Most importantly, we hope this letter finds you and your loved ones healthy and safe. This has been a difficult time for everyone experiencing a great deal of change, loss, and distance. We want to thank all of those on the front lines, putting themselves at risk to provide the critical care many need and to produce and deliver the essential services, supplies and food we all rely upon. We are forever indebted to them for their service.
We are thinking of you and your families and remain optimistic that we are all able to focus on the simple joys of life and to be reunited with family and dear friends again soon. Although it has been challenging to adapt our lives to this new reality, we believe that the health and wellbeing of all our fellow mankind needs to come above all else. Before we begin our investment commentary we want to reiterate our belief that although there will be temptations to rush the process to get back to work and reduce the economic impact, there is truly no price you can put on human life and so we support a well thought out approach.
After a challenging first quarter, we are working to reconcile the harsh reality of the pandemic with the unprecedented measures taken by the Federal government to stabilize markets. When we wrote to you at the beginning of March, we were hopeful the epidemic would create a temporary disruption in the economy and swift government intervention would avoid a deep recession. While a recession is now a given, we are relieved that the Federal Reserve has taken aggressive action to stabilize markets, something that has typically taken months or years to happen in past occurrences. Similarly, the Federal government has already initiated 3 phases of a stability program that is aimed at reducing job losses, keeping small businesses from defaulting on their debt and other obligations, and providing essential support to our healthcare system. Despite some bureaucratic moments and likely an imperfect solution, the government has acted more quickly in this instance than any in the past.
All of this is good news, but it is not a reason to think we are positioned to snap back to the pre-virus status quo. We view the recovery in markets as having 3 phases. The first is the initial stability of financial markets, that we believe we have achieved in part by the Federal Reserve stating that they are prepared to do a lot more if necessary. The Second is a better understanding of the virus and a clearer view of the duration of the epidemic. We have seen progress on this front but cannot yet check that off the list. Lastly, we need to better understand the length of the economic disruption and the magnitude of the fallout. We may not be able to understand this completely until we look at the episode in retrospect.
In many ways we feel that the adage “it is always darkest before the dawn” is most applicable today. Now is clearly a dark time, but we do believe there is light up ahead. While there can be disagreement in the response to the crisis, we have seen some of the best humanity has to offer in the efforts of our doctors, first responders, scientists, and each other in the fight against this virus. The human spirit is something we don’t want to bet against. We believe that in the end, we will persevere and recover, but we are still in the heat of the battle. There are likely to be setbacks along the way and the world may very well be different on the other side.
The Fed Bazooka
Each time there is a new financial crisis, it is almost certain that the cause, as well as the resolution, will be a bit different. The benefit of subsequent market shocks is that there tends to be a higher level of preparedness and willingness to act swiftly and decisively. The Federal Reserve clearly remembered the experience of the Great Recession and took aggressive action to provide liquidity and stabilize the financial markets. Additionally, they quickly cut rates to zero, skipping the usual sequence of multiple rate cuts.
The Fed quickly surmised that this time was different and with a shuttered economy, even the perception of a breakdown in the financial system could have been disastrous. The banking system needed to be preserved in order to leverage the banks and get necessary capital to the companies and small businesses who needed help. We questioned how the Federal government could effectively operate the largest fiscal stimulus program in corporate history, delivering trillions of dollars of loans to tens of thousands of businesses in desperate need. The solution was to use the existing banking system and empower the banks to make the loans directly to their existing customers and utilize the Federal Reserve as a back stop. Two key parts of the fiscal stimulus program work this way: the Payroll Protection Program and the Main Street New (and Expanded) Loan Facility. Instead of building a new lending facility, they used the banks and their infrastructure to simply provide a place to sell their loans or as a backstop if they chose to hold them on their balance sheet. This was similar to a program developed in 2009 called the Term Asset Backed Securities Loan Facility (TALF). The Fed purchased asset backed securities (think credit card receivables or auto loans) from the banks, when few would purchase them, incenting banks to extend credit knowing they wouldn’t be on the hook if the loans went bad. This program was also restarted a few weeks ago to do just that once again.
As we saw in the Great Recession, when significant defaults occur, bank capital erodes, lenders stop lending, additional defaults occur, and the circle continues until something is done to fix the system. Avoiding the breakdown in the system is critical to averting a deep and long recession. The Fed is acting swiftly to prevent it. In addition, we have seen the banking system being a bit more patient, allowing for payment deferrals instead of sending foreclosure notices to their client base. The ability to defer mortgage, credit card, student loan and auto loan payments is a major aid for consumers who may have lost their jobs. The bank’s flexibility on this front is driven by their strong capital position and the expectation there would potentially be a backstop from the Federal Government. The concern is that if the economic shutdown lasts longer than a few months, the banks, credit card companies, and landlords will not continue to be so flexible. If that were the case, we are back to relying on the Federal Government providing the support which is at best uncertain and if applied creates significant concerns about the deficit and potential inflation.
Waking the Patient
result and “flatten the curve” in key areas of the US such as New York and California, as well as in Europe, most notably in Italy and Germany. In terms of virus-related statistics, flattening the curve has been a focal point, with hope that the path to containment may emerge like the one seen in China. The US stock market rallied in reaction, delivering the best week since 1974, only two weeks after posting the worst week since the Great Depression. Perhaps we are on the path to recovery. Perhaps we are just like a patient waking up from a coma in need of rehabilitation.
