Insolvency: A Short-Term Macroeconomic Outlook

May 28, 2020

We are in an interesting time. I believe that the current economic circumstances are ones that all of these readers will not feel again in their lifetimes. Bridgewater Capital estimates the amount of losses in excess of $20T worldwide, an amount which dwarfs the 2008 financial crisis.

Personal Debt

Since mid-March, 38.6M Americans have applied for unemployment, which is roughly 24% of the Americans that were in the workforce prior to the pandemic. It is reported that millions of Americans are asking for deferrals and forgiveness on credit cards. In Q3 2019, credit card debt reached $1T in the US. In its annual stress test dated February 6, 2020, the Federal Reserve bank estimated credit card loss rates at 11.3% in an “adverse scenario” and 16.35% in a “severely adverse” scenario.

In July of 2019, CNBC reported: “Some 40% of Americans would struggle to come up with even $400 to pay for an unexpected bill.”

In Gallup’s paper Put the Gig Economy to Work for You, they identify with their 2017 data set that 36% of workers work in the gig economy sector (Uber drivers, freelancers, Airbnb landlords, task contractors, artists, on-call workers, etc). With trends shifting to the gig economy, of which much is delivered face to face, the resulting economic impact on personal pocket books is immense.

Non-essential high-income healthcare professionals, have seen a drastic dip in income, and the real estate market has ground to a halt. Many of these professionals have auto, student loan, and mortgage debt that also needs to be serviced.

Corporate Debt

In the last 10 years, bond buyers from pension funds have supported the purchase of debt. Rating agencies have increasingly rated these bonds as BBB (investment grade), when fundamentals did not represent the same credit quality. Banks and other lending institutions have financed smaller private corporations with low cost debt. In this period, corporations in search of higher return on equity have shifted their capital structure towards debt in order to return a higher return to shareholders. Stock buy-backs have reached an all-time high, which has elevated price levels in the stock market.

Mass Insolvency Event

Propelled by poor demand from corporations and consumers, revenue for most companies has been decimated, resulting in a deep and extended earnings recession. Within the last 2 weeks, Gold’s Gym, Nieman Marcus, John Varvatos, and J. Crew went into Chapter 11 insolvency protection. With serious compression to the travel sector, face-to-face service, retail, and hospitality will be the first sectors to experience insolvency, with knock-on effects throughout the economy.

Stimulus Effectiveness

Although markets are responding positively to stimulus, I would argue that these policies are simply deferring inevitable insolvencies. Helicopter payments, rent stays, and expanded unemployment insurance only impact the current month. As soon as there is a mismatch between the payments and the losses, personal insolvency will escalate.

Those companies that were suffering before the crisis will find it hard to stay afloat. For those with debt payments, these stimulus packages help to slow the bleed, but are not designed to take the burden of the entire loss.

Even if they were done well, these stimulus attempts are tantamount to trying to land an aircraft by deploying parachutes. Yes, while it is possible, you don’t have the time to do the calculations necessary to make sure the plane lands without significant damage. Also, parachutes aren’t going to lift the plane back into the air.

Contracting Credit

We can expect that insolvency issues will result in people and companies investing and spending less. With few that benefit from the crisis, revenue compression will become the norm with many businesses having trouble repaying debt. As debt is restructured or eliminated, the value of this asset to the lender/holder of the debt asset is significantly reduced.

Short-Term Contraction in Asset Prices

I believe that we are going to see a significant drop in all financial asset prices, as insolvencies and poor demand leads to extremely low stock prices in certain sectors. Led by companies that hold debt as their asset base and industries with no demand, publicly traded assets including cryptocurrency, gold, real estate, stocks, and bonds will be pushed down by increased sales and lack of buyers.

Commercial tenants will find that they resume to work requiring less employees and those that they do have will be capable to work from home. Residential owners will take losses as their tenants fail to make rent payments and governments protect renters from eviction. AirBNB properties will sit empty, enticing many of these owners to sell. All of these will increase inventory of properties for sale, resulting in downward price pressure.

Recovery of Asset Prices

I believe that we will see a quick recovery in gold as severe currency fluctuations cause a flight to stable currency, while stocks and real estate will not reach these highs again for a decade or more as investors search for stability.

As asset prices compress, there will be great opportunities for investors who remain liquid.  Young companies with little debt will have an opportunity to fill gaps in the market, making angel investments more attractive. Massive life-changing events such as this pandemic have a way of shifting purchasing preferences. Personal safety and saving for the future are going to be more important to companies and individuals in the coming decade as this pandemic has threatened both of these things.

While this lockdown seems to be never ending, this too will pass. You will have new appreciation for basic things like seeing your friends and sitting in a restaurant. While these changes will create challenges for many, they also represent opportunity for others. Actively managing your portfolio has never been more important.

Read Part 2: Stagflation & Redistribution: A Longer-Term Macroeconomic Outlook.