The Liquidity Crisis Is Dead. All Hail the Solvency Crisis.
John Leiper – Head of Portfolio Management – 15th May 2020
In response to the corona crisis, global central banks have unleashed a tidal wave of liquidity. This policy action has lifted all assets, which have floated higher on a sea of liquidity (full details in blog here: Economy ≠ Markets)
This week we concern ourselves with what happens when the tide turns…
Specifically, what if the sharp V-shaped recovery currently priced into markets does not materialise and the damage that is undoubtedly taking place to the economy takes years, not months, to recover?
The key issue is debt. Since 2008, global central banks have lowered interest rates so far that corporations have gorged on the cheap debt available. Total debt now stands at 322% of GDP. Since the financial crisis dollar-denominated corporate debt has more than doubled to $12 trillion. This is a demand shock on a global scale where the economy slows to a crawl, but the overhang of debt remains.
If debt-laden businesses cannot operate, as the coronavirus shuts borders and the population hunkers down, then many will struggle.
We are already seeing this play out. In the chart below, the number of credit rating downgrades has outnumbered upgrades over the last few months, according to data provided by the S&P credit rating agency for companies in the US high yield space. The ratio of net downgrades to total upgrades and downgrades is now near all-time lows. The high yield market will also need to absorb downgrades from investment grade debt, where the ratio is also at extreme levels.
On mobile: review chart in landscape mode
Very quickly the focus will shift from the ability of a company to service its debt to asset coverage and whether existing debt can be rolled over at maturity. If not, many companies will face default.
Earlier this month the fashion retailer J Crew filed for bankruptcy and Neiman Marcus and J.C Penney, two retailing giants in the US, recently failed to pay interest on their debt. Ratings agencies predict default rates for companies considered ‘risky’ could hit 15%. That number is likely on the conservative side. Before the coronavirus hit, approximately 1 in 8 US firms were considered ‘zombie’ companies that were barely able to meet debt servicing costs. For such companies, the day of reckoning has been pushed back by a decade of ultra-low interest rates and weak investor covenant protection. That day has now arrived and behind the scenes the US court system is bracing for the biggest surge in bankruptcies it has ever seen.
Using the 2001/2002 dot-com bubble and 2008 sub-prime mortgage crisis as a guide, we have provided 3 forecasts (best, base and worse) for default rates affecting those companies rated Caa by the Moody’s credit rating agency. The base and worst case scenarios are consistent with notably higher credit spreads.
On mobile: review chart in landscape mode
The 2008 crisis is now 12 years distant but it’s effects still live with us today. This is partly due to the political decision to follow a path of economic austerity as well as wide spread revulsion over tax-payer bailouts. But it comes down to a system where you “socialise the losses and privatise the gains”.
There is less political capital to do so today. This time around, creditors will need to take a hit. This would involve large scale debt write-offs and years of ongoing negotiation and litigation. This is good news for bankruptcy lawyers, but little else.
It’s a similar story for equities which sit lower down the capital structure.
Using data since 1994, forecasts for lower GDP growth point to a significant decline in US corporate earnings growth. This is consistent with the decline witnessed in 2008. Meanwhile, the multiple on which investors are willing to pay for these declining earnings is near a 20 year high. That looks like complacency.
On mobile: review chart in landscape mode
Our core concern is that markets are under-pricing solvency risk. The longer the virus continues unchallenged, and the economy remains impeded, the greater the probability that markets start to price this risk-in.
The portfolios remain liquid, highly diversified and defensively positioned. Within credit we are underweight high yield bonds as the market has failed to adequately price in both downgrade and default risk. On a relative basis we prefer US investment grade bonds, which will benefit from Fed purchases, but could still suffer from rising defaults.
Two weeks ago we reduced equities to underweight. We did so in the run-up to a key technical level on the S&P 500, at around 2,950 as shown by the red circle (details in blog here: From Liquidity to Solvency). Since then, that resistance level has held and at the time of writing the index has fallen approximately 6%.
The question is whether this level coincides with the market’s collective perception of this crisis and whether or not that perception is about to morph from a crisis of liquidity to a crisis of insolvency.
This investment Blog is published and provided for informational purposes only. The information in the Blog constitutes the author’s own opinions. None of the information contained in the Blog constitutes a recommendation that any particular investment strategy is suitable for any specific person. Source of data: Bloomberg, Tavistock Wealth Limited unless otherwise stated.
