Category: The Legacy Group Quarterly

After a tumultuous first quarter in the markets, government and monetary intervention along with the hope of a V-shaped recovery have fueled a market rebound that is nothing short of remarkable.  The S&P 500 lost 34% from its peak on February 19^th to its low point on March 23^rd.  As of this writing at the end of June, the market price is right around where it was on January 1st. That seems almost unbelievable given that we sit at double-digit unemployment and are staring down the largest calendar year economic contraction since the budget cuts following WWII.

Despite the exuberance, the market optimism still sits on fragile ground. In mid-June the Federal Reserve remarked that they did not expect a full economic recovery till the end of 2021. That news, along with renewed fears of a second wave of the virus, sent the market down by 5% in a day. The market immediately rebounded over the next few days as the Federal Reserve announced the initiation of their corporate bond buying program. We expect that this kind of news/response will continue as the markets balance the realized and persistent economic damage the virus is causing against the highly accommodating policies from the Federal Government and Federal Reserve Bank. 

In our last commentary, we outlined several unknown questions related to the virus and the economic damage it has caused. Most of those questions continue to be unanswered. The public commentary surrounding the economic recovery has pretty much abandoned the concept of a V-shaped recovery but appears to be optimistically looking ahead to a steady uninterrupted economic recovery. A lot must go right for that to happen. For instance, there cannot be a second wave of COVID-19 that causes the economy to shut down. We are going to “stay in our lane” as the saying goes by not venturing an opinion here, but if history is any indication, the probability of a second wave is high. There were three influenza pandemics in the 20th Century: the 1918 Spanish Flu, the 1957 Asian Flu, and the 1968 Hong Kong Flu. Each of them had a second wave. There are already resurgent pockets of cases in certain areas of the globe. Beijing has re-instated lock-down procedures due to a new outbreak in cases and here in the US several states that re-opened early have seen upticks in the number of reported cases. Second wave or not, COVID is likely to be with us for some time, and will continue to negatively impact the economy.  

In addition, we still do not know how damaging it was to close the economy for two months. Across the economy, short-term concessions are being made: landlords are deferring rents; corporate lenders are relaxing covenants so corporations don’t enter into technical default; PPP loans to small and mid-size businesses kept employees on payroll; and increased unemployment benefits supported people who were “temporarily” laid-off. Those are all temporary measures. Eventually, landlords and lenders will expect payment to be made, companies will begin to assess how many employees they really need to retain, and the government will not likely continue to pay people more to stay at home than they were earning in their jobs. As these short-term concessions end, the ripple effects may threaten a steady economic recovery.

Corporate Debt

What is becoming apparent is the impact all of this is having on Corporate America’s balance sheet. While corporate cash flow is more complex than our personal finances, they are the same at the most basic level. Like you, companies have bills to pay…rent, loans, interest, etc. In order to pay those bills, they need access to cash. That cash can come from one of three places: income, savings, or borrowings. The economic shutdown reduced income substantially for many – probably most – companies. For those companies who no longer had the income and did not have enough savings to pay their bills, their only remaining option was to borrow funds. That’s exactly what corporations did in historic amounts in the 1^st and 2^nd quarter. At one point, corporate debt, as a percentage of US Gross Domestic Product, jumped 10% in a week.

A lot of this money is being borrowed by companies who were not in good shape going into the crisis. The loss of income and increase in debt are threatening technical default for many borrowers. Lenders are currently sympathetic. Many have allowed corporations to report last year’s earnings in order to delay or avoid default. Some companies have even adopted a new earnings acronym. Many of you might be familiar with the term EBITDA. It stands for “earnings before interest, taxes, depreciation, and amortization.” It’s supposed to provide investors/debt-holders with a realistic view of how much money a business is making. It’s not a concept we particularly care for, but I digress. Now, some companies have adopted a new metric, EBITDAC…earnings before interest, taxes, depreciation, amortization and – wait for it – coronavirus. Yes, they’re providing a number of what they would maybe-might-have-earned had COVID-19 never happened. If only we could all live in such a fictional world.[i] 

All this is occurring with the Federal Reserve providing a significant backstop for corporations. When corporate debt markets buckled in March, the Federal Reserve promised the purchase of investment grade and “recently investment grade” corporate debt. This had the immediate effect of attracting money back to corporate debt markets. This lowered interest rates and gave corporations access to money. These corporations would have otherwise been left out in the cold. While those measures provide companies with the ability to pay their current bills, the additional debt will make it more difficult to pay their future bills or invest in the growth of their business. There were already a large number of what has affectionately been termed “Zombie Corporations,” companies who have more debt service costs than profits. With the amount of debt being taken on by corporations, this number will only increase.

