Equity markets are waxing and waning on day-to-day news. Are earnings reports, new infection rates, vaccine development or hints about further policy easing a little better or worse than expected? How bad will the recession be in the coming quarters and what will be the shape of the upturn to follow?
Rather than focusing on short-term income and expenditure flows, investors should dig deeper into the underlying fundamentals. The nature of this sharpest economic shock since the 1930s means the balance sheets of the household, corporate and especially government sectors are materially damaged. Dangerous fissures are starting to appear.
Let us briefly examine the problems, sector by sector.
Low income households suffer from a lack of savings to compensate for the loss of income even under furlough. In the UK, for instance, 15% of people have no savings at all and one in three has less than £1,500 in savings. In the United States, 40% of Americans cannot afford an unexpected $400 expense. The coronavirus has forced millions of homeowners globally to stop making payments on rents, utility payments, auto and student loans.
At first sight, high income households appear to be in a better place. For example, US household debt-to-income ratios are back to their 2000 lows, which together with low interest rates makes debt servicing more manageable. As the stock market has recovered, the immediate hit to wealth has been moderate.
Yet the real pain is only beginning to be felt. Unless an investor is materially overweight the largest Nasdaq-type tech growth stocks, he or she will have been be hurt by depressed stock prices in other sectors and especially by the prospect of sharply lower dividend yields and the widespread withdrawal of share buy backs for years to come.
Looking at small and medium sized enterprises, the loss of cash flow is already leading to a jump in bankruptcies. A National Bureau for Economic Research (NBER) report estimated that the median business has more than $10,000 in monthly expenses and less than one month of cash on hand. In the UK, a survey commissioned by City Hall’s London Growth Hub found 23 per cent of the capital’s businesses will not last more than two months of the coronavirus lockdown.
Large firms quoted on the stock-market are better supported through access to banks and the bond market. Nevertheless, pressure on balance sheets creates a need to conserve cash. After slashing labour costs—over 35 million workers laid off in just two months in the USA—business investment is next in line. Some surveys suggest a 20% fall in capex in 2020, with damaging second round effects on supply chains across companies of all sizes.
Debt is a worrying aspect. The Wall Street Journal reported that for the median company debt was six times larger than earnings before the Covid-19 pandemic undermined profitability and the ability to service the debt. Fitch Ratings has warned that global downgrades in just the first four months of the year have already exceeded the average annual total since 2002. Balance sheet jitters are not limited to companies. A flurry of warnings about the poor balance sheets of many emerging market countries is exemplified today by the plight of Argentina and Turkey. Moody’s has also warned of a sharp pick-up in emerging market corporate debt defaults.
Just as in 2008-09, the deterioration in the balance sheet of the private sector will ripple through to the public sector. Governments will face considerable calls for higher spending on health care and social services, following unprecedented fiscal outlays already pledged to address the pandemic and its economic consequences. For many countries, that follows years of massive increases in government debt. For an average developed economy, debt/GDP ratios are generally forecast to rise from 80% to 100%, and for nations such as Italy towards 160%.
How will governments cope? Assuming central banks do not fall into the trap of excessively monetising government debt, which could result in an inflation shock, then financial repression—capping interest rates and controlling capital flows—will become the order of the day.
Tough political battles are also likely to ensue, as debates heat up over tax increases and spending cuts. In some quarters, populist calls are already appearing for tax hikes on companies, the wealthy and foreigners (via tariffs), with appeals to cut the tax burden on labor. The debate is likely to be joined from all sides, with little prospect for near-term clarity or resolution.
How much of this is already priced into the markets?
On the one hand, share prices of companies with strong balance sheets have outperformed their weaker brethren. Stable growth sectors, such as large capitalization information technology or pharmaceuticals, have trounced cyclicals such as airlines or automobile manufacturers.
But that partly reflects what is happening today, not how things play out in the longer run. Long-term investors who analyze balance sheets carefully, such as Warren Buffet, are not easily finding attractive investments in this environment. Markets are pretty good at differentiating between the winners and losers based on today’s economic and corporate news, but do not pay enough attention to the massive long-term damage to private and public sector balance sheets caused by the economic consequences of the pandemic. They scarcely consider the far-reaching effects from policies that will eventually be required to bring balance sheet stress back under control.
For investors, it is important to focus on balance sheet fissures and the stresses they will impose on economics, policy and markets. Doing so requires an examination of the contours of the financial landscape as it is likely to evolve over time. Investors would be well advised to lift their gaze beyond the short run and consider fault lines likely to be exposed by the severity and duration of this crisis.