Night Flying

In high school my pastor was a veteran of World War II, a war in which he served as a pilot.  A story he told regarding night-flying training has stayed with me all of these years. A trainee would begin as normal, taking off from the airstrip in broad daylight. Once airborne, the trainee would raise a canopy in the cockpit to shield their vision, simulating the darkness of the night sky. In lieu of the view from their windshield, the trainee was forced to rely on their instruments. One can only imagine the difficulty of a trainee’s first experience under these conditions. 

Our current economic environment presents a similar challenge. As detailed in our quarterly review, the last U.S. pandemic occurred in a far different economic environment. Major economic activities, such as small-scale agriculture, could continue unimpeded by social distancing requirements. The population of the Houston metro area was 186,667 in the 1920 census, in contrast to todays’ population of approximately 7 million. And as there were only 5 million cars in an America of 106.5 million people, mobility was significantly constrained. 

Given the lack of an appropriate historical parallel, our only recourse is to review the data as it is released and compare it to what we know about recessions and bear markets in general.

The International Monetary Fund is forecasting a -5.9% GDP growth rate for the U.S. in 2020.  To put this in perspective,  during the global financial crisis the 2008 GDP growth rate was -0.1%. During 2009 it reached -2.5%. Negative growth figures this large have not been seen since the Great Depression and World War II. 

26.5 million people are currently unemployed in the U.S., and later this week that number is likely to approach 30 million. These job losses have erased every job gained since the financial crisis. Many labor economists believe we will see unemployment levels approach or surpass the levels reached during the Great Depression. 

Finally, considering that oil is the commodity at the heart of global commerce and daily life, one can argue that its price serves as a vital indicator of global economic activity.  WTI crude oil futures are currently trading between $10 and $16 a barrel.

The initial effects of COVID-19 on the economy are clear. Social distancing has produced widespread unemployment and a sharp decline in economic growth.

The secondary effects are likely to arrive in coming months. Following the financial crisis, U.S. corporations took advantage of historically low interest rates and leveraged their balance sheets. As a result, the U.S. corporate sector that entered this bear market is the most indebted in history. Unfortunately, many of the companies that took advantage of these low interest rates are considered to be at risk of default by credit agencies. The debt issued by these companies, typically referred to as high yield, has expanded to historic proportions. 

While economic time may have stopped due to social distancing requirements, financial time, in the form of debt liabilities, has not. Interest payments come due regardless of whether previous levels of revenue are maintained. Goldman Sachs expects the default rate for high-yield debt to more than triple from 4% to 14%-18%. The worst case scenario would surpass the financial crisis in its severity. 

A significant portion of high yield debt has been issued by the energy sector, which was already struggling following the oil price rout lasting from 2014-2016. The deadly combination of a global price war and a sudden stop in demand has driven prices to the lowest inflation-adjusted levels in 150 years. Scott Sheffield, CEO of Pioneer Natural Resources Company, believes that if nothing changes it will mean the disappearance of 64 of the 74 independent publicly traded oil and gas companies by the end of 2021.

Companies in emerging markets occupy a similar environment, facing a dollar that has rapidly risen with relation to their domestic currencies, making their dollar-denominated liabilities even more difficult to pay as dollar revenues from international trade evaporate. Specialists in this space believe this may shape up to be the worst emerging markets crisis in history.

This level of economic carnage makes a sharp rise in bankruptcies inevitable. These bankruptcies will result in reduced cash flows to other economic actors, including other corporations, laid off employees, or local governments. The price for companies to obtain financing will increase in order to compensate lenders for the additional risk of default. Many companies will increase layoffs and reduce capital expenditures in order to weather the storm.

Though COVID-19 complicates this calculation, recessions typically last from 11-15 months. Our recession likely began at the beginning of March. This implies we have a long ways to go prior to recovery, and this is not taking into account the idiosyncratic COVID-19 related risks. 

An exit from this crisis will be predicated on greater certainty regarding future economic conditions. We have yet to see a nation return successfully to levels of economic activity held prior to COVID-19. Several nations have loosened restrictions only to reverse them as fresh outbreaks occurred. And the economic effects of COVID-19 will linger with us long after the virus is gone. 

This is not an environment in which corporations are likely to make significant outlays of capital or begin rebuilding their workforce. For corporate investment and economic growth to reverse course we will need to have more clarity regarding the future, both in terms of COVID-19 and the full extent of its economic effects. 

Historically, the onset of recession is a period in which investors are rewarded for maintaining a conservative allocation. As we weather this period of economic contraction, the price of risk assets will fall to levels that have historically presented opportunities to prudent investors. These price levels, which are inexpensive relative to the earnings of the companies they represent, are the levels from which bull markets emerge. We will be anxious to take advantage of these opportunities as they present themselves. In the meantime, like our trainee pilots, we will continue to rely on our instruments. 

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