Authorities Reflate but Restructuring Next

Note Précis March 27, 2020 – Authorities Reflate but Restructuring Next: In the eye of crisis and dependent on the economic philosophy of the period, some cycles have emphasized restructuring and others focused on reflating. With global fiscal and monetary measures announced to late March 2020 nearing $10 trillion, it would appear that response in the midst of Covid-19 currently involves both. Now as compared to 2008/9 in G20 pronouncements, coordination seems loose.

Practically irrespective of cycle, market liquidity dries up in crisis and thus lays bare suppositions in the investment philosophy behind the black box of the day. One example from the mid-1960s was over econometric modelling based on rational behavior, another that on assumptions behind portfolio insurance into late 1987 and then again (especially in mortgages), on the slicing of credit risk into 2007.

Current capital markets are dealing with elements akin to portfolio insurance of 1987 via risk or volatility arbitrage and of elements akin to slicing of credit risk of 2007 via leveraged collateralized loan obligations. Amid over a decade of low administered rates in advanced countries, there has appeared stretching of portfolio structures to deliver yields. Into March 2020, businesses also seem to have made implicit assumptions of stable revenues via a pronounced debt tilt in capital budgeting structure even among major corporations. Common practice has been to in engage in record share buybacks and add corporate debt obligations. Both appear to have accentuated risk via illiquidity. Massive public funding has appeared for reflation but restructuring seems inevitable.

Hard data on economic impact of Covid-19 pandemic is scarce but anecdotal recent announcements underscore revenue stress. It appears for instance in small but open Singapore on GDP  or on industrial production in China or on jobless claims numbers in the United States. The pandemic has brought about a massive fiscal and monetary response. The underlying message accompanying trillions in government rescue is that balance sheet structure needs to change and become more conservative. It took place for the banks after 2007. However reliance on reflation seems to require ever larger sums as seen comparing that after 1987, that after 2007 and that now that proposed in early 2020. Businesses should not assume such ease to be recurring as panacea as it is likely draining reservoirs.

Compared to widespread prior assumptions, upcoming corporate releases are likely to focus on restructure for a different environment. The operational restructuring of businesses and their capital structure has further to go. Especially in quarterly results, even in diversified markets like the United States,  earnings declines from prior peak to trough of over 50% are not unusual and even appear as being greater in cyclical and resource areas like Canada. As experienced from 2009 in global banking, now and irrespective of sector or geography, those businesses restructuring earliest and most thoroughly are likely to pick up long run  competitive advantages.

Severe business cycle downswings usually culminate in spectacular failures in some of the last cycle’s marque organizations. Post 1999, it was in high flying Technology, Media and Telecom services. Post 2007, it was in Finance. In response, Basle III leverage and other constraints did result in a major bolstering of banks. Currently, the risks of excess in Finance likely lie within the non-bank financials wherein portfolios were structured internally or for clients on assumptions of leveraged returns perforce dependent on liquidity. Overall and even on smoothing, we still use 16x earnings and 7% long term earnings growth for the S&P 500 as useful fair value benchmarks. By contrast, the recent cycle has appeared to focus mainly on interest rates and beating consensus, however low. 

Pending misalignments coming to the fore, volatility in markets is likely to remain intense. In overarch across sectors and geographies, we favor strong balance sheets and demonstrable operational leadership over reliance on minuscule rates. Consumer discretionary fervor was especially so in aspirational spending built on leverage in the last cycle so . In cyclicals, we favor Industrials over Consumer Discretionary; and in Financials, we favor banks over non-bank financials where proportionately more excess may also reside from the last cycle. In growth, strong balance sheet Information Technology and Healthcare seem better positioned than Consumer Staples StrategeInvest’s independent consultancy operates as Subodh Kumar & Associates. The views represented are those of the analyst at the date noted. They do not represent investment advice for which the reader should consult their investment and/or tax advisers. Any hyperlinks are for information only and not represented as accurate. E.o.e.