10 Changes from Investors post-Virus

Thoughts on issues we may have to think about when investing post crisis.

INTRODUCTION

I always enjoy Byron Wien’s 10 surprises for the coming year. In a similar vein, here is my response to commentators calling for a 50% market drop or a V-shaped recovery – it’s not that simple. I can find plenty of good stocks at what I think are sensible, albeit not outrageously cheap, prices, and some bargains among the mid-caps. But they could certainly become cheaper.

I think there is some logic to being cautious, but I honestly have no idea what the stockmarket will do – we are in uncharted territory. Experience is of limited help, but I have found that the process of putting thoughts down on paper helps me think through a problem and hopefully these musings may help others formulate their own views.

I admit to a temptation to yield to the clickbait lure of a title which said 10 Reasons why we won’t make a new high until 2030, and you may conclude that would be sensible after reading my arguments below. But I think that it’s far too early to predict the consequences of today’s crisis. We can, however, prepare. Here then are 10 reasons why I believe that the investment landscape will be quite different.

1 Fortress balance sheets

2 Onshoring supply chains

3 Working capital unwind

4 Interest rates may stay low for some time

5 Pension deficits to increase significantly

6 Where now for income funds?

7 Financial repression and capital controls

8 Balance sheet restoration

9 Ripple effects and inflation

10 The “Bezzle” and the Great Reset

I am innately conservative and I should also highlight that one reason for caution is that this may not be a “one and done” period of isolation. The Andrew Marr show in BBC is not my only source of information but two of his recent interviews on the virus made this point:

The Foreign Minister in South Korea stated a couple of weeks ago that she expected future pandemics.
Sir Jeremy Farrar interviewed on 12th April said “second and third waves” are inevitable.

Given the uncertainties, a conservative approach to investment seems only sensible.

1 FORTRESS BALANCE SHEETS

Andrew Smith, former KPMG Chief Economist, told me that he is “quite shocked at how limited a financial cushion many businesses seem to have.” Perhaps not so surprising given that for the last 40-odd years, investors and speculators have enjoyed a tailwind from falling interest rates. So long as you had the stomach for debt, you basically made money. This culminated in a veritable orgy of buybacks in the last decade.

One legacy of the pandemic may be a culture of greater conservatism and risk aversion. Boards are likely to adopt a more conservative approach – the shock we have just experienced will make even the less risk-averse Director appreciate having more cash and more facilities, just in case. Boards will likely want some security against another pandemic. This has two important implications for equity investors:

a. Corporations have been the single largest buyer of equities in the 2010s – buybacks will be much less fashionable, even after balance sheets have been restored post the pandemic

b. Return on equity (RoE) will fall as a consequence – buybacks, even at high prices, usually boosted RoE, as money has been so cheap. It will remain cheap but more conservative balance sheets will be one factor in lowering returns on equity.

As Michael Pettis, notable China commentator put it in a recent series of tweets:

“When an economy goes through many years of rising real estate and asset prices, surging debt, and loose monetary conditions, business balance sheets tend to get structured in highly speculative ways that effectively “bet” on more of the same – ‘inverted balance sheets’.

Over time the whole economy ‘shifts’ towards riskier balance sheets. This is likely to be a problem nearly everywhere, and especially in China, where decades of artificially high growth, soaring real estate prices, excess liquidity and surging debt have transformed the balance sheet structures of nearly all businesses.

Inverted balance sheets are highly pro-cyclical. Economies and businesses with highly inverted balance sheets tend to surprise on the upside when conditions are good, often developing a reputation for smart management, and then destroy this reputation when conditions reverse”.

China may not have seen the last effects of the pandemic. And if investors in developed markets seek safer balance sheets, companies will be forced to respond. Some investor reaction was underway even before this crisis. Grant’s Interest Rate Observer of February 7, 2020, opened with “The lowest interest rates, the most accommodating Fed, the shortest junk-bond durations, the highest corporate leverage and the longest business expansion frame the value proposition for junk bonds and the speculative-grade, tradable bank debt styled ‘leveraged loans.’ ‘“Hold on to your hats!’ is the investment conclusion”.

2 ONSHORING SUPPLY CHAINS

ING economist Mark Cliffe suggested that “businesses are likely to shift from lean ‘just in time’ to bigger ‘just in case’ inventories. Businesses will be warier of single sources of supply or demand, allowing for a greater ability to switch activities or locations.” Clearly there is an associated cost.

