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A new definition for “systemically important” businesses

At the peak of the Financial Crisis in the stretch from 2007 to 2009, we became familiar with the notion of systemically important institutions. With the failure of major banks and investment banks like Bear Stearns, Lehman Brothers, Countrywide and Washington Mutual, the private and public sectors had to come to grips with the idea that for-profit businesses could be so essential to the orderly functioning of the overall capitalist system that they could not be allowed to fail, even if that required the rescue of a public company with taxpayer money. This notion gave rise in part to a series of laws and regulations including the Dodd-Frank Wall Street Reform and Consumer Protection Act. Certain financial institutions were too important either by virtue of function or size or both to be allowed to fail, undermining confidence and the orderly conduct of our economy and markets. These institutions would be protected, but they would also be more critically regulated to mitigate the risk of failure.

Whether standing in long lines of anxious neighbors to stock up on staples or watching a public address from the White House rose garden, we have been presented with a new and really more fundamental notion of what a systemically important business is. In fact, the shelter-in-place approach to mitigating the spread of COVID-19 has created a new class of systemically important businesses as we redefine, on the fly, what used to be luxuries like working from home or having household staples delivered as now being existential.

Through the present market turmoil, it is difficult to see this new order clearly, but in the months and years to come we will collectively be forced to reflect on what we are learning through experience now. There are fundamentals to the orderly functioning of communities and societies that we all know intuitively, and yet we continually fail to prioritize until we are tested. Right now we are sitting at the bottom of Maslow’s hierarchy of needs, focusing on physiological and safety needs. That’s health, food, water, shelter, personal security, financial security, and so on. Our current situation is depriving us of the ability to climb further and focus even on social belonging because of the paramount importance of the first two.

We can make light of the run on toilet paper, canned goods and hand sanitizer, but that is as explicit a manifestation as there is of what matters right now – health and hygiene and nutrition. The systemically important are food producers and grocery stores, pharmaceutical companies and pharmacies, hospitals and laboratories. They are also the providers of basic infrastructure, public and private, that keep the lights on, the water flowing, and goods and services moving from point A to point B so we can be home and be socially distant. We are also going to get a graphic look at how fragile the bottom of the economic ladder is where access to basic physiological and safety needs is not assured on a good day much less in the midst of a crisis.

From an investor’s perspective, this will cause a re-rating of securities according to what really matters when we are against the wall. From municipal finance to support hospitals and emergency workers to ownership of companies that are essential to the food supply chain, we will have a renewed and clarified sense of where our investment capital is the most needed and where it should be treated with the highest levels of stewardship and oversight, whether or not it is backstopped by government, because these companies and services are simply too systemically important to fail. And with that, there is an opportunity for companies and for governments to rethink stakeholder rights and responsibilities, and to provide best-in-class transparency and good governance and prioritize quality and longevity over short term rewards.

WCM Chart of the Week for March 16, 2020

On Sunday, March 15, 2020 after an emergency meeting, the US Fed announced that it was lowering the US Fed funds target rate by 100 basis points to a range between zero and 0.25%, and that it will expand its bond holdings by at least $700 billion.  The expansion of the Fed’s balance sheet, depicted in this week’s chart, will likely bring it to levels surpassing records reached in the aftermath of the Financial Crisis.  Hyper accommodative measures being undertaken by the Fed (and other central banks) are occurring simultaneously with aggressive fiscal measures being enacted by the Trump administration and the US Congress.  The magnitude of the fiscal and monetary spending underscores the degree of uncertainty regarding the economic and social impact of the COVID-19 virus.  What had been a robust economic and fundamental backdrop in America just a few short weeks ago will likely turn out to be a low-growth to stagnating to contracting-growth environment during the current quarter and likely the following quarter.  The economic downshift beyond the Summer is a major question mark and will be dependent on the efficacy of containment measures, potential seasonal dormancy of the virus, and successful treatments and outcomes. [chart courtesy Bloomberg LP © 2020]

