1. Why are the equity markets rebounding when there is so much uncertainty surrounding COVID-19? For example, the S&P 500 Index has increased 28.2% since the lows on March 23 through April 28.
This is an excellent question, and there may be several reasons for this dynamic. First, equity markets are discounting mechanisms, and stock prices are likely responding to (perhaps overly optimistic) expectations of what economic and financial conditions will be like in 12 to 18 months, not what is happening today. Second, the markets may be responding to the Federal Reserve’s (Fed) aggressive actions, which are typically supportive of equity markets. We have all heard the admonition, “Don’t fight the Fed,” and we have all witnessed the run-up in risk assets resulting from monetary stimulus over the past decade. Since the beginning of March 2020, the Federal Reserve has stepped up quickly to support markets with an extraordinary amount of firepower. In the last two months, for example, the Fed has increased its balance sheet by $2.2 trillion and has committed to do whatever it takes to restore normalcy going forward. And third, it could simply be that there is a lack of data to support full price discovery in the market, and investors have simply chosen to take an optimistic view of the situation until economic data and company earnings reports say otherwise.
It’s also interesting to look at the returns of different sectors in the S&P 500. As seen in the chart below, the two worst performing sectors are energy (-40.0%) and financials (-26.3%), while the best are healthcare (+0.2%) and information technology (-2.0%).
In analyzing the dispersion across the sector returns, one might conclude that the market is beginning to differentiate between the companies that can survive the disruption from COVID-19 and those that face material challenges. With the supply-demand imbalance in energy markets, for example, we will almost certainly see a number of energy companies go bankrupt. Many banks will find it difficult to generate sufficient profits as interest rates are now at zero, especially with loan losses that will rise in the near term. On the other hand, one could argue that many information technology and healthcare companies may be the beneficiaries of the changes that will occur in a post-COVID-19 world. Aside from these explanations, we are not in the business of predicting market moves. It would not surprise us if the markets are wrong, and we have another leg down before ultimately recovering.
2. You have indicated that Brown Brothers Harriman’s (BBH) managers are finding attractive opportunities in the stocks of certain companies. What gives you confidence that equities will be attractive given the possibility for severe global dislocations over the next 12 months?
As we noted in question one, we recognize that there is a possibility for continued dislocation in the economy over the next 12 months, which could result in another market downturn. Having said that, being active managers, we don’t invest in the market, but in a concentrated group of companies that are handpicked by our managers based on fundamental, bottom-up research. With certainty, a number of companies will not be able to weather a severe global dislocation over the next 12 months without raising significant additional debt and/or equity. In particular, there are a number of cyclical companies (for example, those in the energy sector, airlines, and so forth) that will either not survive or not return to pre-COVID-19 levels of profitability. We don’t want to own those companies.
To pick the companies that we believe will be the winners − those that will survive (and thrive) − our managers are evaluating three primary criteria:
- What is the demand for their companies’ goods and services?
- How have their companies’ business models changed as a result of COVID-19, if at all, and do the companies have the same compounding potential over the long term as they did before the crisis?
- Do the companies have the balance sheets to ensure that they can sustain at least six to 12 months of disruption and, in some cases, two years and longer?
If the answers are positive to all of these questions, in addition to the managers’ normal investment criteria, and the companies have compelling forward-looking, long-term return potentials, our managers will hold or buy the stocks. It is also worth noting that our managers have sold stocks of companies that they believe do not fulfill the above characteristics, even if they may have declined in price. That is what we want them to do.
Finally, we caution that it is not a good idea to be invested in equities unless investors have a long time horizon. However, if one is a long-term investor and markets decline, causing stock prices to dislocate from their underlying values, it is a particularly good time to make investments. That is the magic of being a long-term investor. Whether a full market recovery happens in two years, three years or longer, it is irrelevant. It just matters that investors stay the course.
3. After the 2008-09 global financial crisis, there were many opportunities in distressed investing. What is the opportunity today?
This is a good observation. Defaults in the U.S. high-yield credit market peaked near 11% in 2009, vs. a long-term average of closer to 4%. This provided attractive distressed debt opportunities for many years both during and immediately after the crisis. While there is always a trickle of distressed opportunities even in benign environments, the most attractive opportunities, both in terms of return and the magnitude of capital that can be deployed, coincide with the onset of a credit crisis. According to Preqin, the median net IRR of distressed debt funds in 2008 was 15.3%, and median returns stayed above 10% for another four years after that (2009 to 2012). This time around, the twin effects of the demand destruction brought about by the coronavirus coupled with the meltdown in the crude oil market have caused a significant amount of distress across a wide range of companies. Despite massive intervention by the Federal Reserve, there remains ample opportunity for distressed debt investors. While recent asset purchases have propped up prices, most of the Fed’s direct efforts focus on the investment grade credit markets, with only tangential involvement in high yield. BBH’s belief is that U.S. non-investment grade credit markets have become so massive over the past 10 years that the supply of distressed debt opportunities in this next cycle will likely be quite large and provide attractive opportunities for skilled investors to deploy large amounts of capital at high returns.
Clients who have questions about the topics discussed, or any other questions about their portfolios, should not hesitate to reach out to their relationship team.
Past performance does not guarantee future results.
High yield bonds, commonly known as junk bonds, are subject to a high level of credit and market risks.
Opinions, forecasts, and discussions about investment strategies represent the author’s views as of the date of this commentary and are subject to change without notice. References to specific securities, asset classes, and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations.
The S&P 500 is an unmanaged weighted index of 500 stocks providing a broad indicator of price movements. The index is not available for direct investment.
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