Financial Engineering

It doesn’t seem possible for corporations that can’t pay their bills to continue borrowing money forever. It flies in the face of good, common sense in fact. Actions taken by the Federal Reserve, however, have served to distort free capital markets.

Their intentions seem to be good. If corporations go bankrupt, people lose jobs. When people lose jobs, they stop spending money. When people stop spending, corporations make less, and then have to lay off more people. The cycle continues, and in healthy and mature economies, it finds equilibrium. Eventually hiring will resume, people will have more money to spend, corporations earn more and hire more people. The Federal Reserve partially fills the role of smoothing those cycles but in the last two crises (Financial Crisis of 2008 and COVID-19), the Federal Reserve has stepped in with ever greater measures of support for financial markets than it had before. Actions thought unimaginable before 2008 are now commonplace. We may look back in another 5 years saying the same thing about 2020.  The result, though, is a system increasingly reliant on outside support.

Federal Reserve actions not only does create a reliant system, but also distorts what should be the natural capital flow in free markets. In a free capital market, well run and profitable – or potentially profitable – companies will attract investments, while poorly run, unprofitable companies will lose the capital support of investors. This motivates corporate operators to run their companies prudently without taking undue risk. It also ensures that companies that should not remain in business due to mismanagement or changing market forces don’t survive. With the support of the Federal Reserve, it appears corporations who shouldn’t continue to attract capital are not having a problem finding capital.

One particular example we saw in the first quarter was Cinemark. As a movie theater operator, the last several months have been particularly hard. Most, if not all, of their revenue was gone due to shutdowns. They needed cash, and when the corporate bond market buckled in March, it didn’t look like they were going to be able to borrow it. Then the Federal Reserve announced its intention to buy corporate bonds. Immediately, capital flowed back into markets, interest rates came down and the liquidity was available for Cinemark to issue a new round of bonds. That’s a win, right? Maybe, but will the current movie theater model survive in a post-COVID world? I hope so. I love going to the theaters, but I wouldn’t want to bet on it right now. Until the Federal Reserve stepped in, it didn’t look like there we many people who were willing take that bet either. That’s happening over and over again in the markets: companies are getting capital that maybe shouldn’t be.

Even with the Federal Reserve’s efforts to keep capital flowing in corporate debt markets, we have still found some good yield within the public and private debt markets. This is a sector we have avoided the last couple of years in anticipation of a turn of the credit cycle. Interest rates had been too low to justify the risk. That changed in the first quarter. With an asset manager who has particular talent in managing credit risk, an attractive yield can now be obtained at an acceptable level of risk. We have taken this opportunity to increase our exposure to debt markets. If equity markets become volatile again, these assets should continue to pay good yield. Plus, the capital is protected so long as the manager has been adequately selective about their lending or purchases. We believe the managers we have chosen have and will continue to exercise the proper prudence. As always, even in this environment, we will continue to look for opportunities to investment capital at acceptable levels of risk.  

Blake

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[i] https://www.ft.com/content/85d6f19c-0eea-4f70-a906-40b03d862f03).

The third quarter brought a lot of movement in the domestic stock market but by September 30^th the S&P 500 had not gone far from where it started the quarter. Geopolitical concerns continue to create a lot of uncertainty.  In the Q2 commentary, we mentioned the smoothing of trade negotiations between the US and China.  About 27 seconds after we hit “print,” President Trump announced the whole thing was falling apart.  This, along with Brexit drama, recession expectations and slowing corporate earnings growth, appear to have the market’s mood moving from cautious optimism to slight pessimism. 

Economically, the US and global economies continue to show signs of slowing.  Many countries across the globe are teetering on the edge of recession, defined as two consecutive quarters of GDP contraction.  Germany and the UK experienced economic contraction in the 2nd quarter.  Italy is also hanging on by a thread.  On the other side of the Atlantic, Mexico and Brazil both contracted in the first quarter and narrowly grew in the second quarter.  Checking in with the other hemisphere, Singapore and South Korea each had a quarter in the first half of the year where their respective economies contracted.   The slowdown in Chinese economic growth is also evident.  

Back at home, economic data is rosier but still pointing to a slowdown.  The US consumer is pulling their economic weight (almost 70% of US GDP) with continued strong spending.  In contrast, production and manufacturing activity both fell in the first and second quarter and the trend is expected to continue when Q3 numbers are reported.  With portions of the economy in a recession, it is reasonable to expect the rest to eventually follow.  That said, the strength of the US consumer – whose spending makes up 67% of GDP – will likely keep us out of recession territory for at least the next couple of quarters.   