WCM Chart of the Moment for March 9, 2020

As of this writing stock markets around the globe are reacting violently to the latest COVID-19 related news. From our perspective, while the past several weeks of volatility has been unnerving, it is important to evaluate the current market in the context of previous global events. We have listed several periods over the span of the past 40 years when the US stock market, as measured by the S&P 500, either corrected or even entered a bear market. While this list is by no means exhaustive, it is intended to show that while previous downdrafts were painful, US equities rebounded impressively over the course of the following year once the market bottomed. It is also important to consider that each sell-off was caused by different events both international and domestic in origin as well as ranging in duration, yet stock prices in the US were higher 12 months afterwards. As tragic as this pandemic has been and will likely continue to be, our sense is that US equities will likely follow a similar pattern and be higher a year from now. [data courtesy Standard & Poor’s and Bloomberg LP © 2020]

The view from here

In these last hours before the US markets open for this week’s sessions, here are a few more thoughts we have shared in our community.

Global markets finally caught up, in the negative sense, to China’s stock markets as worries about the COVID-19 “novel” coronavirus spread to the developed West faster than the disease itself. A contagion of concern overtook markets and left us with a week of returns we have not experienced since the Financial Crisis in 2008. What is materially different from our perspective is that this correction is not a response to a lack of faith in the system itself. During the Crisis, securities prices collapsed on the fear that it was actually impossible to value many of them, and that large parts of the system were in fact worthless. In certain cases this did prove to be the case as a sudden disappearance of liquidity exposed a large quantity of bad loans and mortgages that had been ingested by major financial institutions, causing the collapse of systemically important operations like Lehman Brothers, Bear Stearns, Washington Mutual and Countrywide. There was absolutely widespread panic that we could be facing a new Great Depression as the financial system itself seized.

This past week was very different. As we have previously explained, COVID-19 of course has and will continue to have economic consequences, but it does not call into question the soundness of markets, banks and whole economies as we experienced a dozen years ago. We find it likely that the response to the virus will impact company earnings and the GDP of nations. Shutting down the 2nd largest economy (China) for weeks if not months would never have gone unnoticed and unpriced. Reasonably, that demands revisiting what companies are worth and whether yesterday’s prices reflect tomorrow’s realities. Prior to the outbreak, fundamentals were reasonably solid around the world. Not boom, but certainly not bust. The situation we find ourselves in could take that optimism down to modestly solid, or perhaps slightly weakened. But even a mild global recession triggered by this moment does not call into question the fundamental underpinnings of finance and commerce. We are seeing steep and sudden drops in stock markets that remind us of 2008, and nearly unprecedented lows in interest rates, without anywhere near the breakage that brought about those kinds of corrections historically.

So, in a word, why? We see a few different forces at work which all feed our collective response to unconstrained uncertainty. Emotion, namely fear, is always a powerful motivator. Fear of the virus, fear of losing money, reasonably make people want to be safe. 2008 still looms large in the minds of investors and a PTSD-type response is not out of character. Fool me once, shame on you. Fool me twice, shame on me.

That emotion is being fed by a toxic brew of real, or worse, real but incomplete, data without framing or context, and quite a lot of false narratives. Add to that the markets are now patrolled and exploited by algorithms and artificial intelligence engines that can actually capture and quantify shifting sentiment and strong moves one direction or another in prices, and exploit or even amplify or aggravate those moves for profit. We have seen numerous isolated examples of this played out in the “Flash Crash”, the “Fat Finger”, and other moments over the last many years which show how quickly and to what extremes things can break loose on little information or bad information. Throw something at the market like the novel coronavirus and we could experience those types of extreme (over)reactions again and again.

We anticipate that clarity and greater understanding around the virus’ pandemic qualities and impacts will help markets firm up, and would not be surprised to see a fair price for securities settle at something less than the peaks from just a couple weeks ago after accounting for the drag from lowered economic activity. It is also our expectation that we will see some manner of coordinated global response across the major central banks to compensate not for falling stock prices but for potential lost GDP from less commerce, less travel, and less work. Depending on the magnitude of the response this could put a floor in prices, or at least slow the descent and tamp down volatility while investors regain their footing.

