March 18, 2020
Flattening the "Stress" Curve
What do we recommend?
Markets discount events well before they are reported by the media. At a minimum, economic conditions are expected to deteriorate over the next quarter, and the number of individuals affected by the coronavirus will increase. But like prior periods of stress, markets will begin to stabilize and adjust well before the news on the virus improves, and business conditions improve. As soon as investors can rule out the negative tail of rational distributions, we are confident that markets will begin to recover. Market bottoms usually develop 3-6 months after a panic begins. We believe the next few months are shaping up to be ‘the best buying opportunity’ in over a decade. Being prepared to dollar-cost-average into the market, focusing on those segments offering asymmetrical upside relative to the downside, provides the best opportunity for long term success. Every boom cycle ends in a panic with prices declining precipitously. But panic eventually gives way to more rational thinking and markets emerge to eclipse the prior peak. Now, more than ever is the time to begin anticipating what could go right.
What are the Fed and Administration doing to support the economy?
To alleviate increasing stresses in markets, the Federal Reserve this week initiated significant accommodative measures similar to those passed in 2008, intended to ease financial bottlenecks in the economy. Firstly, the Fed reduced its benchmark rate to 0% to 0.25% and announced plans to initiate QE4, buying $700 billion of Treasury and mortgage securities. This increases the size of the Fed's balance sheet to well over $5.0 trillion (the previous peak was $4.5 trillion). Secondly, the Fed reduced the discount rate to 25 bps, which encourages banks and primary dealers to access the discount window. Finally, the FOMC lowered the price of dollar swap rates with foreign central banks to help smooth global liquidity. We believe the Fed's actions provide much-needed liquidity to the markets and helps reduce friction in primary financing channels. Fed Chairman Powell made it clear that the Fed's primary objective over the next several months will be to facilitate, as much as possible, the efficient flow of funds through the financial markets. Powell acknowledged that the U.S. Treasury remains the foundation of the international monetary system and ensuring daily access and liquidity will be critical in addressing any pressures.
The Administration is also expected to announce a $1 trillion stimulus package directly targeting workers requiring extended leave as a result of the virus, including those subjected to quarantine, individuals caring for family members, and those caring for small children impacted by school closings. Senate Majority Leader Mitch McConnell said the bill would first focus on the families most impacted by the virus, then seek to stabilize small businesses, the health care system, and medical professionals. Treasury Secretary Steven Mnuchin said the bill will include $250 billion of direct payments to individuals with an option to increase payments above this level in the coming weeks, if needed.
How is the credit market responding?
In credit, the spike in the borrowing costs in liquidity constrained companies is raising red flags. An estimated $300bn or 9% of the total inventory of BBB rated bonds now yield more than 6.0% with investors beginning to price in the probability that individual airlines, energy, and auto-related credits will be downgraded. A reduction in the credit rating to below-investment-grade would force the automatic liquidation of these bonds from pension and sovereign wealth funds not permitted to own non-investment grade bonds. On top of that, there is an additional $230 billion of BBB debt trading at yields higher than 5.0%. As the recession unfolds, the potential for downgrades and defaults increases, which could quickly push a company into bankruptcy if they are unable to meet current obligations. Delta Air Lines' bonds, for instance, are currently priced to yield nearly 8.0% and Ford and GM are forced to pay more than 7% to access liquidity. Hospitality and travel-related sectors are also under increasing pressure, with Royal Caribbean Cruises likely to be downgraded to below investment grade in the coming weeks. A trade group representing U.S. airlines called on Congress this week for $50 billion in aid to help soften the impact of the downturn as a result of mass cancellations in bookings.
More broadly, the Barclays Investment Grade Index is ~245 basis points (or 2.45%) over Treasuries, eclipsing the 2016 peak of 221 bps but still shy of the Oct 2011 peak of 260 bps. For perspective, the spread in investment-grade bonds reached a high of 618 bps in Dec 2008. One of the larger risks to the market is the number of bonds rated BBB. According to CreditSights, over half of the high-grade market is now rated BBB, just one step above junk, compared to 36% in 2005.