Where’s the Value and Why it Matters

As we approach the turn of the economic cycle, we are continually reviewing portfolios to assess risk while we scour the financial markets for value.  Domestically, depending on what valuation metric is used, the US market is anywhere from slightly overvalued to highly overvalued.  If corporate earnings continue to fall, market valuations will become richer until the stock market reacts to the downside.  Looking internationally, European markets are also highly valued but not as much as the US.  That does not necessarily make them a better buy…they have a lot more fundamental issues than US markets. When we survey the entire world, though, the best value continues to be in emerging markets.  Admittedly, we have argued this position for some time (and we will argue a little more later in the commentary). We have also allocated our portfolios, in part, based on this position. 

Why pay so much attention to valuations?  Current valuation tends to be one of the largest determinates of market performance.  Increases in the price of a stock (and cumulatively, the stock market) happen for several reasons.  One is the performance of the company.  In the most basic terms, if a company manages to increase their revenue and their profits, the value of the company increases.  The other big factor is an increase in the price investors are willing to pay for those profits.  This measurement is called the Price to Earnings ratio (PE).  We have referenced this ratio many times over the years…let’s take a deeper dive into what it is and why it so important to consider.

Imagine you are a kid looking to get into the lemonade stand business.  You don’t want to start this lemonade stand from scratch (but of course the lemonade will be made from scratch…you can’t run a proper lemonade stand with Country Time) so you start looking at lemonade stands to buy.  After days of beating the streets on your bicycle performing due diligence on the local stands you narrow it down to two.  They are both perfect…on busy streets with lots of foot traffic, nice table set-up, a great chair to sit in and located under a shade tree.  There is only one difference.  The first makes $50 per day; the second makes $30 per day. 

You approach the owner of the $50/day stand and the young lady there says she’ll sell it to you for $1,000.  Next, you go the $30/day stand to talk to that kid.  He says he’ll sell it you for $270.  How do you determine which one is the better buy?  The most basic way is to look at the price of the stand relative to what it earns (Price-to-Earnings).   The owner of the first stand is asking 20x daily earnings for the stand: $50 x 20 = $1,000. The other owner is asking 9x daily earnings: $30 x 9 = $270.  Which is the better deal?  The second stand because at 9x vs 20x you can buy the second at a lower multiple of earnings.  Another way to think about this: it will take you 9 days to earn your $270 back on the second stand and 20 days to earn your $1,000 back on the first (lemonade stand season is short…that 11 days makes a big difference).  So you shell out your $270 and you’re in business.  

Our lemonade stand transaction is a simplified example of what happens in the stock market.  Just as the two lemonade stands were selling at different price to earnings (PE) multiples, individual securities sell at varying PE multiples and, cumulatively, varying stock markets (Dow vs S&P vs Emerging Markets vs Europe, etc) trade at different PE multiples.  Recognizing this is important because if an investor buys an investment at a lower PE their likelihood of making money through a phenomenon called Multiple Expansion increases. Multiples expansion occurs when the PE investors are willing to pay for a stock increases. Below is a basic example from John Neff’s book, On Investing.  Mr. Neff was the manager of the Vanguard Windsor Fund for over 30 years.  He had incredible success through his career, out-performing the S&P 500 by over 3% per year.   

In his example, he shows, with very basic math, why the price paid for an investment is critical.  His example has two identical scenarios

	Static P/E	Expanding P/E
Current Earnings Per Share	$2.00	$2.00
Current Market Price	$26.00	$16.00
Current Price/Earnings	13:1	8:1
Expected Earnings	$2.22	$2.22
New P/E	13:1	11:11
New Market Price	$28.86	$24.42
Appreciation	11%	53%

– same current earnings and same expected earnings – except for the price you pay for the stock.  His example demonstrates what happens to investment returns when you buy a stock at a lower PE and then the stock later trades at a higher PE.  The performance of the company is the same but when you purchase it at a lower PE it has more room for price appreciation.  In this example, a lot more room. 

So, that’s a nice example but how much does this come into play in actual market returns?  A lot.  In every bull market since 1900, multiple expansion has contributed over 50% of the total price growth of the stock market.  For example, from 1982 to 1999 the PE investors were paying for the market went from 9x earnings to 30x earnings.  This multiple expansion accounted for 52% of the price growth of the market during that time.[i]  But multiple expansion is a finite source of return. In each historical case, the market hit a point when it recognized that price increases based on further multiple expansion no longer made sense.  Think back to lemonade stand…you paid 9x earnings, $270, for the stand.  Would you have paid 20x at $500?  What if it was 30x at $900?  There will come a point, if you are not already there, where you will say, nope…that’s too much.  Investors essentially do the same thing with the market.

