. Half of it sits one rung above junk.
David Rosenberg said it well in a post this morning, “We have a battle going on between the extent of the damage being done to the economy and the massive response (from government).”
I can imagine the government putting emergency measures in place to keep people employed, but I doubt the legislative appetite is strong enough to buy up all the bad debts. Is it right to use taxpayer money to bail out irresponsible corporate behavior? A drama coming soon to a (home) theater near you (and me).
There are a number of things to keep top of mind:
- First, recessions are always game changers. It is important for systems to clear, but that doesn’t mean it’s pretty. What does it mean? Strong and responsible leadership prevails, but not everyone makes good decisions. Bankruptcies and defaults will occur. If one-third of the companies in the Russell 2000 Index have been surviving on debt, what might the inability to borrow and/or the high cost of borrowing (thanks to higher interest rates) do to them?
- Leverage is the problem on corporate balance sheets, on sovereign government balance sheets, and in a number of investment structures (margin debt, credit default swaps, risk-parity funds, etc.).
- We entered this recession in a much weaker condition than we were in going into the last recession (the Great Financial Crisis). Last time, China was the world’s growth engine. That is hardly the case today. Global trade was positive in 2008. Global trade was negative at the end of 2019.
- We sit at the end of a long-term debt cycle. The last one ended in the 1930s. Few of us have witnessed a period like this. They are different than the short-term debt cycle resets that happen in recessions. Different means the impact is exponentially greater. Factor this into your risk thinking.
- If we look back to the events of the last two recessions, markets will remain vulnerable for many months (that’s my base case).
- Business has never before shut down on a global scale. The current recession will likely be as severe as the last two. Given the growth in debt since 2008, it could be more severe. Depends on the extent and timing of fiscal rescue.
- Governments are doing the right thing, but it is not enough. $2 trillion is just the start. It will take time to repair the “closed for business” damage. We don’t know what the next bailout package will look like.
Similar to my thinking, Minerd also believes we are entering a period that will be as severe as, if not worse than, the Great Financial Crisis. He expects a 6- to 18-month recession and about four years before affected industries fully recover. The asset-securitization market has essentially stopped functioning. Used airliner prices are now lower than they were post-9/11. Since we have not yet seen capitulation, Minerd would not buy stocks nor credit assets at current levels (I wouldn’t either).
Some additional thoughts on the economy and the markets to keep on your radar:
- Globalization has peaked, and global supply chains are being reset. Imagine an automobile manufacturer waiting for a small part that is holding up an entire assembly line. That process slows global growth. Supply chains will be brought closer to home, with domestic and regional suppliers taking over. But it takes time to reset. For example, 90% of U.S. pharmaceuticals are manufactured in China.
- Prices to produce goods will go up, which will have inflationary implications. It will cost more to produce in the U.S. than what it cost to produce the same goods in China. Higher labor costs. Keep watch.
- More on leverage: The longer the excessive buildup, the longer the duration of downside pain… it will take time to come down, and bankruptcy rates will be huge.
- Government debts will explode to the upside, as will government deficits. The Great Reset remains ahead. We will most likely monetize the debt—a debt jubilee.
- Risk management and buying at a good price matters. Pay attention to the valuation tools I share once a month in OMR.
- Median fair value on the S&P 500 Index is at 2,333. It is based off the prior 12 months of actual earnings. The “E” in P/E (price-to-earnings ratio) will likely come down, maybe by as much as 20%. That means fair value may be between 1,800 and 2,000, not 2,333. So, I’d remain patient and set initial targets at those levels.
- As the cost of producing goods goes up, profit margins will be squeezed, further reducing earnings. Thus, I believe the best buying opportunities will come at levels below fair value.
- We are likely facing a 50% decline, and not a 35% decline. In my view, the best entry point for the S&P 500 Index is around 1,600. No guarantees, of course. Expect trading range markets for the next decade. Active management will be back in favor.
- Markets rarely revert back to fair value; they drop down below it due to investor fear and forced margin-call selling. Remain patient while waiting for those attractive entry points. I’ll be updating my valuation charts in next week’s OMR.
- Global central bankers, including the Federal Reserve, will keep interest rates at or below zero for some time to come. I don’t believe the Fed will move to negative interest rate policy.
