The Liquidity Crisis Is Dead. All Hail the Solvency Crisis.
John Leiper – Head of Portfolio Management – 15th May 2020
In response to the corona crisis, global central banks have unleashed a tidal wave of liquidity. This policy action has lifted all assets, which have floated higher on a sea of liquidity (full details in blog here: Economy ≠ Markets)
This week we concern ourselves with what happens when the tide turns…
Specifically, what if the sharp V-shaped recovery currently priced into markets does not materialise and the damage that is undoubtedly taking place to the economy takes years, not months, to recover?
The key issue is debt. Since 2008, global central banks have lowered interest rates so far that corporations have gorged on the cheap debt available. Total debt now stands at 322% of GDP. Since the financial crisis dollar-denominated corporate debt has more than doubled to $12 trillion. This is a demand shock on a global scale where the economy slows to a crawl, but the overhang of debt remains.
If debt-laden businesses cannot operate, as the coronavirus shuts borders and the population hunkers down, then many will struggle.
We are already seeing this play out. In the chart below, the number of credit rating downgrades has outnumbered upgrades over the last few months, according to data provided by the S&P credit rating agency for companies in the US high yield space. The ratio of net downgrades to total upgrades and downgrades is now near all-time lows. The high yield market will also need to absorb downgrades from investment grade debt, where the ratio is also at extreme levels.
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Very quickly the focus will shift from the ability of a company to service its debt to asset coverage and whether existing debt can be rolled over at maturity. If not, many companies will face default.
Earlier this month the fashion retailer J Crew filed for bankruptcy and Neiman Marcus and J.C Penney, two retailing giants in the US, recently failed to pay interest on their debt. Ratings agencies predict default rates for companies considered ‘risky’ could hit 15%. That number is likely on the conservative side. Before the coronavirus hit, approximately 1 in 8 US firms were considered ‘zombie’ companies that were barely able to meet debt servicing costs. For such companies, the day of reckoning has been pushed back by a decade of ultra-low interest rates and weak investor covenant protection. That day has now arrived and behind the scenes the US court system is bracing for the biggest surge in bankruptcies it has ever seen.
Using the 2001/2002 dot-com bubble and 2008 sub-prime mortgage crisis as a guide, we have provided 3 forecasts (best, base and worse) for default rates affecting those companies rated Caa by the Moody’s credit rating agency. The base and worst case scenarios are consistent with notably higher credit spreads.
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The 2008 crisis is now 12 years distant but it’s effects still live with us today. This is partly due to the political decision to follow a path of economic austerity as well as wide spread revulsion over tax-payer bailouts. But it comes down to a system where you “socialise the losses and privatise the gains”.
There is less political capital to do so today. This time around, creditors will need to take a hit. This would involve large scale debt write-offs and years of ongoing negotiation and litigation. This is good news for bankruptcy lawyers, but little else.
It’s a similar story for equities which sit lower down the capital structure.
Using data since 1994, forecasts for lower GDP growth point to a significant decline in US corporate earnings growth. This is consistent with the decline witnessed in 2008. Meanwhile, the multiple on which investors are willing to pay for these declining earnings is near a 20 year high. That looks like complacency.
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Our core concern is that markets are under-pricing solvency risk. The longer the virus continues unchallenged, and the economy remains impeded, the greater the probability that markets start to price this risk-in.
The portfolios remain liquid, highly diversified and defensively positioned. Within credit we are underweight high yield bonds as the market has failed to adequately price in both downgrade and default risk. On a relative basis we prefer US investment grade bonds, which will benefit from Fed purchases, but could still suffer from rising defaults.
Two weeks ago we reduced equities to underweight. We did so in the run-up to a key technical level on the S&P 500, at around 2,950 as shown by the red circle (details in blog here: From Liquidity to Solvency). Since then, that resistance level has held and at the time of writing the index has fallen approximately 6%.
The question is whether this level coincides with the market’s collective perception of this crisis and whether or not that perception is about to morph from a crisis of liquidity to a crisis of insolvency.
