March 2020: Where We Are Going From Here
By Bram de Haas:
We’ve been in such a raging bear market (the fastest decline of the S&P 500 (SPY) ever) that there has been barely any time to sit back and let everything sink in.
Every day there are opportunities to evaluate and new threats emerge.
But over the past several days I’ve taken the time to think about the big picture. Where's COVID-19, the U.S. election, the market turmoil and the recession all leading? Are there asset classes/types of businesses to invest in that will do great in most futures? How are these priced?
Where are we now?
The current state of affairs can be factually summed up as follows:
- We’re in a bear market.
- We’re 99.5% likely already in a recession.
- There's a lot of uncertainty around COVID-19 and number dead will be increasing over the next few weeks, if not months.
Where are central banks?
- The Fed can lower interest rates by 25bp until zero (possible to go lower but Jerome Powell is not a fan)
- ECB interest rates are -50bp (lowest ever already/Denmark and Switzerland are even lower)
- Japan interest rates are -10bp
- Chinese interest rates are 225bp
- Fed is doing (unlimited) QE 4/5
- ECB is doing QE
- Japan is doing QE
- China isn’t doing QE (it is stimulating through fiscal policy)
Where's the government?
- U.S. is deploying fiscal stimulus (likely to do helicopter money)
- EU countries are deploying fiscal stimulus (some countries are doing helicopter money)
- Japan is doing fiscal stimulus (considering helicopter money)
- Hong Kong is doing fiscal stimulus (helicopter money)
What's perception like?
In an earlier note, I’ve talked about the variant view idea by Michael Steinhardt and how that concept is important to achieve outperformance. I believe the following reflect viewpoints that are commonly held:
- The V-shaped recovery is generally accepted as being off the table.
- Perhaps the current most widely expected scenario is a U-shaped recovery.
- A decent percentage of market participants think we can deal with the virus and move on.
- Most participants put a high probability on further short-term declines in the equity markets.
- The currently announced timeframes for social distancing and/or self-isolation are viewed as “hard” target dates but it could turn out significantly more time is required.
- The crisis will be deflationary.
I never want to disagree just to disagree, but I’d guess the consensus is overoptimistic about the coming crises but probably right that it will initially be deflationary. The data points that I’m looking at lead me to the following viewpoints that probably are not consensus:
A -U-shaped recovery seems unlikely to me and an -L-shaped recovery is more likely.
Standard monetary policy has been depleted.
The “act of god” type of crisis hurting the “real economy” makes it the perfect type of crisis for the political spectrum to come together on fiscal stimulus.
Because of the exponential nature of virus spread, there will be so much pressure on politicians that I expect they do get things done sooner rather than later. I expect better results out of the U.S. compared to Europe both on the fiscal and monetary front. The EU is simply more divided and the ECB already tapped out when COVID-19 first surfaced.
In terms of crisis resolution, there are definitely green shoots with both chloroquine and remdesivir showing a lot of promise as therapies. These could definitely help to lower the mortality rate if not serve as a psychological boost.
Recession in motion
Even if we deal with the virus relatively swiftly and it doesn’t cause prolonged disturbance of our economy, it already set off a deleveraging process.
All kinds of businesses are losing revenue like never before. Some have literally seen revenue drop to zero. Employees are being laid off and more will be laid off, capital investments are curtailed and costs are cut wherever possible.
Employees who lost their job will cut spending and that sets off a vicious cycle of businesses making less revenue. A global recession is likely unavoidable.
This vicious cycle could be mitigated or ultimately even countered by enough fiscal and monetary stimulus, but if you take a long hard look at the possibilities on that front, the situation is chilling.
In the short term, there can be vicious further declines as well as rallies because of the stimulus. In the medium term, the stimulus is unlikely to overcome the amount of damage that will be done.
The Fed is taking unbelievably aggressive steps. A dramatic shift from an earlier more sanguine attitude toward the unknowns surrounding the impact of COVID-19 on the global economy.
The Fed is now likely sensing the first tremors of what it knows could be a devastating earthquake followed by a massive tsunami.
It’s not my default scenario but there's a distinct probability that policymakers over-stimulate and inflation could come back from a decade of hibernation.
Why is this recession potentially highly problematic?
Government debts are particularly high in Japan, the U.S. and many large countries in Europe. That makes it harder to keep interest rates down and issue debt at low rates. The U.S. has the benefit of the reserve currency. I’m not going into questions like unfunded pensions that are less onerous in the Euro area. The table below shows debt as a percent of GDP per country:
The map below shows what type of budget deficits countries have. Red and orange is bad. The U.S. already is running on a large fiscal deficit and on average deficits widen by 6% in a recession. I’m not inclined to take the under on this one and that will really blow out the U.S. deficit. Perhaps to an extent that even deflation can’t keep bond yields down.
