The first quarter was one for the record books. The fastest drawdown on record was immediately followed by the steepest recovery since the Great Depression. The wild swings sent investors’ heads spinning and were all the more unsettling because they came with virtually no warning.
This turbulence didn’t just come out of nowhere, however. The seeds were set in an environment excessively permissive of debt that provided a remarkably fragile foundation for market advances. Investors who appreciate this will have a much greater chance of successfully navigating the bumpy road ahead. Investors who don’t will struggle to preserve what they have.
To be sure, the proximate cause of the turmoil in the first quarter was the spread of the coronavirus and the public policy measures implemented to contain it. To focus on this, however, is to miss the more important structural condition of excess leverage. Jim Grant assessed plainly in his April 3, 2020 letter: “the volume of credit came to exceed the country’s legitimate demand for credit.”
For investors keeping score at home, excessive debt was also a huge problem in the 2008 financial crisis. Unfortunately, very little changed since then. Household debt declined somewhat, but corporate and sovereign debt exploded. There never was a “beautiful” deleveraging.
Kiril Sokoloff captured the landscape in an interview with Real Vision dated March 27, 2020:
“There is a huge amount of leverage in the system, because everyone was trying to squeeze out a profit or getting some return. The pressure to generate profits was massive, and you had to use leverage to do it.”
Debt apologists claim that low rates make debt affordable. While this is technically true, it is also disingenuous. The reason is that affordability is context specific. If that context covers only a very narrow set of potential conditions, then it is unlikely to be representative over longer investment horizons.
Debt is affordable if payments are low relative to income but is not affordable if income falls dramatically and/or there are no reserves to cover the payments when income falls short. This is the underlying problem that the coronavirus has exposed: Almost overnight, debt levels for many companies (and individuals and countries) have transformed from being affordable to being unaffordable.
As a result, debt does matter because higher levels of debt reduce one’s resilience to changing circumstances. Further, the longer your time horizon stretches out, even if the environment seems benign, the more likely some catastrophic event is going to happen. This is exactly why engineers design bridges to withstand a “100-year flood” regardless of the conditions when the bridge is built.
For debt holders, adverse conditions are comprised of any set of factors that reduce cash flow needed to stay current on debt payments and/or reduce the value of assets that were financed by the debt. When defaults on debt do occur, the result is that money (and therefore liquidity) is destroyed.
When defaults are highly correlated, the risk can be systemic and substantial amounts of liquidity can erode quickly. This happened when home prices fell in the mid-2000s and is happening again today. The situation was illustrated nicely by Michael Lebowitz and Jack Scott. They described that the loss of liquidity arising from defaults creates “a hole the Fed is trying to fill.”
Today, those “holes” are appearing in more and different places. The potential for significant defaults exists in emerging market debt, corporate debt, global supply chains, securitizations, and other areas.
For example, Luke Gromen notes in his March 20, 2020 edition of Tree Rings, “A terrifying ‘sudden stop’ in capital flows is happening across Emerging Markets”. Zoltan Pozsar and James Sweeney of Credit Suisse describe: “supply chains are payment chains in reverse. When the flow of parts, components and assembly is interrupted, so is the flow of payments in the other direction.” Further, the Economist highlights that “10-20% of all American corporate debt (bonds and loans) is owned by more esoteric vehicles such as collateralised-loan obligations and exchange-traded funds”.
The widespread and urgent need to procure US dollars to pay these various debts have caused liquidity expert, Michael Howell of CrossBorder Capital to declare:
“These shocks have unhinged the global financial system, probably permanently, and look to have finally destroyed the consensual post-WW2 settlement.”
This is a powerful statement. It says the effects of the coronavirus have tipped the delicate scales of the financial system out of balance in a fundamental way. The economic and financial damage will be meaningful.
Seth Godin laid it out bluntly: “We’re going to need to pay. All of us. To pay for the dislocations and to pay for the treatment and to pay for the recovery.” In short, the investment environment has suddenly become far more turbulent and difficult to navigate.
This will radically reset priorities and will require a radically different mindset for leaders and investors alike. Godin provided a good sense of this by way of generational differences. He said, “My generation was the dominant voice for sixty years. A voice that worried about the next 24 hours, not the next 24 years.” He concludes, “That’s about to shift, regardless of what year you were born.”
Interestingly, Kiril Sokoloff described a very similar phenomenon: “So the players who were successful in the last decade, the last 30 years, it may just be a totally different game, and I’m not sure what it is … I just have an intuition that the world is going to change, and we have to change our game plan.”
A key element of the different mindset that will be required, and one that has enormous implications for investors, is perspective. From a long-term perspective that incorporates historical norms as well as a wide range of things that can possibly happen, the credit crisis and subsequent market turbulence in the first quarter were wholly unsurprising. A stock market built on a foundation of ever-growing debt was an accident waiting to happen; it was a matter of “when”, not “if”. In other words, the wild swings experienced in the first quarter were just a predictable function of living with such enormous excesses.