As credit spreads widen, we expect an increase in bankruptcies in the U.S and Canadian oil sector. With oil prices now down over 58% in just two months and production increasing in OPEC, smaller cash-constrained companies are getting squeezed. The chart below shows the expected increase in U.S. bankruptcies over the next 18 months.
What do you expect to happen in the stock market?
The average peak-to-trough decline in the S&P500 during recessions the past 90 years has been -38.9%. With the S&P500 peaking on 2/19/20 at 3,386, a -38.9% decline would equal 2,068 in the S&P500. The current bear market looks most like the ones in 1980, 1987, and 1990 when the U.S. economy experienced a sharp but relatively short in duration recession. During each of these bear markets, the S&P500 declined an average of -24.7% or to about 2,550 in today’s prices. Splitting the difference between -38.9% and -24.7%, or (2,550 + 2068/2) implies the market could trade to ~2,300, a peak-to-trough decline of 32% to 34%. Earlier this week, the market was already discounting 90% of the expected drawdown.
Will there be a recession in the U.S?
Wellspring now believes a recession began March 2020, that will last 6 to 9 months (see chart below). Over the next six months, we expect consumer demand to decline sharply as economic activity resets to lower levels, prices drop, and the cumulative impact of longer-than-anticipated quarantines adds deflationary pressures to the economy. Increased pressures on small businesses will likely require bridge loans and backstops from the Federal government. The ten largest banks announced they would immediately begin lending to "small businesses and the broader market" and suspend share buybacks through June.
Year-over-year changes in the S&P500 are also correlated with the average change in consumer confidence on a year-over-year basis. The recent 30% decline in the S&P 500 equates to about a 25% decline in consumer confidence, suggesting the U.S. economy is in recession.
Econometric demand models point to the unemployment rate rising in the U.S. to 5.0%-5.5% between now and year-end, up from 3.7% at the end of 2019. A 35% increase in the unemployment rate has always coincided with a recession in the U.S.
The yield on the U.S. 10-year treasury notes bottoms historically at 1.5 standard deviations below trend, which is where the rate is currently (see chart below). Given the positive correlation between stock prices and bond yields, the slope of the yield curve needs to steepen which would signal monetary policy is beginning to have a positive impact which would allow stocks to begin recovery.
How will we know when to reenter the market?
We track several indicators of financial stress, including two of our favorites, the high yield option-adjusted spread on CCC debt and the International Financial Conditions Index. Yields on the weakest credit continue to move higher, closing 16.5% higher than similarly dated Treasury notes. As shown in the chart below, spikes in credit spreads always coincide with significant drawdowns in the market. Alternatively, the rate of change in spreads (the bottom channel) needs to roll-over before the market begins to recover. As of 3-18-2020, credit spreads continue to widen at a fast pace.
We also need to see the global Financial Stress Index (FSI - the red line in the chart below) stop climbing and roll-over before becoming more constructive on risk assets. The FSI is a composite of yield spreads, valuation metrics, various rate term structures, credit spreads, and volatility. The green vertical line in the chart highlights prior peaks in the stress index. These peaks closely align with troughs in the S&P500. As the chart clearly shows, the FSI continues to climb on the assumption of increased downgrades in credit in the coming weeks.
What are the next steps?
The table below shows the performance of different segments of the U.S. stock market for various periods over the last 20 years, as of 2/28/2020. When the rate-of-change in our stress indicators begins to slow, our approach will be to consider first those segments of the market most negatively affected by the combination of falling investor sentiment, declining earnings revisions, and below-average valuations. Through March 17th, small and midcap funds have declined ~40% or nearly 38% more than their large-cap counterpart (S&P500). Typically, funds that decline the most in stress environments are often the best place to find value.