It's also interesting to take a look at tax revenues across the globe. If there’s lower taxation that leaves some room for future tax increases which makes it less likely countries default and allows for lower yields. Europe just doesn’t look good if you add in this datapoint. France and Italy really stand out in a bad way:
Demographics also are important. Keep in mind that COVID-19 hits especially hard among people that are 70-plus. Europe and Japan have an older population with more dependables. That makes these geographies more vulnerable to crises.
Is this a buying opportunity?
Lots of people are asking the question of whether this is a buying opportunity because of the ~30% market decline. Given that we are sure to go into a recession I do not think the market is a giant buying opportunity. There are most surely great buys out there if you have a long time horizon. I’m not thrilled about the idea of buying broad market indexes.
Energy is one area with a lot of opportunities because:
A) It was the cheapest sector within the S&P 500 even before this COVID-19 sell off.
B) Demand issues are compounded by supply issues due to the Russia / Saudi-Arabia fallout. Basically, everything has gone wrong for the energy sector. There's not a whole lot left that can go wrong from here. Be very careful investing in indebted players. But there have to be great buys here.
Where are the weaknesses?
PwC had an interesting white paper into vulnerable sectors within an economic downturn. Metals producers, financial services and hotels/restaurants were at the top.
Brookings published interesting research into areas that are at high risk from COVID-19 and there’s a lot of unsurprising overlap most notably with mining and leisure/hospitality.
Mining has been a focus for me for years now because it has been a very out-of-favor sector. COVID-19 could actually cause supply shortages (demand destruction notwithstanding) because mines could get shut down.
All of the above industries are very interesting to look for short-selling targets and areas to avoid. However, they’ve also in part been re-rated downward to account for their vulnerability, COVID-19 and the upcoming recession.
The stimulus could selectively help companies within these industries. It's not clear to me how that’s going to unfold. Companies within these industries that also are highly indebted are especially vulnerable. The U.S. government can hardly dole out free money to big corporations especially in an election year.
Inflation or deflation?
A key question in order to determine how to position is whether this recession will be deflationary or inflationary.
I think it depends on the magnitude of combined global monetary and fiscal stimulus compared to the damage caused by COVID-19 and the bursting of the “everything bubble.”
I don’t think there will be any talk of austerity this recession and stimulus will arrive sooner than it historically has. I expect it will be more copious and targeted more directly toward spenders.
Here’s a very simple overview of what assets do well under what conditions:
Source: Gavekal research
And a bit more complex overview by Advisor Perspectives which leaves a few more choices besides the U.S. dollar, government bonds and bitcoin (if you want to be creative).
We could end up in either of the two left-side quadrants. Most likely start in the lower left quadrant before moving into the upper left quadrant.
I prefer allocations that do well in either environment. I want to avoid allocations that get killed in either one of the left quadrants. That includes government bonds with longer maturities. These would do great if we end up with deflation but do poorly in inflationary stagnation.
Overall, I’m inclined to expect a deflationary environment at first but believe there's a real probability that a series of fiscal and monetary policies could set in motion a long-awaited inflationary environment.
Given some of the action in 30-year bond yields it's possible that the market actually fears inflation. This could be because the depth of the problem is underestimated. The stimulus is viewed as excessive. However, in my view, it will soon turn out that the stimulus (given what I’m seeing now) is not sufficient to offset the damage caused by COVID-19 and the subsequent credit contraction.
Gold, for example through the SPDR Gold Trust ETF (GLD) and precious metals like silver, for example through the iShares Silver Trust ETF (SLV), should do well in either environment.
Cash and equivalents can do reasonably well on a relative basis if the inflation is muted either way.
Finally, I think it's paramount to consider the relative popularity of the deflationary/inflationary assets.
Commodities are really cheap. I think a commodity allocation is almost mandatory because the risk/reward is so great. I’ve written up Altius Minerals (OTCPK:ATUSF) on The Special Situations Report. It's a great way to have commodity exposure with positive carry. A company I’ve been buying recently is Anglo-Pacific Group (OTC:AGPIF). It's another company I’ve written up for this service in the past a very advantageous way to get diversified commodity exposure.
To go to Treasuries you need to be very certain this is going to be a deflationary environment. I do not love allocations to iShares 20+ Year Treasury Bond ETF (TLT) or iShares 7-10 Year Treasury Bond ETF (IEF) anymore.
It could work out great in the medium term (especially with unlimited QE and possibly Yield Curve Control coming). Yet I’m not thrilled with an allocation like that given there's a reasonable probability we’ll see a scenario where these do terrible.
