Steve Blumenthal – This morning, I sat down and started writing about COVID-19 (Coronavirus) — something you may have expected, considering its impact on the markets. Then, around 7:30 am, my cellphone rang. I looked over and saw it was John Ray. When John calls, I stop what I’m doing and I pick up the phone. John is my long-time mentor.

John nailed the secular cycle high in interest rates—and the story is a good one. Back then, he was a portfolio manager running a popular mutual fund at Delaware Funds, a large money management company. He was buying 14.25% Treasury bonds at a discount of 94 cents on the dollar. That meant the yield was even higher. He sought to put half the money he was managing in Treasury bonds, but his board of directors shut him down. I remember how frustrated he was. Inflation was out of control, and everyone thought rates would move even higher. That’s what it feels like at inflection points. John was spot-on. He nailed the top in yields and he took action.

It’s been months since we’ve spoken, but that never matters. What I love about John is he gets right to business. The first words out of his mouth this morning were, “Steve, listen to me. This is the bottom in yields,” he said. “It has to be. It’s crazy. We have upside down interest rates. It will reverse.”

I’ve been in the camp that we are going to 1% on the 10-year and John agreed that maybe we will. But think about it. The top was 35 years ago—I remember the talks we had to this day. Then, out of the blue, the call this morning. I think John Ray is right.

Here are a few more highlights – advice from John to me:

  • This is not Ebola. There is a 2% to 3% kill rate at best. This coronavirus will pass. If this isn’t the bottom in the fixed income markets, then put me in the grave. In the long-term secular swing, the high was in the mid-1980’s, this is the bottom in yields.
  • Go to cash in your bonds today. It’s over. And my advice to the U.S. government is this: Issue all the 50-year bonds you can right now. Solve the deficit problems. Rates will never be lower.
  • I really believe that the bond market is driving this. It is insanity in the bond market. Who locks up their money for 10 years at 1%?
  • The Fed is promoting inflation appreciation with a target at 2%. Someone has to ring the alarm bell. Enough is enough. This is the low in interest rates.

I told John I’ve seen charts that show we are at 5,000-year interest rates lows. He told me he can’t argue. Who the hell is buying negative interest rate-yielding bonds in Europe? You can’t do it.

He continued,

  • Corporations have been destroying their balance sheets for 10 years. They tell you in business school that cash is trash. This is the one time in our lifetimes that cash is not trash.
  • He advised me to key off the bond market. It is in worst condition than equities. He asked me if I remembered when he had to walk over to my office and address a margin call during the ’87 crash. “Well,” he said, “this is like that for the bond market.”

More from John:

  • The closed-end fund market goes bonkers in times like this. You see insane discounts.
  • With strong emotion he asked, “Why would you buy a 1.02% yielding bond? “

Sage advice. I’m calling my mortgage broker this afternoon. I’ve been looking for a window to refinance and 30-year money is pretty cheap. For me, it’s time to act. It’s been an awesome run but it may be time to sell your bond funds.

There are a few great coaches that come into your life. John is my favorite. I’m not suggesting you act on his advice. I am suggesting you consider his perspective.

 

Fed Rate Cut Last Week

 

Tuesday morning the Federal Reserve announced an emergency 50bp rate cut, its first such move since the financial crisis. This is a major event with consequences yet to be known. Two of our favorite Fed-watchers, Peter Boockvar and Michael Lewitt, are not impressed. Here are their first reactions.

Key Points:

  • Boockvar:Powell acknowledges rate cuts won’t affect the virus and the goal is to ease financial conditions.
  • Financial conditions will ease only if people are confident enough to take risks. They are not.
  • Far from encouraging consumer and business confidence, this type of panicky move does the exact opposite.
  • Lewitt:the Fed was already effectively out of interest rate bullets to deal with a recession. Today’s move confirms its impotence.
  • The Fed now has to either drop rates to zero or below, or employ quantitative easing strategies that monetize financial markets.
  • A confederacy of dunces are destroying the global economy because they lack the toughness to say no to markets.

Another writer, Jim Bianco, told Bloomberg Tuesday morning the Fed knows this action won’t comfort markets much (which it didn’t) and is simply trying to manage the decline. By that standard, they may be succeeding. But the selling hasn’t stopped and neither is the virus.