Want to know more about the Equity Markets?
Please contact us here:
The following is an abbreviated version of John Leiper’s article ‘Tide may be about to turn’ for Investment Week magazine. Follow the link and read his views on page 23.
Welcome to the Q2-2021 ‘Quarterly Perspectives’ publication.
Tavistock Wealth have come together with MSCI and LSE SU Green Finance Society to discuss Innovation in the ESG Eco System, alongside data analytics with MSCI.
Our Portfolio Manager for ESG, James Peel, was recently invited to provide his valuable insights into “Innovating Towards a Greener Future” as part of the London School of Economics Student’s Union Green Finance Society’s video conference: “Green Finance Summit 2021”.
In Nothing Is More Powerful Than An Idea Whose Time Has Come, published in November, we introduced the idea of a Great Rotation across US equity markets. As shown in the chart below, this rotation is playing out in textbook fashion with value stocks outperforming growth by about 20% since the end of last year.
The Fed’s dual mandate is price stability and maximum employment, but Jerome Powell has been unequivocal that it’s all about the latter.
Welcome to the Q1-2021 ‘Quarterly Perspectives’ publication.
This is the first blog since the holiday break. Whilst travel restrictions meant it wasn’t the holiday that had been planned, we adapted, and enjoyed the opportunity to spend some time together as a family and reflect on the last few months.
In its latest economic outlook, the OECD increased its expectations for global GDP.
Markets are ebullient, and they have every reason to be.
Following on from last week’s blog, the dramatic rotation from growth to value remains in place for now. Early signs of quick snapback into the prior channel have not yet materialised and instead the ratio has consolidated and even shown signs of moving.
On Monday afternoon, global stock markets soared on the news BioNTech and Pfizer had created a coronavirus vaccine which proved 90% effective based on initial trial results.
The narrative, heading into the US election, was a ‘Blue Wave’ victory for the Democrats. Polls and betting odds favoured a Biden win and a Senate majority and investors positioned accordingly.
The ACUMEN Portfolios continued their strong run throughout October, largely outperforming the market composite benchmark and IA sectors (used for peer group comparison purposes) which lost ground across the board.
With the US election just 8 days away, financial markets are following the polls and pricing in a Biden win. The prospect for a Democratic clean sweep has contributed to the rising ‘Blue Wave’ narrative benefiting those companies that stand to benefit from Democratic party policy.
Welcome to the Q4-2020 ‘Quarterly Perspectives’ publication.
On Tuesday Fed Chairman, Jerome Powell, made a speech at the National Association for Business Economics, during which he implied the government should err on the side of caution and provide too much stimulus rather than too little.
Our Chief Investment Officer, John Leiper, was recently invited to provide his valuable insights as part of ETF Stream’s video conference livestream: “Beyond Beta Europe Digital: Smart beta unwrapped”.
Saturday Night Live has a reputation for expertly parodying presidential election debates. My all-time favourite is Al Gore (Darrell Hammond) versus George Bush (Will Ferrell) and this year didn’t disappoint with expert performances from Donald Trump (Alec Baldwin) and Joe Biden (Jim Carrey).
Our Chief Investment Officer, John Leiper, was recently invited to provide his valuable insights into emerging markets as part of ETF Stream’s video conference livestream: “Big Call: Emerging Markets”.
Last week the FTSE Russell decided to include Chinese government bonds in its flagship World Government Bond Index (WGBI). The decision follows similar moves, from JP Morgan and Bloomberg, and a failed attempt to do so just one year prior which resulted in a number of reforms, to increase accessibility and currency trading options, that ultimately paved the way for benchmark admission.
The following is an abbreviated version of my recent article ‘A Deep Dive Into… UK Equities’ for Investment Week magazine. Follow the link and read my views on page 17.
In last week’s blog we discussed the ‘Nasdaq whale’, Softbank, and the role it played, alongside an army of retail investors, driving tech prices ever higher prior to the recent correction. These short-term ‘technical’ flows are driven by the options market as traders look to hedge their underlying exposure, amplifying moves both lower and higher.
In a speech for the history books, last week Fed chairman Jerome Powell announced a significant change to the way it conducts monetary policy by formally announcing ‘average inflation targeting’.
