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 19th to its low point on March 23rd. 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.
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 1st and 2nd 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.
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.