- KPB & Co Research
Nowadays the market oscillates between undecided and bullish whereas in the recent past it was decidedly bearish. In Q1 of 2020, COVID-19 threw a monkey wrench into the plans of portfolio managers, leading to a rapid decline in the market, and a widening of credit spreads. The unprecedented response of monetary and fiscal authorities boosted investor sentiment, and lead to a subsequent sharp recovery in stock markets and a tightening of credit spreads. Today, some market pundits are of the view that the v-shaped recovery reflects expectations that diverge from the reality. Others are pretty sure that the stock market reflects the reality. The International Monetary Fund (IMF) presented solid arguments for the "divergence view" in their global financial stability report. On the other hand, some notable hedge fund investors have expressed arguments for a "convergence view". We intend to explore both here.
Before we explore both views, let us take a step back and look on the government's response thus far. As at mid June, governments in the G7 and in some emerging markets allocated approximately US$10 trillion for economic stimulus. The stimulus can be sub-divided into central bank programmes and central government programmes. Central banks across the G7 implemented a range of initiatives that have substantially increased liquidity in financial markets, through interest rate cuts, and balance sheet expansion of over US$6 trillion (including asset purchases, FX swap lines, and credit & liquidity facilities). Central governments implemented a broad range of household income-support transfers and wage subsidies to companies, which took up a significant amount of the remaining US$4 trillion.
The International Monetary Fund (IMF) appears convinced that financial markets have become disconnected from the underlying economic fundamentals, which has led them to be concerned about the risk of a correction in the near term. In their June 2020 financial stability report, the fund pointed to the divergence between the conference board consumer confidence indices and the S&P500 index, as evidence of their claim. The Data show that there have been a disconnect between the two indices beginning after March 2020, after both have been in-sync since 2008.
According to the IMF, the unprecedented government intervention have led investors to become overly optimistic in the face of a number of high probability risks that could derail the economic recovery. Any derailment would lead to significant re-pricing of risk assets, and a sharp fall in the stock market. These risks are as follows:
- A deeper and longer recession that currently baked-into market expectations
- A second wave of infections along with more aggressive containment policies
- Geopolitical tensions and greater social unrest owing to greater global inequality
- Overly optimistic expectations about the amount of central bank support
In our view some of those risks are already playing out. In the past 2 weeks, the virus has re-emerged in some countries, resulting in the re-imposition of lockdown measures by the governments in these countries. In addition, the monetary and fiscal measures that have been undertaken thus far are substantially larger than those implemented during the 2008 financial crisis. In just a short two months, the size of the measures announced are in many cases 10 times the size of the amount distributed in the 2008 crisis. This indicates that governments may be unreceptive to lending further support to the periphery of the economy, and may narrow their focus to big businesses and institutions. There is also the issue of the "household-support cliff", which is when the funds governments have allotted for household-income support and wage subsidies run out at the same time as many people remain unemployed. Furthermore, the level of indebtedness among households and corporations have been growing since 2008, leading to a situation where today the borrowing capacity of many companies are limited. COVID-19 has caused many companies to experience a fall in revenues, and the various government loan schemes have led to even more debt. The longer economic conditions remain soft the more likely that these companies will become insolvent.
Some in the investment community believe that the stock market today reflects the underlying economic fundamentals of the economy. The premise of their view is that the S&P 500 index is the sum total of the discounted future cashflows of the businesses that make up the index. Activist investor - Bill Ackman - in an interview with David Rubenstein explains that COVID-19 will lead to a short-term reduction in cashflows, but the short term reduction is insignificant when compared to the years of cashflow growth these companies will produce in the long term. His second argument is based on the make-up of the S&P 500 Index, it being made up mostly of large capitalization companies. According to Bill Ackman:
when people talk about the market they talk about the Dow or the S&P 500. The S&P 500 is a market cap weighted index and what is interesting is or fortunate or unfortunate about the crisis is that it affects different companies differently and the more dominant large cap, the stronger the balance sheet, and the stronger the market position then those businesses are huge beneficiaries of the crisis. What the market doesn’t reflect are the small businesses, private businesses, the more levered businesses that does not have access to capital and that don’t have the same dominant positions..... If there was an index of these businesses then that index would be down 60% to 70%.
The market is going through a period that is unprecedented in recent history, and so many investors do not have a frame of reference against which comparisons can be made. As is typical in times like these, we have seen uncertainty increase, stock market volatility increase and market opinions become increasingly divergent. Today, on one side of the fence you have the participants who feel that the market is appropriately priced, and on the other you have those who feel that the market is overvalued and should decline. Whatever opinion wins out now is not really consequential for the long/buy side investor, as most people are pretty convinced that there is no reason for immediate bullish sentiments. The typical investor is much better off waiting for the right deal. In addition, there will likely be many bankruptcies in the months ahead. These bankruptcies will also lead to opportunities if these businesses have poor capital structures, and would otherwise have done well.