A number of investors don’t have a broad enough perspective. They may take comfort in a “long-term” orientation, for example, but most standard asset allocations were designed with the last forty years in mind and not for an “unhinged the global financial system”. Further, many common approaches are implemented with passive strategies that can be sorely tested in adverse conditions. Finally, many approaches are not prepared to adapt to such fundamentally different circumstances.
Other investors have almost no perspective at all. These investors assume that the natural state of affairs is for the market to go up every year. Selloffs are rare but transient experiences. Events in the first quarter came out of nowhere and were unusually nasty, but essentially par for the course. Failing to appreciate underlying structural issues, such investors are programmed to buy the dip. The risk, as Sokoloff illustrates, is that “there’ll be maybe fake rallies and people will buy it, and then short it, and it will be whipsawed around.” The lesson from the Great Depression, however, was: “it wasn’t a crash where people lost money. He was trying to buy the many false bottoms.”
The increased relevance of perspective represents an important changing of the guard of investment approaches. Operating with a 24-hour time horizon and adjusting quickly when adversity arises will not solve the bigger structural issues that are pressing with ever-greater intensity. Doing so will lead to a misdiagnosis of conditions that will be punished far more severely than it has in the past. As Godin characterizes the changes:
“Emergencies are overrated as a response mechanism. Preparation and prevention are about to become a more popular alternative.”
With the ideas of perspective and preparation and prevention in mind, there are several useful points to consider as the second quarter unfolds.
Clearly the monetary and fiscal policy machines are ramping up quickly to the potential for numerous debt defaults. While it is foolish to forecast the effect of public policy with too much specificity, there are some general patterns emerging can help to handicap outcomes.
For one, the scale of spending is already massive and there is a good chance it will get even bigger. Rabobank’s Michael Every summed up the monetary response:
“The reality is that the Fed is now providing backstops for pretty much everything save for President Trump’s beloved Dow Jones index.”
Russell Napier addressed the same issue in the April 3, 2020 Grants letter: “Government interventions in banking systems at the bottom of bear markets are not uncommon.” However, Napier also acknowledged the unusual scale of this intervention:
“Government interventions to bail out an entire commercial system or portion of the commercial system, in my opinion, are entirely novel. That changes the nature of this bear market for anybody in the capital structure. The more important question now is under what terms and conditions does government capital arrive.”
This highlights another hugely important issue for investment decisions. The programs implemented thus far almost guarantee uneven distribution of support. The Fed’s decision to purchase investment grade corporate debt (but not non-investment grade debt), for example, highlights the diminishing role of free markets in determining the price and quantity of capital as well as the role of the government in determining which businesses succeed and which ones do not.
Another important aspect of announced policies is that they provide support, but they do not fix any problems. Forbearance of rents and forgiveness of payroll expenses can buy some time and prevent an immediate meltdown, but they don’t do anything to restructure bad debts. Nor do currently announced policies make any provisions for investing in projects that can generate higher future growth.
Finally, an inherent characteristic of any public policy is uncertainty. In the best of times, the outcomes of public policy measures are uncertain. In less settled times, the level of uncertainty related to the reaction function to such policies and the nature and duration of unintended consequences expands dramatically. The short answer is that there are no silver bullets and it will take time to assess and address the economic and financial damage. In investment terms, this means a higher cost of capital.
Another implication for investors is that small businesses are more vulnerable than larger businesses. Agustin Carstens from the Bank for International Settlements (BIS) highlighted this point: “Central bank interventions to quell the crisis need to reach the individuals and businesses who are ultimately affected. The last mile of this channel is not yet in place and the gap needs to be bridged urgently.” The early days of the CARES Act are already demonstrating Carstens’ concern that the transfer of funds will be uneven at best.
As a result, there is likely to be even greater inequality. Since many of those with the highest propensity to spend will be hit hardest, discretionary spending is likely to fall and that will cause disproportionate economic harm. Longer term, the trauma of coping with severe economic adversity may even foster higher savings rates.
It is also important to remember that these economic and financial effects are also being felt all over the world. China is over-leveraged and many countries are having trouble servicing debt. Argentina just defaulted again. This is not a situation in which any country “wins” but rather one in which some countries fall into the abyss and “lose” before others. The bigger picture takeaway is that prevailing forces are likely to be deflationary for some time.
Collectively, thee factors describe an environment that is generally not conducive for increasing long-term exposure to stocks. Further, there have not yet been many company updates through the crisis so it is fair to assume that much of the news from first quarter earnings reports will be bad. As the economic impact becomes more apparent and gets discounted into stock prices, there will start to be opportunities for those scouring the landscape with capital ready to deploy.
In one sense, the market turbulence in the first quarter provided something like a “last call” for investors. On one hand, investors can embrace an approach that favors perspective and preparation. This worked well to insulate investors from the greatest ravages of the selloff and to position them for future opportunities. On the other hand, investors can continue to chase markets in a landscape that they don’t understand with tools that don’t work. Either way, the guard has changed.