A view from the markets – Cash-flow
This is a locked-down musing on the impact that disrupted cash-flows have on different asset classes. While government revenue is undercut by the recession, government can still fund itself and repay its creditors. While governments have quickly established alternative sources of funding for the corporate sector, they have also been able to rely on central banks being the buyer of last resort. Hopefully, the support put in place will allow corporate assets to remain valid even as cash-burns. Some are better placed to withstand the revenue disaster, some are better placed to access alternative sources of funding (government schemes). Most, however, will take a hit to equity valuations. The extent of this depends on the length of the recovery process determined by three phases – the peak of the global infection rate and the risk of any second waves, the speed at which lock-downs can be lifted and the shape and duration of the return to normal. The risk associated with different asset classes will change over time, but for now they are poles apart.
Not what you want to hear
More than ever, investors need to have a clear view on the security of the cash-flows that underpin the value of the assets they invest in. The current crisis has created huge disruptions to all manner of corporate cash-flows, rents and government tax revenues. Reduced cash-flow increases leverage and reduces equity valuations. The safety of cash-flow to an asset depends on a number of factors – the resilience of revenue streams, the availability of cash and liquidity, the amount of leverage and the ability to dispose of other assets to raise funds. The market is perhaps sending a very sobering message right now – that based on an assessment of the security of cash-flow, core government bonds are now safer than ever while some corporate assets are more riskier than ever. Understanding why that might be and how it could change is key to setting a medium term investment strategy.
Any government’s ability to service its debt comes from its power to generate tax revenue and to tap the savings of the private sector to allow the regular refinancing of its liabilities. Revenue comes from taxing economic activity, or, in some cases, through direct government ownership of assets that generate revenue, such as oil reserves. Investors worry about the sustainability of government debt when debt levels exceed a certain threshold of gross domestic product, when economic growth slows and undercuts tax and other revenue growth, and when reduced access to pool of savings causes borrowing costs to rise. The current situation should be threatening on all counts. Debt to GDP levels are going to rise rapidly because governments have taken the (correct) decision to increase spending in order to offset the collapse in private sector demand that has resulted from the disruption to normal economic activity. This will increase budget deficits and raise debt levels. At the same time, the denominator is collapsing. Tax and other revenues will fall sharply as a result of the decline in GDP. The cost of borrowing should also increase. As governments borrow more, the volume of issuance of debt will increase at the same time as investors become worried about the fundamental financial situation. That should demand a higher risk premium for lending to governments. In other words, government bond yields should rise.
Safe as central banks
All of the above is true. However, yields are falling in many government bond markets. This is because the market believes that governments are uniquely positioned to either safe-guard revenues through control of the tax system and the ability to sequestrate private sector cash-lows if necessary, or seek other sources of financing beyond the global pool of savings. That other source of financing is the central bank. It used to be taboo in economic policy circles to contemplate central bank financing of government deficits. However, since the financial crisis this is what essentially has been done through quantitative easing involving the wholesale purchase of government bonds by central banks creating bank reserves. It is less crude than simply crediting Treasury accounts at the central bank with cash and the bond purchasing is done in the secondary market, but the effect is much the same as direct financing. Since the COVID-19 crisis erupted central banks have re-started and resized their bond purchase programmes. For the time being, most of the new issuance that is coming will be absorbed by central banks. Private investors will buy the government bonds through the normal primary issuance mechanisms of auctions and syndications, but in the knowledge that they can sell bonds to the central bank when they want to redeem and that government cash-flow is backstopped by the whole process. This guarantee of coupon and principal repayments is rock solid for most major government bonds. This is why we are seeing yields go down in sectors such as the US Treasury, UK gilt, German bund, Japanese, Australian, Canadian bond markets, amongst others. When there has been a catastrophic hit to revenue growth in the economy, the safest asset is the one issued by the one entity that can change all the rules quickly – government.