Despite the fact the coronavirus has plunged many countries into recession, global equity markets are now back at all-time highs, as measured by the Bloomberg World Exchange Market Capitalisation index.
In The Return Of Inflation (5th June 2020) we made the case for a transition from the existing deflationary narrative to one in which markets start to price-in inflation.
Having identified, and benefited from, the 7% fall in the value of the US dollar index since late April, we have now turned tactically cautious.
The US dollar index, which represents the value of the dollar against a basket of developed market peers, fell through key technical support to its lowest level in 2 years.
There are growing signs that the US dollar may finally roll over.
Despite suffering the worst pandemic in over a century, and the sharpest economic contraction since the second world war, global equity and bond markets staged one of the fastest recoveries of all time in Q2.
The 10 year US Treasury yield has remained remarkably steady over the last few months, particularly as inflation expectations have gradually risen.
Those stocks that outperformed during the corona crisis are the same ‘winners’ that outperformed before the crisis.
The recovery in US equity prices, from the corona crisis, has been one of the most rapid in history.
China’s economy has transitioned, from an industrial export-led model, towards services.
Commodities are nothing if not cyclical. They rise and fall in value with remarkable consistency over time.
Quantitative easing, or QE, is where a central bank creates money to buy bonds. The goal is to keep interest rates low and to stimulate the economy during periods of economic stress.
In January 2019 Jerome Powell pivoted from a policy of interest rate increases and balance sheet cuts to interest rate cuts and, later that year, balance sheet expansion.
Over the last decade, the Fed has increasingly resorted to unconventional monetary policy, such as quantitative easing, or QE, to stimulate the economy.
Flying the global economy into the ground from 35,000 feet will go down as one of the most difficult and controversial decisions in the history of mankind.
Tavistock Wealth is the investment management arm of Tavistock Investments Plc. The investment team is comprised of 7 highly educated and talented professionals.
One question I get from advisers and clients, more than any other, is why global equity markets have bounced back so far.
In the early stages of the Corona Crisis of 2020, the global economy faced a liquidity crisis.
In an unprecedented day in the history of oil trading the price of the front month contract for West Texas Intermediate (WTI) oil fell below zero to -$37.63.
Earth Day, commemorated each year on 22/04 by more than 1bn people, is the largest annual secular observance in the world.
The global economy has been plunged into a deep recession as government leaders struggled with the difficult question of how to deal with the COVID-19 coronavirus.
As the world’s reserve currency, the US dollar is the go-to currency. It is used to price assets, complete transactions and as a store of value.
The COVID-19 coronavirus is a demand shock on a global scale where the economy slows to a crawl, but the overhang of debt remains.
The coronavirus has brought economic activity to a virtual stand-still and transformed a strong global economy, with lots of debt, to a weak economy… with lots of debt.
Last week, we considered the debt story behind the coronavirus. The fear of a large debt overhang, as the economy slows, led to concern that households and companies could start to default on their debt.
In the past three weeks, global equity markets have fallen almost as much as in the Financial Crisis of 2007-08.
In the past week, global equity markets have fallen again and yields on developed market government bonds have collapsed even further.
Today, global equity markets have fallen again and yields on developed market government bonds have collapsed even further. In my opinion, there are two diametrically opposed events playing out at the same time.
This is a time to remain calm, patient and focused on fundamentals whilst relying on sound risk management practices. Over the last week the number of confirmed cases of COVID-19 has risen to more than 83,000 people across 50 countries.
Ironically, the turning point may have been President Trump’s withdrawal from the Paris Agreement on climate change in 2017 that set the tidal wave of “doing the right thing” in motion.
2019 was the year in which ESG investing joined the mainstream and became the “new normal”.
Environmental, social and governance (ESG), a byword for sustainability, has in recent weeks occupied rarefied real estate on the landing page of several finance industry titans.
Welcome to the Q1-2020 ‘Quarterly Perspectives’ publication, which aims to explain our outlook for financial markets over the rest of the year.
The polls have become notoriously unreliable and nothing can be taken for granted ahead of Thursday’s general election.
Welcome to the Q4-2019 ‘Quarterly Perspectives’ publication, which aims to explain our outlook for financial markets over the rest of the year.
Welcome to the Q3-2019 ‘Quarterly Perspectives’ publication, which aims to explain our outlook for financial markets over the rest of the year.