16 Mar Baggot Markets Update – 16th March 2020
It has only been a week since our last update but so much has happened since then. We have seen the type of market behaviour that pretty much always results in extraordinary long term buying opportunities for stocks and other types of risk assets such as commodities (ex-Gold). I’ve been in the business for nearly 27 years now so I’ve seen a few big ones. Baron Rothschild said that “the time to buy is when there is blood in the streets.” He made a fortune buying in the market panic that followed the Battle of Waterloo against Napoleon. Metaphorically speaking we’ve reached that point now I think. Could it get worse? The Virus count is most certainly going to get worse in the near term but remember that markets are discounting mechanisms, they price-in what they know, discount those things and look forward, not backward. This is why global stock markets bottomed in March 2009, long before the economic data suggested recovery.
I don’t always agree with Goldman Sachs, but I do in this case. Peter Oppenheimer recently had this to say in a note from Goldman Insights;
“It’s difficult to say with any certainty, given how much is still unknown about the spread of the virus and the lack of historical precedent. We’ve never before entered a bear market because of a viral outbreak. But if you believe we haven’t hit the trough and we are in fact headed for bear territory, it’s useful to look to the history of bear markets to get a sense of their duration and intensity. There are three different types, each with different triggers and characteristics: structural bear markets, cyclical bear markets and event-driven bear markets. At this stage, we think the balance is still in favour of this being an event-driven bear market, suggesting that the rebound in equity markets will be swift. On average, these kinds of bear markets triggered by exogenous shocks have seen declines of 29% and lasted nine months, with markets regaining their previous levels within 15 months.”
I agree and think that we will most likely see a recovery of extraordinary proportions simply because this is different to any other panic we’ve ever seen. In the western world there is nowhere to invest your money that offers any income at all outside of dividend paying stocks. The US Federal Reserve implemented an emergency rate cut last night to zero. Unlike 2008, 2000, 1987 or any other time in history there literally is nowhere to park money that can generate a yield in excess of inflation in western world bond markets.
We don’t think this is a time to be very active until market volatility cools down and this is not a recommendation but it should serve as an example that many people can understand; Vodafone is now trading at 12.4 X our forecasted 12 month PE ratio and paying a dividend yield of 8.11%. Does that seem rational to you? Do you think it will survive this crisis?
Google is in my view probably the greatest company on earth. In January it was trading at a valuation of 31X the forecasted 12 month PE ratio. A very expensive valuation. Today that valuation is 21.9X. Google has $120 Billion in cash on its balance sheet and $16 Billion in total debt. Google is still expensive and earnings are going to suffer, but with a cash hoard like that it will survive this crisis and come out of it stronger.
Roche AG, one of my favourite healthcare companies, is trading at 13.7X our forecasted 12 month PE ratio and paying a dividend yield of 3.31%. It has a great balance sheet, very strong financial stability and net gearing of 11%. From a long term perspective that seems like a pretty decent income generating alternative to developed market bonds.
We are worried about this crisis spilling over into a credit crisis. We see that as the big danger especially for companies that have a lot of debt. One thing you have to remember is that (particularly in the US) there has been an enormous amount of debt issued by mega-cap companies over the last decade. The proceeds of most of that cash was used to buy back stock. This had the effect of leaving Frankenstein on the balance sheet. As you know much of Europe is in lockdown or near lockdown mode. Ireland is not the only country where large swathes of the economy have come to a screeching halt. It appears the US is heading into the same situation. So what happens to your business if you are a consumer cyclical company with Debt levels 200% in excess of your Equity levels and you need to borrow short term debt to keep the doors open? I mean, in the past it was easy if your business was throwing off cash flow to borrow short term money, but in many cases there is now zero cash flow. If this thing goes on for months rather than weeks, that is going to become a big risk. If Governments don’t act we could see some pretty shocking corporate busts pretty soon.
To that end we are heartened to see Germany on Friday promise “unlimited” credit to help companies hit by the coronavirus pandemic. Finance Minister Olaf Scholtz said “There is no upper limit to credit offered by (state owned development bank) KfW, that’s the most important message.”
German Economy Minister Peter Altmaier stated that the guarantees (the equivalent to half a trillion euro) were just for starters. He said that “We promised that we will not fail because of a lack of money and political will. This means that no healthy company, no job should find themselves in trouble.”
