Blain’s Morning Porridge – April 27th 2020
“The vicissitudes of fortune, which spares neither man nor the proudest of his works, which buries empires and cities in a common grave.”
It feels like the various market threads are now coming together. We’re getting close to a stage where we can make informed guesses on how markets and the global economy plays out in coming months.
There is plenty of speculation in the papers about lockdown. It ranges from pressure on governments to explain, to questions about Sweden seems to have managed without a devasting economic closure. It’s mostly noise. (More worrying is the WHO report about potential reinfection of infected patients as the virus mutates – but let’s discount that for now.)
Clearly, how much longer lockdown continues is going to be critical in terms of setting the tone of recovery.
I’ve been working with a good friend, Robert Hillman, ex-Bank of England and Brevan Howard, who runs modeler Neuron Capital. (He’s also a sailor, and we live in the same village!) There are plenty of models out there, and all suffer from the lack of real data, especially here in UK. However, Neuron’s latest analyses confirm the costs from relaxing too soon will be high in terms of second-wave risk, but the benefits from waiting an extra month are even higher!
Their latest modelling shows that if we wanted to relax current restrictions by 40% then waiting an extra month could reduce the chance of a 2nd wave from around 80% to as low as 25%. The reason that patience is so important is that chance of a second outbreak is so sensitive to the all-important R0 number. The silliest thing of all would be to push it down to 1.1 and then relax things and watch it shoot up!
The hard thing will be trying convert from the models what a relaxation of 40% actually means in the real-world. Other countries are being much more explicit about the range of relaxation measures already. Neuron expects the UK government will start publishing more information soon to help manage expectations.
I suspect we are looking at Mid-May as the optimal time to start reopening UK Inc! It will give Boris something to pull the country back-together when he returns today..
But… does that mean immediate boom? There is bound to be a bounce factor, before economic reality re-establishes itself.
1) Let’s start with economic damage.
There are still a number of commentators who argue for a variation on the V-Shaped recover (or a thin U). Their case is the global economy will swiftly recover because nothing has been destroyed. All the assets of production, global supply and distribution chains, remain essentially in place – waiting to be switched on again. It’s simply a matter of waiting for economies to reopen, lockdowns to end and a vaccine in 8-18 months to end the COVID threat.
That’s a punchy argument – and unlikely to happen cleanly.
I don’t have the space the morning to argue every point, but when 18% of the global economy – Tourism, Hospitality and Aerospace – could be shuttered for years, that’s bound to have knock on effects.
KLM/AirFrance are getting Euro 11 bln to stay afloat (?), Lufthansa is begging a similar package in Germany, Norwegian (yet again) is on the brink of bankruptcy, and Virgin’s boss Richard Branson is learning the consequences of tax-exile. Airbus is warning it could go down as orders and demand plummets. Rolls Royce and GE engines are in serious trouble as no one want’s engines. Hotels, pubs and restaurants around the globe – employing 10% of the global workforce – could be shut for months, and take years to recover.
When lockdowns end, that’s when we find out just how much easier it is to close an economy than it is to reopen it. When 40 million consumers are suddenly out of work, and most of the rest have taken paycuts, how are spenders going to drive a demand driven recovery?
2) Let’s think about Debt Finance
Over the past few weeks we’ve seen record issuance in public bond markets. Since global Central Banks initiated unlimited QEI (QE Infinity) programmes over March/April, allowing them to buy most public bonds and bond ETFs, we’ve seen a deluge of new corporate debt hit the markets – over $450 bln I reckon in Europe and the US. Its increasingly been issuers in the BBB cusp-of-junk rating band that have been able to tap the market.
In addition, nearly every large corporate around the globe has drawn down all its bank financing lines, putting cash in place to sustain themselves through lengthy shutdown and diminished business.
Effectively, large corporates able to access bank lending and public markets have been saved in the short-term by QEI programmes. But, at what cost? See below..
3) What about government support to business?