Similarly, Tim Harford wrote in the Financial Times on April 18 that “It is tempting to fight the last war: we built up reserves in banking after the financial crisis, but we did not pay attention to reserve capacity in health….” The risk inherent in just-in-time and diverse supply chains has become more apparent and companies will surely want higher stocks, more diversity of supply and will onshore more production as a protection against a recurrence. Again this will have two implications:

a. Production costs will rise

b. Returns will fall as inventory and working capital increase

3 WORKING CAPITAL UNWIND

An unwind of working capital will occur on both sides of the balance sheet. I have observed a number of industrial companies which have improved working capital tremendously over the last 10-15 years. But many have done this predominantly by failing to pay suppliers on time – unless their supply chains are extraordinarily robust, these companies will be hit by the need for increased inventory (see 2 above) and by the need to start paying suppliers more quickly. The chart illustrates Electrolux’s working capital over the last 15 years or so:

The collection cycle (number of days sales tied up in working capital) looks to have achieved a marvellous improvement, from 63 days 15 years earlier, and a peak of 87 days, to zero. But look at how this has been achieved – debtor days have been flat at 60-ish. Inventory days have actually increased slightly to c.60 days, while payables days have doubled from c.60 to c.120.

Now perhaps Electrolux’s suppliers are all robust companies in great health after Electrolux has been so bountiful with its custom. But I doubt it; rather, I suspect most of its suppliers will be on their knees right now. Unless Electrolux not only pays its bills but pays them in advance, they will not be able to supply – cue a potentially massive working capital unwind for Electrolux, that’s assuming that housebuilders are back building houses, or homeowners are refurbishing and making big ticket expenditure.

I have singled out Electrolux, but this would apply to any of a large number of quoted industrials which have been engaging in this type of financial engineering (spoiler – it’s not uncommon).

4 INTEREST RATES MAY STAY LOW

It seems highly likely that interest rates will stay low for an extended period. My base case assumption is that as with the situation post the GFC, inflation will remain subdued (this may well be the surprise of the decade as inflation returns as in the mid-1960s, but not for a while).

This should in theory continue to fuel the valuation of growth stocks. With growth scarcer, this becomes an even more attractive feature. Which would suggest that the last decade’s winners – tech, should remain winners. There are certain problems with this.

INTERNET ADVERTISING COSTS HAVE COLLAPSED

a. even the growth stocks are not immune to the general economic malaise. Internet advertising rates have collapsed which will hurt Alphabet and Facebook for example.

b. Can these valuations grow forever? Trees to the sky? Probably not. And relative valuations have already increased significantly

c. See 5

5 PENSION DEFICITS TO INCREASE SIGNIFICANTLY

The good news is that bonds have increased in value, and given the growth in deficits, Governments have huge incentives to keep yields low. But….the pension deficit (perhaps there is a surplus in the S&P 500 or the FTSE 100 but I haven’t seen one for a long time) is the difference between two large numbers:

Assets have gone down significantly for those with a higher exposure to equity, less so for those funds with a larger exposure to bonds. And funds with heavy exposure to alternatives may find that the lack of a mark to market doesn’t help if the private equity portfolio companies sink under the weight of their debt.

Liabilities have gone up significantly, because the liabilities are discounted to present value based on bond yields which have collapsed.

This means that pension deficits will have increased significantly for most quoted companies. This is almost a straight subtraction from equity values.

6 WHERE NOW FOR INCOME FUNDS?

For many companies, the priority will be rebuilding balance sheets. Dividends will be a secondary issue. For those companies subject to Government rescue, dividends are likely to be capped or forbidden until debts are repaid. Income fund managers will have an increasingly narrow repertoire. This is quite an important issue for many UK pensioners (not to mention fund managers). I would sell holdings in this sector.

A corollary may be that some perennial dividend payers may be rerated as these funds are forced into a narrower group of stocks. I think this is more likely to happen in the US, where dividends are often paid quarterly and where companies may sacrifice buybacks but continue to pay dividends (which are generally much smaller) – dividend paying stocks like Apple and Microsoft have seen strong performance for a long time, less so the Johnson and Johnsons and Proctor & Gambles. These types of stocks may be perceived as safer bets for income investors.

7 FINANCIAL REPRESSION & CAPITAL CONTROLS

One clear effect of the pandemic is that almost every government on the planet will have a lot more debt than they did in January. And the situation in January was not looking particularly attractive.

Advanced economies saw a significant increase in debt, above 100%, post the global financial crisis. I doubt whether we should follow Reinhart and Rogoff’s caution that debt above a certain level will cause fundamental problems – can two academics predict future economic events on the basis of historical trends? But simple common sense says that when the debt is larger than GDP, it’s probably not great, and you should think about getting it down. It’s certain that if we drew this chart as of the end of 2020, there will be another huge increase. That surely is a cause for concern.

One way this might not be a problem is that if every Government has huge debts, there will be no relative disadvantage and hence perhaps no real risk that they cannot be financed. I am a simple stock analyst and this is above my pay grade. My guess is that Governments will at some point feel constrained in what they can spend and they will seek to reduce their debt burdens. Most will surely be forced to (continue to) engage in a policy of financial repression so that their interest rates are below inflation. This could be required for decades rather than years and I think this has important implications for equity investors.