That is why there has been a strong correlation between the current market PE and future returns.  Historically, when the aggregate PE of the stock market is high, relative to its historical average, future returns for the following several years are lower relative than when current PE is low (yes, I have data to support this but I’m trying not to turn this into a journal article[ii]).  The reason? PE’s tend to be mean reverting. When there’s a triggering event that draws investors’ attention to high PE’s they start selling, they sell past the average PE to a low PE where the market eventually bottoms. 

GMO, a large institutional investor, maintains a 7-year Asset Class Real Return Forecast based, in part, on this concept of mean reverting PE’s. They look at current market values, make some estimations regarding future growth rates of earnings and profit margins and then come up with an expected return for each market.  Below is their most recent forecast.

The chart has a large spread between their expected performance of US Large Cap stocks and Emerging/Emerging Market Value stocks.  Most of this spread is due to the difference in current day valuations.  Over the last couple of years (2018 and 2019 year-to-date), Emerging Markets have continued to under-perform relative to domestic equities.  Earnings growth has been good but they have not had the returns from multiple expansion that domestic equities have received.  This has resulted in a large value discrepancy between Emerging Markets and Developed Markets.  Emerging Markets growth stocks have not been this cheap relative to US Growth stocks since 2002 (see chart below). 

In the 5 years following 2002, Emerging Markets out-performed domestic markets by a wide margin.  Will history repeat itself?  It’s impossible to say.  Remember the old Danish proverb: Making predictions is hard, especially about the future.  But there are a couple take-aways from the facts: First, domestic equities are facing heavy headwinds.  If return from multiple expansion is tapped out, or nearly so, the market will need to rely on revenue earnings growth and profit margin increases for return inspiring performance.  Not a very promising prospect when the economy is staring down a recession and profit margins (also mean-reverting) are close to an all-time high.  Second, it means domestic equities have a lot more room for multiple contraction.  In other words, in a bear market, they arguably have farther to fall.  Even though Emerging Markets are viewed as the riskier investment, right now, they may not be.    

In the late stages of bull market cycle, which is where we believe we are, is a time when few investors are looking at fundamentals for investment decisions.  The places where assets are over-priced are often the ones that get the most attention (becoming more over-priced) and the ones that are priced remain unfavored until some event – usually not a good one -makes people look around. When that happens, an old investing adage becomes topical again: Valuations don’t matter until they do and when they do, they are the only thing that matters.  We will continue to look for opportunities to invest capital at an acceptable level of risk.

Blake

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[i] Active Value Investing: Making Money in Range-Bound Markets by Vitaliy N. Katsenelson, page 55 for data through 2005.

[ii] Ibid, page 53 for data through 2005.

If you were looking for a little encouragement after a volatile December, the 1^st quarter did not disappoint.  Global markets strongly bounced back, clocking in gains that would be considered good for an entire year.  Chinese Equity Markets and the Emerging Markets Index posted double digit gains. Likewise, the S&P 500 Index had its best quarter since 1998.  While recoveries like this are encouraging, it’s best to temper our excitement.  With the economy still humming along and corporations still making money, a quick bounce in the market is not surprising.  That said, the real test for the global markets may be lurking somewhere around the corner.  Global economic growth is beginning to look tenuous and US corporate profit increases are expected to decline over the next year.  If the signals are accurate, we should expect more market volatility as the mood swings from worry over economic and corporate data to jubilation from an accommodating Federal Reserve.   

The Fed vs. Corporate Earnings

We witnessed this mood swing during the first quarter.  For the last few years, the Fed has steadily increased interest rates and planned to do so at least 3 more times in 2019.  Over the same period, they reduced the size of their balance sheet.  Both policies are intended to remove money from the financial system, so the economy does not overheat (think housing in 2006 and internet stocks in 1999).  However, the Fed risks dampening natural economic growth if they remove too much money too quickly.  In our 2018 Q4 letter, we speculated that economic data would suggest the economy was weakening and, consequently, the Fed would pause the rate increases earlier than planned to not dampen natural economic growth.  In March, citing weakening economic data, that’s what they did…no more rate increases or balance sheet reductions in the foreseeable future.  The market was in a glass-half-full kind of mood and rejoiced about the accommodative Fed in the face of a weakening economy.  

As the year progresses, corporate earnings may sober the markets mood.  Each quarter, during earnings season, corporations report their financial results.  These reports include public conference calls featuring C-suite executives who explain the results and answer analyst’s questions.  Slide decks are produced to provide colorful visuals on how the company performed (or perhaps distract from how the company performed).  The results often have huge impacts on a company’s stock price.  If a company blows past their “expected earnings,” the stock may jump in price.  If they don’t hit their target, the price can tank. The entire process is a bit nonsensical.  It encourages executives and investors alike to think on a short-term basis (bad idea for both) and sets up a strange expectation setting game as companies “adjust” their estimates so actual earnings will surprise to the upside.  

