Thoughts through the cycle: W4 May ’20

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  • At the start of the Fed’s FOMC press conference on 29th April, Chairman Powell highlighted the difference between liquidity and solvency with respect to what the Fed could and could not do: “I would stress that these are lending powers and not spending powers. The Fed cannot grant money to particular beneficiaries. We can only make loans to solvent entities […] with the expectation that the loans will be repaid. Many borrowers will benefit from our programs, as will the overall economy. But for many others, getting a loan that may be difficult to repay may not be the answer.” (FOMC opening statement 29/04/2020). What does this mean in practice?
  • A solvent company is one whose revenues meet its obligations on an ongoing basis. One of the characteristics of the low-rate, easy-money, post-global financial crisis world has been the ready funding of loss-making companies which have targeted top-line (revenue) growth over bottom-line (net income) growth. This is fine so long as there is a ready flow of investment capital (debt or equity). When this dries up, valuations get written-down or at worst, companies have to file for bankruptcy.
  • SoftBank’s (9984.JP) full year 2019 results on 18th May saw a loss of $17.7b due in no small part to write-downs on the fund’s holdings in WeWork and Uber, both of which have never generated a positive free cash flow. While ‘digital disruptors’ and the larger-than-life personalities who run them have been the toast of the town in the good years, in a recession it soon becomes clear that the only thing they truly disrupted was the accounting concept of going concern. The precipitous fall of the WeWork 7.875% 2025 bonds (graph below) as the Covid-19 crisis erupted merely underlines this problem.

Source: Bloomberg, 19th May 2020.

  • An insolvent company is one which not only cannot meet its obligations on an ongoing basis, but one which no one will lend to in order to do this even on an overnight basis. The company literally cannot survive the night. It is this insolvency phase of the recession which Chairman Powell has been warning about, mainly because there is little the Fed can do to stop it, or even ameliorate it. In previous recessions, the Fed has been able to cut Fed Funds rates by up to 500bps in order to ease the cost of financing for households and corporates and also to encourage new borrowing at cheaper rates to aid the recovery. With the Fed base rate at 1.5% to 1.75% coming into 2020, this release valve has not been available, and it is arguable that this alone would mean any recession would be a bad one. Factor in the large stock of corporate debt, then the prognosis is even worse.
  • During the first week of its purchases of US corporate debt, the Fed bought ~$300m of corporate bond exchange-traded funds (the outstanding balance of US investment-grade (IG) is in the region of $10tn so Fed purchases are relatively small so far). Knowing the Fed would act as a backstop has kept the US IG market open; 2020 issuance is approaching $1tn, of which the bulk has come since the middle of March. Usually, recessions are periods of deleveraging. That corporates are gearing up is perhaps an unintended consequence of the Fed having to implement quantitative easing (QE) rather than rate cuts for the reasons explained above (rates were already too low). This is the opposite of balance-sheet repair.
  • An extended period of low interest rates has led to a build-up of leverage. Low rates also encourage malinvestment, with cashflows for financing lower, companies can ‘get away’ with poor business models or poor practices without being punished in the usual manner through higher financing costs. It is important to understand this in terms of the slew of insolvencies which are coming that the Covid-19 pandemic was just a catalyst and in many ways the die was already cast with respect to the build-up of debt.
  • The problem is also a pervasive one, given how ubiquitous debt-financing has become. In an article in the Weekend Financial Times ‘Life and Style’ section, a fashion article lamented the decline of the US brand J Crew (‘How America fell out of love with prep style’, FT Weekend 16/05/2020). While ostensibly about the passing of a particular college-yard fashion look, it is quite apparent that this is an article about debt. J Crew has filed for Chapter 11 because it was saddled with $1.7b of debt following a private equity takeover in 2011. A narrowing of product ranges, fall in product quality, and a general ‘losing track of its customer’ can easily be imagined to be the consequence of the cost-cutting, margin-improving private equity mindset. All it took was a recession to push it over the edge.
  • It has been known for some time that in the great battle of the high street (main street in the US) vs. on-line retailing, the high street has been struggling. The graph below of JC Penney (JCPNQ.US) shows how the department store has slowly been succumbing to the battle of ‘bricks vs. clicks’ for over a decade. Notwithstanding this, it finished 2019 with a net debt to EBITDA ratio of 6.9x and the pandemic has pushed it almost immediately into bankruptcy proceedings which will likely involve it closing nearly 30% of its stores in a bid to cut costs by $1b.

