Tag Archives: COVID19

FED speak

In this time of uncertainty, we can only search for insights as we await actual Q2 figures and see how businesses fare as lock-downs are slowly relaxed. Many businesses, particularly SMEs, may hobble on for a while as demand slowly picks up and governmental support becomes due for withdrawal. Some, like hairdressers, will re-establish their businesses due to the nature of their service or product and with the support of a loyal customer base. Some may even thrive as their businesses adapt to the new normal.  Many may not. Services dependent upon crowds such as the leisure and hospitality sectors look particularly exposed. The digital transformation of many businesses will take a leap forward and the creative destruction of capitalism will take its course. Many of the old ways of doing businesses will be consigned to history in one fell swoop.

The FED this week issued their financial stability report with the following view on the current level of vulnerabilities:

1) Asset valuations. Asset prices remain vulnerable to significant price declines should the pandemic take an unexpected course, the economic fallout prove more adverse or financial system strains re-emerge.

2) Borrowing by businesses and households. Debt owed by businesses had been historically high relative to gross domestic product (GDP) through the beginning of 2020, with the most rapid increases concentrated among the riskiest firms amid weak credit standards. The general decline in revenues associated with the severe reduction in economic activity has weakened the ability of businesses to repay these (and other) obligations. While household debt was at a moderate level relative to income before the shock, a deterioration in the ability of some households to repay obligations may result in material losses to lenders.

3) Leverage in the financial sector. Before the pandemic, the largest U.S. banks were strongly capitalized, and leverage at broker-dealers was low; by contrast, measures of leverage at life insurance companies and hedge funds were at the higher ends of their ranges over the past decade. To date, banks have been able to meet surging demand for draws on credit lines while also building loan loss reserves to absorb higher expected defaults. Broker dealers struggled to provide intermediation services during the acute period of financial stress. At least some hedge funds appear to have been severely affected by the large asset price declines and increased volatility in February and March, reportedly contributing to market dislocations. All told, the prospect for losses at financial institutions to create pressures over the medium term appears elevated.

4) Funding risk. In the face of the COVID-19 outbreak and associated financial market tur­moil, funding markets proved less fragile than during the 2007–09 financial crisis. None­theless, significant strains emerged, and emergency Federal Reserve actions were required to stabilize short-term funding markets.

The point about household debt is an important one and points to the likelihood that this will be a recession with characteristics more akin to those before the 2008 financial crisis, as per the graph below.

The oft highlighted concerns about leveraged loans in recent times has again been highlighted by the Fed as a worry in this crisis, as below, with default rates likely to turn sharply upwards.

However, it was the commentary in the report from the Fed’s market outreach that I thought captured succinctly the current market fears for the future:

Many contacts expressed concern that a U.S. recession brought about by the pandemic could expose highly leveraged sectors of the economy. Contacts noted that corporate default rates were likely to increase sharply, with acute stress in the energy sector. Even before the outbreak spread to the United States, concerns related to nonfinancial corporate debt were cited frequently, with a focus on the growth in leveraged loans, private credit, and triple-B-rated bonds. More recently, surveyed respondents noted that a period of renewed outflows from credit-oriented mutual funds could lead to limits on redemptions and that stressed global insurers could become large sellers of U.S. corporate bonds.

A number of contacts also raised concerns over household balance sheets, especially in low-income segments, highlighting increases in credit card, student loan, and auto loan delinquencies as well as concerns over spillovers from nonpayments of rent and mortgages. Against the backdrop of corporate, consumer, and real estate stress, several respondents noted that bank asset quality could come under severe pressure. Smaller banks with high concentrations of lower-rated consumers, small and medium-sized businesses, and commercial real estate were viewed as especially vulnerable.

Several policy-related risks were also identified, including the risk that funding designated to support small businesses would be either insufficient to address the scale of the need or not timely enough to avert a wave of layoffs and bankruptcies. Finally, a few contacts noted the prospect that state and local governments would face large budgetary gaps, with spillovers to the municipal bond market and local economies. In the euro area, some respondents noted that the absence of more expansive fiscal resource sharing or debt mutualization could underpin a return of redenomination risk in some of the monetary union’s most indebted sovereigns.

A few respondents noted that novel investment strategies and market structures could prove vulnerable in a sustained market downturn. Specifically mentioned were the growth of short-volatility strategies, the expansion of leveraged ETFs, and the reliance in some markets on sources of liquidity that could withdraw in a shock.

Finally, geopolitical tensions were cited frequently as a medium- to long-term risk. A few contacts noted that the COVID-19 outbreak could amplify tensions and accelerate a shift away from multilateralism. Respondents also highlighted the risk of heightened trade tensions and the possibility that the virus and its fallout could accelerate global leadership changes and amplify political uncertainty.