- More defaults, lower bond ratings, and the unwinding of leverage. Borrowing costs for corporations will increase.
- I’ve been encouraging my readers to watch the European banks for several years. The U.S. and Japan have the fiscal structure (via a government bond market) to create new debt. European markets face a structural challenge. There is no common Treasury market like we have in the U.S. The Fed can create dollars to buy Treasury bonds. The European Central Bank can create euros though its member banks, but there is no common Treasury bond market to back its currency. It’s a flaw from the outset of the EU structure. This means the ECB must rely on approval from its member states to be able to expand the money supply. That’s like the Fed having to ask each of the 50 U.S. states for approval to print dollars. The backing of banks is also different. In the U.S., reserves are held in U.S. Government securities. In Europe, they have holdings in French bonds, Italian bonds, Greek bonds, German bonds, etc. Since the sovereign debts are not consolidated, will the northern countries vote yes to bail out the borrowing sins of the southern countries? Doubtful. If the banks are in trouble, the only tool the ECB has is to lower rates. Bottom line: If a bank in France gets in trouble, the bank depositors will be stuck with the losses. It’s called a “bail-in” and that day may be nearing. The U.S.’s corporate debt-to-GDP is 80%, and we know that’s a big problem. Italy’s corporate debt-to-GDP is 100%. It is 200% in France. Watch the EU banks. They’ve been under pressure and I suspect there are greater challenges ahead. Expect “bail-ins.”
- Why does this matter? U.S. banks and investors have thousands of cross trades with EU banks. Back to the web of counter-party risk. In the 2008 crisis, it was a U.S. leveraged mortgage-driven crisis that affected the globe. Don’t underestimate the risks to U.S. banks and institutions. Frankly, I believe this accounts for some of the dysfunction we are seeing in the repurchase (repo) markets. There is no trust to be found, and the Fed is stepping in with the capital. It remains the “canary in the coal mine.”
- One last note to sweeten your day. The biggest challenges show up where leverage is greatest. Emerging Markets are the most at risk because they were the ones that created the biggest credit excesses since the last crisis. And much of that was borrowed in dollar-denominated debt. Avoid EM and EM debt for now.
I know you must feel as if someone (me) just hit you on the side of the head, but don’t despair. Take a step back and look at the picture from a distance. Investing is not easy, precise, or guaranteed. It’s about risk and assessing the probabilities of risk and returns. The current odds are not stacked in our favor. We sit overleveraged, late cycle, and in crisis. But with that in mind, we can turn to strategy: more defense than offense. The day to put your best offense on the field remains in the months ahead. It may come this year, or next. I don’t believe the forward returns are good enough just yet.
More next week. Stay positive and healthy and know I’m thinking about you and your family. Thanks for reading my weekly letter. I do hope you find it helpful.
Forget the coffee… A fine wine, a well-prepared Manhattan, or your favorite cold beer is what I think the doctor is ordering. This too shall pass—hang tough!
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Included in this week’s On My Radar:
- “The Fed’s Cure Risks Being Worse Than the Disease”
- Trade Signals – $2 Trillion is a Good Start
- Personal Note – It’s Not All Bad
By Jim Bianco, written for Bloomberg (March 27, 2020)
Jim’s a friend from Camp Kotok. We meet every August in Maine with other friends to discuss macroeconomic issues and global markets. Jim’s brilliant. Here’s the article:
An alphabet soup of new asset-buying programs will essentially nationalize large swaths of the financial markets, and the consequences could be profound.
The economic debate of the day centers on whether the cure of an economic shutdown is worse than the disease of the virus. Similarly, we need to ask if the cure of the Federal Reserve getting so deeply into corporate bonds, asset-backed securities, commercial paper, and exchange-traded funds is worse than the disease seizing financial markets. It may be.
In just these past few weeks, the Fed has cut rates by 150 basis points to near zero and run through its entire 2008 crisis handbook. That wasn’t enough to calm markets, though — so the central bank also announced $1 trillion a day in repurchase agreements and unlimited quantitative easing, which includes a hard-to-understand $625 billion of bond buying a week going forward. At this rate, the Fed will own two-thirds of the Treasury market in a year.