Mutual support needed
Theoretically, the share of government bond markets that the central bank holds will keep increasing. That means a scarcity premium in bond prices for the private sector who still need to hold government bonds for the purpose of capital security as well as matching cash-flows to their own liabilities. Thus yields are likely to keep falling until the supply of bonds becomes overwhelming, the pace of central bank purchases slows and the cash-flow security in corporate assets improves again. This has obviously been the case for much of the past decade which is one reason why betting that yields will rise has tended to be the wrong trade. Outside of the core government bond markets the outlook is a bit murkier. In the peripheral sovereign bond market in Europe there will be a lot of security provided by the fact that the European Central Bank is buying. However, the starting point in terms of debt/GDP, economic distress and access to the appropriate pool of savings is worse for countries like Italy and Spain. This is why the current discussions about the use of the European Stability Mechanism or the creation of mutually guaranteed Corona bonds is important. If Italy also can rely on the mutualisation of part of its debt as well as the programmes of the ECB, then its risk premium will come down and cash-flows will be more secure. But there is uncertainty in the short-term. The economic costs of the pandemic are still rising, Italy’s economy was weak anyway, and the Italian government will need more financing. Having confidence in buying Italian BTPs needs more assurance that the infection rate is peaking, that the full economic costs can become clearer and that there is a long-term assurance on financing the Italian government. In my view, we are nowhere near that point and I would not be surprised to see Italian yields higher again.
Emerging markets need global recovery
Moving further away from the anchor of security we get to emerging market government bonds. This is a sector that has suffered a lot in the current crisis. The JP Morgan EMBI Diversified sovereign bond total return index is 16.6% off its high point of 21st February. Governments in emerging markets rely on tax revenue but also on revenues from assets that they exert control over, like oil. The collapse in the oil price itself has weakened the financial position of some emerging market governments. Typically, governments also have had to rely on tapping foreign investors to finance part of their debt because of the inadequate size of domestic capital markets. When crisis hits the terms of trade of emerging markets economies normally deteriorate, this causes the domestic currency to weaken, and thus increases the cost of financing debt denominated in foreign currency. This would also be associated with a decline in economic growth and an increase in the cost of borrowing as access to capital markets would be reduced. Historically, this process has led to sovereign debt crises resulting in internationally financed bail-outs and debt restructuring. No wonder the average cost of borrowing for emerging market countries (5-7 year maturities) is over 8% today while for the US government it is just 0.5%. For investors to get more confident on emerging market debt, we need to see that the re-opening of the Chinese economy will start to reflect positively on trade, that oil prices might recover in the wake of any production cuts brokered by President Trump and some evidence that capital markets are again open to new borrowing.
For the corporate sector there is always a difference in risk between corporate bonds and equities. Bond holders are creditors and are preferred in the capital structure. Coupon payments take precedence over dividends. We have already seen the pressure on cash-flow from reduced revenue leading to the suspension of dividends for many companies. For corporate bond holders the security of cash-flow (and the probability of receiving coupon and principal repayments on time) depends on revenue, the level of debt that has to be serviced, the access to cash and the ability to refinance. Credit ratings are supposed to reflect the relative risks between corporate borrowers. It is pretty obvious but in a crisis like this you want to be exposed to assets of companies that have diversified revenue streams, low levels of existing debt, high cash reserves and access to credit lines. Ideally they are also cheap when you buy them. At the asset class level, the provision of liquidity by central banks helps the corporate bond market because it provides a “get-out” for investors that hold corporate bonds. Companies are also able to benefit from some financial support provided by governments. However, key here is for how long. A prolonged period of revenue growth at substantially lower levels than usual will reduce the equity valuation of companies and make it more difficult to meet debt obligations. Central bank buying paper in the market doesn’t change those corporate fundamentals. Eventually, the equity holders will be left with nothing and bond holders will assume control of the business in a bankruptcy situation and try to recover some value. Allowing the bond market to function is key to minimise the increases in defaults and bankruptcies. For those that are able to survive their “Merton Moment”, they do look cheap from valuation point of view. Adding risk to portfolios in investment grade credit should be the first step.