Further it got overlooked because there were so many things going on last week, but the ECB under Madame Lagarde’s leadership announced €2.3 Trillion in TLTROs. She also loosened the capital requirements and rates on the program: · More favourable operations to support bank lending to those affected most by the spread of the coronavirus, in particular small and medium-sized enterprises
- Interest rate on TLTRO III reduced by 25 basis points and can be as low as 25 basis points below average deposit facility rate during period from June 2020 to June 2021 for all TLTRO III operations outstanding during that period
- Borrowing allowance raised to 50% of eligible loans
- Bid limit per operation removed on all future operations
- Lending performance threshold reduced to 0%
- Early repayment option available after one year from settlement starting in September 2021
- Modification accompanied by series of longer-term refinancing operations (LTROs) designed to bridge liquidity needs until settlement of fourth TLTRO III operation in June 2020, starting from next week
This from (the very highly respected) Kevin Muir of The MacroTourist;
“The Governing Council of the European Central Bank (ECB) today decided to modify some of the key parameters of the third series of targeted longer-term refinancing operations (TLTRO III) to support the continued access of firms and households to bank credit in the face of disruptions and temporary funding shortages associated with the coronavirus outbreak. The changes will apply to all TLTRO III operations.
For the period from 24 June 2020 to 23 June 2021, the interest rate on all TLTRO III operations outstanding during that time will be 25 basis points below the average rate applied in the Eurosystem’s main refinancing operations over the same period. From 24 June 2020 to 23 June 2021, for counterparties whose eligible net lending between 1 April 2020 and 31 March 2021 reaches the benchmark, the interest rate applied on all TLTRO III operations outstanding over that period will be 25 basis points below the average interest rate on the deposit facility prevailing over the same period, and in any case not higher than -0.75%.
The maximum total amount that counterparties will henceforth be entitled to borrow is raised from 30% to 50% of their stock of eligible loans as at 28 February 2019 for all future TLTRO III operations. The amount counterparties can borrow under future TLTRO III operations is reduced by any amount that they previously borrowed under TLTRO II or TLTRO III that is still outstanding.
The limit of 10% of the stock of eligible loans for the amount of funds that can be borrowed in each operation is removed on all future operations.
In view of the changing economic environment, the lending performance threshold that needs to be met in the period between 1 April 2020 and 31 March 2021 in order to attain the minimum interest rate on TLTRO III operations has been lowered to 0%, from 2.5%.
The option for counterparties to repay the amounts borrowed under TLTRO III earlier than their final maturity will now be available one year from the settlement of each operation, instead of two years, starting in September 2021.
The ECB has effectively said, “we’ve got your back – go buy whatever you want” to the European financial system.
But, the most important part of the announcement was that they DID NOT LOWER THE OVERNIGHT RATE! This is a huge development! I cannot overstate this enough.
It took a non-PHD economist, but the Europeans have finally realized that pushing overnight rates even more negative is not only not beneficial, but actually harmful. Halle-frigginlujah!
Of course there were some head-in-the-sand economists who expressed disappointment about this development, but I took it as an extremely positive sign. Lagarde has finally broken the cycle of “the beatings will continue until morale improves.”
Not only that, she once again threw it back to the government officials by stating that fiscal action was needed. Obviously this had clearly been coordinated with the German Government.
We see these actions as very encouraging signs that the ECB and European governments are going to do everything they can to avert a credit crisis. Hopefully other developed markets are taking notice.
I’m unsure that the US government will be able to find the political will to do the same thing. I hope so, but it is an election year and the Democrats will not want to help Trump.
Hopefully they can put politics aside for the sake of the people.
David McWilliams wrote an article this last weekend in the Irish Times entitled “Why Central Banks must give everyone free money right now”. He’s spot on. I’d encourage you to read it if you haven’t yet done so.
These types of actions should be very supportive of the stock market once this crazy volatility cools down. I think the big concern now is going to be on long dated western world bond holders. Government Fiscal policies have put a bullseye on them.
The end of flu season is pretty much here and we are taking the necessary precautions to slow the spread so that the hospital system is not overwhelmed. China’s actions have clearly had a very positive impact.
This will come to an end and when it does, we are going to see extraordinary long term opportunities to invest in good businesses. Now is the time to draw up a list of stocks you’d like to own once some of the uncertainty goes away. Focus on companies that have high levels of cash and low levels of short term debt. Companies that you think can pay consistent dividends in the future (they will replace bonds as income generating assets in the future, there is no choice).
We think Healthcare/Drugs is going to get a lot of stimulus in the future and that should be a great area to focus on once the uncertainty abates. We see that as being the most obvious area to benefit in the longer term.
Now, I’m going to get back to being calm, cautious, rational and washing my hands!
If you have any questions please let us know.
David Flynn, Chief Investment Strategist and Director
Baggot Investment Partners