After a wild few weeks that’s seen most major equity indexes fall by a third, before a rally of around 20%, even the most experienced investors are scratching their heads. Less than a month after his last memo, Howard Marks from Oaktree Capital is back at it, asking the question on most people’s minds: which way now?
COVID-19 infections are still rising rapidly in the USA, having just recorded their biggest ever daily jump in new cases and deaths, with little sign yet of any ‘flattening of the curve’. A serious recession is widely (and correctly) considered unavoidable. The price of oil, equities, high yield bonds, and many other assets have fallen precipitously, but have the moves been too much, too little, or just right?
“We have to consider the outlook and the appropriateness of value, in the context of unprecedented uncertainty and the total absence of guidance from analogies to the past.”
As with any important question, it’s important to consider both sides of the argument.
The bull case
Marks goes to efforts to point out that these are other people’s views, but the case that optimists are currently pedalling could be summarised as:
- Positive recent data on new cases and deaths from places like South Korea, Japan, Singapore, and even China
- The curve will be flattened, and the outbreak brought under control quickly
- The downturn will be short and sharp, with a quick recovery
- The government will provide support to allow businesses and consumers to survive this ‘hibernation’ period
- The banks are better capitalised and carry less risk than leading into the GFC
“When I read the more positive views regarding the current episode, I can’t help but think back to my favourite newspaper headline, which included the phrase “Bankers Optimistic". Usually the case, perhaps, but it’s worth noting that the story in question was published on October 30, 1929, reporting on the prior day’s stock market crash. On that day of optimism, the Great Depression still had eleven years to run.”
The bear case
Marks is known for his propensity for bearishness, and this note is no different. In fact, he even acknowledges this bias, wondering aloud whether it’s part of why he’s a better credit investor than equity investor. The key points from his bear case are:
1) The spread of the disease in the USA is particularly concerning. Even though the note was released yesterday (and presumably written a couple of days earlier), the numbers he quotes already look outdated.
- He mentions that US cases had passed Italy and China – they’re now at more than 2.5x the cases in China, and nearly double that of Italy (which is still rising quickly itself)
He mentions daily deaths reaching 2,000, from 1,000 a few days earlier. Yesterday there were 4,883 deaths recorded globally. The US alone has reported over 1,000 deaths in the last 24 hours.
- He mentions 11 US states having hit more than 1,500 cases (in China, only Hubei had over 1,500 cases). There are now 9 states with more than 5,000 cases and 20 states with more than 1,500 cases.
The US lacks supplies to fight the disease… This hasn’t changed.
2) The scale of the economic contraction will be unprecedented. A decline in GDP of between 15% and 30% is expected, while estimates for earnings declines in the S&P 500 range from 10% at the low end, to 120% (i.e. moving to a net-loss) at the high end.
3) The trade-off between the health costs and the economic costs will be a major challenge for every government. The inescapable fact during this pandemic is that what’s good for the economy is bad for public health, and vice versa. Countries that open up too early will face secondary outbreaks, while those that leave it too long will damage their economy more than necessary.
4) Oil prices have fallen massively, meaning job losses and financial losses in America’s oil and gas industry.
5) Many companies will suffer from operating leverage – where costs and fixed and incomes are variable. Companies with high fixed cost bases may find it hard to survive, as they’ll find it hard to cut costs as quickly as revenues fall. That will be particularly true for some industries where revenues have instantly fallen to zero (e.g. travel and tourism).
6) Balance sheets are also highly levered, as many companies have borrowed at low rates and bought back stock to boost earnings per share.
“I believe we’re likely to see defaults on the part of leveraged entities, based on price markdowns, ratings downgrades and perhaps defaults on their portfolio assets; increased “haircuts” on the part of lenders (i.e., reduced amounts loaned against a dollar of collateral); and margin calls, portfolio liquidations and forced selling.”
So which case is winning?
In case his earlier comments didn’t make it clear, Marks comes down more on the bearish side than the bullish. While he acknowledges both outcomes are possible, the bull case relies on everything going right, whereas the bear case only needs one element to go wrong.
“Today the range of negative outcomes seems much wider (than during the GFC). Social isolation, disease and death, economic contraction, enormous reliance on government action, and uncertainty about the long-term effects are all with us, and the main questions surround how far they will go.”
He thinks prices were about right for the bull case as of Friday last week (at the time of writing, the S&P 500 in down around 2.8% from that level), but that prices didn’t reflect the risk that something could go wrong from here. Therefore, he expects asset prices to decline further.
“The most important thing is to be ready to respond to and take advantage of declines. The world will be back to normal someday, although today it seems unlikely to end up unchanged. What matters most – in terms of both health and finances – is how we do in the interim.”
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Thanks Patrick, I'm not sure on the bull case side that our banks are better capitalised than before and the risk is still there. The risk of mortgage holders and businesses defaulting on loans. The risk of margin loan and leverage unwinding. The risk of very tight margins and possibility of zero interest. Banks are being squeezed from all angles. I'm also not sure on the bull cases side that the downturn will be short and sharp. Definitely it was sharp, but I'd have to question if it's going to be short.