Source: Bloomberg, 19th May 2020 .

  • Despite furlough programmes to protect workers and loans to allow businesses to survive the lockdown, highly leveraged businesses are tumbling in both the US and UK. In the UK, private equity firms have jumped on the casual dining trend, and the high-debt model has seen a number of well-known brands crumble almost as soon as the lockdown started. Byron Burger, Carluccio’s, Chiquito, and Food and Fuel are just a few of the casualties so far in 2020.
  • The most recent casualty is The Casual Dining Group which owns Las Iguanas, Bella Italia, and Café Rouge and has just appointed administrators to help decide its future (‘6,000 jobs at risk as dining chain brings in administrators’, The Times, 19/05/2020). A pattern is emerging here; heavily indebted operating companies folding almost as soon as the first stresses of the end of the business cycle are felt. For The Casual Dining Group, this is not the first time this has happened. The Times article goes on to say:

‘The company, formerly known as Tragus, is no stranger to restructurings. In 2014, it went through a CVA and in 2018 it underwent a financial revamp, including a debt-for-equity swap, that handed majority control from Apollo Global Management to KKR. Apollo and Pemberton Capital Advisors have minority stakes.’

  • It is perhaps not surprising that a company which appears to be little more than a financially engineered dog toy which has been thrown about between private equity titans over the past decade has fallen at the first hurdle. However, given what will likely be an operationally-onerous return to normality for the leisure sector due to social distancing, the rapid V-shaped recovery is looking increasingly unlikely. It would be unwise to bet against more bankruptcies in the sector.
  • 6,000 jobs are at risk due to The Casual Dining Group situation. Many of these workers are currently on furlough. Some will become unemployed. This is the real cost of the recession and one which financial markets appear to be taking in their stride with some insouciance.
  • This being said, insolvency doesn’t necessarily have to mean unemployment, provided it is not done in an uncontrolled or thoughtless way. A prime example of this is American Airlines (AAL.US) which filed for Chapter 11 in 2011 due to high fuel prices and low demand following the global financial crisis. It emerged to fly again, only to falter with the travel bans associated with the Covid-19 pandemic. The graph below shows the 5yr credit default swap price (CDS) of AAL at 6534, which roughly corresponds to a bond price of 44 cents in the dollar (the AAL 3.75% 2025 bond currently trade at $.0.35). Should there be a bankruptcy (a CDS price of ~6500 suggests an imminent issue), the equity will be wiped out and the bond holders will take a haircut. The planes will still be there, and so should some of the jobs should air travel resume to a recognisable degree. Such is the pattern of creative destruction in the capitalist system. No bail-out needed.

Source: Bloomberg, 19th May 2020. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested

  • Outside insolvency, the credit cycle completes with balance-sheet repair. This means either reducing costs, raising equity or using profits to pay down debt (as opposed to paying dividends for example). All of these involve reducing the debt-to-equity ratio. It is perhaps instructive that in his testimony before Congress on the 19th May, Secretary of State Mnuchin has had to admit that only 8% ($37.5b of $500b) of emergency loan funding has so far been taken up. This may in part be due to onerous conditionality. It may be because large corporations with investment-grade ratings have been able to access the bond market itself. At the same time, Fed Chairman Powell has said the main-street lending programme will be up and running by late May. It is as yet unclear what the lending terms will be.
  • The question with all this is whether taking on more debt to get through the crisis is really what corporates, large and small, want to do or need to do. Having the government run a deficit while households and companies repair their balance sheets is part of the standard Keynesian counter-cyclical stimulus approach. Having companies gear up at the same time as the government runs a deficit (this appears to be the plan in the US and UK) is a little more experimental. As the stock of debt rises, so does the overall servicing cost, even at lower rates. This is the way into the debt-deflation trap of the like which Japan has struggled with for so long.
  • Unfortunately, the process of deleveraging after a bubble can be a protracted and painful one. In the US, it is not so much a question of what the Fed has done in terms of there being a correct course of action. Having thrown a wall of liquidity at the market because it could not cut rates as much as it would normally do, there is a sense that there is a bifurcation between real economy (crushed) and the financial markets (buoyant). The events of the next few months will shape the story of which recovers or falters to meet the other. How balance-sheet repair progresses, both at a corporate and household level, will be the key metric for this.

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