Most of the bank drawdowns and new public debt has been raised by large companies. The SME sector lacks such immediate access to finance – it’s been forced to rely on government emergency support packages. We’ve seen that work with various degress of effectiveness. In the UK the banks, who run the system, have responded with lethargy, unwilling to lend, and wrapping requests in red-tape. (The last thing they want is rising corporate exposure when they expect the highest corporate debt defaults in history.) In other countries greedy larger companies managed to trough their greedy snouts into money intended for SMEs – the US in particular.
The result is large companies have been able to seize a far larger slice of the available emergency fund pie than SMEs. That is going to result in a long-term mis-balance in the economy. SMEs are far more likely to go bust as a result.
Some people have argued the COVID-19 is akin to a massive meteor strike on the global economy. It’s not. Had that been the case, then large over=levered Zombie companies would have died out and been replaced by smaller nimbler SMEs eating their niches. What’s happening this time is not business evolution – its de-evolution as the large inefficient dinosaurs are allowed to survive and the nimble smaller smarter SMEs get crushed.
4) What about Markets?
Ask yourself: what’s the point in buying zero or negative yield Government Bonds? Or buying high risk BBB bonds when the only reason for buying them is the Fed is buying them? They still yield very little, and although spreads will tighten as a result of QEI, they don’t produce meaningfull returns.
Where should you invest instead?
What about stocks? The stock markets comprise large companies who have been able to access bond market and government money! But they are also now highly overleveraged, burdened for the future and likely to suffer from increasing oversight as governments seek to show they care about Moral Hazard by restraining dividends, pay structures etc. Government interventions will make for a less efficient market. In the last crisis it was banks that suffered from governments and regulators trying to run them. This time the list will be much wider..
Some stocks will do genuinely well – those that thrive through the crisis like food retail, online delivery and entertainment, and especially those with large cash reserves able to keep leverage low, and see to make cheap acquisitions or create whole new markets in the wake of the crisis. That’s one reason the current equity bull rally in a bear market is so loaded on certain cash-rich and advantaged Tech stocks. Disclosure time: my own portfolio is long Microsoft, Apple, Netflix, Amazon, Tencent, some others and my 6 Tesla shares which I really should get rid of.
5) What is the biggest danger?
This might surprise you, but I reckon the biggest danger is insidious creeping bureaucracy.
Remember, all commerce is about social inter-reaction. And social behaviour tends towards.. “taking it easy and feathering your own nest”.Bureaucracy exists in many forms. From the ways governments work (or don’t), right down to the way departments in firms function.
Bureaucracy controls how policy is delivered. Where bureaucratic goals and behaviours start to mould strategic imperatives, then everyone from might governments to small companies become less efficient. Less efficient businesses, surviving on increased debt and increased government and regulatory oversight become increasingly bureaucratic an less responsive to customers and business.
In a market place where government money means the sanction of bankruptcy and failure has been removed – then the lack of Moral Hazard means companies become flabby and complacent. The trend will be towards internal bureaucracies taking over the effective day-to-day running. (Bureaucracy can hide under many names: management accounting, cost-control, HR, internal audit, compliance…) You get the drift…
“Good” bureaucracies become so embedded they become the company or government. What really killed communism? The bureaucracies that evolved within it.
6) Conclusions – What about future investment strategy?
My conclusion is its fine to follow the central banks in the short-term. At some point the current distortion of QEI and ultra-low rates will end badly.
A number of market chartists think the current rally is about to snap, although others think increasing good news from the virus frontlines could push stocks higher.
To avoid a global market crash that would potentially crush fragile business sentiment and destabilise financing, the Central Banks have little choice but to continue juicing markets. However, I would get very selective about which stocks have the real resources to thrive and are going to be less vulnerable to the dead hand of bureaucracy, and thrive when the invisible hand returns..
There is also a very strong argument to look for real returns in Alternatives. Instead of buying financial assets – distorted stocks and bonds, look at financing real assets producing real returns. For instance, we are currently financing the construction of a commodity play. It will be producing product in 18 months, just as we expect the global economy to be in recovery. It will produce real returns, and a real product the market is crying out for. It’s not without challenges and difficulties, but it’s real!
Five Stories to Read This Morning
Torygraph – Airbus bleeding cash as jet orders dry up
Out of time, and back to the day job!
Bill Blain, Shard Capital