Since the fall of the Berlin wall we have seen globalization increase with a rapid pace. A globalized economy clearly has its merits, but there are costs as well. My intent in this article is not to present another long article on the merits for, or, against globalization. Instead, I would like to present where we are today, and what should we consider to improve the future for ourselves, our neighbors, our country and our world.
The Covid-19 effect on the world is unprecedented. The loss of life continues to mount at an alarming rate and being compared to the Spanish Flu of 1918. Peak levels in Europe will be reached this week. The U.S. is three/four weeks behind Europe and faces the worst over the next month. Three quarters of the world is currently under strict isolation rules. To some it may appear an over-reaction, but this “lockdown period” is proving to be effective. Life will not return to normal until sometime this summer, at best, but we will beat this.
The onset of Covid-19 has shown us how inter-dependent we have become. As a result, the dependence on global supply chains will continue to show its negative effects for some time to come. Globalization, which has been a positive development over the past 30 years is now showing its limitations.
Financial markets have, with reason, corrected significantly as a consequence of Covid-19. It would, however, be a mistake to come to the conclusion that this has occurred purely due to that alone. Serious cracks have been developing in the financial markets for time which I have written about in previous articles. Fortunately, the banking system is not under threat as it was in the “Great Financial Crisis”. Problems lie elsewhere, particularly in the corporate sector which has taken on debt at a rate never seen before. With interest rates at such low levels who can blame corporates, but the key question is how have they using this debt? Instead of using it to re-invest in their businesses a large majority of this debt has been used for share buy-backs.
Now, who benefits most from share buy-backs? Consider this: if a company buys back 1 million shares, then the earnings per share will increase because there are 1 million fewer shares, so the price of what’s still available goes up. Therefore, individual shareholders will see some benefit. Clearly though, insiders, particularly senior management, is the main beneficiary as their compensation is based on improving earnings and they are rewarded with share options. The basic premise for this type of compensation has merits, until it becomes the sole driver for share buybacks. For example, when one looks at Boeing, use this link for a great explanation of what happens.
A significant issue today is the dwindling middle class. The world’s richest 1% now control 82% of the world’s wealth. This is the widest gap ever. In addition, only the top 20% have recovered from the GFC. The middle class has been shrinking for the past 30 years. This has been creating a more vocal opposition to the top 1%, the wealthy in general and large corporate America. With the current performance systems in place a CEO can easily walk away with +$20 million per year.
With Covid-19 we are seeing more consequences of a world solely focused on financial prosperity. We have heard reports of individuals being refused testing and treatment because they don’t have health insurance. Now in a country as wealthy as America, this just should not happen! The president and Congress have put together a $2 Trillion Cares program to combat the effects of Covid-19. Before we all applaud and say thank you to Congress and the president let’s click here to take a look at where the money is going:
In brief, I will only state that more should have gone to the individuals and small businesses. BIG Corporates have had enough bailouts! There is also far too much discretion, there needs to be more transparency.
A new term is beginning to be used, with merit if I may say, “socialized capitalism”. This is when corporates/banks etc. are repeatedly bailed out by the government. We are walking down a dangerous road here with the government being a stop gap for corporates who repeatedly manage for personal gain are only encouraged to continue this behavior. Boeing is a prime example of mismanagement for the sole interests of senior management, yet, it is the first in line for government bailout money. The general population, particularly the dwindling middle class is not blind to this and has had enough. They have become more vocal and even many in the financial markets have been voicing concern. Yet the voice of the corporate lobbyists appears to be the only one listened to by the powers that be in D.C.
I would have hoped with so many lives at stake that Congress would have instead presented a plan for the people with the Cares Act, after all how far will $1200 take someone who has been laid off indefinitely? The capitalists hate socialism, this is the excuse given, but what is the difference from bailing out corporations for miss-behavior to individuals in need? My question is… do we want socialist capitalism for corporate benefit, or a kinder world?
