Blain’s Morning Porridge, July 14th 2020 – Long Hot Summer just passed me by
“There seems to be something wrong with out stock markets…”
A few weeks ago I was sucked into the positive vibe of surprisingly strong economic numbers and a sense the virus was diminishing. I was expecting stocks to have hit new record levels in June. For a moment on Monday, it felt like they did as the S&P turned briefly positive on the year… but then it faded. It felt like the last bloom of a fading rose….
Markets feel tired – I expect we’re in for long summer stuck in a rut. The economic data looks more sobering while the virus is still burning its way through the sunshine states, and threatens a southern hemisphere resurgency. Expectations aren’t quite what they once were…. For the meantime…
As Q2 Earnings season accelerates… just how painful could it get?
Not at all if Governments have any say:
· The US budget deficit has topped $3 trillion, 14% of GDP, the largest share since WW2. In June, US government spending touched $1.1 trillion, as tax revenues crashed by 28% to $241 – a deficit of $864 bln! Over $3.3 trillion. Of Federal cash has already been earmarked to support recovery, but the economy is still wheezing badly. A rising tide of corporate crisis, and renewed shut-downs in the US, means Congress will support yet another round of emergency spending to keep the economy from collapse later this month when the first round of emergency measures end.
· Europe will be having a make or break meeting later this week to push the €750 bln recovery plan. Merkel has put her credibility behind it – but the Frugal five northern countries are set to say “Non”. The whole thing is effectively an Italian bailout – and like all plans intending to resolve Italian debt it will prove too small, never-ending and ineffective.
· Here in the UK, Rishi Sunak has already thrown the kitchen sink at the crisis and is now stripping lead off the roof for the next bailout. Apparently wearing masks is going to allow us to reopen the economy, and we’ve all got to go back to work… Yep.. I am so looking forward to queuing to get on a train (20% max capacity) and then waiting even longer to get on a lift (3 people max per lift…)
These are three very different perspectives of the crisis highlighting; i) the enormous fiscal implications across the occidental economies of massive government spending (we still don’t know how it will be paid for), ii) the political ramifications, and iii) the actual practicalities of reopening economies when we need to socially distance. I could write much more about broken supply chains and the effects of such large swathes of the economy remaining shuttered… but we all know it.
What happens next?
What’s the glue holding markets together in these fraxious times? Clearly that’s the amount of liquidity the global central banks are providing though QE Infinity and other support programmes. Some investors characterise these as Central Bank puts on the market – and believe it gives unlimited upside to stock markets.
If that’s true.. then we really are in trouble.
Financial markets have been the cornerstone of Capitalism’s success by efficiently allocating scarce capital to the best businesses. Private enterprise was disciplined to ensure returns to attract capital. Markets worked. The private sector proved vastly superior at generating wealth than government bureaucracies that squandered it. The failure of command and control economies (from Russia to France) highlighted just how attractive market economies could be.
But, accelerated by the last few months of Coronavirus, we’ve seen the complete breakdown of the financial markets as efficient allocators of capital. Markets have become little more than parasites, feasting on government bailouts and central bank QE Infinity programmes. The massive disconnect between the real economy and looming recession versus frothy global stock markets is unprecedented. Rising stocks suggest record earnings, while tumbling bond yields send the contradictory signal of economic calamity.
Equity players are no longer focused on the strength of company managements, their earning potential, their credit worth or their ability to pay dividends. All that matters is how much prices will continue to rise as governments rescues and central bank money buoys them up through unlimited monetary policy distortions.
Fund managers are blithely buying corporate bonds, junk bonds and emerging market debt on the expectation they will all tighten, rising in price, as a result of Central Bank QE. They aren’t particularly worried about the coronavirus recession, or whether it will be V, U, W or L shaped. They don’t particularly care about company risk metrics either. As long as the Central Bank is prepared to buy, then they are effectively guaranteed against default.
These are very dangerous assumptions for any investor to make.
I reckon the toughest job on the street today is probably being a corporate credit investor.
No matter how much glue you slather over the broken structure of markets, eventually they will be just too broken. I suspect we might be getting to that stage in corporate debt. There is only so much money that can be uselessly thrown at Zombie bust companies.
Bankruptcies across retail businesses are bound to leave a mark – for each high-street store that goes bust, a landlord is left with an unpaid rental, and a bank has to up its expected LGDs and provision on its corporate mortgage lending. Each company that’s fully drawn down all its bank lines, managed to raise a cheeky bond issue during April’s debt orgy, has taken advantage of every single government bailout/lending scheme, but is still facing a lack of parts to reopen its factories, and finds its customers are still shut, is facing a simple dilemma – how long can it remain solvent? Its choices are limited… cutting costs by shedding staff…
Shareholders might think the rising stock markets will bail them out as earning crash out – but when the solvency equation runs flat… they will be wiped as debtors carve up the bones of the company. If you are wondering why distressed debt is the best paid gig in town – that’s why.. The DD vultures are circling Zombie companies looking to pick up cheap debt – and expect first dibs at the carcass when the inevitable happens.
Despite all the liquidity central banks are chucking at the system – corporate defaults are going to soar… More and more companies will tumble into fallen angel status – losing investment grade status the longer the economy remains partially closed.
So…. it might sound perverse to suggest that corporate debt might also be a highly attractive market in which to invest. As I’ve written above, there is a massive Zombie sector, but there is also a healthy vibrant SME sector – where debt is proving difficult to access; because banks won’t lend, these companies are too small for public or private debt markets, and government schemes too byzantine to access.
There are a number of credit funds doing direct lending into the SME sector. One of the top performing SME funds is our own Shard Credit Partners – happy to introduce you to them – institutional investors only. By focusing on strong-credit fundamentals and the underlying business the SME lenders illustrate the real issue:
The coming crisis in Corporate Debt is not sudden, it’s a long-term disease that’s been developing for years – since the last crisis. Ultra-low interest rates and QE has sustained too many broken companies for years – crowding out smaller, more nimble, smarter and fundamentally sound SMEs.
If you want a healthy corporate herd, you need to weed out the infirm, the sick and weaklings – brutal, but necessary. We need space for new, vibrant firms more likely to create jobs, growth and generate overall wealth. That’s the way market capitalism should work.
Five Things to Read This Morning
Out of time and back to the day job!