WCM Chart of the Week for February 28, 2020

Heightened fears of COVID-19 spreading to other countries and regions over the past few days has unnerved investors and sent global equity markets lower.  Since hitting an all-time high on February 12th, the FTSE Global All Cap Stock Index fell 6.4% just through February 25th. Taken in context, global stocks may continue this week’s trend.  In 2003 the SARS pandemic temporarily derailed the post dot-com recovery in the U.S. The S&P 500 Total Return Index contracted nearly 11% from late November 2002 through early March 2003.  The Zika virus outbreak in 2015-16 also had a similar impact on stocks as the index fell 12% from late July 2015 until bottoming in mid-February 2016.  These instances are cited in this week’s chart.

The corporate environment in America is still quite strong compared to the two periods cited above and the rest of the world today.  One indication can be found in credit markets where investment grade corporate credit prices continue to grind higher in the midst of stock market volatility.  The toll on the human condition is tragic but our sense is that this will pass in time and may turn out to be shorter in duration due to advancements in biotechnology. That is certainly our hope but in the meantime equity markets will likely continue to be volatile. [Data courtesy S&P, chart courtesy Bloomberg LP © 2020]

Less than a novel on novel coronavirus

Following are a few notes we shared with our clients and their trusted advisors earlier in the week that we think warrant repeating as we finish what has shaped up to be the worst week in the markets since the Financial Crisis.

COVID-19, popularly and generically referred to as “the (novel) coronavirus” has become that X factor we look for that comes from outside the markets and the normal news cycle to disrupt the status quo. While issues we have previously discussed like Brexit, the Hong Kong protests, and Iranian conflict are meaningful, markets generally take them in stride and try to price the risk. It may result in days or weeks of volatility, but eventually investors settle on how to value it. COVID-19, like Zika and SARS before it, is different. Brexit or HK are the product of people making active decisions. They may be decisions with adverse outcomes, but they are understandable, observable, and follow some kind of reasoning, whether or not we agree with it. Something like this virus introduces another dimension of uncertainty, because for now, we do not fully grasp the impact it will have on global health. So, even though we can observe and predict human decisions on how they are likely to respond to set information, the responses are and will continue to be dynamic based on the emerging understanding of and consequences of the virus.

We are not doctors, nor do we play them on TV, but we have been closely following not just the news cycle, but the output of expert organizations tasked with addressing this challenge. Indications continue to be that it is more easily spread than SARS and the bird flu, but the health impact appears to be less for healthy populations and the fatality rate lower for at-risk individuals, although most definitely and regrettably not zero. That does not mean this is something we take lightly either as investors or as global citizens. But it does help us chart a path forward. In the near term, the containment efforts are aggressive and the impact on society and commerce severe. As we have seen in China and now in South Korea, this has had an enormous impact on daily life and stopped business more or less in its tracks. The latest round of market reactions was triggered by a cluster of cases in Italy, which brings developed Europe into play. Emerging clusters in other areas like Iran suggest that with China as the vector, anywhere globally they have engagement and influence is a likely launch point for more cases. Inevitably this will lead to spread in parts of the world that either do not have the autocratic control of China or the health care infrastructure of Italy or Japan to address them, and we could see this accelerate to a global pandemic.

But, as counterintuitive as it sounds, from the investor’s perspective this may not be the worst thing. The economic damage being done is mostly from the preventative measures being taken to slow or stop the spread of the virus. Public transit is halted, air travel grounded, borders closed, events canceled, factories shut down, etc. If we find ourselves at a moment where these measures no longer restrain the spread of the illness, the focus will shift to healthcare and hygiene, as with seasonal flu and other communicable illnesses, and business ought to return to some semblance of normal. But in the near term, we are observing the volatility that comes with uncertainty, and also expect some degree of repricing as global economies absorb the consequences of lower activity. It is also not out of the realm of the possible that central banks will follow China’s lead and intervene to keep the economic engines running.