Higher yields for some time though
Of course, central bank buying of corporate bonds is not a blanket guarantee for the entire private sector. Purchase programmes are focussed on the better quality companies – which in the end do make up for a large part of economic activity and employment. But this is good. If the central bank is a buyer of investment grade paper, then private investors should also feel comfortable about buying and holding investment grade credit themselves, notwithstanding the need to do the credit analysis at the individual issuer level. This is playing out as we speak. There has been a huge amount of new issuance in the last couple of weeks in the US and European markets. It has been well received by investors. The yields on offer are higher than what would have been the case before the crisis. But companies need money and are willing to pay for it. In a sense, depending on how long it takes for us to get into some kind of economic recovery, the prospects for some companies are better than they are for some stressed governments where open-ended commitment to supporting incomes and employment is a real burden. Companies are able to furlough staff for some time and thus reduce costs, the government is having to pay for that. After government bonds, investment grade credit remains the safest asset class for now. I am not expecting credit spreads to narrow much and there are bound to be more downgrades and market liquidity is going to remain horrible for some time. But the medium term performance from credit, starting from these currently stressed levels, should be quite attractive.
Eeking out the cash
High yield companies are more leveraged, may operate in sectors where revenue growth is more volatile and have less easy access to funding markets. Traditionally the high yield sector has been where most defaults have been seen as companies burn through cash quickly in recessions and face a rapid closing down of access to refinancing. I’ve discussed high yield a couple of times recently. The cash-flow to the investor is uncertain in some cases and this is reflected in market yields and spreads. Again, the common thing here how long the crisis goes on. An extended period of lock down raises the number of companies that will run out of money and not even government funding can stop that playing out entirely. From an investment point of view holding a diversified exposure to high yield is the best way forward. The valuations are attractive but it could still be ugly.
L-shape risk for EPS
I believe that if you can take a long-term view then equity markets offer very good value right now. However, the value of equity depends on the value of future earnings. What we don’t know right now is how much earnings are going to fall and how long it will take them to recover. And we don’t know those things because we don’t see yet a sustained turning point in the spread of the disease or a clear exit strategy. Even in the Wuhan province of China, free movement and normal activity is yet to be fully restored because of the fear of a second round of infections. Even if we did know what the earnings trajectory looked like for the next two years, the ability of a company to sustain itself today depends on its current free cash-flow, reserves, levels of leverage and access to financing. Companies with limited leverage, more sustainable earnings outlooks and access to cash are the ones most likely to hold their equity values. However, the market outlook is still fraught with risk given the potential for the disease’s life cycle to be extended and for the consensus to start to focus on moving towards more of an L-shaped recovery and away from a V-shaped one that seemed to be the right view a few weeks ago.
When do risks change?
Ultimately investing is about giving up consumption today to achieve higher income in the future, with that income being generated by the cash-flow and higher equity values received on the invested capital. Key to this is the security and variability of the cash-flows that the assets themselves are able to generate, either distributed or retained into equity. At the macro level they come from government and corporate revenues. In this crisis, revenues have been severely interrupted and leverage has necessarily increased. What determines the safety of an investment in the near term is the extent to which this fundamental process has happened, the existence of sources of cash-flow that are able to compensate for reduced revenues and the ability to cut costs to stretch out the window of survival. For now, the safest cash-flow assets are government bonds. That changes when investors start to concern themselves with the longer-term sustainability of debt, when supply starts to overwhelm what will at some point be scaled back QE and when and if inflation starts to rise. For credit, the prospects for investors depend on the longevity of the crisis and whether the backstops can be sustained for a prolonged period. The guess is that they will remain in place for some time. Equities are where there should be more concern about cash-flow and valuations. I am starting to hear -50% type of numbers for EPS forecasts. The longer term outlook should be better because businesses will eventually recover, but that lack of visibility on cash-flows in the short-term might mean lower equity valuations before we get that recovery. However, for the moment, the recovery from the lows of March seems to be holding – but watch this space.
Three stages to go
This has been a bit rambling. To summarise, different asset classes have different risks associated with the cash-flow. This economic crisis has exacerbated these differences. The common factor is how long the period of dislocation lasts. This period of dislocation has three stages to go through from here. First, the playing out of the infection cycle. Second, the speed at which lock-downs are dismantled. Third, how quickly and robustly recovery takes place. Government bonds will remain the safety first asset until we get to stage three. Credit can start to perform better in stage two and equities and high yield will really come into their own when recovery is foreseen. One positive is that government assistance to support incomes does provide some hope for recovery, certainly compared to the almost unthinkable position the world might have been in if they had not acted quickly and in huge size.
Stay safe and #StayAtHome