Deciphering a Dystopian Market
March 31, 2020
We Examine Five Clouds with Three Silver Linings
It is hard to believe that not even eight weeks have passed since the Coronavirus turned into a global problem. Perhaps it is the opposite principle to “time flies when your are having fun”. While the disease progresses at a frenetic pace, a part of you feels like the world is in suspended animation in the midst of the Covid nightmare.
Yet clear positive and negative patterns are emerging for capital market participants. We have noted three potential positives, and five huge negatives driving global risk markets. While we will explore several of these in some detail in the coming weeks, we will use this opportunity to simply enumerate them and draw a straightforward set of conclusions: namely that the market faces formidable downside risks near term, but that there is the likelihood of a strong recovery once these risks are digested, yet to valuations well below pre-crisis peaks.
For my own investing, I continue to assign an 80% probability of the SPX trading between 1500-2500 over the next 8 weeks, and a 20% probability that it does not test the 2500 level again in that period.
In the following, conclusions are separated into short term (6-12 weeks) and medium term (3-6 months).
The Positives
Large fiscal and monetary stimulus and strong stock technicals, as passive accounts and asset allocators buy depreciated equities and sell bonds. But April is another story- we cannot extrapolate the past week. The fretting may well begin anew, although the catalyst could be one of several. But there are at least two other positives.
Conclusion: Explains the strong rally into March month-end.(Ends March 31)
A high probability of new and existing cures, solutions to equipment shortages, and vaccine development being rolled out in coming months. The tentative nature of positive medical advances related to Covid 19 is entirely to be expected given that we are at the earliest stage of discovery and data collection. Do not mistake the seriousness or underestimate the positive outcomes when the world’s brightest minds and unlimited dollars race to find these solutions. The prestige, profit and impact potential for the winners, and there will be many, are enormous, even if hard to qualify. once these are found, it will be far easier to return people’s lives and countries economies to normalcy.
Conclusion : An ultimate relatively sharp recovery for risk assets by 2021 (medium term effect)
Virus isolation and stay-at-home protocols will prove impossible to sustain economically , though they must continue for now and even strengthen near term, so they seem likely to be relaxed eventually, probably by May, for better or worse. There are two ways this can happen - the good way is if more efficient protocols can be found that do not cripple the economy. For example, there is increasing discussion and acceptance of limiting isolation to only the elderly and otherwise vulnerable.
Conclusion: Hugely contractionary near term, but economic, if not healthcare normalcy to be restored relatively soon and not priced in (medium term)
The Negatives
Balanced against these positives and looming NOW, five huge negatives:
Dysfunctional credit capital markets, likely to be ongoing despite Fed driven liquidity. There are many major dislocations. The mortgage market is in trouble despite the Fed purchase program, with lenders unable to meet margin calls on TBA hedges and the primary market sputtering due to closures and the collapse of risk appetite. Over $150B of BBB corporate bonds have been junked and perhaps another $400B or more likely to follow, flooding the junk bond market with Fallen Angels. Over $2T in BBBs are ultimately at risk. Large swathes of the corporate, sovereign and structured bond markets are frozen (although volumes did pick up somewhat into month end). Spreads are elevated. The bond market has been a key engine that has allowed corporations to lever up, buy back stock, and pay dividends over the past few years.
Conclusions:
Suspension or reduction of buybacks and dividends (medium term)
Higher borrowing costs and short term delevering (short to medium term)
Downgrades and defaults in select distressed and over leveraged names (short to medium term)
Broken primary mortgage and microcredit markets - The last mile of mortgage and other credit that keeps the operating capital flowing from borrowers to creditors has been severed abruptly, and remains frozen notwithstanding the top down Fed infusions of liquidity. Mortgage servicers, small banks, landlords, and small and medium businesses face a crunch now and many will be in default unless action is taken now. Some of the damage may be irreversible. Even larger commercial enterprises such as retail , restaurant and hotel chains (for example, Cheesecake Factory) cannot pay rents or make mortgage payments.
Conclusions:
Major disruption of commercial RE, especially retail and hospitality sectors (medium term)
Major disruption of non capital markets credit, such as accounts receivable, project finance, small business loans, rents, mortgage payments and servicing, small bank lending. (short to medium term)
Disrupted supply chains and decimated consumer buying power as consumers emerge with finances battered and confidence low. Some supply chains will remain broken even after the US and Europe reopen for business because they involve other countries still grappling with the virus. Consumers licking their wounds will be a lot less inclined to spend. And we know that certain sectors like travel won’t recover until a permanent fix is found.
Conclusions:
Disastrous corporate revenues and earnings for at least the first two quarters (short term)
Lower post-crisis highs based on lower revenue/earnings prospects (medium term)
The cacophony of mostly Invalid forecasts, both epidemiological and economic, will continue to inject huge uncertainty. For example, forecasts of morbidity and mortality rates are extremely sensitive to assumptions about infection rates in the untested population and the number of infected people with low-grade or no symptoms. These assumptions can add or subtract two zeros from the forecasts of fatalities. Similarly, the negative economic impact is a sigmoidal (S-shaped) function of the duration of isolation, and the current 4-8 week self-quarantine in most parts of Europe and US puts us right on the cusp of that S. If, as is quite likely, we are forced to extend quarantines, the impact on businesses and consumers alike will be both acute and long lasting.
Conclusion: Continued market uncertainty and high volatility (medium term)
Divergent policy responses and natural conditions for the virus across 200 countries means a problem in any one country is potentially a problem for all.Witness the second wave of virus that has come back to haunt Asian countries that had successfully quelled the first wave. Policy changes several times a week in the US. The policy itself is a function of scientific data, political opinion, and at times poor decision making. Perhaps most relevant, policy will remain under severe time pressure and will continue to be sloppily executed in practice in many countries.
Conclusion: It will be hard to eliminate the Covid 19 virus quickly globally even if we succeed in controlling its spread (medium to long term)
Consequences for Current Valuations
The market recovery last week is understandable to a degree, and may even eventually prove to be justified, but…
There are heavy economic and financial disruptions at work NOW that will hobble the economy for several quarters even in the most optimistic case.
The market, when it recovers, will trade at a lower multiple of a lower earnings number for a long time, possibly for some years.
Therefore, we should expect continued distressed markets short term and although a strong medium to long term recovery is likely, it may be to levels much lower than pre crash peaks. In short, there is not much room left for a short term equity rally.