This investment Blog is published and provided for informational purposes only. The information in the Blog constitutes the author’s own opinions. None of the information contained in the Blog constitutes a recommendation that any particular investment strategy is suitable for any specific person. Source of data: Bloomberg, Tavistock Wealth Limited unless otherwise stated.
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Welcome to the Q2-2021 ‘Quarterly Perspectives’ publication
In its latest economic outlook, the OECD increased its expectations for global GDP. For 2020, the improvement is minimal, reflecting an upward revision, in real GDP, from -4.5% to -4.2%. But beyond that, growing economic momentum should boost global growth to pre-pandemic levels, estimated at 4.2% in 2021 and 3.7% in 2022.
Markets are ebullient, and they have every reason to be.
On Monday afternoon, global stock markets soared on the news BioNTech and Pfizer had created a coronavirus vaccine which proved 90% effective based on initial trial results. The story behind the breakthrough, which you can read here, is fascinating, not least because the husband and wife team behind the virus don’t yet know why it works.
The narrative, heading into the US election, was a ‘Blue Wave’ victory for the Democrats. Polls and betting odds favoured a Biden win and a Senate majority and investors positioned accordingly. Anticipation for a huge fiscal stimulus package, estimated at $3 trillion+, lent itself to the global reflation trade which would stimulate the economy and revive inflation, benefiting cyclical assets whilst hitting government bonds.
The ACUMEN Portfolios continued their strong run throughout October, largely outperforming the market composite benchmark and IA sectors (used for peer group comparison purposes) which lost ground across the board.
With the US election just 8 days away, financial markets are following the polls and pricing in a Biden win. The prospect for a Democratic clean sweep has contributed to the rising ‘Blue Wave’ narrative benefiting those companies that stand to benefit from Democratic party policy. Meanwhile a long/short basket of companies more closely aligned with Republican policy and values has steadily underperform.
Welcome to the Q4-2020 ‘Quarterly Perspectives’ publication.
On Tuesday Fed Chairman, Jerome Powell, made a speech at the National Association for Business Economics, during which he implied the government should err on the side of caution and provide too much stimulus rather than too little.
Saturday Night Live has a reputation for expertly parodying presidential election debates. My all-time favourite is Al Gore (Darrell Hammond) versus George Bush (Will Ferrell) and this year didn’t disappoint with expert performances from Donald Trump (Alec Baldwin) and Joe Biden (Jim Carrey).
The following is an abbreviated version of my recent article ‘A Deep Dive Into… UK Equities’ for Investment Week magazine. Follow the link and read my views on page 17.
Last week the FTSE Russell decided to include Chinese government bonds in its flagship World Government Bond Index (WGBI). The decision follows similar moves, from JP Morgan and Bloomberg, and a failed attempt to do so just one year prior which resulted in a number of reforms, to increase accessibility and currency trading options, that ultimately paved the way for benchmark admission.
In last week’s blog we discussed the ‘Nasdaq whale’, Softbank, and the role it played, alongside an army of retail investors, driving tech prices ever higher prior to the recent correction. These short-term ‘technical’ flows are driven by the options market as traders look to hedge their underlying exposure, amplifying moves both lower and higher.
The ACUMEN Portfolios continue to perform well. As you can see from the table below, performance for the rolling quarter (to the end of August) remains strong relative to the market composite benchmark and the current assigned IA sector, which I understand many advisers use for comparison purposes. ACUMEN Portfolios 3-8 were all in the first quartile and ranked in the top 15 within their category.
In a speech for the history books, last week Fed chairman Jerome Powell announced a significant change to the way it conducts monetary policy by formally announcing ‘average inflation targeting’. This means the Fed will now allow inflation to overshoot its official 2% target to compensate for prior years where inflation failed to reach that level.
Despite the fact the coronavirus has plunged many countries into recession, global equity markets are now back at all-time highs, as measured by the Bloomberg World Exchange Market Capitalisation index.
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There are growing signs that the US dollar may finally roll over.
Welcome to the Q3-2020 ‘Quarterly Perspectives’ publication.
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