Two ways. Gradually and then suddenly

Montreal, April 20, 2020

This is what one of the protagonists in Hemingway’s 1926 novel The Sun Also Rises responds when asked how he went bankrupt. In many respects, this is how the Covid-19 crisis unfolded; gradually, until February 20th, and then suddenly. In fact, it sliced the quarter in two nearly equal parts. In the first part, from the beginning of the year through February 19th, markets continued to rise on the back of renewed growth optimism following the signing of the Phase I of the US-China trade agreement. As Covid-19 was barreling through China, the attack ordered by the US President against a top Iranian general in charge of the country’s foreign policy and ongoing money market dysfunctions were dismissed. In the second part, once outbreaks were revealed elsewhere in Asia and in Italy, things happened quite suddenly, sending risky assets reeling.

The result was that many equity markets experienced their fastest 30% decline in history before stabilizing in anticipation of immense stimulus programs. Still, at the end of the quarter, the MSCI All Countries World Index[1] had declined 19.97% while the S&P 500 Index and the S&P TSX Composite lost 19.72% and 20.90%, respectively. Stocks outperforming were the large capitalization, higher quality and secular growth names who stand to benefit from the acceleration of the economic digitalization theme. Stocks underperforming were smaller capitalization with higher perceived cyclicality and those excessively leveraged.

Separately, credit markets also fell dramatically from their highs even though the downward movement occurred a couple of weeks after a similar move in the equity markets took place. In fact, it is only when the markets moved from a “risk-off” environment – an environment during which the behavior of safe assets tends to offset losses experienced on risky assets and where the premise of a diversified asset allocation policy works – to what we would characterize as a “risk out” environment, where even safe assets lose value as a synchronized deleveraging takes place across all asset classes, that the credit markets cratered. Over the quarter, the ICE Bank of America Merrill Lynch Global Corporate & High Yield Index and the ICE Bank of America Merrill Lynch US High Yield Master II Index declined 5.83% and 13.12%, respectively. Many markets broke daily and weekly records during the quarter, up and down, as the CBOE Volatility index surged to an intraday high of 85.47 and stayed above 50 for most of the month of March. This index oscillates between 15 and 20 normally.

A Recession by Decree and a Patchwork of Programs

For the first time in history, governments all over the world have imposed travel restrictions and self-confinement recommendations, called for the cancellation of large public gatherings and ordered the closure of a number of businesses providing services deemed “non-essential”. The immediate effect was a cascade of simultaneous sudden supply and demand shocks which were ultimately leading to near economic paralysis.

In order to offset the effects of having large parts of the global economy being shut down by decree, central bankers and governments responded by quickly assembling a patchwork of programs targeted to large and small corporations suffering from an abrupt drop in revenues and to the large number of individuals having to suddenly lost their employment. In the developed world, the magnitude of the programs announced range between 2% and 11% of the prior year Gross Domestic Product. In many countries, the legislation followed equally unprecedented actions by central bankers which are now engaging in open-ended quantitative easing and introduced their own economic backstop mechanisms[2].

While these announcements seemed to have the intended effect on the financial markets, at least temporarily, we remain concerned about the longer-term unintended consequences of these large scale Modern Monetary Theory (MMT) experiments, where central bank finances budget deficit by purchasing government debt issued to finance tax cuts or public spending increases. For those unfamiliar with this left-leaning theory, MMT holds that countries with their own central banks and with their own currencies do not need to worry about budget deficits and spending to spur economic growth so long as their central banks can purchase all the debt that the government issues. Opponents of MMT have decried it as oversimplified and exaggerated in that it supposedly offers great benefits without imposing a burden on anyone. Among other things, opponents argue that unrestrained budget spending could translate in a loss of confidence in a country’s central bank, which could lead to a severe depreciation in the value of the country’s currency and high domestic inflation. So far, inflation break-even have not moved much but we suspect that MMT is about to get tested. With that in mind, it may be relevant to start watching closely the evolution of the price of gold (which made a multi-year high on April 6th) as well as the spread of Chinese Government bonds over US Government bonds for an update on the status of the American exceptionalism dogma.

The other issue we are concerned with is that there is always a lag between policy announcement and its implementation. Since backlogs and errors are a normal feature of any government administration during normal circumstances, isn’t it likely that backlogs lengthen, that the frequency of errors increase and that citizens find it difficult to navigate through the innumerable programs being temporarily made available to find which one may apply to them?

Dividend and Interest Scarcity

Notwithstanding the various relief measures discussed above, as was the case following the Great Financial Crisis (GFC) we expect that many companies will be forced to cut dividends and that the percentage of companies that will default on their corporate bond payments will be greater than in recent years as Covid-19 hits free cash flow generation capacity. While those cuts might be temporary, this is important for investors who are dependent on dividends and coupons as sources of income supplement. This is a situation we will be monitoring closely over the next couple of weeks because with short-term rates back to virtually 0%, it leaves few options to investors.

