Why We Are Cautious
Monday, April 06, 2020
Much of what we’re reading is on the state of corporate credit. Unfortunately, it’s ugly! It was always going to be a problem during the next recession. Not only did COVID-19 bring the problem forward, but the sudden halt to the global economy will greatly amplify the negative economic consequences of excessive corporate leverage.
During the best of times, we have a general preference for large companies over small- and medium-sized firms. It’s now a very strong preference, as those larger companies are much better capitalized.
Nancy Lazar, the Chief Economist at Cornerstone Macro, suggests that the fallout from excessive leverage could be minimal because it’s the small firms that are over leveraged. We worry it could be worse, when record high leverage hits an economic brick wall. Just because the “averages” indicate less leverage in large-cap land, doesn’t mean there aren’t going to be some very big companies in trouble. After all, Ford had its debt downgraded to junk last week.
We believe the authorities will succeed in keeping markets liquid and limiting the corporate carnage in the short term. It’s the medium term we worry about more (i.e. the recovery period as we move past COVID-19). Even if we assume that happens fairly soon, we worry that the corporate world will be very shaken and weak. Government programs will no doubt save many businesses, yet corporate balance sheets will almost surely be in worse shape than they were before this crisis. Interest rates will be rock bottom, but we doubt companies will be in a mood to borrow and spend, or buy back stock. Rather, having survived a near-death experience, we think companies will be much more conservative. Lenders too.
Once we are allowed to leave our homes, there is no doubt there will be explosive growth in consumption from pent-up demand. But what happens next? We think consumers will become thriftier. Fewer will wish to live paycheck-to-paycheck, and more will endeavour to squirrel away money for the next rainy day.
This is the same paradox of thrift dynamic we discussed following the 2008/09 Financial Crisis. Saving more individually is a good thing, but when individuals and corporations do it simultaneously it’s paradoxically bad for the economy. That’s because one person’s (or business’) savings is another’s foregone income.
The world will recover, but it will be a new “new normal”. We didn’t really learn the lesson about the perils of leverage following 2008/09. But we probably will this time. If so, we should expect even slower global growth.
Quality will matter even more in the new “new normal” environment. Get used to big government, because it’s the essential counterbalance to a timid private sector. We’ll be thinking of ways to benefit from bigger government and the types of companies to like/avoid in these new circumstances.