History in the Making

I think it’s safe to say that earnings reports coming through in the next two quarters will qualify as “History in the Making”, especially in view of the fact that the U.S. stock market has bounced 25% since its low point in March.   We do expect earnings in 2021 and 2022 to be higher than forecasted 2020 levels, but right now it appears that markets are looking completely past this earnings trough.  This is puzzling as we are still in the Covid-19 quarantine period.  There seems to be a disconnect between what is happening in the markets and what is happening in the underlying economy.   On the one hand there are many important figures implying that the worst is over such as those saying we will have a V shaped recovery.  While it’s true that volatility in the markets has gone down, firms like JP Morgan and Bank of America are saying it will not be smooth sailing going forward, and recovery will take much longer than people think.   Meanwhile the Federal Reserve is battling to rescue the economy for the second time in 12 years.

There are pressing questions about how quickly life and work will get back to normal – and the economy will recover.  One market we are keeping a close eye on that may provide some clues is the high yield market.   Nearly $130 billion of high yield debt will be coming due over the next two years – nearly 10% of the entire market.  Furthermore, many hard-hit areas of the economy have significant debt coming due such as oil and gas, real estate, and retail.  This two year period coincides with an estimate by Citi private bank saying that it will take 9 quarters to get back to the level of economic activity that was in place just prior to Covid-19.

Will bond investors be willing to refinance this debt?  Ideally, high-yield companies would like to refinance ahead of time, but during economic downturns such as this one, bond investors look to safety and this is bad news for lower-rated high yield companies.  Yes, the FED’s plan to buy fallen angels and some high-yield bond exchange-traded funds will lend support.  But Goldman Sachs predicts that the junk-bond market’s default rate will peak at 13% this year before declining in 2021.  If indeed high yield bonds can be refinanced that would be a great sign.  High yield bonds are down about 8% this year, suggesting the market predicts some but not catastrophic defaults.   It’s doubtful anyone will soon forget 2020; we’re making history.

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*As of 2/28/19