April 2020 Macro Commentary
The Federal Reserve’s Monetary and Liquidity Measures Provide Significant Support to Markets….
They will not be a panacea, however, for the enduring impacts of this recession
by Sanjay Khindri, CFA on May 4, 2020
The market declines in late March reflected not only a dramatic weakening of near-term fundamentals but also a significant tightening of global financial market liquidity. At one point even prices for U.S. Treasuries dropped while the equity markets tested new lows, a reflection of the freezing-up of financing for U.S. dollar assets.
The U.S. Federal Reserve responded forcefully, creating numerous facilities to increase the liquidity in the financial system. The magnitude of the Fed’s liquidity backstops is unprecedented, amounting to over 13% of nominal U.S. GDP. The table below lists these facilities:
As a comparison, the initial increase in the Fed’s balance sheet during the ‘08/’09 recession was ~ 8.75% of nominal GDP. There are three important things to keep in mind about the Fed’s actions:
1) The table above does not include “Quantitative Easing”, or the outright purchase of Treasury and Agency Mortgage-Backed Securities. The Fed’s balance sheet has already increased by over $2.4 trillion (11.5% of GDP) since the beginning of the year, while most of the facilities above are not yet up and running. The ultimate increase in the Fed’s balance sheet from QE alone is going to dwarf that experienced during and immediately after the Financial Crisis.
2) Most of the above facilities might not be heavily utilized, if at all (Main Street, PPP and MLF facilities should be heavily drawn upon). The immediate effect of the announcement of the Fed’s liquidity support was a rebound in equity markets, a tightening of credit spreads and an overall loosening of financial conditions. The Fed’s support for the time being is more psychological than tangible, but has been highly effective.
3) All of the liquidity measures above (except for the PDCF) are temporary injections of capital equitized by the U.S. Federal Government (i.e. taxpayers). The mechanics of the facilities entail the creation of a special purpose vehicle (SPV) in which the U.S. Government provides the equity capital and the Fed provides the debt capital. The SPV makes loans, not grants. The liquidity provided by the facilities eventually comes back out of the system.
Point #3 is the most important one that long-term investors should focus on. The support provided by the Fed and U.S. Government are important given the magnitude of the temporary drop in economic activity. In fact, Jerome Powell noted in his last press conference that the U.S. Treasury has another $454 billion of available equity for further liquidity and loan facility support if needed (levered at 7 to 1, this implies another $3.6 trillion in total support). But these measures cannot solve the enduring structural impacts from the virus.
While the cause of this recession is exogenous, the end result will resemble that of a typical recession: there will be structural impacts to the economy which will affect supply and demand for a period time. In the Financial Crisis, the supply of credit was impaired until non-bank financial companies could fill the void. In this crisis, there will likely be permanent shifts in consumption, and it will take time for companies to adjust. In each case, however, leverage in the overall economy increases, and companies must work off this debt before they can invest in fixed-capital formation and increase wages. The Fed support simply serves to: a) provide a financing backstop in case markets aren’t functioning, and b) prevent the cost of credit from deviating materially from the true underlying risk of that financing.
An interesting example of the limits of Federal Reserve and government support is within the airline industry. Until we have a vaccine, it is difficult to visualize global travel returning anywhere to pre-virus levels. When travel does resume in the near-term, only one-half or two-thirds of seats will be full in order to maintain distance between passengers. But airlines aren’t viable going concerns with those load factors. If that is the new reality, even if just in the near-term, the airline industry will need to shrink. Over-levered airlines will need to sell assets and recapitalize. The overall industry cost structure will need to be adjusted downward. This means that a lot of those employees being kept on payrolls thanks to the payroll-protection plan will eventually be laid off. Another example of a sector that will undergo structural change is energy, but one can find examples elsewhere of companies that must shrink or change the way they deploy capital.
So, we argue that the U.S. Government and Federal Reserve’s measures are significant and greatly smooth the ride, but they can’t change the general direction of that ride. What are the investment implications?
Prior to the virus, the price-to-earnings multiple of the S&P 500 had expanded to 18 to 19x, well above historical averages (see chart below). One of the reasons for this expansion in the valuation multiple was a shift in the Fed’s policy response to persistently below-target inflation (contact me for details on this). Now the outlook is for sustained zero interest rates, but this level of rates coincides with weaker corporate earnings and balance sheet pressure (see last month’s commentary for a snapshot of corporate-sector leverage). An 18 – 19x multiple is no longer rational: At least for the foreseeable future, we should not depend on higher multiples “bailing out” equity investors.
Accommodative monetary policy has kept valuation multiples high….is this sustainable?
Source: Yardeni Research, Inc.
If one accepts this conclusion on multiples, then at current equity and fixed-income valuations, active-management of investment portfolios provide the best chance for investors to earn attractive returns going forward. In this environment of high uncertainty, we advocate and practice a bottoms-up analysis to flesh-out investment opportunities where: 1) the secular trend or mid-cycle earnings power is intact, 2) the company can manage the increase debt-load or lower liquidity position, and 3) if in a structurally challenged sector, the company will be a survivor that can eventually gain market share and pricing power.
The following months will lead to much more clarity on the sustainability of economic re-opening and our advancement towards effective therapeutics and vaccines. Perhaps a vaccine will be developed quickly and deployed effectively, making many of the points in this note moot; but given the current level of asset valuations and uncertainty, investors can find much more comfort if they’re invested in sustainable businesses that can better manage anything but a V-shaped recovery.
Gallatin Capital Management, LLC
Important Disclaimer: This material is for your information only and is not intended to be redistributed or used by anyone other than you. The information contained herein should not be regarded as an offer to sell or a solicitation of an offer to buy any financial products. This material, including any investment recommendations herein, is intended only to facilitate discussions with Gallatin Capital Management as to its investment offerings and strategies. The given material is subject to change and is not guaranteed as to accuracy or completeness and it should not be relied upon as such. The material is not intended to be used as a general guide to investing, or as a source of any specific recommendations.