In any case, the game is on and corporations have started to set investor expectations for lower earnings.  One of the most telling warnings came from Federal Express.  Given their global reach and the nature of their business (they ship stuff, but I’m guessing you knew that), FedEx’s revenues tend to be a leading indicator on the direction of the global economy.  In their most recent earnings call, the CEO and CFO both expressed concerns over the global economy and reduced their earnings guidance for the remainder of 2019.  FedEx is not alone in projecting lower earnings.  S&P 500 companies are expecting an aggregate drop of 4% in earnings from 2018 Q1. 

It would not be a surprise if reported results end up beating expectations…that is part of the game. But even if companies do beat expectations, their profit growth will likely be slowing.  If that trend does play out and earnings continue to slow, one of two things will happen: either the markets will cool or valuations will become stretched as profits decrease and stock prices increase.    

Now…where’s that recession everyone is talking about?

In our 2017 Q4 commentary, we considered where the US economy was in the economic cycle.  We speculated that we were near the end of the expansionary period of the cycle and that signs of an economic slowdown would emerge in the first half of this year.  We didn’t make a call for a recession to begin in 2020.  That is beyond our predictive abilities, and everyone else’s despite their best efforts.  We still believe the economy is heading that direction but there is one factor that does give us pause…. everyone sees a recession coming.  It is constantly talked about in the news.   Over the last few months, people who I would never expect to talk economics have brought up the upcoming recession.  It is widely reported and almost universally expected.  Whenever there is consensus in finance, you should always pause to consider the other side.  

If there is one thing this economic and market cycle has reminded us, it is that things can continue for longer than we expect.  Ten years ago, I was reading about how the Japanese economy is a bug in search of a windshield because of its massive governmental debt (210% of GDP).  Since then, the Japanese have increased government debt substantially to over 250% of GDP (in comparison, the US is at 105%) and the bug is still freely flying in the breeze.  Similarly, there have been countless warnings and many books written (I’ve read a few of them) about the collapse of the Chinese economy over the last 10 years. And yet it is still growing at a 6% clip per year.  Everyone thought the European Union was toast in 2011 with the financial ruin of Greece; it wasn’t. Then the same was feared for the other members of the PIIGS acronym (Portugal, Ireland, Italy, Greece, Spain). Then Greece again. Then Brexit. And then Greece again. And now it’s Italy. Again. Through it all the EU continues.  

With these examples in mind, a year and a half from now we might still be talking about the coming recession. We have never had an economy grow so slow for so long.  This economic expansion is now the second longest in US history and, unless things deteriorate very fast, it will become the longest in just a few months.  The other two economic expansions that lasted nearly this long had much higher GDP growth rates.  The 120-month economic expansion in the 1990’s had GDP growth of 3.6%/year.  In the next longest expansion, during the 1960’s, GDP grew at 4.9%/year.  This economic expansion has seen GDP growth of just 2.3%/year.  Economic busts are typically preceded by economic booms but there has been no boom.  It has been a slow, mediocre rise.  With such mediocrity, this economy could grind along at a slow pace for a long time.  

Whether the recession is just around the corner or two years away, we expect the trend in the market to continue to be volatile.  While we could return to the calm experienced in 2017, especially during the summer months, there seem to be too many conflicting themes in the markets for a lasting calm environment.  There are also still unresolved major geopolitical issues – Brexit and the trade war with China, to name two – that continue to contribute to market uncertainty.  Our portfolio is positioned for the peak of the economic and business cycle: a focus on strong balance sheets; avoiding low quality credit; growth positions in transformative technology or rapidly growing industries and economies that should play out in the long term, recession or not.  We will continue to look for opportunities to invest capital at an acceptable level of risk.

Blake

Happy New Year.    Last year while writing the year-end commentary, we were contemplating the Zen-like calm that had taken over the markets.  Nothing could scare investors: rising interest rates…no biggie; potential trade wars…nothing to see here; geo-political conflict with North Korea…why worry?   But we all knew the calm would not last.  In that commentary we wrote: 

We don’t know what the year (2018) will bring.  Our guess is that there will be more volatility in the markets this year.  It is hard to imagine such a calm, steady year being followed up by yet another calm, steady year.  However, just because it is more volatile does not mean it will be worse or better.  But, predictions aside, the most important thing to take from all of this is not to buy into the calm.  It will not last. 

