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.
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.
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 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.
In The Return Of Inflation (5th June 2020) we made the case for a transition from the existing deflationary narrative to one in which markets start to price-in inflation.
Having identified, and benefited from, the 7% fall in the value of the US dollar index since late April, we have now turned tactically cautious.
In last week’s blog, This Time It’s Different (24 July 2020), I suggested the US dollar was on the cusp of crashing through its decade-long uptrend.
There are growing signs that the US dollar may finally roll over.
Welcome to the Q3-2020 ‘Quarterly Perspectives’ publication.
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One question I get from advisers and clients, more than any other, is why global equity markets have bounced back so far.
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Bosses at Tavistock Investments have taken a voluntary, significant pay cut…
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Brian Raven tells Proactive Investor its two protected UCITS trusts have proved themselves during the current market volatility caused by the coronavirus pandemic.
The coronavirus has brought economic activity to a virtual stand-still and transformed a strong global economy, with lots of debt, to a weak economy… with lots of debt.
Last week, we considered the debt story behind the coronavirus. The fear of a large debt overhang, as the economy slows, led to concern that households and companies could start to default on their...
In the past three weeks, global equity markets have fallen almost as much as in the Financial Crisis of 2007-08.
Investment sector veteran Hugh Simon has taken a near 5% stake in wealth consolidator Tavistock in a strategic partnership.
In the past week, global equity markets have fallen again and yields on developed market government bonds have collapsed even further.
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