A string of worst evers

As the COVID19 deaths peak, in the first wave at least, across much of the developed world the narrative this week has moved to exit strategies. The medical situation remains highly uncertain, as the article in the Atlantic illustrated. A core unknown, due to the lack of extensive antibody testing, is the percentage of populations which have been infected and the degree of antibodies in those infected. What initially seemed to me to be a reasonable exit framework announced by the US has been fraught with execution uncertainty over the quantity and quality of the testing required, exasperated by the divisive ramblings of the man-child king (of the Orangeness variety).

The economic news has been dismal with a string of worst ever’s – including in retail sales, confidence indices, unemployment, energy and manufacturing. The number of turned over L shaped graphs is mind-blowing. And that’s only in the US! The exhibit below stuck me as telling, particularly for an economy fuelled by consumer demand.

In the words of the great Charlie Munger: “This thing is different. Everybody talks as if they know what’s going to happen, and nobody knows what’s going to happen.” The equally wise Martin Wolf of the FT, who penned an article this week called “The world economy is now collapsing” posted a video of his thoughts here. His article was based upon the release of the latest IMF economic forecasts, as below.

The IMF “baseline” assumes a broad economic reopening in the H2 2020. The IMF also details 3 alternative scenarios:

  • Lockdowns last 50% longer than in the baseline.
  • A second wave of the virus in 2021.
  • In the third, a combination of 1) and 2).

The resulting impacts on real GDP and debt levels for the advanced and emerging/developing countries respectively are shown below.

A few other interesting projections released this week include this one from Morgan Stanley.

And this one from UBS.

And this one from JP Morgan.

In terms of S&P500 EPS numbers, this week will provide some more clarity with nearly 100 firms reporting. Goldman’ estimates for 2020 compared to my previous guestimates (2020 operating EPS of $103 versus $130 and $115 in base and pessimistic) were interesting this week given the negative figure for Q2 before returning to over $50 for Q4. The “don’t fight the fed” and TINA merchants amongst the current bulls have yet to confront the reality of this recession for 2021 earnings where the fantasy of an EPS above $170 for 2021 will become ever apparent with time in my opinion. Even an optimistic forward multiple of 14 on a 2021 operating EPS of $150 implies a 25% fall in the S&P500. And I think that’s la la land given the numbers that are now emerging! We’ll see what this week brings…..

Stay safe.

Peak Uncertainty

As we face the peak weeks of the COVID19 virus in the major developed economies, one thing the current COVID19 outbreak should teach us is humility. As humans, we have become far too arrogant about our ability to shape the future. A new book by the economists John Kay and Mervyn King (a former Bank of England governor during the financial crisis) called “ Radical Uncertainty” argues that economists have forgotten the distinction between risk and uncertainty with an over-reliance on using numerical probabilities attached to possible outcomes as a substitute for admitting there are uncertainties we cannot know. How many one in a century events seem to be happening on a regular basis now? Their solution is to build more resilient systems and strategies to confront unpredictable events. Such an approach would have a profound impact on how we organise our societies and economies.

Currently, planning for events with a large impact multiplied by a small probability allows us to effectively continue as we have been after assigning the minimal amount of contingency. Imagine if sectors and industries were run based on been prepared for tail events. That would be a radical change. Very different from our just in time supply chains which minimise capital allocation and maximise return on investment. Our approach to climate change is an obvious case in point and how we have heretofore ignored the environmental externalities of our societies and economies. Given the financial costs this crisis is going to place on future generations, I would suspect that the needs of this cohort of our society will become ever more urgent in the aftermath of the COVID19 pandemic.

As many people grapple with the current uncertainties presented by this pandemic, we are currently at peak uncertainty in Europe and the US. We are only now getting a sense of how the outbreak is peaking in Europe given the lock down measures in place. How the virus reactions to the relaxation of current measures, how the outbreak will peak across the US and other continents, the economic impact of the outbreak, or the societal impact amongst many other issues are as yet unknown. We do know however that with time over the coming weeks some of these answers will become clearer. For example, as the graph below from the FT shows, we known the approximate path of the outbreak given the policies being pursued today.

A positive narrative could be that existing medications pass rushed COVID19 trials and prove they can blunt the impact of the virus thereby altering the shape of the curve. We can also speculate that once the first wave is contained, we will develop strategies on a combination of mitigation measures (e.g. reduced isolation methods, antibody and other testing to return sections of the population to work, immunity passports, etc) to slowly transition to the new normal. The logistics of such a phased return to normal will be complex and a nightmare to enforce, particularly if self-isolation measures are in force for lengthy periods and people believe any second wave can be well contained by battle hardened health systems. We can be confident that a vaccine will be developed, hopefully by early 2021, but it will take time to get the vaccine distributed and administered in bulk. Mid 2021 is likely the best we can realistically hope for.