The calm didn’t last.  2018 ended up being a volatile year with almost every major asset class ending the year at losses.  That quote is not meant as a victory lap.  There was nothing prophetical about our prediction.  It was just a recognition of investor behavior.  When markets are serenely calm, we can be certain that things will eventually turn volatile.  People will ignore bad news until suddenly they don’t.  We saw that transition in 2018.  What didn’t scare investors before became unsettling:  rising interest rates, trade wars, slowdown in corporate profit increases, and a potential recession on the horizon.  

What will markets do in 2019?  Every year we ask this question, and every year we give the same answer: we don’t know.  If you’ve been reading this commentary for a while, you know we are not big on market predictions.  “Expert forecasting” is rarely accurate (need I make the accuracy comparison to that of dart-throwing chimpanzees again?).  Last year, 85% of Wall Street banks surveyed by Fortune predicted the S&P 500 would post positive returns in 2018.   Well, that didn’t work out.  Even the banks surveyed who did predict negative returns were still over 200 points off with their projected ending points.  We don’t know why people think they can accurately predict where the markets are going to be at year end.  They crunch the numbers and somehow come up with a target, but they’re almost always wrong.  They ignore the reality that market movements from year to year have very little to do with numbers and almost all to do with investor sentiment. 

While we think predicting asset class returns for a given year is often a fruitless activity, we are confident that one thing will likely happen in 2019: the  economy will continue to slow.  Financial conditions are weakening.  Liquidity has been tight at times during the last few months.  The possibility of a recession is increasing, and indicators point to it starting sometime in 2020.  In the face of the changing conditions, the Federal Reserve is likely to slow their interest rate increases.  If history is any indicator, the markets will cheer the slowing of rate increases, but the applause won’t last long as economic activity continues to slow.  Financial markets will likely continue to exhibit volatility, but this will hopefully produce some opportunities to buy assets at cheaper prices.  Our conclusion is to remain wary of overly rosy predictions and to remain vigilant in allocating capital.  

Good Ol’ Fashioned Debt Binge

As we near the turn of the economic and credit cycles one area we are closely watching – and have been for some time – is corporate debt.  Corporations have two different methods to access financing: sell equity in the business or borrow money.  There is a cost to each method, and any time a corporation goes to financial markets for money, it assesses which market is the better option.  Over the last decade, tax law, the regulatory environment and extremely low interest rates made it very attractive for companies to finance activity through debt.  Corporations responded by going on a debt binge: total corporate debt in the US has gone from about $4.9 trillion in 2007 to over $9 trillion today.  That’s almost a doubling of corporate debt in the last decade. 

Investment Grade:

AAA

AA

A

*BBB*

Speculative Grade (Junk):

BB

B

CCC

CC

C

D

As more debt has been taken on, the overall financial condition of US corporations appears to have deteriorated. To the right is Standard & Poor’s credit rating system.  In their infinite wisdom, Standard & Poor’s and their contemporaries—Moody’s and Fitch—grant long term debt (bonds) issued by companies a rating.  This rating is meant to provide an indication of how likely it is for a company to make the scheduled interest payments and eventually re-pay its debt.  The better the rating, the more likely the lender is to get their interest and their money back. Think of the rating scale as an expanded school grading system: AAA is the best, awarded to bonds believed to be the most financially secure; head of the class.  As the chart descends, the quality of the debt decreases; i.e., the likelihood of the interest being paid and the lender getting their money returned goes down; the school drop-out, so to speak. I want to draw your attention to the BBB category.  BBB is the lowest “investment grade” category, just a step above what is “speculative grade,” which is also more affectionately referred to as “junk debt.”  Standard & Poor’s defines BBB as follows: An obligation rated ‘BBB’ exhibits adequate protection parameters.  However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitment on the obligation.  

Why go to lengths to point this out?  Well, because there are a few of these BBB bonds floating around in the financial system.  And by a few, I mean a lot.  And by a lot I mean 50% of all outstanding investment grade bonds…somewhere around $3 trillion.  This is very different than it has been the past.  In 1990, BBB only made up about 25% of the market of investment grade bonds.  Going back to 1980, the median bond rating was A (that’s great!), and now the median is BBB- (not so great).  On average, corporate debt is as poorly rated as it has ever been, but that’s not where the problems end.  When you dig a little deeper, things deteriorate even further: companies rated BBB have almost twice the leverage (what they owe versus what they own) than they did in 2000 (1.7x vs. 2.9x). 

Based on these ratings, overall indebtedness, and leverage multiples it is clear there has been deterioration in the financial condition of the debt market to where almost half of all investment grade corporate debt is with companies who under adverse economic conditions or changing circumstances are more likely to have a weakened capacity to pay their debt.  The terms “adverse economic conditions” and ” changing circumstances” are vague and open to various interpretations. Here are a couple scenarios that may fit those terms: recession and rising interest rates. That interpretation yields the following reality: half of all investment grade corporate debt in the U.S. is likely to have a weakened ability to pay their creditors during a Recession or while Interest Rates are Rising.

