1930 or 1942?

Up 25% off its lows in March, the US stock market appears to be looking through bleak economic news—including unemployment not seen since the Great Depression—toward better growth perhaps later this year. Are investors too optimistic?

As we discuss in this report, our view is that:

• This pandemic has potential to be a watershed event in modern history, but visibility is truly difficult. There are a wide range of positive and negative outcomes, which we review briefly. We think neither extreme is likely but do offer policy insights.
• Markets, despite their rally, are still broadly cautious. That said, we see early confirmation that gives us confidence in our long-term positioning toward smaller stocks and a focus on value, as recovery prevails—the opposite of today’s winners.
• Given weak visibility and a downward trend in earnings, markets should remain volatile, moving between offense and defense. The fact that earnings forecasts are now -18% for the year and risk spreads in bonds are wide may help offer some cushion.

We’ll start this edition of Road to Recovery by looking at some history, then examine what credit markets, stock markets, and consumer behavior is telling us.

Is it 1930 or 1942?

To predict markets, it is tempting to look to clues from other eras that saw comparable global unemployment (over 20%) and/or government stimulus spending (at least 50% of GDP), which is where we expect to be by this summer in the current crisis.

In 1930, markets had just rebounded over 45% after being cut almost in half only a few months prior, only to usher in the worst global depression in history—including four straight years of negative US GDP growth and unemployment peaking at almost 25% in 1933. Markets returned an annual -7% for the seven years following 1930.

In contrast, in spring of 1942, markets had fallen 25% since the prior fall (including Pearl Harbor), initiating a dramatic period where government mandate shuttered traditional business and stimulus surged to 55% of GDP—to be followed by a clean hand-off to the private sector as post-war US GDP growth exceeded expectations. Markets returned 16% annually for the seven years following 1942.

In the first case, stimulus was too slow or not potent enough, leaving economies with excess capacity and sustained unemployment for a decade. People protected cash, and deflation became the ultimate risk.

In the second, the government co-opted industrial production for war-time use, deploying unprecedented stimulus for years. Upon re-opening the economy, pent-up demand unlocked and industrial production ramped. The transition went better than expected. Inflation became the challenge over time.

Industrial capacity, growth, inflation, or deflation—these are pivotal questions for investing, and it’s tempting to want to frame an investment approach based on a specific outcome. But the reality is that predictions become true only in hindsight, and the wrong decision can have major implications.

We provided our own view of the path to recovery here. To summarize, we think a quick recovery is not probable; we expect a “U” or “W” shaped pattern, reaching a “new normal” economy. We do not think a vaccine is required to get there. We see broader inflation risk over time, although excess capacity in some industries will see deflationary pressures.

State of the Credit Markets: Corporate Liquidity a Challenge

Credit markets are functioning again after seizing up in March, thanks to the pledge of “unlimited support” by the Federal Reserve and other central banks.

Despite the support, many companies face potential liquidity challenges in the coming quarters:

• Corporate balance sheets were arguably stretched even before the Covid-19 crisis.
• Airlines, oil producers, hospitality companies, and retailers may now see revenue shortfalls of 10%, 20%, or more, putting further pressure on cash generation and debt servicing.
• About half of US firms, according to the Bank of International Settlements, will not have enough cash to cover debt servicing in 2020 if commercial activity remains restricted, particularly those in textiles & apparel, metals & mining, and oil & gas. Companies in emerging markets appear to be even worse off.
• Estimates are that a third of junk bond issuers might default, vs. about a fifth in the Financial Crisis of 2007-09.

On the positive side, credit markets already reflect heightened risk, to at least some extent. Credit spreads, a measure of risk, improved during April considerably but are still wide. Investment grade bonds and municipal bonds trade at spreads exceeded only by the Great Financial Crisis, and junk bonds are elevated. The dispersion is more pronounced by sector and company, showing that investors are discriminating between issuers.

