Benjamin J. Michaud, CFA Coming into 2020, the US economy was firing on all cylinders, with the unemployment rate under 4%, 4th quarter 2019 GDP growth at 2.1%, and the number of Americans filing for unemployment insurance averaging 226,000 per week (a historically low figure). It’s hard to believe, but current data suggests the US economy is likely to contract by at least 10% in the 2nd quarter due to the nationwide shutdown to stop the spread of COVID-19. For instance, Wall Street economists project the number of unemployment claims last week (reported today) jumped to between 1 and 4 million1, a level associated with economic contraction. There is no other way to say it: the US economy is in a recession, and potentially a severe one at that.
It is tempting to jump to the conclusion that the economy can restart as fast as it shut down, especially with the federal government injecting trillions of dollars into the economy (more on that later). We in fact have one foot in this recovery camp. But it is important to be prepared for the worst-case scenario because historically all major stock market declines (declines of at least 40%) have occurred inside of US recessions.
As we’ve outlined in recent notes, holding three to five years of portfolio spending in liquid cash and short-term bonds allows you to avoid selling stocks at the depressed levels often seen inside of recessionary environments. Within the equity portfolio, balance sheet strength is of paramount importance for weathering a recession. Profitability and cash flow generation are critical drivers of long-term stock price performance, but balance sheet strength is what allows a company to survive in times of economic duress.
We look at three components of the balance sheet to assess its strength and durability: total debt outstanding, when the debt comes due, and the amount of liquid assets a company has to pay of debt and other liabilities due in the next 12 to 24 months. Our portfolio companies have a limited amount of debt outstanding, and the debt they do owe does not mature for many years. Many of our companies, particularly in the Technology sector, have more cash than total debt, putting them in excellent position to improve their competitive position through the economic downturn, buy back stock at attractive prices, and raise their dividend. Due to the extreme uncertainty around the COVID-19 recession, we are actively stress-testing our companies for even the worst economic outcomes.
As evidenced by the 2007-2009 recession, it is critical to avoid the worst balance sheets in times of economic duress. From the peak of the stock market in October 2007 to its nadir in March 2009 the companies with the largest amount of debt outstanding underperformed the S&P 500 by more than 10%.
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With speed and aggression that would make former Federal Reserve Chairman Ben Bernanke, famous for his helicopter money policies, blush, the Federal Reserve has cut its Fed Funds policy rate by 1%, launched an open-ended bond-buying program, and reopened a number of lending facilities that the Fed has not used since the 2008 crisis…all since the beginning of March. And as we type Congress is on the cusp of passing a stimulus package worth more than $2 trillion.
Suffice it to say, the federal government is “all in” in the fight against COVID-19. This is an unprecedented amount of economic stimulus and will more than likely expand as the full scope of the economic downturn comes into view. So, while current stimulus efforts may not immediately exceed market expectations, we believe that ultimately the government will do whatever it takes to reduce the economic impact of America’s fight against COVID-19.
We continue to believe that with the benefit of hindsight this crisis will ultimately prove to be a tremendous buying opportunity for the long-term oriented equity investor. While we hate to steal a line from Warren Buffett, the situation calls for it: Buy American (stocks). We Are.
Sincerely,
Your HM Payson Team
