Will there be a market reckoning?

It is to the U.S. government’s credit that stock and bond markets have remained strong despite unprecedented unemployment claims and substantial economic losses to many businesses brought on by the COVID-19 pandemic. Not only has the government provided individuals and small businesses with stimulus checks to help them weather the storm, but it has revived its policy of quantitative easing (“QE”) — firing up the printing presses to create money to buy long-term securities — that we last saw in action during the 2008 crisis. With talk of another round of stimulus, many of us are asking ourselves at what point does government support end so that we’re faced with a market reckoning?

There are two primary reasons that government stimulus could end:

• (1) it no longer benefits the economy, or
• (2) it becomes unpopular.

Some countries have seen #1 manifest itself as hyperinflation, like what happened to Russia in the 1990s or Zimbabwe starting in 2007, but hyperinflation did not happen with prior rounds of QE beginning in 2008, in part because QE funds tend to remain in the financial sector to shore up weakened balance sheets.

A bigger concern may be stagflation, a combination of high unemployment, stagnant economic growth and inflation. A number of small businesses will not be able to survive restricted operations, much less another lockdown, and larger business are continuing to announce additional layoffs. Many businesses that have reopened have had to make fundamental changes that add to their operating costs and reduce their revenues, including fewer tables or stations, customer limits and sanitation infrastructure like shields, masks and gloves and more frequent and thorough cleanings. While we can probably expect the Federal Reserve to continue to act to prevent a spiral like in the 1970s, prices of everyday goods and services, including food, entertainment and salons, may rise sufficiently so that consumers will notice.

Nevertheless, a more likely trigger, given that monetary policy may be able do little to address it, is if government stimulus becomes unpopular. Lack of public support happened relatively quickly in 2008 — indeed, from the beginning the stimulus was characterized as a “bailout” that benefited the greedy denizens of Wall Street and pit them against the victims of Main Street.

Unlike in 2008, there is no clear enemy here. Everyone is at risk of contracting the virus or suffering its consequences, so the public will likely have a higher tolerance for a longer and more expensive stimulus program before they, as taxpayers who are ultimately footing the bill, call for limits on government spending. An additional consideration is that 2020 is an election year with a sitting President running for reelection, so we can likely expect government support to continue through at least November to keep the economy afloat as people go to the polls.

After election politicking dies down, we expect the public will start seeing cracks in the government’s stimulus approach that are too big to ignore any longer. We’re past the point of a V-shaped recovery. Even if a vaccine is found tomorrow (and conventional thinking says 12 to 18 months, perhaps shortening to six months based on recent trials), it will have to be tested, produced, distributed and administered worldwide. Moreover, if there are negative effects from the vaccine, even among a very small portion of the population (as there was with the 1976 American flu vaccine program that resulted in hundreds of people developing Guillain-Barre syndrome), people are going to fear getting the vaccine. Maybe it won’t be enough to derail the success of the program, but it will delay the speed at which people get vaccinated, thereby delaying the speed of an economic recovery.

As school resumes (via indefinite distance learning or a hybrid approach) and the holidays roll around, we suspect people will truly appreciate that life isn’t going to go back to the way it was for quite some time, if ever. Early on, people took comfort in the notion that we just needed to “flatten the curve” and adjust our summers. But it’s now clear that many policymakers will impose significant restrictions until we have a vaccine or an effective treatment. With the recognition that there may be no limit to government spending, we think people will begin to focus on who or what is receiving stimulus funds, especially with more anecdotal evidence that people are not getting their stimulus or unemployment checks and have no idea how much longer they can make it.

We suspect that zombie companies that can’t adapt to the “new normal” will become the 2020 bailout enemy. Mall-based retailers, E&P companies, movie theaters, sit-down restaurant chains, cruise lines, car rental companies, airlines and hotels should start receiving backlash for continuing to access the credit markets as more and more people adjust to life without as much use for these goods and services. Moreover, retail investors who are using their time at home to bet on the stock market will become (if they haven’t already) victims of zombie company shenanigans, like what Hertz attempted in June 2020 by seeking to do an equity offering while it was in bankruptcy, a time when its stock was almost certainly worthless. Indeed, amateur investors who loaded up on J.C. Penney stock as the company was pursuing bankruptcy are now urging the court to give them some recovery instead of wiping them out. Government stimulus is enabling many high-risk opportunities, and the more the average American loses by betting on them, the greater the likelihood that legislators will respond.

Our feeling is that these factors will work their way through the system and result in calls for accountability and more targeted government support at the start of 2021, triggering a wave of interest payment defaults on recent high yield bond issuances, as well as other covenant defaults for zombie companies that have been able to “kick the can down the road,” which will cause these companies to declare bankruptcy. This will be a great time for distressed debt investors, who have raised billions in capital for just this sort of thing, but discipline will be key. Assuming there is not a clear path to a vaccine roll-out or an effective treatment by this time, many of the zombie companies should not exist absent massive innovation (and perhaps accompanying capital infusions) to adapt to the “new normal.”

We’ve already seen bankruptcy filings and contemplated restructurings from companies like Brooks Brothers, which may not be able to adjust from at-the-office suits to work-from-home athleisure, Chesapeake Energy, a shale revolution darling that has floundered with low oil demand, and Chuck E. Cheese, which offers ball pits, slides and games that now look like impossible-to-keep-clean petri dishes. We’re not sure any of these, with their current business models, belong in a post-COVID world.

A wave of bankruptcies will create inevitable downward pressure on credit and debt markets, including for those investors that bought into the record high yield bond issuances in the last few months at par. Will this be enough to bring about a market reckoning? Our suspicion is that the government will continue to do everything it can to ensure the recovery is U-shaped and early 2021 events can be characterized as a “necessary correction.” The Great Recession is too fresh in everyone’s minds to turn the stimulus spigot off completely, BUT we think creativity and innovation will be key, as it was with the New Deal legislation. While we think the government learned a lot about the dangers of not bailing out one company (“too big to fail” Lehman Brothers in 2008), we think it still has a lot to learn about “money pit” investing. We think government support must shift to jobs creation via infrastructure and innovation spending, including better telecommunications networks, enhanced online experiences (including government services, education and medicine), and novel sanitation solutions, to have any hope of a U-shaped recovery. Getting people back to work building a world that is adjusted for the inherent risks of interconnectedness is, in our minds, necessary to avert a full market reckoning. As much as we would like it to be, a vaccine for COVID-19 is not a panacea. A deadly virus can originate anytime, anywhere and be on a plane across the world before anyone has any idea of its severity.

Targeted programs, like tougher mortgage lending criteria and rules governing financial institutions and their products, including derivatives, helped get the country back on track after 2008. If government support remains untargeted, then we think we are ballooning the national deficit and buying nothing but a delay in the inevitable catastrophe, which we could see coming to a head in the third or fourth quarter of 2021. As investors, we are trying to do our part, offering growth financing to companies appearing in our “New Normal” Index, a list of business that are positioned to flourish during this time, rather than inefficient businesses that have held on because of cheap credit. With innovation, we are hopeful we can find a way out of this crisis.

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