P&L round done, balance sheet round next?
By Baniya Beast,
World is going through three shocks at the same time, something not witnessed in recent history.
- Global demand shock – caused by virus
- Supply shock from China – mainly it seems contained but resurgence in fall is possibility
- Crude oil supply shock – led by Saudi’s decision to increase oil output
International research houses are projecting 1% contraction in global GDP, which is similar to economic impact caused by GFC in 2008. Projection assumes resumption of economic activity by May and if it delays further by 90-120 days then Great Depression of 1929 is real benchmark.
In that sense, 2008 was much easier to handle as major economies were pumping high GDP growth rates (China, India above 7% real GDP growth with healthy inflation rates) and mildly levered balance sheets. We are entering 2020 crisis on bad footing, except USA all major economies are struggling with weak economic activity, growing unemployment and levered balance sheets.
Global equity markets have been punctured with 30-35% fall in the index from recent highs. Dissecting the fall into possible buckets:
- Downward revision in earnings
- Trimming of lofty valuation
- Change in sentiment driving prices below fair valuation
- Oil price crash putting pressure on oil and gas dependent economies like Canada, majority of OPEC, Russia and large oil companies in US
Even if virus is contained, price damage due to oil shock and change in earnings and valuation will be present.
So 15-20-25% fall in the index is rational in my view. But this is irrelevant as there are many moving parts currently and a change in one variable can change this 15-20-25% figure.
Whether to buy equities now depends on answers to below questions. I’ve got very low confidence to predict the situation from here on and remember we are walking on tight rope between two cliffs.
- When does the virus peak out in US and Europe? This decides our real benchmark 2008 or 1929.
- Peak out could mean 3-4 consecutive days with deceleration in increase of new local cases
- US and Europe because their contribution to world GDP is meaningful and also they are the ones which are highly levered
- What is the possibility of virus not re-emerging in fall?
- 1918s Spanish flu impacted in three waves over every new season in a period of 15 months which led to 1/4th world population getting infected and over 50 million deceased
- This virus has led to some permanent loss of demand in few sectors like aviation, hospitality and others. What is the extent of loss these companies will go through?
- Can this lead to 2nd order issue with trimming of work force or paycuts?
- Can this lead to 3rd order impact where highly levered companies default, exposing risks to banks equity
- What ammunition does the government have in terms of stimulus to fund these losses?
- Country-wise fiscal deficit rates will be reference point to ascertain maximum room for stimulus
- It will be prudent to assume stimulus room of less than 2% for small economies as their debt is vulnerable and also it poses risks to Fx
- US then becomes the key economy to monitor. Economists suggest 5% of GDP as maximum room for US government. We are talking about $1-1.25 Tn stimulus package as maximum room without dislocating the global bond, Fx and equity markets.
- Is this enough to fix the broken economy and pare corporate losses?
- Can the current fallout lead to debt crisis in USA and Europe?
- What is the position of Debt to GDP of these economies?
- Possibility of PIIGS economies defaulting? Remember tourism forms 10-14% of GDP for these economies
- How will companies with high debt manage multiple challenges of low cash flows, service interest, repay debt? Debt market is certainly weak to raise or refinance debt.
- This is already leading to widening of credit spreads. When do these spreads narrow?
Finishing the note – Regardless of the answers to above questions (rebound or deepening of cuts), I would like to talk about Howard Marks July 2004 memo:
The mood swings of equity markets resemble the movement of a pendulum. Although the midpoint of its arc best describes the location of the pendulum “on an average,” it actually spends minuscule time there.
Instead, it is always swinging toward or away from the extremes of its arc. But whenever the pendulum is near either extreme, it is almost inevitable that arc will move back toward the midpoint sooner or later. It is movement toward the extreme itself that induces energy for the swing back.
This article was originally published by author Baniya Beast.