The disconnect could not be more jarring. As images of rioting, torched buildings and police thuggery in American cities gripped the world, the stock markets surged, as if investors were not bothered a whit by the street-level carnage and boarded-up retailers.
By Friday, the S&P 500 had staged its biggest 50-day rally ever, having climbed more than 40 per cent since its COVID-19-whacked low in March, taking the one-year return to 11 per cent. Virus, what virus?
Strong 50-day rallies are often exceedingly bullish indicators; momentum kicks in and equities tend to keep rising. Repeat performance this time? The proponents of the V-shaped recovery, like JP Morgan and Morgan Stanley, are convinced the recovery is on track and that equities are heading higher.
Their argument is that quarantines are ending and central banks are expanding their balance sheets like never before to prop up the economy. Add in cheap money, income support and corporate bailouts and you allegedly have a recipe for an enduring rally. Never mind that no COVID-19 vaccine exists and may never exist, and that the novel coronavirus is barely contained in many big countries and only suppressed in a few.
The fundamental flaw in the bull market scenario is debt. In simple terms, equity is what’s left after debt has been repaid, and debt was exploding even before anyone had heard of COVID-19. American companies have been binging on cheap debt since the 2008 financial crisis, using it to finance lavish share buybacks, dividend increases and executive compensation packages.
American companies have never held so much debt as they do today. At the end of last year, non-financial companies had borrowed US$9.6-trillion, up 57 per cent since the financial crisis, according to the Securities Industry and Financial Markets Association. Corporate debt as a percentage of GDP went to about 47 per cent, up from the post-crisis low of about 40 per cent. According to Forbes magazine, the S&P as a whole had a debt-to-equity ratio of almost 1.6 at the end of last year, meaning that for every buck in cash and other assets they held, they had US$1.60 in liabilities. Furthermore, a lot of those liabilities is low-quality debt – the BBB-rated near junk which costs a lot more than high-quality debt.
The explosion of debt helps to explain why most companies were in a bear market even before COVID-19 arrived. It was the awesome performance of Big Tech and its monopoly power that had kept the indexes rolling since early 2019.
The virus crisis in March sent the markets plummeting. Lots of companies went into bankruptcy protection, including the department stores Macy’s, Neiman Marcus and JC Penney. Many others were saved by the unprecedented fiscal and monetary response that came with hundreds of billions of dollars of bailout loans, loan guarantees and grants to distressed companies of all sizes, regardless of their profitability, or lack thereof, before the virus crisis.
While some of the debt will inevitably be forgiven, or converted to equity owned by the taxpayer – see the Lufthansa bailout – a lot of it won’t. The upshot is that companies that were highly indebted before the crisis will be even more indebted after it. But their ability to service that debt will be compromised by waning revenues and profits.
There is no doubt that the worst of the pandemic-related drops in GDP and employment are over. Data released on Friday showed that both the U.S. and Canadian economies added jobs far faster than expected. In the United States, the May jobless rate fell to 13.3 per cent from 14.7 per cent after 2.5 million jobs came back.
But the employment rebound is a rare bit of good news in a sea of despair. United States and many other Western countries remain mired in the deepest economic downturn since the Second World War. Entire industries are suffering from the twin supply and demand shocks. In the absence of a vaccine or a COVID-19 therapy, the prospect of a quick return to normal seems absurd. “COVID-19 will do far deeper damage than most experts anticipate because it is reducing productive capacity on a lasting basis in many sectors including restaurants, hotels, entertainment, airlines, conferences and maybe higher education,” says market strategist Marshall Auerback of the Levy Institute.
At the same time, companies that are in distress, but alive, are busy laying off workers and reducing the pay of the survivors. How many of the hundreds of thousands of protesters who took to the streets since George Floyd’s death were jobless and struggling to feed their families? Probably a lot of them. Will they be shopping at malls and booking airline tickets any time soon? Not a chance. And if consumers are not spending, inflation probably will stay low, preventing debt from being inflated away.
The stock market seems to have gotten way ahead of itself, all the more so since the pandemic has not disappeared. As the lockdowns come off, the chances of a second wave of COVID-19 infections can only rise. Meanwhile, corporate debt rises, pinching the equity. This will not end well.
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Eric Reguly