As economies and countries tentatively reopen after the lockdown, market opinion is becoming divided between glass-half-full optimists and glass-half-empty pessimists. And central to their thinking is the notion of LUV – the potential shape of the recovery as plotted on a graph.
The rosiest outlook is for a V-shaped recovery, whereby a sharp fall in asset valuations is swiftly followed by a return to previous levels. The U-shaped recovery predicts a return to pre-crisis levels, but not before a period of bumping along at the bottom of the valuation range. The worst outlook is the L-shape, where a precipitous fall is followed by a long-term trough with no upturn in sight.
There are other shapes, of course: a ‘W’ predicts rollercoaster volatility; the ‘bath-shape’ predicts a prolonged recession before a return to higher valuations, and so on.
The latest Bank of America Merrill Lynch Fund Managers’ Survey, the long-standing and highly respected poll of institutional investor views, reveals a distinctly glass-half-empty outlook: just 10% expect a V-shaped recovery, while 75% expect a U or W-shaped recovery. And these money managers are positioning their portfolios accordingly: cash occupies the highest proportion of portfolios since the 9/11 terrorist attacks in 2001.
The asset mix of these institutions is highly defensive: healthcare stocks are the biggest equity sector holding, while investment grade bonds are the largest asset class.
This downbeat outlook is compounded by other indicators: PMI scores around the world remain stubbornly below fifty, the score indicating shrinking activity. Fear of a second wave of coronavirus continues to dominate public health and political thinking. Economic forecasts remain profoundly gloomy, and geopolitical risk continues to rise.
And yet amid the gloom, there are some real opportunities for companies: the BAML survey’s respondents are also asked to offer advice for CEOs, and the overwhelming majority spoke with one voice: 73% of investors said corporations should reduce debt.
And yet the market conditions mean that debt has never been cheaper. Banks are advising their clients to take advantage: “We definitely feel that the markets are way ahead of reality. We really are telling every client to tap the market if they can because we think the pricing now couldn’t get any better,” Manolo Falco, investment banking co-head at Citigroup, said this week in a media interview.
As if to prove the point, Amazon set a new record low borrowing cost this week, when it issued $10 billion of bonds, with the three-year tranche offered at a rate of 0.4%. That is less than a quarter of the rate Amazon offered when it last tapped the bond market in 2017, and the lowest coupon for US commercial paper ever. Yet the offering was three times oversubscribed.
With central banks around the world pledging to buy corporate debt, bonds have developed an aura of invincibility, and investors are snapping up these bomb-proof securities like never before: US corporate bond issuance has already passed $1 trillion this year, another record.
While borrowing your way out of a crisis is a questionable strategy, these unique circumstances mean that corporates accessing the debt markets can be exposed to new investors, can re-formulate their relationship with existing investors and can – hopefully – emerge from the pandemic with their balance sheets strengthened and their business models intact.
The key element in this scenario is the relationship with investors. Equity valuations remain at historically high multiples, while debt, as we have seen, is cheap and plentiful. The discussions that companies have with their investors must take this changing dynamic into account and must adapt accordingly.
Whatever happens in terms of the shape of the recovery, there will be damage and economic pain: Unemployment, government debt, company failure and depressed energy markets are going to be with us for a while. But there are some reasons to take a glass-half-full outlook. All you need is LUV.