Fire Starter

Over the weekend most of the developed world moved to full shut down with the exception of essential industries. The Covid-19 data flow will dictate how long these measures stay in place, but it is possible they persist for at least another quarter. From a macro perspective, that is likely to lead to a depression-like decline in activity, with a similar collapse in corporate earnings and cash flow. On the flipside the economic life support measures from the fiscal and monetary authorities have been large and swift. As a proportion of GDP, the fiscal response from most developed countries is now around 10% of GDP (although the US measures have not been approved yet by Congress). These measures are also being directly accommodated by central banks. The problem for economies and markets is that the impact of the lockdown measures probably outweigh the offsetting support measures. As we noted last week, consensus estimates for US Q2 GDP have moved to around -30% at an annual rate. That could even prove too conservative. For equity markets, that type of contraction is probably consistent with a -40 to -50% corporate earnings given operating leverage to economic growth.

Every aspect of the Covid-19 crisis is ratcheting up. Policy makers, quite rightly, are focussed on avoiding Hubei-like infection rates, which overload the health care systems and hence increase fatality rates. Unfortunately, Italy, followed by the United States, the United Kingdom and other developed countries appear to be tracking the infection rate curve in Hubei. Consequently, economic restrictions have become more severe and consistent with an almost total shut down of activity except for essential industries. If the US and Europe continue to follow the Italy/Hubei trajectory, the restrictions are likely to remain in place for at least another two months. Therefore, economic activity could remain restricted until at least June and might contract by at least 30%. On the positive side, policy support measures from both the fiscal and monetary authorities have been steeped up. They are essentially designed to keep the economic activity going or structurally intact so it can recover once the virus passes.

From a slightly longer term perspective, a key implication of this crisis is that it has exposed the fragility of the system: leverage. As we have noted in the past, a lesson from history is to follow the leverage. In the current expansion that has been in the corporate sector, particularly in the United States and China. Therefore, the potential collapse in corporate cash flow from the shut down of activity is systemic and material.

From our perch, central banks are also culpable or at the very least have underestimated their own role in the process. As Jonathan Tepper noted in an excellent report last week, over the years since the 2008 crisis, central banks have been trying to stamp out every single fire (draw down in risk assets) that flares up; the European crisis in 2011-12, China slowdown in 2015-16 and the correction in Q4 2018. However, suppressing volatility and risk only creates bigger fires later on. Risk is like energy and cannot be destroyed. It can only be transformed. Put differently, the actions and promises of central banks to reduce interest rates, provide liquidity and suppress volatility, contributed to an increase in corporate leverage and an allocation to “spread” or “carry” trades across a range of credit, equity and other risk assets. Once the Federal Reserve either hiked rates as they did in 2018 to withdraw liquidity or corporate cash flow and the ability to service debt collapsed (as it has done today), the support for spread trades evaporates and risk assets get liquidated. It is also not easy for central banks to reverse the process once the fire takes hold. For investors, the tactical point to note is that markets appear to be heading to historical extremes in price and valuation terms. It is now a widely held consensus belief, but the necessary condition for markets to stabilise is for the Covid-19 infection rates to moderate. The sufficient condition is a stabilisation in the news flow on growth and profits (corporate cash flow). The economic support measures from both central banks and fiscal authorities have been large and swift. However, they have probably been outweighed by the shutdown impact in the short term. That is the policies to protect people and health care systems have had a greater impact on growth. The second order impact on cash flow has also exposed the leverage (naked swimmers) in the corporate sector and the levered “spread” or “carry” trades. We remain defensively positioned, but recognise that the current episode has created some attractive long term valuation anomalies and opportunities (as we discussed last week).