If the global economy is closed for business, due to the mandatory lockdown, why markets still see so much value on financial assets? Markets can ignore harsh facts for a while if you have enough firepower (money) and the right narrative.
Investors already know and expect most company's revenues will diminish. Their earnings reports will be below expectations, and the future economy reports will be terrible at least for the rest of this year. Still, the U.S. S&P 500 stock market index has bounced back quickly to 2,800.
They also know that the U.S. Federal Reserve and the Government have provided an aggressive plan to support corporations' debt, municipalities, small businesses, and they might continue to do it for a while.
These extraordinary relief packages have created a temporal floor for financial assets valuations in the investor's minds, a sort of bridge towards a future economic opening—an economy opening expectation which it has become the main narrative for markets.
And by doing that, Governments have created winners and losers in the process. Entities who have access to the Fed direct lending or have them buying its debt, even if they are junk bonds, has by default, become too important to fail.
We may have a similar situation for those private small and medium-size companies who got the government Paycheck Payroll Program.
These new privileges for the companies who are financially supported by governments have helped them sustain decent valuations and suppress the risk for their public assets in the short term. The Federal Reserve has effectively added financial insurance to those companies, or in business jargon, they have issued a put option against losses.
Therefore, if a company thrives, you will get the benefits, but if it fails, the government might finance them. A great deal so far for investors in the short term.
This added financial option can easily explain why investors are buying certain assets avidly. Where else can you be somewhat confident of your returns? And especially during these chaotic times.
In the short term, these money facilities have alleviated liquidity issues for companies, helping pay for the cost that otherwise they will not be able to pay, like employee salaries.
In a couple of quarters, a different constraint might take shape for the most indebted companies; they will face insolvency.
The weight of the interest and debt capital payments might be overwhelming, forcing many of them to declare bankruptcy or seek changes to their capital structure, adding equity, and lowering debt levels. By then, we will see whether or not the governments will be willing and able to finance these problems as well.
Now, we must not lose sight that these illusions of goldilocks conditions might change in the blink of an eye. The economic weight of 26 million unemployed it is not easy to forget. The immediate negative quarterly earnings results, any delay or hiccup on the economic opening, or any unforeseen surprise could quickly reverse course. So asset prices are high, and so are their risks.
Of course, these companies are not guilty of anything. And they might deserve all the government support. But there are, and there will be a long list of losers, a lot of companies might not get the direct lending programs, which creates a moral dilemma.
These extraordinary assistance programs are a phenomenon present in almost every developed economy and a couple of most advanced emerging economies.
If you think about it, under this challenging environment, if you do not support your country companies, they might not survive, but if you help them, some might even thrive globally.
Those economies and companies, in some emerging markets, who might not receive their local government financial support, they might struggle. It happened ten years ago during the great financial crisis, and we are just reapplying what we learned at a new scale.
Those economies without plans for financial support might have no other options than to restrict public and private spending, sharply collapsing their savings, and hope for a recovery of the rest of the world to increase their exports—a tough path to recovery.
In the end, as investors, we are left with four broad groups of stocks.
First, the innovators, these are companies that were leading before COVID-19. Still, they are thriving by their own merits even during this situation. They might reach new highs, rising above everyone else.
Second, the essentials, these companies provide us with everyday necessities, but investors did not appreciate until now, and we need them the most. They might reach and sustain considerable valuations.
These last two groups have had a better performance than the general market index, before and after the government support packages.
The third group, those companies that were defined tacitly as too important to fail, which the governments aimed their efforts to provide extraordinary support.
They are mostly in cyclical sectors, with high debt loads. Without direct support, they will have had a bankruptcy in the short term. The list of companies in this group keeps expanding every day. They have recovered its valuations, and if the economy restarts as expected might crawl back to stable levels.
And lastly, the fourth group, the forgotten companies, those who are not directly benefiting from public debt, private funds, or government funds, and have nothing to differentiate themselves. They have no option but to cut costs drastically, fire employees, and hope for a better tomorrow. Well, it is difficult to see a recovery for them until the whole economy gets back on track.
I know what you are thinking, is it not capitalism about creative destruction and survival of the fittest?. There are always willing capitalist investors ready to buy trouble assets and improve them for a profit.
But it seems we are living times, due to an emergency, where centralize political decision making will replace the free market allocation of capital for a while. This temporary suspension of capitalism dynamics will certainly have unforeseen consequences, but not evident in the short term.
In the short term, investors are incentivized by the Central Banks and Governments to take more risks, a leap of faith, trusting that they have their backs in the form of unlimited financial support. But for how long and to what extent will they sustain them?.
So in these critical conditions, the government might say that it is best to save as many companies as you can as fast as you can, regardless of moral hazard or preferences, and they might be right.
The economic history will define by the winners; they will write history to fit their needs. So a savvy government has to make sure they win.
As an investor, you must ensure you pick your investments from Santa's nice companies list and avoid any investments from the naughty (or forgotten) company list. Be sure to reach your financial advisor to help you find them.