 

 

We wanted to highlight four takeaways:

  1. Stocks, predictably, were down in the two weeks before the Fed stepped in and lowered rates.
  2. One month later, the benchmark S&P 500 Index was in the green six out of the previous seven times.
  3. Six months later, the index has been down five times.
  4. And one year later, the S&P 500 has been down double-digits in five of the seven instances.

Federal Reserve to the rescue?

It is one thing for the Fed to cut rates to support economic growth. It is quite another for the Fed to slash rates by 50 basis points between meetings.

It smacks of “fear.” 

Previously, such emergency rate cuts have not been done lightly, but in response to a bigger crisis which was simultaneously unfolding.

 

 

If history is any guide, that’s exactly what’s about to happen. The “Fed put” refers to when a central bank takes action to boost asset prices after a big market correction. It does this by flooding the financial system with liquidity to support asset prices. We have repeatedly seen this response from the Fed since 2008. And it looks like we’re about to get another round of stimulus.

 

 

Good News!  February Jobs Report!

 

Time for a break from Coronavirus news. Today’s US jobs report covering February beat expectations by a mile. Peter Boockvar quickly dissects the data to give us the highlights.

Key Points:

  • Payrolls grew 273,000 last month, well above the 175,000 Wall Street estimate. Prior months were revised as well, by a net +85,000.
  • Much of the growth came from government hiring, mostly at the state level though the federal government hired more Census workers.
  • The headline unemployment ticked down to 3.5%.
  • The U-6 rate, which includes involuntary part-time workers, rose slightly to 7%.
  • Wage growth continued but stopped accelerating months ago.
  • Education/health continues to be a major source of job growth.

Bottom Line: This was a generally strong report, but with virus uncertainty now driving markets is unlikely to give anyone much comfort. The numbers we see a month from now will be much more enlightening.

 

Corporate Debt

 

In the 1990s, more than 60 U.S. companies operated with the highest credit rating – “AAA.” But today, just two U.S. companies – consumer-products behemoth Johnson & Johnson (JNJ) and technology giant Microsoft (MSFT) – maintain a perfect AAA rating.

According to Bloomberg, the largest portion of U.S. corporate bonds outstanding today is rated “BBB” – the lowest tier of “investment grade” debt. It totals $3 trillion… or 40% of all corporate-bond debt. It’s the largest percentage ever… four times higher than in 2008.

The chart below shows the growth of U.S. corporate debt by credit rating since 2001…

 

 

This could soon become a major problem…

You see, many institutional investors can only invest in investment-grade debt (BBB or higher). So if the debt is downgraded to noninvestment-grade – also known as “junk” status (BB or lower) – these investors will be forced to sell… no questions asked.

And the junk-bond market is much smaller than the investment-grade market. So when that happens, there won’t be enough buyers. As a result, bond prices will collapse.

And here’s the thing…

Credit downgrades are on the rise again. Last year, credit-ratings agency Standard & Poor’s (S&P) downgraded the credit of 1,053 companies in North America – the most since 2009.

 

 

In 2016, many of the downgrades occurred in the oil and gas space. But the trouble isn’t centered on one industry this time… It’s spread across different parts of Corporate America.

Many companies’ balance sheets are stretched to the limit and bloated with debt. They’re completely dependent on banks and the junk-bond market to keep rolling over (refinancing) their debt.

It’s a game of “kick the can down the road”… But the game can’t go on forever.

You always see a spike in downgrades before defaults rise.

Many companies today can barely afford to pay for the interest on their debt. The Fed’s artificially low interest rates have kept these “zombie” companies alive for much longer than in the past. The central bank is simply delaying the inevitable…

Allowing bad businesses to go bankrupt is a natural part of capitalism. It frees up resources that can be invested in better ideas.

But the credit markets aren’t as liquid as the equity markets. They can dry up quickly.

We’re not there yet… But it will end in a sudden, massive crisis. The past sins of the corporate-debt binge will finally catch up… and bankruptcies will soar.

 

China

 

What’s happening right now in China is a fresh reminder that “the stock market is not the economy.” The coronavirus brought Chinese trade to a screeching halt in February. But you’d never guess that by watching the Shanghai Stock Exchange, which is down just 4.7% from its highs seen in January. That’s despite dreadful economic data, like the Chinese Purchasing Manager’s Index (PMI) shown below:

 

 

The PMI is a survey of purchasing managers across the country, and it measures whether they think economic activity is expanding, contracting, or about the same. Any reading below 50 indicates contraction, and the index skidded to 29.6 in February from 54.1 in January. Clearly, purchasing managers have experienced a huge contraction in business activity. It doesn’t take a rocket scientist to figure out that the Coronavirus will slow economic growth in the near term. But the Chinese stock market does not seem to mind.