Silver is very interesting because it's very cheap based on the historical relationship to gold. Treasuries are likely at such low yields because a deflationary recession is expected. That raises the question of how much money are you going to make if it turns out to be right?
Besides physical silver, the only company I really like in the silver mining space is Wheaton Precious Metals (WPM), which is definitely not a pure-play that I wrote up in 2017.
The graph below shows the gold/silver relationship. Gold is rarely this expensive vs silver.
About Special situations
Special situations are not included in most models but I believe subsets of these are actually very attractive in the coming environment. Not all of them do as well in a growth environment although from a risk/reward perspective I love them throughout cycles.
This is a graphic with the wide range of situations that I’m usually very interested in:
Image: authors own
Over the past year, I’ve been very engaged in M&A and that worked out very well over 2019. We were very early in the Bristol-Myers (BMY) and Celgene deal anticipating that it couldn’t be blown up by an activist. I still hold the very juicy contingent value right (BMY-RT). We also did well when Occidental Petroleum (OXY) acquired Anadarko, although unfortunately, Chevron (CVX) didn’t come through with an overbid. I’m definitely still interested in M&A but it is now a much tougher environment (although spreads have really blown out with the VIX at 60-plus).
Last year I did not like the special situations very much that also have a lot of market risk in them like spin-offs, hidden assets and obscured growth type of situations. Going forward I still don’t think these are the best type of situations to focus on.
Where are the opportunities in special situations going forward?
M&A is great, but opportunities will be rarer. Deals will be few and far between in the short and medium term. Liquidations are great and these are likely to pick up. I think distressed or discounted credit also is becoming very attractive. Closed-end funds are currently also an area I’m looking at with great interest as the volatility has blown out the discounts.
Shorting equities is potentially very rewarding as neither environment we could move into is one where equities typically do well. Because of that - the inverse or shorting them should do well.
In the U.S. banks have been recapitalized and do not look vulnerable. However, a lot of the business development companies, high yield and leveraged loan asset managers could be in trouble. Fixed-income ETFs stand out as problematic. The problem with these is that once you see massive outflows from high-yield fixed income for, example, bonds will get dumped on the market without bidders.
The NAV of these ETFs, like the iShares iBoxx $ High Yid Corp Bond (HYG) and SPDR Barclays Capital High Yield Bond ETF (JNK), can be partly based on the “market price” of a set of bonds that hardly trade.
But the ETFs can have $5 billion up to $13 billion in assets under management. Under normal circumstances, a fund may be hit with outflows, but even if the liquidity isn’t there in the underlying it can trade with other ETFs to obtain liquidity.
If they are all hit with withdrawals at the same time, that road is cut off. The ETFs have to obtain liquidity in the market, but it simply isn’t there. In the current conditions where traders are working from home or camping on the floor in tents, things may get rough.
If the ETF gets hit with an avalanche of outflows there's simply no choice. It has to execute a sell order bid or no-bid. After a few rounds of that, the ETF price drops very quickly.
This then affects the ability of the issuer of those bonds to refinance or issue new bonds. It becomes apparent to the remaining investors that if others leave the entire ETF gets hammered down because of the newly discovered very disadvantageous market prices.
With every exit, prices of more and more bonds get ground down. Investors may not like the prices at all but see themselves facing a situation with a high likelihood that others will start bailing and that further limits their options to exit in a reasonable way. If an investor employed leverage investing in these apparently liquid high yield ETFs he or she is almost forced to get out or get cornered.
There’s been a carnage in closed-end funds. From time to time I buy into closed end-funds and this is an opportune time, although I have to say there are opportunities in other special-situation pockets as well. What I like here is that I’ve been able to buy actively-managed credit funds at large discounts to NAV with great operators. These offset some of the risks of shorting credit ETF’s which I expect to do horrendously.
Features that are important to me in closed-end fund investing are:
- A strong strategy
- An attractive discount to NAV (also relative to its historical discount)
- A good manager or firm with a great culture (preferably a value tilt)
- And reasonable fees (fees are often high in this space)
Funds I’ve bought in the last few trading days are GDL Fund (GDL) which is an arbitrage fund currently trading at a 28% discount to NAV. That’s historically an incredibly wide spread to NAV. It's not a super high returning strategy but it is usually highly volatile either. On the current share price it pays a backward-looking distribution of 6%. Its portfolio is quite diversified but it has a leverage ratio of about 47% which is substantial.
Another one I’ve bought is the Guggenheim Strategic Opportunities Fund (GOF) which is run by a very strong operator. It runs a credit-managed fixed-income portfolio with access to a diversified pool of alternative investments and equity strategies.