We have embarked on an uncharted path, a coordinated worldwide economic shutdown, where the recovery is a great unknown. In the US, state after state issued stay at home directives and the economy has quickly ground to a halt as illustrated by the record jobless claims. For the week of March 21st, initial jobless claims reached 3.3 million, easily trouncing the prior record in 1982 of 695,000. That record stood only a week when claims topped 6.6mm. While the comparison is a bit skewed due to the lifting of many prior restrictions on unemployment qualification, the results are still extraordinary. The estimates of the eventual peak unemployment figures as well as the depths of the GDP contraction in the 2nd quarter are downright frightening.
So, does the economy snap right back once businesses re-open? Unfortunately, it is unlikely that the economy reverts back to pre-virus conditions. It is likely that not everyone will have a job to come back to as most companies tighten their budgets and weak companies simply don’t make it. We hope the latter is a small subset, but we will not know the extent until this is over.
A Difficult Recovery
Many have targeted early May for opening states back up for business, which from an economic perspective is encouraging. However, if it is too early, the results could be disastrous both from a disease and an economic perspective. If we were to open the economy and infections spike again, driving another shut down of businesses, we could see the economy experience a downturn that is much more difficult to recover from.
The ability to test, track, and trace those who are infected remains uncertain. Without any clarity on the timing or availability of a potential anti-viral treatment, let alone a viable vaccine, continuing to segment the population appears to be the best option. Until we can determine those who have had it, those who may be immune to it, those who have it and need to be quarantined, and those who have not had it but are healthy, it is difficult to create a plan on how to go back to work and keep people safe.
A New Take on Life
We are hopeful that we can start to get back to a semblance of normalcy, but we
believe it is unwise to believe that we will see people return to their prior habits quickly. There will clearly be a reluctance to eat at restaurants, travel, attend conferences or sporting events, at a minimum. Perhaps the most notable change has been the ability to work remotely. Many companies, including Bainco, have experimented with this in the past in order to improve business continuity due to short disruptions such as snowstorms or hurricanes, to reduce office overhead, or to give employees a better work-life balance. This disruption has pushed almost all companies to become work-from-home capable (we have even adopted an acronym: WFH). We think this is likely to be embraced by more and more companies on a go forward basis, now that it has been proven to be possible and many employees are likely to request it. It also could be a cost savings measure as some companies reduce their office space.
With so many working from home and not traveling for work or pleasure the demand for oil has fallen precipitously. We grew concerned about demand due to the shut down in China and general economic demand and reduced our portfolio exposure significantly, selling all individual energy holdings. What we did not see coming was the fallout that would result within OPEC whereby Saudi Arabia and Russia would start a price war. The commodity has fallen back to prices not seen since the 1990’s and created additional stress across financial markets. Although things have stabilized a bit with Russia and Saudi Arabia agreeing to cut production, we believe that the demand environment may be significantly changed for the foreseeable future.
The ability to do your job at a safe distance is also driving adoption of innovations such as video conferencing, remote computer access, and cloud software. These are trends that we had seen emerging prior to the virus, but this crisis has sent them into hyperdrive and could change how we meet and work on a go forward basis. Why spend all that time commuting to a meeting or the doctor’s office for a short checkup if it can be done from your home? The technology offerings may not be perfect, but adoption is happening much more rapidly than previously forecasted. Microsoft’s remote work platform, called Teams, surged to 44 million daily active users in early March, up from 20 million in November, and has likely continued to rise dramatically. In the home, there are similar trends as the Disney Plus streaming service almost doubled in a month to more than 50 million users blowing past analyst projections that they might hit 20 million at the end of the year.
From a company management perspective, this economic shutdown has made clear how little cash most companies have on their balance sheets. It was well known that many Americans lived paycheck to paycheck, but it was less well known how many companies were also fiscally vulnerable. The economic expansion was incredibly weak by historical standards, yet equity returns were tremendous as cost savings and financial leverage drove earnings growth. The market rewarded strong returns on equity and utilization of low interest debt to repurchase stock instead of building strong balance sheets. This has pushed some to a point where they may need to lay off many quality employees and possibly raise capital at unattractive terms.
We have prided ourselves in avoiding many of these companies, staying a bit away from the trend and favoring companies with strong balance sheets and robust cash flow profiles. We favor companies that control their destiny and are the buyer of cheap assets in times of distress instead of a forced seller.
As we emerge from this time, we are looking to have done two things. First, we want to be certain that we have taken all necessary steps to ensure our clients’ assets are secure and protected. Second, we are looking to emerge from this having made improvements to an already high-quality portfolio. You should begin to see some new names in your portfolio, most will be familiar, and we believe will be great companies to own as the economy recovers. So far, we have added Intel, Starbucks, Waste Management, and Nvidia to our individual equity portfolios. The path forward is likely to be volatile and as such we are working hard on our shopping list and plan to be disciplined and patient in adding to portfolios. The cash we built on the way down gives us some great flexibility to do so.
In the coming months we are all likely to be challenged further both personally and professionally. While we can’t guarantee performance, we can guarantee that we stand ready to work hard for you to continue to protect your money and capitalize on opportunities when the risk is worth the reward. We look forward to the days where we can meet in person again and look back on this period as just a difficult memory. Stay safe and healthy. We have done our best to communicate with you during this crisis and look forward to continuing that dialogue and our discussions with you.
MARKET COMMENTARY DISCLAIMERS
This commentary contains the current opinions of the authors as of the date of publication. All opinions are subject to change at any time. This commentary has been distributed for informational purposes only and is not meant to convey a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell securities or investment services. The opinions and statements set forth do not consider the investment objectives or financial situation of any particular individual or group of individuals. Individuals will need to consider their own circumstances before making an investment decision.
Information contained herein, including market forecasts and forward-looking statements, are derived from proprietary and nonproprietary sources Bainco deems to be reliable; Bainco does not, however, warrant the completeness or accuracy of the information obtained from these sources.
Past performance is not a guarantee of future results.