At this stage, my rough guess at a base case scenario on the timing for European and US lockdown is 3 to 5 weeks with another 6 to 10 weeks to transition to a semi-new normal. That’s somewhere between mid-June and early August with Europe leading the way followed by the US. A more pessimistic case could be that discipline amongst the population gets more lax as the weeks drag on and a second wave gathers momentum with a second lockdown required over the summer followed by a more timid and gradual transition afterwards lasting until the end of the year. Obviously, these timings are pure guesses at this time and may, and hopefully will, prove way off base.

The economic impacts are highly uncertain but will become clearer as the weeks pass. For example, with just the first fiscal stimulus package passed in the US, the politicians are already listing their priorities for the second (and likely not to be the last either), Morgan Stanley expect the cyclically adjusted primary fiscal deficit to rise to 14% of GDP and the headline fiscal deficit at 18% of GDP in 2020, as per their graphic below. Given the unknown impact of the crisis on GDP numbers, these percentages could approach 15% to 20% with total debt of 110% to 120%. It’s depressing to note that prior to this crisis the IMF said the U.S. debt-to-GDP was already on an unsustainable path.

Although the euro zone comes into the crisis with less debt, last year it was 86% of GDP, Jefferies said in a ‘worse case’ outcome where nominal GDP falls 15% this year, the bloc’s budget gap would balloon to 17% of GDP from just 0.8% last year. They estimate in this scenario that the euro zone debt-GDP ratio could rise above 100% in 2021. As a percentage of GDP, Morgan Stanley estimated the G4+China cyclically adjusted primary deficit could rise to 8.5% of GDP in 2020, significantly higher than the 6.5% in 2009 immediately after the global financial crisis. Unemployment rates in the short term are projected to be mind boggling horrible at 20%+ in some countries. It seems to me that the austerity policies pursued after the financial crisis will not be as obvious an answer to repayment of this debt, not if we want western societies to survive. Addressing generational and structural income inequalities will have to be part of the solution. Hopefully, an acceleration of nationalism wouldn’t.

On the monetary side, the Fed’s balance sheet is now estimated to be an unprecedented $6 trillion, an increase of $1.6 trillion since the start of the Fed’s unprecedented bailout on the 13th of March. Bank of America estimates it could reach $9 trillion or 40% of GDP, as per the graphs below.

As to corporates and the stock market, dividends will undoubtably be under pressure as corporate delevering takes hold and without the crack cocaine of the bull market, share buybacks as the graph below shows, I fear there will be more pressure on valuations. The Q1 results season and forward guidance (or lack thereof), although it may have some surprises from certain firms in the communication, technology and consumer staples space, will likely only compound the negativity and uncertainty.

Using unscientific guesses on my part, I have estimated base and pessimistic operating EPS figures for the S&P500 as below. Based upon a forward PE (on a GAAP EPS) of 15 (approx. 12.75 on operating EPS basis), which is the level reached after the dot com bubble and the financial crisis, the resulting level for the S&P500 is 2,000 and 1,600 in the base and pessimistic scenarios respectively. That’s a further 20% and 35% drop from today’s levels respectively.

The coming weeks will likely be horrible in terms of human suffering and death across the developed world (one cannot even comprehend the potential suffering in the developing world if this insidious virus takes hold there). There is always hope and uncertainty will reduce over time. Major decisions will need to be made in the months and years ahead on the future of our societies. Learning from this pandemic to build more resilient societies and economies will be a task that lasts many years, possibility even generations. Major changes are coming after this health crisis subsides, hopefully they will be for the better.

Stay safe.

Where to now?

There can be little doubt that March 2020 will go down in history. I fear that April 2020 will bring more pain and suffering across this little planet of ours. I have, like I am sure you have also, looked on in horror as events unfolded over the past weeks and felt emotions I never thought possible as I fear for family, friends and communities. We have to hope that medical science will come to assist us with treatments to take some of edge off this insidious pandemic until we can mass produce and distribute a vaccine for COVID19.

Until recent days, I have not had the stomach to sit down and try to read up on how this nightmare may end. The data, both medical and economical, that will come out in April will likely shock but will hopefully at least help us to figure a route out of this. Right now, I doubt we will ever go back to the world we lived in just a short few weeks ago. The price that will have to be paid for this human tragedy once the virus is conquered will, I fear, include destroyed businesses, unemployment, financial hardship for many and a debt crisis (both corporate & sovereign). If things get really bad, I would fear for social cohesion in the months and years ahead in many communities and countries. So, in trying to start to figure out where we go to now, the exhibits below are those I have taken from some recent reports (as credited) that I thought worth sharing.

Notwithstanding these fears, I do think it’s important to have hope and there are many things happening during this crisis that point to hope. Families getting stronger through adversity and a focus on what is important for us all are just two positives. We’ll see what the coming weeks bring….

Stay Safe.

Deloitte US GDP Forecasts