I am reminded of when I closed my hedge fund a major investment bank wanted me to start a new business (hedge fund group inside bank). The CEO was backing me for the role, so I was all but assured of getting the role. I went through the interview process and met who would be my direct report (one level below the CEO). This individual made a comment to me that I will never forget “you have to kill to eat here”. I left the meeting disturbed by this and wondered where the world was going. In the end I called my friend, the CEO, and apologized to him but that I could not accept the role and why. It’s a decision I have never regretted.
Where are we now, and how do we move forward in light of recent events? The unemployment data came out yesterday and was worse than expected. In the last two weeks some 10 million Americans have become unemployed. This means some 7.6% of U.S. Americans working have lost their jobs (131 million full time employees in U.S.). At this rate we will see an unemployment rate of +20% very rapidly. To put this in other terms it took 5 years for the U.S. to create 10 million jobs after the GFC. More alarming is we have yet to see many large corporates announce layoffs as they await government assistance before making any decisions. It is on the back of the small/medium size businesses that much of the recent layoffs have come from. Small businesses have little flexibility and are often in the sectors most sensitive to shocks. As we all know, the restaurant industry, hotels, retail and others are the first to get hit.
Not everything is black however, there is hope. We are seeing a stabilization on COVID-19 in Europe. In Asia the rates have come down significantly. Unfortunately, we are probably still a couple of weeks away from peak levels in the U.S. The only solution thus far has been isolation, meaning stay at home. There is no cure, no magic solution. Dr. Anthony Fauci, the nation’s top infectious disease expert “hopes” we will have a vaccine next year. In the meantime, isolation is the only answer. This isolation period, if followed, should end by August, then slowly life will come back to normal. The important thing is to stay the course, we have no choice.
Now what should we expect once the global lockdown period ends? In Europe they are already beginning to discuss how to bring life back to normal. The lock down will certainly not end all at once, it will happen in phases, we should be prepared for this. My view is that life will not begin to be “normal” before Q4 of this year. What should we expect for businesses to return to a more normal environment? Looking at Refinitiv consensus estimates where are they now? At the beginning of this year full year estimates for the SP500 was $172 per share, however, the latest estimates as of April 1st is $158.39 for full year 2020. This is vs. full year 2019 of $162.93, therefore a decline of earnings of only 2.8% vs 2019. At first glance based on this estimate the SP500 trades on 16X 2020 estimates, not particularly expensive.
So, the first question that comes to mind is does a -2.8% earnings growth seem reasonable considering the impact of Covid 19? I would find it very difficult for Covid 19 to have such a small impact on corporate earnings. The world has never seen a close to complete shutdown of economic activity. Earnings estimates have much further to fall in my view. Economists are currently forecasting GDP estimates of -25% for Q2 AND -10% for Q3 of this year. Although it is purely an educated guess on my part, I cannot see the SP500 earnings down less than 10% for 2020.
This would mean the SP500 is trading on 20 X 2020 PE. While this is expensive, particularly as I am just taking numbers out of the air, with no real concrete data. We also have to remember that during the GFC we saw earnings fall -40%, so I am not being dramatic with my estimates. The big question is how will the recovery be? Will we see a V, an L or a U shaped recovery? This is anybody’s guess, I would think the chance for a V shaped recovery is slim, if only because the entire global supply chain has been disrupted and it will take time to recover. The current earnings estimate for the S&P500 for 2021 is now $183.44 which will definitely receive further revisions to the downside.
Where does this leave me in terms of equity valuations today? If I put on my optimistic hat and say that we will see a U shaped recovery and I would not buy the SP500 before 2300, and I would do this in stages as we see concrete evidence of economic recovery. My current downside projection for the SP500 is at 1850. This is assuming we have a more L shaped recovery. This would mean a 44% retracement from the highs, pretty normal when looking at history. Bear in mind my view is based on no further disruptions or financial stress (like GFC), so markets could deteriorate much further if one wants to be bearish.
Most important at a time like this is to remember to be grateful for all we have. For our families, friends and co-workers. Times like this also give us the opportunity to “reset”. Evaluate our priorities, what are the important things in life and what opportunities lie before us. Let us move forward with purpose, not forgetting to bring others along-side us.
Best wishes,
Alan