WCM Chart of the Week for February 21, 2020

More and more companies, including airlines and oil companies, are announcing an intention to achieve carbon-neutral operations over the next couple decades. But, it is important to look behind the headlines and understand what that sort of pledge actually means.  What business is the company actually in and does the pledge include their supply chain or product output? From the Climate Accountability Institute (Oct. 9, 2019, data through 2017), global fossil fuel and cement emissions from 1965 to 2018 totaled 1,354 billion tonnes of carbon dioxide and energy-related methane (GtCO2e); The twenty largest investor-owned and state-owned fossil fuel companies produced carbon fuels that emitted 35% of the global total (480 GtCO2e); Looking over the entire historical data set they find their current database of 103 fossil fuel and cement entities emitted 1,221 GtCO2e, or 69.8% of global since 1751 (1.75 TtCO2e); of which the Top Twenty companies are responsible for 526 GtCO2e, or 30% of all fossil fuel and cement emission since 1751. [Charts and data, Climate Accountability Institute, October 2019]

Climate Accountability Institute, October 2019
Climate Accountability Institute, October 2019

WCM Chart of the Week for February 10, 2020

The US Bureau of Labor Statistics has been reporting impressive trends across many demographic categories for several quarters. One of the most important trends we see is development in the female workforce. Total US Labor Market participation reached an impressive 83.1% rate in the key age category of 25-54 year-olds. These levels have not been reached since the pre-crisis era over a decade ago. The real story is gains made by female workers. Women in this demographic have led the overall participation rate, rising from 73.3% in late 2015 to its latest reading of 77%, three times the percentage gain of men in the same category who rose from 88.2% to 89.3% over the same period. Even with this good news, we cannot lose focus on UN SDG #5 (Achieve Gender Equality and Empower All Women and Girls). Women in the US still earn only about 80 cents on the equivalent dollar wage for a man, a gap which expands further for Latinas, black women and women of Native American and Hawai’ian descent. [Chart courtesy Bloomberg LP © 2020, data US BLS]

WCM Chart of the Moment for February 3, 2020

In the wake of Brexit and the risk of a pandemic it was time to take a diligent step back and compare current happenings with a bit of history. As the Coronavirus spreads within China and the WHO raises the specter of a global pandemic, investors have become concerned about the impact on the human condition and the global economy. During the SARs outbreak in 2003, Chinese economic activity was sharply impacted as GDP decelerated from 11.1% to 9.1% in the second quarter of 2003, and retail sales growth plummeted from 11.1% to 4.5% in the April to May months of that year. The SARS epidemic may, in contrast, look reasonably contained given what we don’t know about the Coronavirus. From a global economic standpoint, the Coronavirus impact is likely to be more severe given that China’s economy in 2003 represented a much smaller share of the world and it was much less consumer-oriented then.  Chinese officials have limited travel and quarantined large segments of their population in order to limit the spread of the virus.  Those actions will likely lead to stunted manufacturing output, and more importantly lower levels of consumption and retail sales which today represent a larger share of China’s economy.  The impact of an even slower growing China will likely be a challenge for growth in the rest of the world. [chart courtesy of Bloomberg LP © 2020]

WCM Chart of the Week for January 22, 2020

Earnings estimates across corporate Asia are gaining ground on European and even American companies.  This is a welcome sign especially compared to the US with its well publicized solid fundamentals.  Beyond the headlines stemming from social unrest in Hong Kong, many of the region’s stock markets exhibit favorable valuations and may attract investors pursuing stronger growth that is difficult to find in Europe at the moment.  Also, with US equities continuing to hit all-time highs, investors may opportunistically rotate into this part of the world until American indices consolidate. [chart source Bloomberg LP © 2020]

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