Look lower down in credit quality, down in the junk bond portion of the markets, conditions have also grown riskier.   With low interest rates the past ten years, investors sought higher yields.  On Wall Street, there is no such thing as unmet demand.  Collateralized Loan Obligations (CLOs), Speculative Grade loans that are broken apart and then re-bundled with other loans, were sold at a record pace.  These types of loans were typically financed by banks, and the terms of the loan contained covenants – legal parameters that are meant to protect the lender.  Over the last few years, they are increasingly being issued “covenant-lite,” meaning without many of the normal lender protections.  To make the situation more precarious, more of these loans are being financed by non-bank entities who are not as closely regulated as banks.  When lending occurs outside of the banking industry, underwriting standards tend to suffer.  Simply put, junk debt is becoming junkier.  

Given these circumstances, we can see a scenario playing out where a lot of companies struggle under their debt load during a recession.  The cost to finance with debt has been rising over the last couple of years, but it has been outpaced by the high tide of earnings growth in a positive economic environment.  When earnings turn negative during a recession, the tide will wash out, and we will see who is swimming without a bathing suit.  Default ratios will increase among Speculative Grade bonds (they always do during recessions, but we wouldn’t be surprised if defaults rise more than normal), and a lot of these BBB bonds may drop from Investment Grade to Speculative Grade.  If those things happen, there will be a lot volatility and repricing in the debt markets.

As we look ahead to these risks, we will work to structure the debt portion of our portfolio to withstand these shocks and be ready to take advantage of any repricing opportunities.  We will continue to look for opportunities to invest capital at an acceptable level of risk.

Blake

Past performance is not a guarantee of future earnings.  Asset allocation does not assure a profit or protect against loss in a declining market.  Blake A. Stanley, CFP® is an Investment Advisor Representative of Legacy Advisory Group, LLC a Registered Investment Advisory Firm.

Global Trade – Keeping It Brief

The last two commentaries were largely focused on the developing global trade war…which country has said what, who’s threatened who with which tariffs, etc. Trade continues to be the dominating geo-political event moving financial markets, but quite frankly, writing about it is starting to feel like writing the gossip column for a junior high school newspaper (do those even exist anymore?).  If we are tired of writing about it, you are probably tired  of reading about it. So, a quick update, and then we’ll look elsewhere for this commentary: some things have been resolved (Europe and, most recently, Mexico and Canada); others have digressed (China) and will likely deteriorate further. There is your official trade war update from we at Legacy  Advisory Group. And now for something completely different….

Emerging Markets

After two years of strong returns, emerging markets have been on a steady decline since January 26th of this year. Like domestic markets, emerging markets started the year with very strong gains, but then experienced volatility towards the end of January. Emerging markets have continued to be pressured throughout the year by global trade fears (we just can’t get away from it, can we?), a strengthening dollar and rising US interest rates.

While these factors do weigh on emerging markets, we believe their ultimate impact will be small.  For one, US trade pressure has been focused on  China. This is not necessarily bad for other countries’ economies,  especially in  Asia.  As the world’s largest exporter,  China is as much of a competitor to those countries as they are to us, if not more so. The world’s largest consumer placing tariffs specifically on imports from the world’s largest exporter may open opportunities to other countries.

As to the other concerns, a strengthening dollar and rising interest rates (which are highly correlated) have been the cause of volatility in emerging
markets for 20 years now. Emerging markets are one of the few asset classes where investors have a long memory. Whenever interest rates start rising and the dollar begins strengthening, investors’ minds go back to the Asian Financial Crisis in 1997/98. Leading up to the crisis, Asian countries and corporations had acquired large amounts of debt denominated in US Dollars. In order to pay this debt, these countries would first need to convert their currency into dollars. This works out ok, so long as their currency doesn’t weaken relative to  the US dollar.  Towards  the beginning of 1997 that’s  exactly what started happening… their currency weakened relative to the dollar and it became more difficult to pay this debt. As  their  currency weakened, more investors sold the troubled currencies, which only accelerated and accentuated the problem. By the end of 1997 the International Monetary Fund had provided emergency loans to the Philippines, Thailand, Indonesia and South Korea  to  the tune of $1  billion, $17  billion,  $40 billion and $57 billion, respectively.

Not wanting a repeat of that disaster, those countries (and others) made significant adjustments that have made them far more resilient  to  currency market changes. They have since built up large financial reserves denominated mostly in US dollars. Of the four countries listed above, the Philippines has the smallest reserve account, at $77 billion. South Korea’s reserve account is north of $400 billion. These funds can be used  to support  their  currency and provide emergency financing to corporations, if needed. Another adjustment was that these countries now finance more of their debt domestically and denominate it in their currency. A much smaller percentage of their total debt is in US Dollars than it was in  the Asian  Financial  Crisis. Because of these changes, these countries are much better prepared to deal with currency fluctuations.

