Baggot Markets Update – 20th March 2020

I’ve been in the business for 27 years now. Before the current crisis I thought I had seen it all, but this time is different compared to the Russian currency crisis, the Asian Contagion, the Tech Wreck or the Global Financial Crisis of 2008. This one is very different because it is a health crisis. In some ways it is similar though. Each event involved high levels of uncertainty.
I don’t have all the answers but I’m going to do my best to explain what’s going on.

So first let’s talk about the economic environment. The coronavirus has caused the greatest demand shock in at least the last 100 years, if not ever. Here in Ireland and many other counties around the world normal life as we knew it has ceased. Different countries are responding differently but in many parts of the world all businesses that do not operate online and do not provide services that are not considered to be “essential” have been closed until further notice. The level of business activity has dropped dramatically around the globe. Many highly leveraged businesses are very exposed because of that, particularly in the US, which I wrote about extensively in my piece on US Corporate Debt from March 18. It is a big issue because there are many companies who have high debt/equity levels that have shorter term funding needs, meaning they need to borrow money within the next 12 months. That didn’t seem like a big issue 2 months ago as these companies had the free-cash flow to service debt, but many of these businesses have stopped generating free cash flow quite quickly. There is a very real risk for highly leveraged companies that if we don’t get back to our normal way of life soon, bankruptcy could be imminent.

Central Banks and Governments have implemented unprecedented levels of stimulus in order to try to calm the markets, but no amount of stimulus can bring us back to normal levels of demand while we are all staying home.

Further, if all these businesses are kept afloat as a result of Central Bank and Government action, it seems to me that the consequence will be much like it was in 2008. As an example, the Irish government bailed out the banking system with help from the IMF and the implicit guarantee by the Irish taxpayer, but the result was a dramatic increase in the amount of bank shares and debt in existence. Of course, the banks survived. However because there were so many more shares/debt in existence it heavily dilutive earnings per share (eps). This is the biggest reason why the share price recovery of the banks was so muted once the recovery occurred. That and higher regulatory costs.

There are a lot of things that we don’t know the answers to right now such as:-
How long will this go on for? Is it weeks, or months? If it is weeks there will be consequences for the Irish, European and Global economy, but that wouldn’t be the worst outcome. Is it a month or two, or does this go on until summer? The longer we are living like this the greater the bill. China seems to have gotten the virus under control and business activity is picking up there. I showed this graph earlier in the week in my US Corporate Debt Update, it is a good sign.

The graph below shows the avg. congestion index in 100 Chinese cities. Clearly activity has picked up which is promising.

How will the bill for all this stimulus be paid? Governments will likely borrow money by issuing bonds at record low interest rates to pay for it. Who will buy that Government debt? Central Banks will print money and buy the debt, serving as the lender of last resort. It is called Modern Monetary Theory otherwise known as MMT. I don’t want to debate whether they should or should not do MMT. I’m just telling you that it is happening! What will the effect of MMT be? It should be very bad for long duration government bonds. All the bond issuance at zero or negative interest rates, guarantee that the holder will not earn any return on those bonds. However, remember that governments and central banks sometimes change the rules on us. The Japanese changed the rules a few years back and basically would not allow the interest rate on long dated Japanese Government Bonds to go up….If that is the case then it will trash the purchasing power of fiat currencies (government-issued currency that is not backed by a physical commodity, such as gold or silver). What are the consequences of that? Well, once we get back to our normal lives and business activity picks back up, everything that is finite in terms of supply will be worth more in time, not really because they’ve gone up in value, but because paper money has lost purchasing power.

The big question here is how bad can it get and how much has the market discounted? From a humanitarian standpoint I think things can get worse in the US. They haven’t yet dealt with this the way we have, which means they are behind the curve on it. From a stock market standpoint, it feels like we have reached fever pitch. All the signs are there. VIX (the fear
gauge) was trading at levels we haven’t seen since 2008 this week. Credit markets have gotten spooky. We’ve seen unprecedented levels of stimulus and government support, flu season is nearing that point in the year when it pretty much disappears in the northern hemisphere….I don’t know what the future holds but I do know that when risk perception is this high, well from a longer term perspective, it is always a good time to own stocks. I believe that even if we are heading into a recession that we may have already discounted the worst of it. The S&P 500 has dropped 31% in the last month. The Italian MIB index is down 45% in the last month. Markets have a funny way of under-discounting things in the beginning and over-discounting them in the end.

I had intended to write about where I see opportunities and where I see major issues (Developed Market Government Bonds) for investors going forward but it is late in the day now on Friday (6PM) so I’ll do that piece separately and get it out to you early next week.
If you have any questions or wish to speak, feel free to email me.

David Flynn
Chief Investment Strategist and Director