 

Coronavirus Update

 

The number of confirmed global cases of the coronavirus has risen to 110,159, according to the Johns Hopkins Center for Systems Science and Engineering, and deaths sit at 3,829.

The U.S. has 563 cases of the virus and deaths have climbed to 22.

 

 

Hotel occupancy collapsed in countries hit by the Coronavirus. Other nations are also likely to experience this trend in the coming months.

 

 

Global economic growth is expected to be the slowest since the financial crisis.

 

 

It will take considerable time — perhaps several quarters —

before we can be confident that the virus has been contained.

It will take even longer for the global economy to recover its footing.”

– from Sequoia Capital to Founders and CEOs of its Portfolio Companies

(March 5, 2020)

 

The current movement in the markets is unprecedented. It took just five days for the market to drop 11%—the largest decline in the shortest amount of time on record. If your head is spinning, it should be. One-day moves of 5% have happened just a few times since 1928. We’ve had two in the last week.

Supply chain issues could turn into a simultaneous supply shock (with the US unable to obtain critically needed imports) and demand shock as millions can’t work or travel. Either of those alone would be bad. Together, they would be devastating.

I don’t care how they cook the books in China, because that’s what they do, but China will be in a recession in the second quarter and perhaps the third quarter. Europe was already at stall speed and could be in recession soon, if not already.

Is there a Silver lining?  Check out airfares.  Round trip to Phoenix is now $83 and round trip to Kauai is $153.

 

The Fed

 

 

Clearly, the “flu” is a much bigger problem than COVID-19 in terms of the number of people getting sick. The difference, however, is that during “flu season,” we don’t shut down airports, shipping, manufacturing, schools, etc. The negative impact on exports and imports, business investment, and potential consumer spending are all direct inputs into the GDP calculation and will be reflected in corporate earnings and profits.

Importantly, earnings estimates have not been ratcheted down yet to account for the impact of the “shutdown” to the global supply chain. Once we adjust (dotted blue line) for the negative earnings environment in 2020, with a recovery in 2021, you can see just how far estimates will slide over the coming months. This will put downward pressure on stocks for the rest of the year.

 

 

Our Pharmaceutical Dependence on China

 

China produces 97 percent of all antibiotics and 80 percent of the active ingredients we use to make other drugs. Last year, manufacturing of intermediate or finished goods as well as pharmaceutical source material in China, accounted for:

  • 95 percent of U.S. imports of ibuprofen,
  • 91 percent of U.S. imports of hydrocortisone,
  • 70 percent of U.S. imports of acetaminophen,
  • 40 to 45 percent of U.S. imports of penicillin, and
  • 40 percent of U.S. imports of heparin.

Although In­dia is the world’s leading supplier of generic drugs, India gets 80 percent of its active pharmaceutical ingredients directly from China.

The United States also imports 80 percent of its active pharmaceuti­cal ingredients from overseas (primarily from India and China). Meanwhile, a substantial portion of America’s generic drugs come either directly from China or from third countries like India that use ac­tive pharmaceutical ingredients sourced from Chi­na.

If you’re the Chinese and you want to really just destroy us, just stop sending us antibiotics. And while this has not happened, the coronavirus itself has exposed the frailty of global supply chains and the fallacy of intercontinental supply chains and just-in-time inventory management for such indis­pensable products.

“What would happen if there was “a coronavirus outbreak in the United States and a lot of people ended up in hospitals with severe cases?” The medicines needed to care for them if they can’t breathe and are on a ventilator —including fentanyl and propofol — [are all made in China]. — If they go into shock, the epinephrine and dopamine we need to care for them, depends on China. — If they have bacterial infections, we depend on China for the antibiotics.”

America has already lost much of its manufacturing capabilities for medicines to China via globalization.

 

Market Data

 

  • Unhealthy behavior. Fewer than 40% of S&P 500 stocks have been holding above their 200-day moving averages.

 

 

All content is the opinion of Brian Decker