We have scrubbed our fixed income portfolio:

• Leading into this crisis, we were proactive in our search for higher quality yield. Before the downturn, we had trimmed or avoided most bond holdings that had deteriorated.
• For those bonds at potential risk with the latest developments (select airlines, retail, oil-related, manufacturers, etc.), we have reviewed timing of debt obligations, government support, and cash flow levels.
• We continue to monitor our clients’ holdings.

US Equity Markets: Broadly Cautious but Confirming Indicators

We note three things about the current rally in stocks:

• The first half of the rally (late March to mid-April) was largely defensive, while the second half saw more risk-taking. Big tech, health care, and utilities led in the first phase, while smaller stocks and emerging markets led in the second.
• The market is broadly distinguishing between perceived “haves” and “have-nots.” During both phases, for example, airlines and related equipment providers traded down.
• Our strategies—which favor smaller stocks and fundamental pricing—outperformed for the entire period, mainly during the second phase. We believe that as recovery is sustained, this positioning will be correct.

Importantly, earnings forecasts already factor in a lot of bad news. Analysts started this year expecting a 9% growth in earnings, which has now changed to a -18% decline. Estimates still fall across a wide range, so it’s possible that forecasts continue to fall, meaning that the markets will remain volatile during this period of major uncertainty.

To help manage risk, we believe our emphasis on cash flow generation and our detailed balance sheet tests (including leverage and accruals trends), among other factors, helps us reduce exposure to companies possibly going bankrupt in this environment. The End Note below offers detail about our equity positioning and recent activity.

As a final note, during the sell-off in March, we saw some capitulation by the average investor, as we would expect. Investors pulled over $380 billion from stock and bond funds in March (source: Investment Company Institute and CornerCap Research), almost twice as much as during 4Q19, when the S&P 500 was down 16% from its highs on recession fears. Only after the strong rebound in mid-April did money show positive net-inflows of about $25 billion.

Bottom Line

• There’s unprecedented limited visibility in markets today, but earnings estimates and credit spreads are actively adjusting where possible.
• We have actively scrubbed our credit portfolios, and we are comfortable with how we’ve positioned portfolios toward recovery, within a diversified, balanced portfolio.
• It’s too early to assess whether inflation or deflation will prevail in the medium term. We expect the former is more likely, but the latter is probably in industries with excess capacity.

END NOTE: DETAILS ON OUR EQUITY POSITIONING

• During March and April, we were seeing good quality companies priced for recession across most sectors.
  • Not seeing a disproportionate exposure to any one industry. Since January, the biggest changes are a 20%-25% reduction in health care and consumer services holdings, and similar increase in technology.
  • Our sector composite forces this natural diversification to some extent, allowing us to find the better quality companies among its peer group.
  • Our emphasis on cash flow generation and our detailed balance sheet tests (including leverage and accruals trends), among other factors, helps us reduce risk of companies possibly going bankrupt in this environment.
• Portfolio Positioning/Stance
  • Valuation spreads (the difference in earnings yield between the best 20% and universe average) remains at extremes.
    • Now at 3-standard deviations by our analysis, we last saw this extreme in the 2008 Financial Crisis.
    • Outlook for value looks very appealing one-year out. We remain tilted toward Value.
  • Defensives vs. Cyclicals: After starting the year in a balanced state (30% each), cyclical stocks vs. defensives is now closer to 36%-22% as cyclicals have become relatively cheaper.
  • Smaller capitalization remains more attractive than Large cap. Differential has expanded during this period.
• By sector:
  • Energy: We have not increased our exposure, but we have been able to swap from weaker ranked companies to better ranked, higher quality in our view.
  • Financials: Banks remain incredibly cheap. Our exposure remains the same, but we have swapped into better quality, in our view.
  • Tech: Added three net new names
  • Health Care: Pharma holding up better than hospitals, diagnostic testing and medical equipment. Look to reduce the former and add to the latter.
  • Defensives: as measured by low-beta, portfolio exposure has dropped from 30% to ~22%.