Fed QE is over for now but might not matter that much for a few months. Treasury crowding out last time showed up with a curve inversion and its a little hard to invert the curve at ZIRP, but anything below 40-50bps on the 10yr I would see as major warning sign. In fact any break below 60bps.
But other CBs still expanding so USD may slightly rise over summer?
In the short term today we had the quad witching and with VIX in low 30s and dealers rebuilding theta it should drop next week and technicals push the market higher. I would really like to see the VIX in the teens and CTAs fully long in the next move higher.
S&P might break through the resistance at 3214 which is the January low it was struggling with but normally you get a risk off in the summer holidays, then perhaps a bounce into election as both sides promise deficit spending, but then not make a new high while internals weaken.
Many other assets might not rally much from here. Look for a flattening TSY curve, reasonably supported USD and peripheral assets start to flatline.
In 1929 the market bounced for about 5 months after the initial sell off, and that was under a hard money standard with no QE.
I have no idea how many of the jobs losses will be recovered in 3-6 months but it will be far less than 100%, even 60-70% would be a borderline miracle and after that, it will be the slow grind that can take years.
After the election, Trump, who I assume wins, doesnt really need to care about the stock market, he has the real economy to worry about and he cant magic up corporate margins during the worst recession since 1929. Particularly when it becomes clear the recovery is drawn-out, defaults are picking up and Schumpeter comes back from the dead like the ghost from Christmas past.
Low rates, QE, fiscal deficits have forced institutions up the risk curve and down the liquidity one in this cycle and two of the worst areas, in my opinion, are LBOs and blue-chip CRE yielding 4-5%, particularly in 'Global Gateway Cities' like London which are so inflated ordinary people can't afford to live in them.
We were late-cycle before Covid hit. I don't actually think Covid is that big a deal if you are not vulnerable -we don't shut the economy down every Winter due to flu. But the lock-downs initially to stop ICUs being overwhelmed with otherwise survivable working-age patients, has now transformed into a huge recession and soon a solvency and default cycle.
So I think this year corporate margins will fall heavily and then not fully recover. Additionally, the demand for CBD office space will permanently fall. The exodus of ordinary people from Gateway cities will be accelerated etc. Potentially decades of change are being catalyzed by a few weeks shutdown and its aftermath.
So what should the impact be on these two popular LP plays, LBOs and blue-chip CRE?
LBOs have been done recently at 11-12x pro-forma EBITDA, late cyle, with more or less peak margins.
I present a few charts below from the prior blogs:
Longer run average after-tax
profits as a percent of GDP are 5-7% vs 8.7% in Q3 2019, i.e. 5%
after a downturn and 7% after a growth cycle. If US profits fell to the middle of that range, 6%, from 8.7% in Q3 19, profits would fall 41%, after the recovery.
EDITDA is not as sensitive as after-tax profits, but let's assume a 41% profit drop equates to roughly a
30% EBITDA drop for an average LBO company.
Let's assume a recent LBO with
$1 of EBITDA was done at $11 enterprise value, financed with a $5.50
senior loan and $5.50 of equity. Then after a downturn the loan market
is only willing to finance LBOs at 8.5x EBITDA.
Using the $1 of current EBITDA,
this drops to 70c. At 8.5x the 70c EBITDA the company is worth just
$5.95. But the senior debt was $5.50, so the equity residual has fallen
to just 45c, vs the original LP commitment of $5.50; that's over a 90%
loss of equity driven by a fall in margins and a fall in mulitples.
So you would assume this would breach loan covenants and the deal would be toast?
But here is where it gets more interesting. LBO GP's are judged, in part, on how many deals go to zero. So if a company's business has not
blown up and the issue is more the amount of debt/ EBITDA, then the GP's
have a huge incentive to keep a bad deal alive.
Over 5-10 years, as nominal GDP grows, most companies should see
substantial revenue and therefore EBITDA growth, so by keeping a bad
deal alive, even if it involves drip-feeding more equity in after a
the downturn, it keeps management fees coming to the GP, a positive carry
option for the GP on recovery and avoids difficult conversations with
LPs, but all at the cost of the fund IRR and liquidity to the LP.
In conclusion, with the incentives and ability of the GPs to keep bad deals alive, this looks more like a land of the living dead outlook for LBO LPs.
The situation is broadly similar in blue-chip CRE.
With 4-5% yields recently and 7-8% post-GFC for several years. Land Securities in the UK predict a 20% drop in rent values as a function of remote working lowering overall demand levels.
Setting aside whether I think 20% is a big enough rent drop:
Building rent: $1
4.5% yield value: $22.20
60% LTV CM: $13.30
40% equity: $8.90
Building rent: $0.80
7.5% yield value: $10.70
60% LTV CM: Capital loss of $0/ -$2.60 if no Directors Guarantee
40% equity: -$2.60 if there is a Directors Guarantee
In a 50% debt, 50% equity capital structure the debt would still be under the water by $0.40.
This scenario ignores anything like skipped rents this year leading to non-payment of mortgages, rental drops of more than 20%, occupancy slumps, auctions changing hands for higher yields than 7.5% yield or Class B or C properties performing worse or going empty...
In conclusion, Commercial Real Estate looks more like a money heaven scenario - for existing investors.
So far in May its only really the Nasdaq that is up. So its a fairly narrow market post the April bounce.
The Corona shutdown fall out is starting to hit the headlines.
For example a Reuters report showed 10% of Spanish businesses closed in March.
If it creeps lower for now and then starts to sell off, people will panic sell and we could easily punch through the March lows.
This chart shows Business Loans in the US.
Prior to Covid they had fallen to almost flat YoY.
Business loans normally shrink in a recession.
But now they are growing almost 30% YoY.
That is debtor in possession type financing whether it is PPP type loans or revolvers being drawn, its debt (a liability and part of the capital structure) being used to cover lost cash flow (an asset and part of the current flow/ activity of the business).
Basically businesses are being bled dry and will have to drastically cut costs, which makes a second leg of contraction more likely than even a U-shaped stabilisation.
Additionally, some of the most hit areas like Casual Dining or Hotels will take a lot of time to get back to prior operating volumes, so are likely to be defaulting in Q4.
The PMIs suggest that global industrial output is collapsing. Global supply chains are part of this, but put simply if you have one part missing for a valuable product you cant produce it. Your output goes to zero. Thats worse than even 1929.
China ended their lockdowns starting 10th March yet by the end of April the Caixin PMI survey showed industrial output was still flattish/stabilizing, not recovering and supply chain disruptions were a key factor.
At the same time they are collapsing output, the governments via furlough schemes are trying to maintain demand via credit expansion...