"The news slows People forget The shares crash, hopes are dashed People forget Forget they're hiding Behind an eminence front"
Eminence Front - Pete Townshend - The Who
Past economic cycles and investment markets have heard the phrase ‘this time is different’ over and over but soon saw things were not so different. This time however we are dealing with a worldwide pandemic, not your typical unwinding of your ordinary financial or speculative excess. The last significant pandemic, the Spanish Flu of one hundred years ago, offers little in comparisons of use to present day investors. World economies have changed and grown more integrated and thus offer a vastly different landscape. Now players such as China, Japan, and the EU occupy an important part of today’s world economy. Also, recent recessions have proven milder due to the transition away from a more volatile manufacturing sector led by inventory cycles to service-based economies. Unfortunately, it is the service sector that the government mandated lockdowns to attempt to slow the spread of COVID-19 has decimated and precipitated a massive increase in unemployment, particularly in the small business sector. Canadian small businesses, defined by having less than 100 employees, are the backbone of the Canadian economy. These businesses account for 69.7% of the total private labour force or approx. 8.3 million people. How bad is it in Canada? March saw a 7.5% drop in Canada’s GDP, followed by a 11.6% decline in April. This was the largest monthly economic decline on record.
Source: Canadian Federation of Independent Business
Although up about 5 pts from June, SMEs still operating at less than 2/3 capacity. Arts, recreation, hospitality, health, education biz stuck at half that.
We are now entering phase three of this pandemic, it is difficult to make short-term predictions on the future course of economies or financial markets. The reaction of central banks and governments worldwide has seen massive fund transfers to corporations and the unemployed. While this has kept economies afloat, government deficits have reached record levels. So far, a tight control of interest rates by central banks at low levels has made it easier for borrowers to reduce their costs. However, historically massive deficits supported by the running of the money printing presses has eventually resulted in inflation and rising interest rates.
Financial markets have been significantly influenced by the unprecedented cash injections from central banks and governments. Canada for example has increased its money supply by 500% in the past 4 months. For comparison, our money supply only increased by 100% during the period of the Great Depression and WWII (1935 to 1945). Federal debt has exploded from $670B to more than $1T in the past 3 months. Central banks have artificially held interest rates low despite high demand for financing by corporations seeking funds to offset operating losses. Much of the new debt is of BBB rating, one grade above the non-investment grade (aka ‘junk’) level. Any further deterioration in corporate prospects leading to downgrading would hit fixed income markets hard. While we have no issues investing in the non-investment grade bond market (as it’s still senior on the capital stack vs preferred shares and equity), as the yield and potential for appreciation can provide a good return for the risk taken, the best values are obtained after a downgrade, not before.
Equity markets have been a beneficiary of fiscal and monetary stimulus (aka ‘cash injections’) by the central banks and governments. Despite significant easing, declining equity markets appear to have recovered most of their March price declines. However, leadership has narrowed, and the technology sector has risen to new highs, offsetting losses in other sector of the economy. Retail investors rather than institutions have been the main drivers of these market increases. The current conditions are comparable to the late 90s where equity market multiples are at levels that can only be deemed speculative, making equity markets, especially tech stocks have reduced expected returns going forward.
How will governments deal with the challenge of significant new debt added to their balance sheets? Examining previous long-term debt cycles, when these types of imbalances occurred, governments will monetize their way out – paying creditors back with depreciated currency.
Historically, it’s been the most politically palatable way to deal with excessive government debt levels. This is a form of default as the debtholders do not receive the full ‘purchasing value’ of what was lent to the government. Given today’s 0% interest rates, the cost of servicing vast amounts of debt is only a confidence game. In this scenario, assets that have a high stock-to-flow rate (i.e. limited new supply) such as gold and bitcoin may act as portfolio insurance. In addition, private debt which could generate sufficient return premium in excess of public fixed income can make sense. Strategies such as secondary private equity investments and distressed debt have the potential to capitalize on opportunities where investors need to shed high-quality assets quickly due to cashflow or other concerns.
Looking forward even with a potential vaccine in place, it is unlikely that we will not see major changes in how the world economies function. Many corporations will have found they can operate with fewer employees and many employees will continue to work from home. Many small businesses and family enterprises will disappear, and it will be some time before they resume their key role in providing employment. Artificial intelligence and robotics will also provide alternatives to renewing the jobs lost during the pandemic. The pandemic is a world-changing event both economically and politically. It’s almost certain people will forget how it was before January 2020. It’s an Eminence Front.