An ugly storm gathers steam

In our quick & dirty strategy review dated 06/02/2020, the title read that the Coronavirus had “Minsky moment” potential as the disruption of supply chains was bound to morph into a financial crisis since Chinese companies would go belly-up and individuals would draw on their savings.

That view still holds but the tsunami looks to be coming first from hitherto overheated western credit markets. Now that the Coronavirus has a western mutation, junk spreads have been widening massively, catching junk holders by surprise.

Credit investors have been basking in the widely held view that the Fed would save markets. The Fed may try, but the Coronavirus is a supply shock against which its magic wand can do only little. With credit markets offering no liquidity as soon as fear takes over, the mess spreads at pixel time to equities which offer liquidity and can thus be shorted. The junk debt market is primarily a US shale oil risk so that this segment is suffering from both not being in a position to roll its debts and from the crude price correction which started with the Chinese-induced global GDP slowdown. Obviously, Big Oils suffer in sympathy.
The next shoe to drop would be owed to the fact that investors have looked for round-about ways to dodge zero returns. These round-about ways are called Structured Products, ETF and… Private Equity. These are amongst a variety of strategies that all aim at leveraging up to spruce returns or cut on execution costs while losing the link with the underlying securities.

Start with ETFs, a promise of near-zero friction costs and perfect liquidity. Credit ETFs are mechanically overexposed to junk oils while equity ones will have to face global fears with their liquidity heavily tested. We suggested back in December that there was a potential for a ‘liquidity tragedy’ as ETFs amount to herding into the same assets, say like Nestlé. This herding may create friction even for the most liquid stocks.

Private equity should have its own interesting moment as well. After all it needs an exit, closed for the near term; it also needs to fund the leverage that helps extract immediate returns at the expense of the underlying assets. The average LBOs last year took place at more than 11x forecast EBITDA (with a highly volatile definition of what EBITDA means).

Needless to say that such businesses will need to restructure their financing when real EBITDA in a real world of slower GDP growth sinks in. Bain & Co, in a recent article, also reminded investors that exit prices were not determined by improved earnings (i.e. PE is useless) but by expanding multiples, sorry we meant, by the Fed. This asset class is in a bind and will also contribute to put pressure on valuations.

The Coronavirus-induced confidence crisis may turn into a financial crisis. It is likely to have a silver lining for active investors /fund managers: prick the vanity bubbles of alternative fund management strategies. They merely amplify risk.