The health of many emerging market economies is often ignored by investors due to ontology. Ontology is the study of the nature of being, and more specifically, the development of categories within a subject area. Take food groups for example. Somebody somewhere at sometime considered all the properties of various foods, found commonalities among them, came up  with  the groupings  and  then  built  that  food  pyramid  we are all  familiar with. That is ontology, and it is very useful for analysis. The process of categorizing helps us better understand an object as we consider  the properties and characteristics of that object. Once categorized, we can deepen our understanding by looking at one category’s  relationship  to another.  However,  the categorization of an object can have shortfalls that can hurt analysis as well. Going back to our food example, some apparently would argue that by stuffing the breadbasket of the original food pyramid with all things grain, it failed to distinguish that whole grains are healthier than refined grains (I don’t like it either, but it’s true: https://www.hsph.harvard.edu/nutritionsource/mypyramid-problems/ ). Through an inappropriate broadening of application, the pyramid implied that all bread was created equal.

A similar broad application has arguably created the same result in emerging market economies. The “Emerging Markets” moniker was coined in the  early 1980’s by economist Antoine von Agtmael, who worked at the then  International  Finance  Corporation,  an arm of the World  Bank.  His  intent was to encourage investment in countries that were between  poor and  rich and that had  publicly listed securities.  Now there’s a broad  definition for you. And that broad definition continues today.  It is used  to describe  both Kenya, with an average GDP  of $350  per person, and China, with an  average GDP of $5,000 per person, and everything between. There are huge disparities across these countries, but this broad categorization causes investors to generally view all these markets the same. When something goes wrong in one or two emerging market economies, investors act like the canary in the coal mine just dropped dead, and they go rushing for the exits.

This year’s dead canary award goes to Turkey and Argentina (Venezuela gets honorable mention). Both countries  have serious  problems.  They each have inflation in the double digits. Argentina’s inflation  is over of 40%.  Unlike many of the Asian countries listed above, Argentina has continued  to take on large amounts of debt in US Dollars and does not have the reserve funds to combat a weakening currency. This has resulted a massive budget deficit. They recently secured an emergency loan of $57 billion from the IMF to help cover their shortfall. This will only calm fears some, as Argentina has a history of default and restructuring (5 times in the last 50 years). Turkey is only two years removed from a good ol’fashioned military coup d’etat attempt. President Erdogan responded by consolidating power and just recently passed a new constitution  that  basically makes  him king.  He  has bullied their central bank to take an unorthodox approach to monetary policy, which  is arguably causing damage  to the economy.  As these countries have suffered, they have stoked the fear of contagion across emerging market and have driven the whole sector lower.

These two countries are not representative of many of the emerging market economies; rather many of them are far more stable both politically and economically. Plus, the long-term fundamentals have not changed. Virtually every estimate of GDP  growth has emerging markets growing at a faster  rate than developed markets. Emerging markets generally have far less debt than developed markets. Furthermore, almost every developed country has an aging population, which creates a drag on economic growth. At its most basic calculation, GDP growth is workforce  growth  plus  productivity growth. In short, you need more people being more productive. With a shrinking working age population, developed countries will have to rely on productivity growth to grow their economies.

Emerging economies, for the most part, do not face the same headwinds. With growing populations (China being the major exception here… their one child policy was short-sited and will cause a huge demographic drag on the economy starting in the next 15-20 years) and ample opportunities  to  improve productivity, their long-term growth perspectives are better than their developed country counterparts. Lastly, on a more philosophical note, countries classified as emerging markets represent roughly 85% of the world’s population. Many of these people are looking for the exact same thing as the developed world … higher quality of life. I recently ran across a quote from Adam Butler of ReSolve Asset Management that rings accurate: An investment in emerging markets is a bet is on tbe expanding prosperity and innovation of our species.

These markets will continue to have their ups and downs. They will continue to face challenges. They are far from risk free  but  our long-term  conviction in emerging markets remains the same. We have carefully selected funds for our portfolio that will invest consistent with the thoughts above. We believe the long-term opportunity is worth living through the ups and downs. We will diligently continue to look for opportunities to invest capital with an acceptable level of risk.

Blake

Past performance is not a guarantee of future earnings. Asset a/location does not assure a profit or protect against loss in a declining market. Blake A. Stanley, CFP® is an Investment Advisor Representative of Legacy Advisory Group, LLC a Registered Investment Advisory Firm.