It’s worth noting that this is not just a Governmental problem, the corporate sector is also highly levered. So total debt excluding financial institutions is over 250% of GDP in advanced economies – it will certainly be a lot higher at the end of 2020, irrespective of a V, W , U, or L shaped recovery or indeed any other type of recovery.

The best way of reducing debt to GDP is higher growth – timely fiscal stimulus should be a priority for all Governments, and correctly delivered, gets us all out of a mess.

Other options for Governments will presumably at some point be higher corporate and personal taxes, although there is an economic impact. Others cited by eminent financial historian Russell Napier include an unpalatable menu for investors:

Wealth taxes
Dividend controls
Restrictions on investment
Gold ownership restrictions (it happened in the 1930s)
Capital controls

The last one is the most interesting and raises all sorts of issues that your simple analyst is unable to answer. It seems unimaginable in a global inter-connected financial environment. But what would you do if you were President of, say, Turkey? The solution for Governments must be to engineer higher growth – lets hope they can achieve this, as the alternatives are unpalatable.

8 BALANCE SHEET RESTORATION

Personal and corporate balance sheets need to be restored. This is likely to weigh on economic growth for a number of years. I pondered whether in our new caring society “on the other side”, if bling might become unfashionable, but after reading in Tatler that the Chinese bought a record $2.7m of Hermes Birkins and assorted goods in one day post lockdown, I wonder if the world will be that different.

My takeaway is that there may be two sorts of consumers immediately post lockdown. Those wealthy employees who have seen no impact on their earnings may well have pent-up demand to spend, in spite of the hit to their savings. They may go out and buy big-ticket items, and trade up in their restaurant choice – they cannot eat the lost meals out, but they can upgrade. My guess is that these will be in the minority, and will be outweighed by the self-employed, the furloughed and the unemployed, all of whom will need to reduce their spending. Even if luxury is partly immune (and I wonder), large swathes of the lower end of the income distribution and the middle class will be, and will feel, much poorer. If stockmarkets stabilise at higher levels, the rich won’t feel as bad, but they too will have suffered losses as business owners and if markets fall, there will also be a further reverse wealth effect. Note that this will affect both corporate and personal balance sheets. Companies will likely rein in capex for the 2020-2022 period. Consumers will buy fewer and cheaper big-ticket items. This seems inevitable, although the impact is hard to model on corporate earnings at this point – we do know, however, that earnings will be lower than formerly forecast. The one slightly odd exception to the big-ticket expense may be the leisure sector where there will be a massive pent-up demand for holidays. Exhausted mums will demand holidays and this is the one luxury item which many upper income households at least will be loathe to sacrifice.

9 RIPPLE EFFECTS AND INFLATION

The coronavirus crisis has created huge, survivability issues for a limited number of sectors, notably airlines, travel and hospitality. The duration may be variable – for example, as long as the threat of virus transmission remains, cruise lines may face a long struggle to persuade holidaymakers to take such vacations, but the risk of short haul air travel may be perceived as lower.

There has obviously been an indirect effect across all sectors, even internet advertising, as was illustrated in the earlier chart. A primary impact has been felt in the oil industry where there is an existential crisis, as Saudi and Russia co-operated, possibly to undermine US shale.

These have been fairly obvious and direct impacts. What we have yet to understand is the indirect impacts beyond the general economic decline. This could be manifested in food shortages, a break in manufacturing supply chains, an inability to pay footballers wages, the collapse of secondary Formula 1 teams leading to a death of the sport or many other potentially more serious impacts which we have not yet thought of.

My candidate for the most impactful would be an increased propensity to save which would slow economic growth. Second would be the potential for the imposition of a police state, as track and trace measures are implemented, with the loss of personal privacy, as foreshadowed in Yuval Noah Harari’s piece for the FT on March 20.

I alluded earlier to the prospect of a return to inflation. It seems impossible, given the depressed state of demand, but it also looked unlikely in the mid-1960s, yet inflation returned leading to a dramatic wealth destruction in the following 15 years. This would be the one surprise that would really help governments – could it happen again? There may after all be some consequences of freely printing money.

We did not get inflation in the last decade, in spite of huge bouts of quantitative easing. It could happen this time, though for two reasons:

a. The system has been flooded with more money, on top of its already liquid state

b. Last time round, demand growth was anaemic and the allowed continued existence of zombie companies meant that the supply impact was lower than it would otherwise be. This time, there is no question that there will be multiple bankruptcies and some interruption to supply.

Inflation could well return in the short term, as oil demand returns causing a sharp increase in oil prices, feeding through to plastic and chemicals, and sectors of the economy which are hardest hit see supply shrinkage:

Airline seats will be scarcer at least temporarily as airlines fail, and carriers are slow to re-introduce capacity
The restaurant industry will see sharp reduction in capacity as demand to eat out returns to close to pre-crisis levels (pent-up demand offset by lower affordability)
Hotels, another mom and pop industry like restaurants will see a capacity reduction and an ability to push prices.

