Perhaps it is just common sense that markets, as a reflection of human nature, breed repeatable patterns. The tenet that supported risk based strategies held that an all seeing, all knowing Fed could indefinitely extend the cycle by cooking up a witches’ brew of macro-prudential policies, dot plots, QE, not-QE, and if need be, by adding a pinch of negative rates. Well, that way of thinking, has, for now, been banished to the ash heap of history.
At least until the next financial bubble fades the memories of these times.
Once again, the markets have schooled us that risk and volatility can be suppressed, delayed, repriced and mispriced, but as uncertainty is the human condition, risk cannot be avoided nor conquered, just lived with.
If central banks were more reflective, they might learn to practice what they sometime preach: that it is their very penchant for suppressing volatility through low rates and market interventions that encourages imprudence, leverage, and excesses in the use of credit and in risk-taking.
Shield a business from its “natural” ups and downs, provide it with cheap and ready credit, and you can be pretty sure that, over time, such a business will “learn” to be under-equitized and hence ill-prepared for a downturn from which it cannot be so shielded. Ditto for the private citizen who is “taught” that a world without recessions is a world that needs no rainy day fund nor indeed any cushion between expenses and earnings. In short, the central bankers’ “best intentions” set up the private economy like so many bowling pins.
This time around, the bowling ball came down the alley with a fury that hooked all the pins with one single strike. And, of course, no one could have foreseen the first global pandemic of its kind in generations; that said, COVID-19 has revealed the excesses that had been building for years and, alas, had this disease not been the catalyst of the downturn, some other ill wind would surely have done so eventually.
Where does this leave us as investors?
Let’s begin with the poisoned chalice handed to the financial markets by the Fed itself: an improperly arranged economic system with an imprudent financial system to match.
Are we being too harsh?
Consider some of these candidates for practices that perhaps never should have been, and in any case, are unlikely to be standing in the post- COVID-19 economy in any form even resembling their former glory:
WeWork, a company that in just the third quarter 2019 alone managed to lease an incremental 2.8 million square feet of space in the U.S., winning the “crown” of number one leaser in 9 out of the top 10 markets for “flexible space.” Sorry, but the business of taking on long-term leases for top dollar as liabilities and then expecting to be profitable by leasing the space out short-term never was a full cycle strategy.
Covenant-lite leveraged bank lending: no financial reporting, no restrictions…no problem? That is, until credit tightens or the rating agencies downgrade the leveraged loan space pre-empting the distribution of loans into the now voided space of CLO underwriting.
Unicorns with operating losses. Okay, so who now wants to pay for those operating losses hoping that these “bad pennies” can be profitably passed off to the IPO market?
In-rush of non-banks into the riskiest parts of the mortgage lending and investing space encompassing such sectors as non-qualified mortgages (non-QM), non-performing loans (NPLs), re-performing loans (RPLs), and credit risk transfer (CRT) securities. The seizing up of credit combined with margin calls on many of the mortgage REITs has exposed the vulnerabilities of these business models.
Retail commercial space. There’s too much of it.
Massive share repurchases and concomitant re-leveraging of the Fortune 500. EPS accretes in the good times while fallen angels proliferate in the bad.
The relentless expansion of private equity driving over 60% of LBO deals to leverage beyond 6x, in many cases justified with EBITDA add-backs.
Marketplace lending offering “better” terms than regular banks to the small business customer. It’s “better”, that is, until the marketplace lender loses its own financing and is forced to cut the credit lines to its own customers. Again, this never was going to be a full-cycle lending model.
This list could go on and on, but the purpose of the enumeration is to address the question of the day: can we expect a V-recovery when we get to the other side of this, or will we experience a lengthy and painful de-leveraging, even with the helicopter drops?
Many might be inclined to “punt” at this point, as to some the dispositive question is the one that can’t be answered: when does the country—the planet—re-open for business. Obviously, we have no more insight into this matter than does anyone else, though we will be monitoring developments in China as a clue to when the U.S. might re-open. But is this the right question to be asking? It is not. We fervently hope for a quick passing of the public health danger. But even should our wish be granted, we are dubious about the potential for a V-shaped recovery.
Why is this?
The optimists are blithely assuming that when all is said and done, the global economy will more or less reset itself to where it was in January 2020 and resume its preordained trend line of growth. In fact, say some, future growth will be accelerated by the alphabet soup of Fed and government programs providing a multi-trillion dollar Keynesian kick. Were that it was so! Rather, we are inclined to understand the challenges of these times differently.
Even supposing the pandemic fades and the helicopter drops “stimulate” demand, is it really reasonable to believe that:
Consumer and lender preferences return to their pre-pandemic forms and levels? Will the 20%+ of households that find at least one member of their household laid off blithely assume that their jobs are as safe after the event as they perceived them to be before? Will lenders, say in underwriting a candidate for a first time mortgage, be willing to make the same assumption as well?
After having sustained true losses to their incomes and revenues, do preferences surrounding discretionary purchases return to their January levels? Does any small business that nearly went under put its expansion plans back on the front burner and start hiring with enthusiasm again?
Does the newly minted college grad seek out that hip position with the unicorn scooter company (oops, now out of business) or does he decide that while his peers might think him “uncool” that perhaps a position with a more established company makes more sense?
Will those businesses most exposed to the pandemic be willing to commit themselves financially to the proposition that once the quarantines are lifted, the base case becomes “no recurrence?” Even if a business is willing to so stake its future, will investors accept the January 2020 risk premiums associated with these businesses, or will these businesses face a substantial elevation in their cost of capital?
The upshot is that to assume a return to “normalcy” unconsciously assumes that the January 2020 economy was “normal.” It was not. A good thought experiment might be this: what percent of the labor force is likely to be impacted by the combination of factors that will necessarily mean a different “normal” on the other side of this? If you are still an optimist, you might posit that perhaps only 5% of the labor force might be so impacted. Were that so, then we might suppose that unemployment might semi-permanently seek out a level of January’s 3.5% level plus the additional 5% virus impacted such that we arrive at an 8.5% unemployment rate on the “other side.” High, but the U.S. economy could likely work that number down to a few points over a few years. What it won’t do is work 8.5% unemployment down to January’s “normalized” 3.5% figure by the end of the summer! We’ll eat our hats if it does!
Our view is that the 5% number is too low. Perhaps a number closer to 10% might be more realistic, but we don’t really know. Either way, much higher unemployment – perhaps “European levels” – will be with us for a long-time to come. But perhaps you thought we forgot to factor in all that helicopter money coming our way? We did not! Recessions are not caused by demand shortfalls per se. Demand comes from income and income comes from labor and capital collaborating to deliver valuable goods and services.
Helicopter money blunts the pain but does not incentivize or otherwise call into existence profitable companies. Hopefully, the Fed understands this by now: they know less than they think and all of their actions must work through people with results that can’t be entirely predicted by econometric models.
Lest we end on too dour a note, let us say that U.S. institutions—both economic as well as political—have proven to be remarkably adaptable. The collective “we” will arrive at a future economy that will profitably deliver what is demanded by the consumer. That process of adjustment though does not work by Fed magic and will take time.
For the investor, this means that opportunity to deploy capital in highly profitable ways will continue since risk fell into a bear market 1-2 months ago. To date, we have exploited the opportunity presented in fortress corporate balance sheets that have repriced in some cases 150-200 basis points wider in spread, in agency mortgages which reached yield spreads not seen since the last crisis, and in some select portions of the securitized credit markets. In an environment that may take 1-2 years to “re-normalize”, we expect the opportunity to be abundant and we expect to keep adding substantial value to the portfolios of our clients and shareholders.