It’s a very flexible fund (which is great if the manager is good). The backward-looking distribution rate is nearly 16%. The fund usually trades at an 8%-9% premium instead of the current 5% discount. The discount is not very large but that’s because the manager is highly regarded. If volatility decreases, I’d expect it to ultimately get back to a significant premium.
The Guggenheim credit allocation fund (GGM) trades at a 12% discount to NAV vs. its usual 2%-3%. The backward-looking distribution rate is about 16%. The leverage ratio is about 28%.
Doubleline Income Solutions (DSL) employs a 40% leverage ratio which really stands out. It currently trades at a 12% discount to NAV. Long term it usually trades at a 2% discount. Its backward-looking distribution rate is about 16%. Doubleline is managed by Jeffrey Gundlach (Barron’s dubbed him the new bond king) and he’s an extremely savvy investor.
Both Guggenheim and DoubleLine run funds of a limited size run by excellent operators that I expect to make the most of the current market volatility. The funds don’t trade at the largest discounts to NAV (you can surely find deeper discounts) but in the credit space, I prefer making sure the teams are talented and have the ability to navigate a very tough environment with liquidity constraints.
I’ve written a few times about the Renn fund (RCG) which trades at a ~18% discount to NAV. It doesn’t pay a distribution but it actually held 40% of funds in money markets. I don’t discount the cash (because of a trustworthy and excellent manager in Murray Stahl, also Chairman of my FRMO Corp (OTCPK:FRMO) holding. That implies the rest of the portfolio actually trades at a 33% discount to NAV:
Generally speaking about closed-end funds I don’t count on the distributions holding up at these levels but think that over time the discounts to NAV will revert back to normal. Hopefully, while the portfolio did not depreciate too much in value or even appreciated.
I also wanted to go over M&A opportunities quickly which I intend to revisit in more detail soon. Here are a number of great deals, there are other good ones too but I’m not ready to include those. I think dealmaking is dead for a while but there are definitely attractive spreads out there although risks have markedly increased.
Just a few days ago I wasn’t too confident about the Tiffany’s (TIF) and LVMH merger but since that time I’ve learned that the spread blew out because of personnel transition at Citadel (the positions of the M&A head were closed) and LVMH chief Arnauld desires to buy shares in the open market. This deal is definitely back on my favorites list.
About the Alphabet (GOOG) (GOOGL) deal. Governments are violating citizens right, and privacy everywhere in the name of COVID-19 containment but regulators are going to block the acquisition of a health watch company? A watch that could actually be helpful in combating pandemics going forward without governments having to shell out? I mean, it could get blocked but it would be a game-changer in M&A.
A negative sign for the deal is that execs have been selling some shares ahead of the merger. The only explanation that isn’t negative I can come up with is that they’ve got margin calls on their other investments.
|Name acquirer||Name target||Target ticker||Acquirer ticker||gross spread|
|Private equity||Tech Data Corp||TECD||non-public||21.20%|
|Alphabet Inc Class C||Fitbit Inc||FIT||GOOG||16.05%|
|LVMH Moet Hennessy Louis Vuitton SA Unsponsored ADR||Tiffany & Co.||TIF||LVMUY||9.81%|
|Franklin Resources, Inc.||Legg Mason Inc||LM||BEN||8.44%|
|AbbVie Inc||Allergan plc||AGN||ABBV||5.25%|
|Waste Management, Inc.||Advanced Disposal Services Inc||ADSW||WM||5.58%|
|Gilead Sciences, Inc.||Forty Seven Inc||FTSV||GILD||2.30%|
|T-Mobile Us Inc||Sprint Corp||S||TMUS||2.33%|
Implied volatility is very high across the market. That means options are generally very expensive. Even M&A targets have been unusually volatile. This has likely resulted in funds blowing up. That must have further exacerbated the volatility. With the Fed turning super-aggressive recently you could sell puts on M&A targets. The Fed's actions will likely suppress volatility, which decreases the value of the puts as well as closing the spreads on M&A deals.
This also can be interesting if you expect deals to get delayed beyond what the market expects to be closing dates. But careful because the losses are potentially large if the deal breaks. Keep in mind that targets are likely to fall further than their pre-deal prices because of market developments.
- Most likely we are entering a deflationary negative growth environment
- Subsequently, we could move to an inflationary negative growth environment (could happen fast)
- Gold tends to do well in either environment
- Silver tends to do well in either environment and is undervalued based on the relationship to gold
- Treasuries do great in a deflationary environment but can get killed by strong inflation
- ETF credit space could get destroyed
- There are interesting dislocations in closed-end funds
- M&A market is dead but remaining deals selectively offer great spreads
To be continued…
See also FOMC Press Conference Adds To Downside Risks on seekingalpha.com
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.