But it’s the alphabet soup of new programs that deserve special consideration, as they could have profound long-term consequences for the functioning of the Fed and the allocation of capital in financial markets. Specifically, these are:
- CPFF (Commercial Paper Funding Facility) – buying commercial paper from the issuer.
- PMCCF (Primary Market Corporate Credit Facility) – buying corporate bonds from the issuer.
- TALF (Term Asset-Backed Securities Loan Facility) – funding backstop for asset-backed securities.
- SMCCF (Secondary Market Corporate Credit Facility) – buying corporate bonds and bond ETFs in the secondary market.
- MSBLP (Main Street Business Lending Program) – Details are to come, but it will lend to eligible small and medium-size businesses, complementing efforts by the Small Business Association.
To put it bluntly, the Fed isn’t allowed to do any of this. The central bank is only allowed to purchase or lend against securities that have government guarantee. This includes Treasury securities, agency mortgage-backed securities and the debt issued by Fannie Mae and Freddie Mac. An argument can be made that can also include municipal securities, but nothing in the laundry list above.
So how can they do this? The Fed will finance a special purpose vehicle (SPV) for each acronym to conduct these operations. The Treasury, using the Exchange Stabilization Fund, will make an equity investment in each SPV and be in a “first loss” position. What does this mean? In essence, the Treasury, not the Fed, is buying all these securities and backstopping of loans; the Fed is acting as banker and providing financing. The Fed hired BlackRock Inc. to purchase these securities and handle the administration of the SPVs on behalf of the owner, the Treasury.
In other words, the federal government is nationalizing large swaths of the financial markets. The Fed is providing the money to do it. BlackRock will be doing the trades.
This scheme essentially merges the Fed and Treasury into one organization. So, meet your new Fed chairman, Donald J. Trump.
In 2008 when something similar was done, it was on a smaller scale. Since few understood it, the Bush and Obama administrations ceded total control of those acronym programs to then-Fed Chairman Ben Bernanke. He unwound them at the first available opportunity. But now, 12 years later, we have a much better understanding of how they work. And we have a president who has made it very clear how displeased he is that central bankers haven’t used their considerable power to force the Dow Jones Industrial Average at least 10,000 points higher, something he has complained about many times before the pandemic hit.
When the Fed was rightly alarmed by the current dysfunction in the fixed-income markets, they felt they needed to act. This was the correct thought. But, to get the authority to stabilize these “private” markets, central bankers needed the Treasury to agree to nationalize (own) them so they could provide the funds to do it.
In effect, the Fed is giving the Treasury access to its printing press. This means that, in the extreme, the administration would be free to use its control, not the Fed’s control, of these SPVs to instruct the Fed to print more money so it could buy securities and hand out loans in an effort to ramp financial markets higher going into the election. Why stop there? Should Trump win re-election, he could try to use these SPVs to get those 10,000 Dow Jones points he feels the Fed has denied everyone.
If these acronym programs were abused as I describe, they might indeed force markets higher than valuation warrants. But it would come with a heavy price. Investors would be deprived of the necessary market signals that freely traded capital markets offer to aid in the efficient allocation of capital. Malinvestment would be rampant. It also could force private sector players to leave as the government’s heavy hand makes operating in “controlled” markets uneconomic. This has already occurred in the U.S. federal funds market and the government bond market in Japan.
Fed Chair Jerome Powell needs to tread carefully indeed to ensure his cure isn’t worse than the disease.
[SB here: What might we be enabling? As a free society, we must be careful indeed. I’ll reach out to Jim and see if we can record a podcast.]
March 25, 2020
S&P 500 Index — 2,564 (close)
Notable this week:
A default wave remains ahead. While $2 trillion in support will be a good start, it pales in comparison to the wave of defaults that are coming ahead. It is a good start. I’ll be sharing my bigger thinking in this Friday’s On My Radar… following are a few quick thoughts and a look at the market move since 2009. Waterfall decline lows are almost always retested. I suspect that will be the current case. Technically speaking, a short-term floor was found at 2,200 in the S&P 500. The market took out its December 2018 low at 2,346.58 and closed last week at levels last seen in 2016. Support is in the 1,810 to 2,150 range. After a strong start to the week, the market is trading at 2,550 at the time of this writing. Overhead resistance is at 2,800. That defines the trading range I see. I believe it is probable we retest and possible break below 2,150. I don’t have any idea as to timing but do believe we are not yet out of the woods.
