A Month’s Time
In just a month’s time, the U.S. stock market’s value is back to where it was in late 2018. The speed and intensity of the recent decline is unusual as the United States’ equity markets lost $11 trillion (30%) in just one month. This 30% decline is also reflected in the Dow Jones Industrial Average seen below. The chart shows how this episode compares with past notable declines. In contrast to a month’s time, it took eight months for the Dow to give up 30% during the 2000-2002 market decline and fourteen months for the index to shed that amount in the 2007-2009 financial crisis.
Intensity of ’87
The intensity of the current market dislocation compares better to the October 1987 market drop. That episode saw the Dow Jones Industrial Average drop to 1,738 on October 19, 1987 from a pre-decline peak of 2,722 on August 25, 1987 for a 36% total decline in a little over a month’s time. Of course, the 10-year Treasury rate was near 9% back then, giving policymakers more latitude to implement traditional policy responses.
Unlike the situation in 1987 the cause of today’s situation is different as are available policy tools. Today’s policy response toolkit needs to be more expansive given extremely low interest rates and recent decline in credit market liquidity. We have seen the Federal Reserve turn to asset purchases and an array of direct lending programs designed to support liquidity in credit markets. A range of backstops, guarantees, and fiscal initiatives are also being discussed and are likely on the way. In time, we expect these actions and market dynamics to help restore liquidity to credit markets.
Direction of Causality
Another distinguishing characteristic of this latest crisis is the direction of causality between the economy and markets. Unlike past crises, which often spread from financial markets to the real economy, this one is moving the other way. The Covid-19 virus is a biological and social health-crisis which requires the shutting down of activities that not only drive the spread of the disease but also the economy. When restaurants, health clubs, malls, places of employment, etc. are shut down, incomes are lost. Businesses with significant fixed costs, including interest payments on debt, are potentially most exposed to losses and most at risk of default. Employment is also likely to be significantly impacted in coming weeks especially in front-line occupations like retail and restaurants. This economic process will not take more than a month’s time to show up in the data.
Disruption and Survival
Profits for most firms are going to be disrupted for a while. We maintain, however, that companies going in to this crisis with higher growth, higher profitability, and more efficient investment are better positioned to survive this crisis than those who have lower growth, lower profitability, and less efficient investment. How much debt companies has is also very important. All else equal, the more a company borrowed pre-crisis, the more at risk the company is of not making it through the crisis. While debt can increase a firms return on equity, the addition of debt to a company’s capital structure can also increase fixed interest costs, lower net income by the amount of interest expense, and lower bond ratings. The degree to which the debt is efficiently employed is key in understanding the difference between “good” and “bad” debt. Moreover, the effect of debt should be considered under conditions of worsened business conditions as well as normal conditions. During tough times, it becomes clear that debt shifts risks onto equity investors as it has in just a month’s time.
According to the credit ratings firm Moody’s Investor Services, baseline default rates are moving up. From Moody’s website on March 10: “The global speculative-grade default rate remained unchanged at 3.1% in February. However, we have raised our baseline default rate projection for year-end 2020 to 3.6% from 3.4% based on rising risks to growth, commodity prices and financial markets amid the coronavirus outbreak. Under a more pessimistic scenario, the default rate would go up to 9.7%.” While the 3.7% base case would be below the 20-year average of 3.7%, the 9.7% figure would be consistent with the 2000-2002 and 2007-2009 recessions.
Liquidity and Solvency
It is important to distinguish between liquidity and solvency issues when the economy becomes challenged as it is now. We believe tight liquidity conditions in credit will eventually normalize as markets adjust and policymakers enact supports. Companies with less indebtedness, greater profitability, and stable cash flow should prove more resilient and durable than those with significant debts coming due. As we mentioned last week, more profitable and less leveraged firms have suffered less during this period of stress. Accordingly, we continue to look for opportunities in this difficult period with a continued emphasis on creditworthiness, profitability, and consistency of operating results.
Opportunities can also be created in a month’s time!
Kevin R. Caron, CFA | Senior Portfolio Manager | 973-549-4051
Chad Morganlander | Senior Portfolio Manager | 973-549-4052
Matthew Battipaglia | Portfolio Manager | 973-549-4047
Steve Lerit, CFA | Client Portfolio Manager | 973-549-4028
Fixed Income Group
Paul Clark, CFA | Senior Portfolio Manager | 415-364-2635
Rick Marrone | Senior Portfolio Manager | 415-364-2917
Daniel Urbanowicz | Senior Portfolio Manager | 973-549-4335
Suzanne Ashley | Internal Relationship Manager | 973-549-4168
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Dow Jones Industrial Average — The Dow Jones Industrial Average (DJIA) is an index that shows how 30 large, publicly owned companies based in the United States have traded during a standard trading session in the stock market.
S&P 500 Sector Indices — All components of the S&P 500 Index are assigned to sector indices, which track major economic segments. Stock classifications are based on the Global Industry Classification Standard (GICS®).
WCA Fundamental Conditions Barometer Description: We regularly assess changes in fundamental conditions to help guide near-term asset allocation decisions. The analysis incorporates approximately 30 forward-looking indicators in categories ranging from Credit and Capital Markets to U.S. Economic Conditions and Foreign Conditions. From each category of data, we create three diffusion-style sub-indices that measure the trends in the underlying data. Sustained improvement that is spread across a wide variety of observations will produce index readings above 50 (potentially favoring stocks), while readings below 50 would indicate potential deterioration (potentially favoring bonds). The WCA Fundamental Conditions Index combines the three underlying categories into a single summary measure. This measure can be thought of as a “barometer” for changes in fundamental conditions.
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