We will not have cost-push inflation, as labour will be in plentiful supply, nor will it be demand led. But a new form of supply shortage driven inflation is possible, at least in certain sectors, and the problem with inflation is that it’s difficult to make it disappear. It should be positive for equities as long as it is contained to a limited number of sectors, but inflation above 4% severely impacts valuation multiples.

10 THE “BEZZLE” AND THE GREAT RESET

JK Galbraith coined the term the “bezzle” in his book The Great Crash 1929.

“In many ways the effect of the crash on embezzlement was more significant than on suicide. To the economist embezzlement is the most interesting of crimes. Alone among the various forms of larceny it has a time parameter. Weeks, months or years may elapse between the commission of the crime and its discovery. (This is a period, incidentally, when the embezzler has his gain and the man who has been embezzled, oddly enough, feels no loss. There is a net increase in psychic wealth.) At any given time there exists an inventory of undiscovered embezzlement in – or more precisely not in – the country’s business and banks. This inventory – it should perhaps be called the bezzle – amounts at any moment to many millions of dollars. It also varies in size with the business cycle. In good times people are relaxed, trusting, and money is plentiful. But even though money is plentiful, there are always many people who need more. Under these circumstances the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly. In depression all this is reversed. Money is watched with a narrow, suspicious eye. The man who handles it is assumed to be dishonest until he proves himself otherwise. Audits are penetrating and meticulous. Commercial morality is enormously improved. The bezzle shrinks.”

I have been preaching for the last 18 months that too many companies were cooking the books. This has been the “bezzle”.

The chart shows the gap between the S&P profit margins and the NIPA margins, an economic measure. The S&P number has been moving straight up, while the economic margins have been in steady decline. This is exactly what happened in the late 1990s, and it indicates that margins are being goosed – back then, it corrected when S&P margins fell back to the economic margin level, and this will happen again. (There are some technical reasons why the S&P should be somewhat higher, but not to this degree).

Now finance chiefs have an opportunity, presented by the virus, to engage in the Great Reset – earnings will be reset, the virus will be the excuse.

Even if there were no lasting effects from the virus, earnings for the vast majority of quoted companies would be reset down. They have been stretching the elastic of earnings for some years and now they have the opportunity to get their books in order. Forecasts will go down, even before you factor in the virus effects.

One final point regarding company profits – the Japanese earthquake in 2011 is the best analogy for an economic halt such as we are currently experiencing. It took industry there a long time to restart the supply chain and return to normal. We are told that China is already nearly there, but that process may take longer in other economies.

Now finance chiefs have an opportunity, presented by the virus, to engage in the Great Reset – earnings will be reset, the virus will be the excuse.

CONCLUSIONS

I confess that I don’t know where the market will end up. Even doing a forecast for an individual company is incredibly difficult at this point, more difficult than it has ever been in my (long) career – as difficult as it was post 9/11 when I was researching airline stocks, for example. The good news is that I think there are a lot of great opportunities in current markets on both the long and short sides- rarely does such an opportunity set present itself.

Structural trends will continue regardless:

Climate change
Ageing population
Emerging middle class

But we may also see impacts that we don’t expect – ice cream sales collapsed by 44% in the 1930s depression, as the chart illustrates. It took a further 4¼ years to surpass the 1930 peak.

What we now know, however, is that the impossible can happen – who would have thought that forward oil could trade at a negative price? The single conclusion that you should take away from this article is that you should assess the resilience of your portfolio to every eventuality – probabilities may be low, but look at the impact that those extreme events at the left tail of the normal distribution can have. Analyst teams should sit down and brainstorm what they think could happen, assign a probability, and assess the impact on portfolios.

One simple example: lets assume that this is indeed a point like 1965, and we see a return to inflation. Interest rates reached 15% in 1982. Now it may not reach that quantum, especially starting from effectively 0. But what would happen to your portfolio if rates reached 10% in 2030 or 2035? Most young investors probably cannot imagine a world in which rates are 15%. Thinking the unthinkable is one of the lessons I am trying to take away from this crisis.

Finally, I would make one point to those doomsters predicting a 50% fall in markets from here and the newsletter writers predicting a new high within 18 months. It’s too early to tell the outcome for markets – that will depend on the balance between the downward pull of economic forces discussed here and the sheer weight of liquidity. And it’s critical to remember that our starting point was record profitability, an extended economic recovery and the longest bull market on record.

I believe that navigating these markets will take skill, a lot of work, and some new analytical techniques. I therefore plan to hold a webinar to explain some of the analytical approaches and forensic techniques necessary for investment survival in this new world – sign up on the button below.