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June 08, 2020

MFS insights: market knowns and unknowns

Markets are a discounting mechanism of “known knowns” and the weighted probabilities of many “known unknowns". MFS delves into how both will shape the post crisis economy.

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In brief:

  • Macroeconomic data may potentially worsen, but that’s a market known.
  • CEOs and CFOs are scrambling to secure liquidity. Profit maximization is no longer the priority. Survival is. Recapitalizations will likely become necessary, diluting existing shareholders. The post crisis economy may not resemble the pre-crisis one.
  • While many are making high-conviction calls that the economic recovery will be strong, we don’t share that level of conviction. We don’t think you should either.

Over the next several weeks, investors are unlikely to be surprised by the horrendous macroeconomic data. For instance, based on initial jobless claims data, more jobs have been lost in the past four weeks than were created during the entirety of the now-ended eleven-year business cycle. So yes, economic data will get worse, but they may not matter to capital markets because this is a market known.

Markets are a discounting mechanism of “known knowns” and the weighted probabilities of many “known unknowns.” And an upcoming earnings recession won’t surprise markets any more than terrible labour data will.

Two known unknowns are the pace of the economic recovery and the path of post recession earnings. Since the March lows, U.S. equities have retraced over half of their losses. Stated another way, in the face of the worst recession of our lifetimes, equity valuations are down only to June 2019 levels. Over the past few weeks, investors have increasingly assigned a higher probability to a shorter-than-anticipated recession and a stronger acceleration in profits. We’re not epidemiologists, so we won’t opine on the infection curve or the risks of a second wave, though we certainly hope for the best. But as they say, hope isn’t an investment thesis.

Regardless of when the virus peaks or the economy reopens, life will be different. Politicians, the media and investment strategists and economists (but not us!) have equated the world’s efforts to contain COVID-19 with fighting a war. While it may feel that way with everyone pulling together (thank you to the brave health workers and first responders!), pandemics alter long-term behaviour differently than wars. The catalysts that generally drive V-shaped postwar recoveries are very different from pandemic-driven ones. We’ll address this another time, but in short, precautionary savings by both consumers and businesses create very different economic and inflation environments than those previously observed in postwar economies. Now, back to the concern and the point of this article.

In “Looking at Equity Markets Through an Earnings Lens, Part II,” we detail some of the reasons we believe this earnings recovery will be weaker than what’s being priced. A market known unknown, if you will, that we want to explore further is the likely earnings dilution resulting from future equity capital having to be raised.

During periods of economic strength, many corporations take advantage of all available levers to maximize their appeal to equity investors. Part of the reason for this is that the wrong incentive structure is in place for many corporate leaders, but that too is a topic for another day. Over the past decade, working capital has been the priority for most CEOs, and lower balance sheet quality has been the lever. That dynamic has been on display more in the recent past than in any other period of recorded history. See Exhibit 1 below, which details the steady increase of billions of dollars’ worth of shares repurchased in the S&P 500 Index.

Exhibit 1: Equity recapitalizations surged during the financial crisis

This graph shows the net buybacks of all companies in the S&P 500 index. There was a bottom of around negative 280 billion $ USD in 2008 and then a trend upwards until the latest figure of 580 billion $ USD in 2019.

Source: Goldman Sachs Global Investment Research. Annual data from 31 December 2007 to 31 December 2019.

This isn’t new information, so we highlight 2008. As the fat tail risk of the global financial crisis faded, emphasis turned from maintaining liquidity toward recapitalization. That recapitalization came via the equity market and at the expense of shareholders who suffered substantial dilution on a per-share basis.

Today, CEOs and CFOs — particularly those of companies that might not be able to carry on — are scrambling to secure liquidity. Profit maximization is no longer the priority. Survival is the goal, as meeting next month’s debt maturity is all that matters. Balance sheets are now the focus, unlike in the past dozen years. However, the nature of this recession is different from that of 2008, and not only because the recession is driven by a pandemic. The 2008 meltdown was driven by an overleveraged financial sector. However, this time around, banks and REITs weren’t the entities that extended balance sheet leverage to unsustainable levels in order to repurchase stock. Instead it was every corporate sector but financials. And a fresh wave of recapitalizations is likely just getting started. Over the past couple of weeks, for instance, there’s already been equity issuance by leisure and professional services companies in the U.S. and Europe.

None of us can guess what the duration of this recession may be, nor can we tell how strong the recovery may be. Yet many seem to believe they have sufficient visibility into any such recovery’s many known unknowns to make the high-conviction call that the recovery will be strong. We wish we had such conviction, but we don’t, and we don’t think you should either.

Instead of trying to make those calls, we’ve chosen to invest carefully, owning assets of enterprises for which the growth of working capital isn’t dependent on externalities such as financing, recognizing that you can’t plan perfectly for black swan events such as the one we’re experiencing.

IMPORTANT INFORMATION

MFS or MFS Investment Management refers to MFS Investment Management Canada Limited and MFS Institutional Advisors, Inc.  This article was first published in the United States by MFS. in March 2020 and is distributed in Canada by Sun Life Global Investments (Canada) Inc., with permission. This document is provided for information purposes only and is not intended to provide specific financial, tax, insurance, investment, legal or accounting advice and should not be relied upon in that regard and does not constitute a specific offer to buy and/or sell securities.

Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the fund’s prospectus. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated.

The views expressed in this commentary are those of the authors and are subject to change at any time. Views expressed regarding a particular company, security, industry or market sector should not be considered an indication of trading intent of any mutual funds managed by Sun Life Global Investments (Canada) Inc. or sub-advised by MFS. These views are not to be considered as investment advice nor should they be considered a recommendation to buy or sell. Information presented has been compiled from sources believed to be reliable, but no representation or warranty, express or implied, is made with respect to its timeliness or accuracy. This document may contain forward-looking statements about the economy and/or markets; their future performance, strategies or prospects. Forward-looking statements are not guarantees of future performance, are speculative in nature and cannot be relied upon. They involve inherent risks and uncertainties so it is possible that predictions, forecasts, and projections will not be achieved. A number of important factors could cause actual events or results to differ materially from those expressed or implied this document.  The views expressed in this commentary are those of the authors and are subject to change at any time.

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© Sun Life Global Investments (Canada) Inc., 2020. Sun Life Global Investments (Canada) Inc., MFS Investment Management Canada Limited and MFS Institutional Advisors Inc are all members of the Sun Life group of companies.

This commentary contains information in summary form for your convenience, published by Sun Life Global Investments (Canada) Inc. Although this commentary has been prepared from sources believed to be reliable, Sun Life Global Investments (Canada) Inc. cannot guarantee its accuracy or completeness and is intended to provide you with general information and should not be construed as providing specific individual financial, investment, tax, or legal advice. The views expressed are those of the author and not necessarily the opinions of Sun Life Global Investments (Canada) Inc. Please note, any future or forward looking statements contained in this commentary are speculative in nature and cannot be relied upon. There is no guarantee that these events will occur or in the manner speculated. Please speak with your professional advisors before acting on any information contained in this commentary.

© Sun Life Global Investments (Canada) Inc., 2020. Sun Life Global Investments (Canada) Inc. is a member of the Sun Life Financial group of companies.

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