A much better investment opportunity remains ahead. Stick to your risk management processes.
Not a recommendation for you to buy or sell any security. For information purposes only. Please talk with your advisor about needs, goals, time horizon and risk tolerances.
Click here for this week’s Trade Signals.
“Being positive doesn’t mean being fake, Pollyanna. We are positive, not because life is easy.
We are positive because life can be hard. It’s not about ignoring your current reality.
It’s about facing it while believing the best is yet to come.”
– Jon Gordon
I’ve spent a great deal of time this week reaching out to my contacts and listening to webinars. I’ve been fielding worrisome calls from clients, colleagues, and friends. It feels as though my phone is glued to my ear. What I tried to do above is answer the many questions that are on our minds. Yet this pales in comparison to the stress on doctors, health care professionals, and hospitals.
I do believe that we are nearing the peak of the virus challenges. We will likely see a shift in a few short weeks and start making our way to the other side of all this. I’m hearing that from well-positioned friends. But the economic challenges will last longer than the virus. Call it the “leverage-virus.” In this area, too, we will find our way through.
The weekend weather is looking wet here in the Northeast, so while it was 65 degrees and sunny, I snuck away to celebrate son Matt’s 22nd birthday—18 holes of golf at Stonewall. We arrived to find the driveway gates locked. The course is appropriately closed, complying with the governor’s social distancing mandate. With entrances blocked, we found some questionable parking, put our bags on our backs and did what you and I used to do when we were kids… we hiked up through the woods to the 15th green. A necessary break. And another 20 bucks into Matt’s pocket. Ugh.
Let’s finish today with some much-needed good news. This comes from Andrew Ross Sorkin’s piece in The New York Times. Each day he writes a post titled, “DealBook.” A daily briefing on the markets. If you know Sorkin from CNBC, I bet you like his way as much as I do. Smart, candid, kind, and direct. He received help on the article from colleagues Michael J. de la Merced and Jason Karaian in London. Michael and Jason were assisted by two very good dogs: Harry and Maggie. Here it is:
What companies are doing
Apparel companies are retooling to make masks and other protective garments. Factories that churn out T-shirts in the Carolinas. A company in Pennsylvania that makes uniforms for baseball teams. European luxury brands like Prada and Gucci. Across the world, clothing manufacturers are converting their workshops to produce much-needed medical equipment.
The production of ventilators and N95 respirators is particularly critical, and some deep-pocketed companies, like Apple, Facebook and Salesforce, are using their clout to source supplies. Ford, G.M. and Tesla are also tapping their supply chains and looking into building ventilators to send to hospitals. (Though admittedly, coordination among the state, local and federal governments in directing these efforts could be much better.)
Tech companies are donating their huge computing power to crunch data in the search for a cure. A consortium including Amazon, Google, IBM and Microsoft was recently formed to enlist their supercomputers in making calculations and modeling scenarios for the spread of the disease.
Distilleries and breweries are making hand sanitizer, with Anheuser-Busch InBev, Diageo and Pernod Ricard rejigging their operations to meet shortages. Surplus alcohol generated from alcohol-free beers has come in handy for the process.
Leaders are learning about empathy as they try to manage multinational companies from their spare rooms. “This is a human crisis, and companies need to treat their employees in a human-centric way,” Natasha Lamb of Arjuna Capital told the NYT. Tending to employees’ mental health is important, of course, but so is helping them weather the blow by compensating for lost hours, covering sick pay, assisting with child care and avoiding layoffs (especially since government help is on the way).
🏭 Pollution has fallen dramatically in major urban areas as people have stayed home.
Empathy—amen to empathy.
Hang in there. Thinking about you and your family. Ever forward!
Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Executive Chairman and CIO. Steve authors a free weekly e-letter entitled, “On My Radar.” Steve shares his views on macroeconomic research, valuations, portfolio construction, asset allocation and risk management.
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