Further down the road, if the large-scale bail-out of national champions becomes the norm, as an example Boeing, we expect governments will want to have their say over corporate dividend payouts and share buyback practices. To this point, Germany already announced that companies requiring assistance will have to pause dividend payments. We believe other governments will be inspired by Germany.

In Canada, while the rise in unemployment numbers is more significant than during the GFC, that western Canada’s economic activity is curtailed more dramatically due to record low crude oil price and that consumer debt is even more elevated than it was 12 years ago, we are not overly concerned about the risk of seeing Canadian banks cutting their dividend. However, given the various measures they have voluntarily put forward themselves (suspension of mortgage payments, lower interest charges on credit cards, etc.) we think they are more likely to issue more shares than resorting to dividend cuts. That being said, the prospect of dilutive equity offering is already, at least partially reflected in the bank’s share prices.

Ultimately, we are not in the business of making stock specific or sector calls. We empower active managers whose investment process we trust. That said, we are wary of the risk of falling into the recency bias trap and looking to acquire stocks that benefit from Covid-19 or that are seen as less vulnerable as this will come to pass.

Are all Bad News in Yet?

At the time of writing this (April 7, 2020), risky assets have staged an impressive recovery from the March 23rd intraday lows. The recovery seems driven by positive developments on the spread of Covid-19 with daily new cases having seemingly peaked in the worst-hit countries in Europe (Italy and Spain) and showing signs of peaking in the state of New York, the epicenter of the US outbreak. This is welcome news as it means that even though California, Michigan and Florida appear a couple of weeks away from peaking, temporary relief for the health care system and a slow return to normal life may be in sight.

The peaking of daily new cases is one of a series of indicators that we track but we do not feel it is sufficient to green-light risk taking yet. After all, we remain unsure of the consequences if the virus returns in the fall and whether large parts of the economy will have to endure rolling lockdowns until a cure is found. As such, we do not know if the consensus third quarter recovery will indeed take place, if such recovery will be delayed or if the various backstop programs will be sufficient.

Additionally, we find that a number of predictable secondary effects do not get a lot of media attention. First, the havoc that low oil prices is wreaking on oil exporters who need prices to be in excess of US$50/barrel for them to balance their budget. Second, there are dire consequences that countries such as Mexico and Brazil potentially face with their quasi-business as usual approach when it comes to dealing with the pandemic. Third, we are concerned with the situation in India, a country where basic sanitary needs are not available to everyone and where “social-distancing” is simply not applicable. Fourth, there is also the impact that the bear market has on the numerous municipal and public pensions plan funded status whose portfolios are declining in value at the same time as their tax receipts are either reduced or postponed.

Early Thoughts on Post Covid-19 Capitalism

Crises like the ones we are going through have the tendency to trigger profound changes in the behavior of various economic agents. For instance, as mentioned above, we already know that governments globally are taking a closer look at corporate dividend payouts and share buyback policies for companies seeking relief. We would not be surprised to see governments forcing enhanced corporate responsibility and come after companies that are using independent contractors disguised as employees. These independent contractors are facing a revenue collapse but it is unclear if their status allows them to apply for one of the many programs recently announced. Lastly, given the unprecedented pace at which fiscal deficits are set to increase, we cannot think of a scenario under which corporate income taxes do not increase and exemptions are not eliminated, which would represent a reversal of the liberalist doctrine championed by the likes of Ronald Reagan in the United States and Margaret Thatcher in the United Kingdom.

In the corporate world, we expect to see broad attempts to improve working capital positions, the establishment of to establish higher treasury reserves, to build-up supply chain redundancies and, last but not least, to embrace broader and more permanent work from home policies as a way to reduce costs associated with excess office space. With respect to the last point, we would not be surprised that once seen prime office space in certain areas might become stranded assets.

Our view is that all else equals, these reactions, which we view as sound risk management response, are nonetheless likely to impact negatively corporate profitability. We do not think that this view is currently mainstream.

Back to Hemingway

One of the central themes in The Sun Also Rises is the apology of the lost generation, the generation that came of age during World War I. In contrast to the broad perception that members of this generation were generally decadent, disoriented and profligate, Hemingway depicts them as strong and determined. Judging by how people over the world have come to accept major restrictions to their civil liberties as necessary countermeasures to the most significant public health crisis it witnessed in the past century, Hemingway would probably come to the same conclusions today as there are indeed more discipline and resilience than consternation and discouragement. As such, the sun will rise again.

Dimitri Douaire, M. Sc., CFA
Co-Chief Investment Officer


[1] Returns refer to the index total return in local currency terms, unless stated otherwise.

[2] In the US, the Federal Reserve’s charter only allows it to purchase or lend against securities that have government guarantee. As such, for many of the new programs that it is instigating, The Federal Reserve will instead finance special purpose vehicles (SPVs) and it is the US Treasury, using the Exchange Stabilization Fund, that will make an equity investment in each SPV and be in a “first loss” position. The US Treasury is the buyer with the Federal Reserve acting as lender. Separately, BlackRock Inc. has been hired to purchase these securities and handle the administration of the SPVs on behalf of the owner, the US Treasury.

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